**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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

** **

**For the quarterly period ended June 30, 2006**

** **

**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 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 x  No o

 

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

 

Large Accelerated Filer x                       Accelerated Filer o                             Non — Accelerated Filer o

 

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

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of July 31, 2006 was 47,192,922.

 

 

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**Websense, Inc.Form 10-QFor the Period Ended June 30, 2006**

**TABLE OFCONTENTS**
|                                | ** ** | ** ** | ** ** | ** **                                                                                    | ** ** | **Page** |
|--------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------|------------|----------|
| Part I. Financial  Information |       |       |
|                           |       |       |       |                                                                                          |       |     |
|                           |       | Item 1.    |       | Consolidated  Financial Statements (Unaudited)                                                |       |     |
|                           |       |       |       | Consolidated Balance  Sheets as of June 30, 2006 and December 31, 2005                        |       | 1        |
|                           |       |       |       | Consolidated  Statements of Income for the three and six months ended June 30, 2006 and  2005 |       | 2        |
|                           |       |       |       | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2006   |       | 3        |
|                           |       |       |       | Consolidated  Statements of Cash Flows for the six months ended June 30, 2006 and 2005        |       | 4        |
|                           |       |       |       | Notes to  Consolidated Financial Statements                                                   |       | 5        |
|                           |       | Item 2.    |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations   |       | 16       |
|                           |       | Item 3.    |       | Quantitative  and Qualitative Disclosures About Market Risk                                   |       | 26       |
|                           |       | Item 4.    |       | Controls and  Procedures                                                                      |       | 27       |
|                           |       |       |       |                                                                                          |       |     |
| Part II. Other  Information    |       |       |
|                           |       |       |       |                                                                                          |       |     |
|                           |       | Item 1.    |       | Legal Proceedings                                                                             |       | 28       |
|                           |       | Item  1A.  |       | Risk  Factors                                                                                 |       | 28       |
|                           |       | Item 2.    |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                  |       | 28       |
|                           |       | Item 3.    |       | Defaults upon  Senior Securities                                                              |       | 28       |
|                           |       | Item 4.    |       | Submission of  Matters to a Vote of Security Holders                                          |       | 29       |
|                           |       | Item 5.    |       | Other Information                                                                             |       | 29       |
|                           |       | Item  6.   |       | Exhibits                                                                                      |       | 29       |
|                           |       |       |       |                                                                                          |       |     |
| Signatures                     |       | 31         |

 

i

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**Part I — FinancialInformation**

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

**Websense, Inc.Consolidated Balance Sheets(Unaudited and in thousands)**

 
| ** **                                                   | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | ** **              | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                              |       |                    |       |                        |       |
| Cash and cash equivalents                                    |       | $                       | 20,577     |                        | $          | 61,629 |   |
| Marketable securities                                        |       | 317,785                 |       | 258,760                     |       |
| Accounts receivable, net of allowance for doubtful  accounts |       | 36,854                  |       | 50,570                      |       |
| Prepaid income taxes                                         |       | 744                     |       | 1,962                       |       |
| Current portion of deferred income taxes                     |       | 15,983                  |       | 15,772                      |       |
| Other current assets                                         |       | 4,634                   |       | 3,467                       |       |
| Total current assets                                         |       | 396,577                 |       | 392,160                     |       |
|                                                         |       |                    |       |                        |       |
| Property and  equipment, net                                 |       | 5,618                   |       | 4,923                       |       |
| Deferred income  taxes, less current portion                 |       | 8,213                   |       | 6,043                       |       |
| Deposits and  other assets                                   |       | 563                     |       | 549                         |       |
| Total assets                                                 |       | $                       | 410,971    |                        | $          | 403,675 |   |
|                                                         |       |                    |       |                        |       |
| **Liabilities  and stockholders’ equity**               | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current  liabilities:                                        |       |                    |       |                        |       |
| Accounts payable                                             |       | $                       | 1,553      |                        | $          | 2,073 |   |
| Accrued payroll and related benefits                         |       | 7,536                   |       | 8,476                       |       |
| Other accrued expenses                                       |       | 5,364                   |       | 5,085                       |       |
| Income taxes payable                                         |       | 4,018                   |       | 2,305                       |       |
| Current portion of deferred revenue                          |       | 122,417                 |       | 119,118                     |       |
| Total current liabilities                                    |       | 140,888                 |       | 137,057                     |       |
|                                                         |       |                    |       |                        |       |
| Deferred  revenue, less current portion                      |       | 59,736                  |       | 60,807                      |       |
|                                                         |       |                    |       |                        |       |
| Stockholders’  equity:                                  |       |                    |       |                        |       |
| Common stock                                                 |       | 505                     |       | 500                         |       |
| Additional paid-in capital                                   |       | 218,542                 |       | 197,826                     |       |
| Treasury stock                                               |       | (81,410                 | )          | (48,340                     | )          |
| Retained earnings                                            |       | 73,016                  |       | 56,449                      |       |
| Accumulated other comprehensive loss                         |       | (306                    | )          | (624                        | )          |
| Total stockholders’ equity                              |       | 210,347                 |       | 205,811                     |       |
|                                                         |       |                    |       |                        |       |
| Total liabilities and stockholders’ equity              |       | $                       | 410,971    |                        | $          | 403,675 |   |
| ** **                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |

 

Seeaccompanying notes.

1

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** **

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

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                             | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Revenue                                |       | $                                | 44,149     |                           | $          | 36,026 |   | $ | 86,583 |   | $ | 70,208 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Cost of revenue                        |       | 3,704                            |       | 2,501                          |       | 7,082 |   | 5,001 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Gross margin                           |       | 40,445                           |       | 33,525                         |       | 79,501 |   | 65,207 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                   |       |                             |       |                           |       |   |   |   |   |
| Selling and marketing                  |       | 18,922                           |       | 13,872                         |       | 36,936 |   | 26,200 |   |
| Research and development               |       | 5,535                            |       | 4,007                          |       | 10,978 |   | 8,031 |   |
| General and administrative             |       | 5,225                            |       | 2,938                          |       | 10,433 |   | 5,809 |   |
| Total operating expenses               |       | 29,682                           |       | 20,817                         |       | 58,347 |   | 40,040 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Income from  operations                |       | 10,763                           |       | 12,708                         |       | 21,154 |   | 25,167 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Other income,  net                     |       | 2,821                            |       | 1,201                          |       | 5,456 |   | 2,155 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Income before  income taxes            |       | 13,584                           |       | 13,909                         |       | 26,610 |   | 27,322 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Provision for  income taxes            |       | 5,216                            |       | 4,975                          |       | 10,043 |   | 9,776 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Net income                             |       | $                                | 8,368      |                           | $          | 8,934 |   | $ | 16,567 |   | $ | 17,546 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Net income per  share:                 |       |                             |       |                           |       |   |   |   |   |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Basic net income per share             |       | $                                | 0.18       |                           | $          | 0.19 |   | $ | 0.35 |   | $ | 0.37 |   |
| Diluted net income per share           |       | $                                | 0.17       |                           | $          | 0.18 |   | $ | 0.34 |   | $ | 0.35 |   |
| Weighted average shares — basic   |       | 47,586                           |       | 47,670                         |       | 47,766 |   | 47,508 |   |
| Weighted average shares — diluted |       | 48,368                           |       | 49,498                         |       | 48,710 |   | 49,480 |   |
|                                   |       |                             |       |                           |       |   |   |   |   |

 

See accompanying notes.

2

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**Websense,Inc.Consolidated Statement of Stockholders’ Equity(Unaudited and 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, 2005                                                                      |       | 47,942                |       | $          | 500        |                             | $          | 197,826             |       | $                      | (48,340    | )                                           | $          | 56,449 |   | $ | (624 | ) | $ | 205,811 |   |
| Issuance of common stock upon exercise of options                                                 |       | 568                   |       | 4          |       | 6,426                            |       | —              |       | —                 |       | —                                      |       | 6,430 |   |
| Issuance of common stock for ESPP Purchase                                                        |       | 101                   |       | 1          |       | 1,987                            |       | —              |       | —                 |       | —                                      |       | 1,988 |   |
| Share-based compensation expense                                                                  |       | —                |       | —     |       | 9,710                            |       | —              |       | —                 |       | —                                      |       | 9,710 |   |
| Excess tax benefit of share-based compensation                                                    |       | —                |       | —     |       | 2,593                            |       | —              |       | —                 |       | —                                      |       | 2,593 |   |
| Purchase of treasury stock                                                                        |       | (1,300                | )          | —     |       | —                           |       | (33,070             | )          | —                 |       | —                                      |       | (33,070 | ) |
| Net income                                                                                        |       | —                |       | —     |       | —                           |       | —              |       | 16,567                 |       | —                                      |       | 16,567 |   |
| Net change in unrealized gain on marketable  securities, net of tax                               |       | —                |       | —     |       | —                           |       | —              |       | —                 |       | 202                                         |       | 202 |   |
| Net change in unrealized gain on fair market  valuation of foreign currency contracts, net of tax |       | —                |       | —     |       | —                           |       | —              |       | —                 |       | 116                                         |       | 116 |   |
| Comprehensive income                                                                              |       |                  |       |       |       |                             |       |                |       |                   |       |                                        |       | 16,885 |   |
| Balance at June  30, 2006                                                                         |       | 47,311                |       | $          | 505        |                             | $          | 218,542             |       | $                      | (81,410    | )                                           | $          | 73,016 |   | $ | (306 | ) | $ | 210,347 |   |

 

See accompanying notes.

3

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** **

**Websense, Inc.Consolidated Statements of Cash Flows(Unaudited and in thousands)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                         | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **Operating  activities:**                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                              | 16,567     |   | $ | 17,546 |   |
|                                                                               |       |                           |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                           |       |   |   |
|                                                                               |       |                           |       |   |   |
| Depreciation                                                                       |       | 1,571                          |       | 1,248 |   |
| Share-based compensation                                                           |       | 9,710                          |       | — |   |
| Deferred revenue                                                                   |       | 2,228                          |       | 11,231 |   |
| Unrealized gain (loss) on foreign exchange contracts                               |       | 116                            |       | (118 | ) |
| Tax benefit from exercise of stock options                                         |       | —                         |       | 8,775 |   |
| Excess tax benefit from share-based compensation                                   |       | (2,593                         | )          | — |   |
| Changes in operating assets and liabilities:                                       |       |                           |       |   |   |
| Accounts receivable                                                                |       | 13,716                         |       | 11,643 |   |
| Prepaid income taxes                                                               |       | 1,218                          |       | (177 | ) |
| Other current assets                                                               |       | (1,167                         | )          | (1,746 | ) |
| Deposits and other assets                                                          |       | (14                            | )          | (50 | ) |
| Deferred income taxes                                                              |       | (2,381                         | )          | — |   |
| Accounts payable                                                                   |       | (520                           | )          | 492 |   |
| Accrued payroll and related benefits                                               |       | (940                           | )          | (146 | ) |
| Other accrued expenses                                                             |       | 279                            |       | 76 |   |
| Income taxes payable                                                               |       | 4,306                          |       | 213 |   |
| Net cash  provided by operating activities                                         |       | 42,096                         |       | 48,987 |   |
|                                                                               |       |                           |       |   |   |
| **Investing  activities:**                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchases of property  and equipment                                               |       | (2,266                         | )          | (1,447 | ) |
| Purchases of  marketable securities                                                |       | (355,839                       | )          | (142,960 | ) |
| Maturities of  marketable securities                                               |       | 297,016                        |       | 93,676 |   |
| Sales of  marketable securities                                                    |       | —                         |       | 1,042 |   |
| Net cash used in  investing activities                                             |       | (61,089                        | )          | (49,689 | ) |
|                                                                               |       |                           |       |   |   |
| **Financing  activities:**                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                                           |       | 6,430                          |       | 10,662 |   |
| Proceeds from  issuance of common stock for stock purchase plan                    |       | 1,988                          |       | 1,647 |   |
| Excess tax  benefit from share-based compensation                                  |       | 2,593                          |       | — |   |
| Purchases of treasury  stock                                                       |       | (33,070                        | )          | (17,335 | ) |
| Net cash used in  financing activities                                             |       | (22,059                        | )          | (5,026 | ) |
|                                                                               |       |                           |       |   |   |
| Decrease in cash  and cash equivalents                                             |       | (41,052                        | )          | (5,728 | ) |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents at beginning of period                                  |       | 61,629                         |       | 38,878 |   |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                              | 20,577     |   | $ | 33,150 |   |
|                                                                               |       |                           |       |   |   |
| **Supplemental  disclosures of cash flow information:**                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Income taxes  paid                                                                 |       | $                              | 6,334      |   | $ | 633 |   |
| Unrealized gain  (loss) on marketable securities                                   |       | $                              | 202        |   | $ | (37 | ) |
|                                                                               |       |                           |       |   |   |

 

Seeaccompanying notes.

 

4

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**Websense,Inc.**

**NotesTo Consolidated Financial Statements (Unaudited)**

1.  *Basis ofPresentation*

The accompanying unaudited consolidated financialstatements have been prepared in conformity with accounting principles generallyaccepted in the United States for interim financial statements and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,certain information or footnote disclosures normally included in completefinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States have been condensed or omitted pursuantto the rules and regulations of the Securities and Exchange Commission. In theopinion of management, the statements include all adjustments necessary, whichare of a normal and recurring nature, for the fair presentation of ourfinancial position and of the results for the interim periods presented.

These financial statements should be read inconjunction with the audited consolidated financial statements and notes theretofor the year ended December 31, 2005, included in Websense, Inc.’s AnnualReport on Form 10-K filed with the Securities and Exchange Commission.  Operating results for the three and sixmonths ended June 30, 2006 are not necessarily indicative of the results thatmay be expected for any other interim period or for the year ending December31, 2006.  The balance sheet at December31, 2005 has been derived from the audited financial statements at that datebut does not include all of the information and footnotes required byaccounting principles generally accepted in the United States for completefinancial statements.

2.  *Net IncomePer Share*

Websense computes net income per share as permitted bythe Financial Accounting Standards Board (FASB) with Statement ofFinancial Accounting Standards (SFAS) No. 128, *Earnings PerShare* (EPS) (SFAS No. 128). Under the provisions of SFAS No. 128,basic net income per share is computed by dividing the net income for theperiod by the weighted average number of common shares outstanding during theperiod. Diluted net income per share is computed by dividing the net income forthe period by the weighted average number of common and common equivalentshares outstanding during the period. Common equivalent shares for all periodspresented consist of dilutive stock options and restricted stock. Dilutivestock options and restricted stock are calculated based on the average shareprice for each fiscal period using the treasury stock method. Under thetreasury stock method, the amount the employee must pay for exercising stockoptions or acquiring restricted stock, the amount of compensation cost forfuture service that the Company has not yet recognized, and the amount of taxbenefits that would be recorded in additional paid-in capital when the awardbecomes deductible are assumed to be used to repurchase shares.

During the quarters ended June 30, 2006 and 2005, thedifference between the weighted average shares used in determining basic EPSversus diluted EPS related to dilutive stock options totaled 782,000 and1,828,000 shares, respectively. Potentially dilutive securities totaling4,369,000 and 356,000 shares for the quarters ended June 30, 2006 and 2005,respectively, were excluded from historical basic and diluted earnings pershare because of their anti-dilutive effect.

During the first six months of 2006 and 2005, thedifference between the weighted average shares used in determining basic EPSversus diluted EPS related to dilutive stock options totaled 944,000 and 1,972,000shares, respectively. Potentially dilutive securities totaling 3,834,000 and192,000 shares for the first six months of 2006 and 2005, respectively, wereexcluded from historical basic and diluted earnings per share because of theiranti-dilutive effect.

5

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The following is a reconciliation of the numerator anddenominator used in calculating basic EPS to the numerator and denominator usedin calculating diluted EPS for all periods presented:
| ** **                       | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30, 2006:**              | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 8,368      |              | 47,586     |               | $          | 0.18 |   |
| Effect of stock options          |       | —                                                                |       | 782               |       | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 8,368      |              | 48,368     |               | $          | 0.17 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30, 2005:**              | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 8,934      |              | 47,670     |               | $          | 0.19 |   |
| Effect of stock options          |       | —                                                                |       | 1,828             |       | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 8,934      |              | 49,498     |               | $          | 0.18 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **For the  Six Months Ended:**   | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30, 2006:**              | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 16,567     |              | 47,766     |               | $          | 0.35 |   |
| Effect of stock options          |       | —                                                                |       | 944               |       | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 16,567     |              | 48,710     |               | $          | 0.34 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June 30, 2005:**               | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 17,546     |              | 47,508     |               | $          | 0.37 |   |
| Effect of stock options          |       | —                                                                |       | 1,972             |       | (0.02              | )          |
| Diluted EPS                      |       | $                                                                     | 17,546     |              | 49,480     |               | $          | 0.35 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |

 

3.  *ComprehensiveIncome*

The components of comprehensive income, as required tobe reported by SFAS No. 130, *Reporting ComprehensiveIncome*, were as follows (in thousands):
| ** **                                                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                 | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Net income                                                                                                 |       | $                                | 8,368      |                           | $          | 8,934 |   | $ | 16,567 |   | $ | 17,546 |   |
| Net change in  unrealized gain (loss) on  marketable securities, net of tax                                |       | 23                               |       | 288                            |       | 202 |   | (37 | ) |
| Net change in  unrealized gain (loss) on  fair market valuation of foreign currency  contracts, net of tax |       | 57                               |       | (100                           | )          | 116 |   | (118 | ) |
| Comprehensive income                                                                                       |       | $                                | 8,448      |                           | $          | 9,122 |   | $ | 16,885 |   | $ | 17,391 |   |

 

6

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4.*  Stockholder’sEquity*

**Share-Based Compensation**

Through December 31, 2005, the Company accounted forshare-based employee compensation plans under the measurement and recognitionprovisions of Accounting Principles Board (APB) Opinion No. 25 *Accounting for Stock Issued to Employees* (APB No. 25), andrelated Interpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation* (SFAS No. 123).Accordingly, the Company recorded no share-based employee compensation expensefor options granted under its Amended and Restated 2000 Stock Incentive Plan(2000 Plan) or its predecessor plans (or options granted as non-plan inducementoptions) during the six months ended June 30, 2005****asall other options granted had exercise prices equal to the fair market value ofthe common stock on the date of grant. The Company also recorded nocompensation expense in connection with the Employee Stock Purchase Plan duringthe six months ended June 30, 2005 as the purchase price of the stock was notless than 85% of the lower of the fair market value of the common stock at thebeginning of each offering period or at the end of each purchase period. Inaccordance with SFAS No. 123 and SFAS No. 148, *Accountingfor Stock-Based Compensation — Transition and Disclosure* (SFAS No.148), the Company disclosed net income or loss and net income or loss per shareas if the fair value-based method was applied in measuring compensation expensefor share-based incentive programs.

*Employee Stock Purchase Plan*

In February 2000, theCompany adopted the 2000 Employee Stock Purchase Plan (Purchase Plan). ThePurchase Plan provides for automatic annual increases in the number of sharesreserved for issuance thereunder (beginning in 2001) equal to the lesser of (i)1% of the Company’s outstanding shares on the last business day in December ofthe calendar year immediately preceding or (ii) 750,000 shares. The PurchasePlan is intended to qualify as an employee stock purchase plan within themeaning of Section 423 of the Internal Revenue Code. Under the Purchase Plan,the Board of Directors may authorize participation by eligible employees,including officers, in periodic offerings following commencement of thePurchase Plan.

Unlessotherwise determined by the Board or precluded by laws of foreignjurisdictions, employees are eligible to participate in the Purchase Planprovided they are employed for at least 20 hours per week and are customarilyemployed for at least five months per calendar year. Employees who participatein an offering may have up to 15% of their earnings withheld pursuant to thePurchase Plan. The amount withheld is then used to purchase shares of commonstock on specified dates. The price of common stock purchased pursuant to thePurchase Plan will be equal to 85% of the lower of the fair market value of thecommon stock at the commencement date of each offering period or the relevantpurchase date. Employees may end their participation in the offering at anytime during the offering period, and participation ends automatically ontermination of employment. At June 30, 2006, 1,579,013 shares were availablefor issuance under the Purchase Plan.

During the six months ended June 30, 2006 and June30, 2005, the Company issued 100,816 and 217,880 shares, respectively, underthe Purchase Plan.

*Employee Stock Option Plan*

TheAmended and Restated 2000 Stock Incentive Plan (2000 Plan) provides for thegrant of stock options to the Company’s directors, officers, employees andconsultants. The 2000 Plan provides for the grant of incentive andnon-statutory stock options, restricted stock units and rights to purchasestock to employees, directors or consultants of the Company. The 2000 Planprovides that incentive stock options

7

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will be granted only toemployees and are subject to certain limitations as to fair value during acalendar year.

Inaddition, the 2000 Plan provides for automatic annual increases in the numberof shares authorized and reserved for issuance thereunder (beginning in 2001)equal to the lesser of (i) 4% of the Company’s outstanding shares on the lastbusiness day in December of the calendar year immediately preceding or (ii)3,000,000 shares. At June 30, 2006, a total of 19,558,162 shares have beenauthorized for issuance under the 2000 Plan, of which 732,335 remain availablefor grant.

The exercise price ofincentive stock options must equal at least the fair value on the date of grantand the exercise price of non-statutory stock options and the issuance price ofcommon stock under the stock issuance program may be no less than 85% of thefair value on the date of grant or issuance. Through April 2005, the optiongrants were generally exercisable for a period of ten years, and beginning inMay 2005, the option grants are generally exercisable for a period of sevenyears after the date of grant and generally vest 25% one year from date ofgrant and ratably each month thereafter for a period of 36 months. Unvestedcommon shares obtained through early exercise of stock options are subject torepurchase by the Company at the original issue price. Restricted stock unitsare subject to vesting and the holders of the restricted stock units areentitled to delivery of the underlying common stock on the applicable vestingdate without any payment. To date, the Company has awarded restricted stockunits as part of competitive hiring packages to replace foregone compensation.The vesting schedules, including acceleration events, for restricted stockunits may vary in the individual cases. To date, only non-statutory stockoptions and restricted stock units have been granted under the 2000 Plan.Through June 30, 2006, the Company granted 96,000 restricted stock units. Theunvested restricted stock units have a weighted average grant date fair valueof $32.24 and an aggregate intrinsic value of $2.0 million as of June 30, 2006.

In 2002, the Company issuedstock options as an incentive for certain persons to commence employment thatwere not covered under the 2000 Plan. In accordance with Section 4350(i) of theNASD Marketplace Rules for the Nasdaq Global Select Market, the Company issued354,000 such stock options, which have substantially the same terms as stockoptions issued under the 2000 Plan.

In January 2006, the Company entered into an employmentagreement with Gene Hodges to serve as the Company’s President and ChiefExecutive Officer, reporting to the Company’s Board of Directors, withemployment commencing on January 9, 2006 and continuing “at will” until eitherparty gives notice of termination. On January 9, 2006, Mr. Hodges was grantednon-qualified stock options to purchase an aggregate of 1,200,000 shares of theCompany’s common stock outside the Company’s 2000 Plan (the “Options”) with anexercise price per share equal to the fair market value of the Company’s commonstock on that date. On April 13, 2006, at the request of the Company, Mr.Hodges agreed to the cancellation of the Options and the immediate re-grantunder the 2000 Plan of non-qualified stock options to purchase an aggregate of1,200,000 shares of the Company’s common stock with identical option terms,exercise prices, vesting schedules and vesting commencement dates as theoriginal Options. The Company requested the cancellation and re-grant to bringthe Options under the 2000 Plan for U.S. federal income tax reasons and tobetter align Mr. Hodges’ compensation with stockholder approved limitations onstock option issuances. Mr. Hodges received no income tax or other personalbenefit from the cancellation and re-grant.

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Thefollowing table summarizes stock option activity both under the 2000 Plan andthe 1,554,000 stock options issued in 2002 and January 2006 not covered under aformal plan and related information:

|                               | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------|------------|----------------------------|------------|----------------------------------------|------------|
| Balance at  December 31, 2005 |       | 5,214,702                  |       | $                                      | 17.86      |   |
| Granted                       |       | 4,210,430                  |       | 29.05                                  |       |
| Exercised                     |       | (568,284                   | )          | 11.31                                  |       |
| Cancelled/forfeited/expired   |       | (1,534,595                 | )          | 29.93                                  |       |
| Balance at June 30,  2006     |       | 7,322,253                  |       | 22.27                                  |       |
|                               |            |                            |            |                                        |            |  |

 

Theweighted average fair value of stock options granted during the six monthsended June 30, 2006 was $13.76 per share based on the grant date fair value ofthe stock options estimated in accordance with the provisions of SFAS No. 123(R), excluding Mr. Hodges’ April 2006 re-granted stock options described above.The fair value of the April 2006 re-granted stock options to Mr. Hodges wasless than the original stock option grants in January 2006 as the market priceof the Company’s common stock declined from January 2006 to April 2006.  The Company will continue to amortize the higherfair value associated with Mr. Hodges’ original stock option grants in January2006 rather than the lower fair value associated with the April 2006 re-grantedstock options.

Thetotal intrinsic value of stock options exercised during the six months endedJune 30, 2006 was $9.3 million.

The following table summarizes all stock options outstanding andexercisable by price range as of June 30, 2006:
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number of**           | ** ** | **Contractual Life**    | ** ** | **Average** | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **Shares**                   | ** ** | **In Years**            | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $ 0.10-$15.00       |       | 1,534,939                    |       | 5.85                         |       | $ | 9.60 |   | 1,218,155 |   | $ | 9.61 |   |
| $15.01-$21.77            |       | 2,006,673                    |       | 7.44                         |       | 19.88 |   | 357,776 |   | 17.89 |   |
| $21.81-$25.85            |       | 1,484,684                    |       | 6.67                         |       | 24.95 |   | 281,688 |   | 25.10 |   |
| $25.89-$32.24            |       | 2,112,557                    |       | 7.66                         |       | 30.93 |   | 125,652 |   | 28.16 |   |
| $32.42-$33.85            |       | 183,400                      |       | 7.01                         |       | 33.13 |   | — |   | — |   |
|                     |       |                         |       |                         |       |   |   |   |   |   |   |
|                     |       | 7,322,253                    |       | 7.00                         |       | 22.27 |   | 1,983,271 |   | 14.48 |   |
|                          |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

The Company definesin-the-money stock options at June 30, 2006 as stock options that had exerciseprices that were lower than the $20.54 market price of our common stock at thatdate. The aggregate intrinsic value of all stock options outstanding and in-the-moneyat June 30, 2006 was $19.3 million. The aggregate intrinsic value ofexercisable stock options outstanding and in-the-money at June 30, 2006 was$14.3 million. There were 2.6 million stock options in-the-money at June 30,2006, of which 1.6 million were exercisable.

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Effective January 1, 2006, the Company adoptedthe fair value recognition provisions of SFAS No. 123(R), using the modifiedprospective transition method. Under that transition method, compensationexpense that the Company recognized beginning on that date includes:(a) compensation expense for all share-based payments granted prior to,but not yet vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS No. 123, and (b) compensationexpense for all share-based payments granted on or after January 1, 2006, basedon the grant date fair value estimated in accordance with the provisions ofSFAS No. 123(R). Results for prior periods will not be restated. 

The following tableillustrates the effect on net income and earnings per share if the Company hadexpensed share-based compensation in accordance with the provisions of SFAS No.123 for the three and six months ended June 30, 2005 (in thousands, except pershare amounts):
| ** **                                                                                                   | ** ** | **Three Months**

**Ended** | ** ** | **Six Months  Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                                                   | ** ** | **June 30,  2005**          | ** ** | **June 30,  2005**    | ** ** |
| Net income as  reported                                                                                      |       | $                                | 8,934      |                       | $          | 17,546 |   |
| Deduct:  share-based compensation expense determined under fair value method for all  awards, net of tax (1) |       | (2,686                           | )          | (5,074                     | )          |
| Pro forma net  income                                                                                        |       | $                                | 6,248      |                       | $          | 12,472 |   |
|                                                                                                         |       |                             |       |                       |       |
| Basic net income  per share as reported                                                                      |       | $                                | 0.19       |                       | $          | 0.37 |   |
| Pro forma basic  net income per share                                                                        |       | $                                | 0.13       |                       | $          | 0.26 |   |
|                                                                                                         |       |                             |       |                       |       |
| Diluted net  income per share as reported                                                                    |       | $                                | 0.18       |                       | $          | 0.35 |   |
| Pro forma diluted net  income per share                                                                      |       | $                                | 0.13       |                       | $          | 0.25 |   |

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(1)   The Companyhad an effective tax rate of 36% in the three and six months ended June 30,2005.

The table below reflects net income and diluted netincome per share for the three and six months ended June 30, 2006 compared withthe pro forma information for the three and six months ended June 30, 2005 asfollows (in thousands, except per share amounts):
| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,  2006**          | ** ** | **June 30,**

**2005**    | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
| Net income — as  reported for prior periods (1)                                                              |       | N/A                              |       | $                              | 8,934      |   | N/A |   | $ | 17,546 |   |
| Share-based  compensation expense related to employee stock options and employee stock  purchases, net of tax (2) |       | $                                | (3,684     | )                              | $          | (2,686 | ) | $ | (7,264 | ) | $ | (5,074 | ) |
| Net income,  including the effect of share-based compensation expense (3)                                         |       | $                                | 8,368      |                           | $          | 6,248 |   | $ | 16,567 |   | $ | 12,472 |   |
| Diluted net  income per share — as reported for prior periods (1)                                            |       | N/A                              |       | $                              | 0.18       |   | N/A |   | $ | 0.35 |   |
| Diluted net  income per share, including the effect of share-based compensation expense  (3)                      |       | $                                | 0.17       |                           | $          | 0.13 |   | $ | 0.34 |   | $ | 0.25 |   |
|                                                                                                              |       |                             |       |                           |       |   |   |   |   |

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(1)            Net income and net income per share did notinclude share-based compensation expense for employee stock options andemployee stock purchases under SFAS No. 123 because the Company did not adoptthe recognition provisions of SFAS No. 123 prior to January 1, 2006.

(2)            Share-based compensation expense prior toJanuary 1, 2006 is calculated based on pro forma information based on FAS 123.

(3)            Net income and net income per share prior toJanuary 1, 2006 represents pro forma information based on FAS 123.

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The results for the three and six months ended June30, 2006 include share-based compensation expense of $5.0 million (excludingtax effects) and $9.7 million (excluding tax effects), respectively, in thefollowing expense categories of the consolidated statement of income.
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
| Share-based  compensation in:                        |       |                             |       |                           |       |   |   |   |   |
| Cost of revenue                                      |       | $                                | 368        |                           | $          | — |   | $ | 694 |   | $ | — |   |
| Total share-based compensation in cost of revenue    |       | 368                              |       | —                         |       | 694 |   | — |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Selling and marketing                                |       | 2,054                            |       | —                         |       | 4,005 |   | — |   |
| Research and development                             |       | 890                              |       | —                         |       | 1,731 |   | — |   |
| General and administrative                           |       | 1,658                            |       | —                         |       | 3,280 |   | — |   |
| Total share-based compensation in operating expenses |       | 4,602                            |       | —                         |       | 9,016 |   | — |   |
| Total share-based  compensation                      |       | $                                | 4,970      |                           | $          | — |   | $ | 9,710 |   | $ | — |   |

 

At June 30, 2006, there was $68.2 million oftotal unrecognized compensation cost related to share-based compensationarrangements granted under all equity compensation plans (excluding taxeffects). That total unrecognized compensation cost will be adjusted for estimatedforfeitures as well as for future changes in estimated forfeitures. The Companyexpects to recognize that cost over a weighted average period of approximately3 years.

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The Company estimates the fair value of optionsgranted using the Black-Scholes option valuation model and the assumptionsshown in the tables below. The Company estimates the expected term of optionsgranted based on the history of grants and exercises in the Company’s optiondatabase. The Company estimates the volatility of its common stock at the dateof grant based on both the historical volatility as well as the impliedvolatility of publicly traded options on its common stock, consistent with SFASNo. 123(R) and Securities and Exchange Commission Staff Accounting BulletinNo. 107 (SAB No. 107). The Company bases the risk-free interest rate thatis used in the Black-Scholes option valuation model on the implied yield ineffect at the time of option grant on U.S. Treasury zero-coupon issues withequivalent remaining terms. The Company has never paid any cash dividends onits common stock and does not anticipate paying any cash dividends in theforeseeable future. Consequently, the Company uses an expected dividend yieldof zero in the Black-Scholes option valuation model. The Company amortizes thefair value ratably over the vesting period of the awards, which is typicallyfour years. The Company uses historical data to estimate pre-vesting optionforfeitures and records share-based expense only for those awards that areexpected to vest. For purposes of calculating pro forma information under SFASNo. 123 for periods prior to January 1, 2006, the Company accounted forforfeitures as they occurred.

The Company used the following assumptions to estimatethe fair value of stock options granted for the three and six months ended June30, 2006 and 2005:
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
|                                |       |                             |       |                           |       |   |   |   |   |
| Average expected  life (years)      |       | 3.9                              |       | 5.0                            |       | 4.3 |   | 5.0 |   |
| Average expected  volatility factor |       | 51.1                             | %          | 44.4                           | %          | 55.4 | % | 44.3 | % |
| Average  risk-free interest rate    |       | 5.0                              | %          | 3.7                            | %          | 4.8 | % | 3.9 | % |
| Average expected  dividend yield    |       | —                           |       | —                         |       | — |   | — |   |

 

The Company used the following assumptions to estimatethe fair value of the semi-annual employee stock purchase plan share grantduring the six months ended June 30, 2006 and 2005:
| ** **                          | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005** | ** ** |
|                                |       |                           |       |   |   |
| Average expected  life (years)      |       | 1.25                           |       | 1.25 |   |
| Average expected  volatility factor |       | 36.1                           | %          | 45.4 | % |
| Average  risk-free interest rate    |       | 4.9                            | %          | 3.4 | % |
| Average expected  dividend yield    |       | —                         |       | — |   |

 

The Company’s determination of fair value ofshare-based payment awards on the date of grant using an option-pricing modelis affected by the Company’s stock price as well as assumptions regarding anumber of complex and subjective variables. These variables include, but arenot limited to the Company’s expected stock price volatility over the term ofthe awards, and actual and projected employee stock option exercise behaviors.Option-pricing models were developed for use in estimating the value of tradedoptions that have no vesting or hedging restrictions and are fullytransferable. Because the Company’s employee stock options have certaincharacteristics that are significantly different from traded options, andbecause changes in the subjective assumptions can materially affect theestimated value, in management’s opinion, the existing valuation models may notprovide an accurate measure of the fair value of the Company’s employee stockoptions. Although the fair value of employee stock options is determined inaccordance with SFAS No. 123(R) and SAB No. 107 using an option-pricing model,that value may not be indicative of the fair value observed in a willingbuyer/willing seller market transaction.

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**Treasury Stock**

On April 3, 2003, the Company announced that its Boardof Directors authorized a stock repurchase program of up to 4 million shares ofits common stock. On August 15, 2005, the Company announced that its Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 8 million shares. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may commence or be suspendedat any time, or from time to time, without prior notice. As of June 30, 2006,the Company had repurchased 5,170,060 shares of its common stock under thisprogram, for an aggregate of $112.1 million at an average price of $21.68 pershare.

As of December 31, 2004, the Company retired all2,012,000 shares of its common stock that had been repurchased prior to thatdate.  In accordance with APB 6, *Status of Accounting Research Bulletins*, the treasury stockretirement was effected by reducing the following on the Company’s ConsolidatedBalance Sheet:  treasury stock by $30.7million, common stock by $0.1 million, additional paid-in capital by $6.4million and retained earnings by $24.2 million. There was no effect to theCompany’s overall equity position as a result of the retirement. The Companydoes not expect to retire shares of its common stock that it repurchased during2005 or 2006 in the foreseeable future.

5.* Foreign Currency Hedges*

The Company uses derivatives to manage foreigncurrency risk and not for speculative or trading purposes.  The Company’s objective is to reduce the riskto earnings and cash flows associated with changes in foreign currency exchangerates.  Gains and losses resulting fromchanges in the fair values of those derivative instruments will be recorded toearnings or other comprehensive income depending on the use of the derivativeinstrument and whether it qualifies for hedge accounting.

During 2005, the Company utilized Euro foreigncurrency forward contracts and British Pound foreign currency forward contractsto hedge anticipated expenses. During 2006, the Company utilized Euroforeign currency forward contracts and British Pound zero-cost collar contractsto hedge anticipated expenses. All such contracts entered into weredesignated as either fair value hedges or cash flow hedges and were consideredeffective, if applicable, as defined by SFAS No. 133,*Accountingfor Derivative Instruments and Hedging Activities* (SFAS No. 133), asamended.  None of the contracts wereterminated prior to settlement. Net realized losses related to the contractsdesignated as fair value hedges settled during 2006 are included in otherincome, net, in the accompanying consolidated income statements and amounted toapproximately $84,000 and $131,000 for the three and six months ended June 30,2006, respectively. There were no such gains or losses in 2005. Net realized gainsrelated to the contracts designated as cash flow hedges settled during 2006 areincluded in the respective operating categories the Company hedges its BritishPound expenditures against in the accompanying consolidated income statementsand amounted to approximately $70,000 and $50,000 for the three and six monthsended June 30, 2006 respectively. Net realized losses related to the contractsdesignated as cash flow hedges settled during 2005 are included in otherincome, net, in the accompanying consolidated income statements and amounted toapproximately $64,000 and $71,000 for the three and six months ended June 30,2006, respectively.

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Notional and fair values of the Company’s hedgingposition at June 30, 2006 and 2005 are presented in the table below (inthousands):
| ** **    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
|---------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional**                | ** ** | ** **                  | ** ** | ** ** | ** ** | **Notional** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Value**                   | ** ** | **Notional**                | ** ** | ** ** | ** ** | **Value** | ** ** | **Notional** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Local**                   | ** ** | **Value**                   | ** ** | **Fair Value** | ** ** | **Local** | ** ** | **Value** | ** ** | **Fair Value** | ** ** |
| ** **    | ** ** | **Currency**                | ** ** | **USD**                     | ** ** | **USD** | ** ** | **Currency** | ** ** | **USD** | ** ** | **USD** | ** ** |
|          |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Euro          |       | €                      | 785        |                        | $          | 1,004 |   | $ | 1,003 |   | € | — |   | $ | — |   | $ | — |   |
| British Pound |       | £                      | 900        |                        | 1,581      |   | 1,626 |   | £ | 2,300 |   | 4,212 |   | 4,101 |   |
| Total         |       |                        |       | $                           | 2,585      |   | $ | 2,629 |   |   |   | $ | 4,212 |   | $ | 4,101 |   |

 

Euro forward contracts at June 30, 2006 weredesignated as fair value hedges and were not required to be tested foreffectiveness as hedge accounting was not selected.  Euro forward contracts at June 30, 2005 weredesignated as cash flow hedges and determined effective. All Euro contractswill be settled before August 31, 2006. Realized gains or losses related to thesettlements, if any, will be recorded in other income, net at the time ofsettlement.

All British Pound contracts were designated as cashflow hedges and were determined effective as of June 30, 2006 and 2005. AllBritish Pound contracts will be settled before September 30, 2006.  Realized gains and losses related to thesettlements, if any, will be recorded in the respective operating categoriesthe Company hedges its British Pound expenditures against.

6.  *Interest onCash and Marketable Securities*

The Company’s interest on cash and marketablesecurities, included as a component of other income, net, is $2.9 million and$1.4 million for the three months ended June 30, 2006 and 2005, respectively.Interest on cash and marketable securities amounted to $5.5 million and $2.4million for the six months ended June 30, 2006 and 2005, respectively.

7.  *Tax Matters*

From time to time, the Company is audited by variousstate, federal, and international authorities relating to tax matters. TheCompany fully cooperates with all audits, and defends its positionsvigorously.  The Company’s audits are invarious stages of completion; however, no outcome for a particular audit can bedetermined with certainty prior to the conclusion of the audit and appealsprocess.  Adjustments, if any, areappropriately recorded in the Company’s financial statements in the period theybecame probable and estimable.

8.  *Recently Issued AccountingStandards*

In July 2006, the FASB issued FASB InterpretationNo. 48 (FIN No. 48) *Accounting for Uncertaintyin Income Taxes*, an interpretation of SFAS No. 109, *Accounting for Income Taxes*, which prescribes a recognitionthreshold and measurement process for recording in the financial statementsuncertain tax positions taken or expected to be taken in a tax return. Inaddition, FIN No. 48 provides guidance on the de-recognition, classification,interest and penalties, accounting in interim periods and disclosurerequirements for uncertain tax positions. The accounting provisions of FIN No.48 will be effective for the Company beginning January 1, 2007. The Company isin the process of determining the effect the adoption of FIN No. 48 will haveon its financial statements.

9.  *Reclassifications*

Certain reclassifications have been made forconsistent presentation.

 

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10. *Subsequent Event*

On July 25, 2006, the Company announced that its Boardof Directors increased the size of the stock repurchase program by anadditional 4 million shares, for a total program size of up to 12 millionshares. The repurchases will be made from time to time on the open market atprevailing market prices or in privately negotiated transactions. Depending onmarket conditions and other factors, purchases under this program may commenceor be suspended at any time, or from time to time, without prior notice.

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

The following discussion and analysis should be readin conjunction with the financial statements and related notes containedelsewhere in this report. See “Risks and Uncertainties” regarding certainfactors known to us that could cause reported financial information not to benecessarily indicative of future results.

**Forward Looking Statements**

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

·                  anticipatedtrends in revenue;

·                  growthopportunities in domestic and international markets;

·                  new and enhancedchannels of distribution;

·                  customeracceptance and satisfaction with our products;

·                  expected trendsin operating and other expenses;

·                  anticipated cashand intentions regarding usage of cash;

·                  changes ineffective tax rates; and

·                  anticipatedproduct enhancements or releases.

These forward-looking statements are subject to risksand uncertainties, including those risks and uncertainties described in ourAnnual Report on Form 10-K for the fiscal year ended December 31, 2005 (our “2005Annual Report”), that could cause actual results to differ materially fromthose anticipated as of the date of this report. We assume no obligation toupdate any forward-looking statements to reflect events or circumstancesarising after the date of this report.

**Overview**

**Weprovide web filtering and web security software products that enableorganizations to reduce the risks associated with web-based malicious attacks,spyware, and phishing, as well as analyze, report and manage how theiremployees use computing resources.  Atthe foundation of our product offering is the Websense Enterprise® softwareapplication, which serves as a central policy engine and management andreporting console and enables the extended functionality of our add-onproducts.  Websense Enterprise givesorganizations the ability to enhance network security, improve employeeproductivity, mitigate potential legal liability and conserve network bandwidthby allowing organizations to identify potential risk areas and implement webaccess and application usage policies that reduce these risks. Over the past 10years, our products have evolved from software that prevents employees fromdownloading unacceptable content to products that prevent employee access tothe most undesirable and dangerous elements on the internet, such as websitesthat contain or will download viruses, spyware, keyloggers, phishing exploitsand an ever-increasing variety of malicious code.**

**In 1996,we released our first software product, Websense Internet Screening System.Since that time, we have focused our business on developing and selling web filteringand web security solutions. Websense Enterprise and Websense Enterprise —Corporate EditionTM are our core web filtering solutions, providing fullyfeatured web filtering and serving as management platforms for related Websenseadd-on modules, such as our Security Filtering, Real Time Security UpdatesTM,Bandwidth OptimizerTM, Client Policy ManagerTM and Remote Filtering. We have alsocreated suites of some of our products to address specific customer needs, suchas the Websense Web Security SuiteTM and Websense Web Security Suite — LockdownEditionTM.  We currently derive all of ourrevenue from subscriptions to the Websense**

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** **

**Enterprise-based solutions andexpect this to continue in the future as more offerings are added to theWebsense Enterprise platforms.  InOctober 2005, we announced an agreement with Nortel Networks to develop a webcontent filtering solution to protect GSM/UMTS mobile handsets from receivingand accessing unwanted content.  Weexpect field verification for the mobile handset filtering product to occur inthe second half of 2006.**

During the six months ended June 30, 2006, we derivedapproximately 36% of revenue from international sales, compared with 32% forthe six months ended June 30, 2005, with the United Kingdom comprisingapproximately 10% of our total revenue in both periods. We believeinternational markets continue to represent a significant growth opportunityand we are continuing to expand our international operations, particularly inselected countries in the European, Asia/Pacific and Latin American markets.

We sell Websense Enterprise through both indirectchannels and directly. Sales through indirect channels currently account formore than 80% of our revenue. Our strategy is to increase new and renewalcustomer sales through independent software distributors and resellers andincrease the focus of our internal sales and marketing force on supporting ourchannel strategy. As a result, we expect to increase the proportion of oursales made through indirect channels.

As described elsewhere in this report, we recognizerevenue from subscriptions to Websense Enterprise, including add-on modules, ona monthly straight-line basis over the term of the subscription. We recognizethe operating expenses related to these sales as they are incurred. Theseoperating expenses include sales commissions, which are based on the totalamount of the subscription contract and are fully expensed in the period theproduct is delivered. Operating expenses have continued to increase as comparedwith prior periods due to expanded selling and marketing efforts, continuedproduct research and development and investments in administrativeinfrastructure to support subscription sales that we will recognize as revenuein subsequent periods.

**CriticalAccounting Policies**

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

***Revenue Recognition.***When apurchase decision is made 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 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 the 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.

*Accounting for Share-BasedCompensation.*ThroughDecember 31, 2005, we accounted for share-based employee compensation plansunder the measurement and recognition provisions of Accounting Principles Board(APB) No. 25 (APB No. 25), and related Interpretations, as permitted byFinancial Accounting Standards Board (FASB) SFAS No. 123 *Accounting for Stock-Based Compensation* (SFAS No. 123).Accordingly, we recorded no share-based employee compensation expense foroptions granted under our Amended and Restated 2000 Stock Incentive Plan (2000Plan) or predecessor plans (or options granted as non-plan inducement options)during the six months ended June 30, 2005 as all other options granted hadexercise prices equal to the fair market value of the common stock on the dateof grant. We also recorded no compensation expense in connection with theEmployee Stock Purchase Plan as the purchase price of the stock was not lessthan 85% of the lower of the fair market value of the 

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common stock at the beginning of each offering period or at the end ofeach purchase period. In accordance with SFAS No. 123 and SFAS No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*(SFAS No. 148), we disclosed net income or loss and net income or loss pershare as if the fair value-based method was applied in measuring compensationexpense for share-based incentive programs.

Effective January 1, 2006, we adopted the fairvalue recognition provisions of SFAS No. 123(R), using the modified prospectivetransition method. Under that transition method, compensation expense that werecognized beginning on that date includes: (a) compensation expense forall share-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (b) compensation expense for allshare-based payments granted on or after January 1, 2006, based on the grantdate fair value estimated in accordance with the provisions of SFAS No. 123(R).Results for prior periods will not be restated. The results for the six monthsended June 30, 2006 include share-based compensation expense of $9.7 million(excluding tax effects). Compensation expense related to share-based awards isgenerally amortized over the vesting period in the related expense categoriesof the consolidated statement of income.

At June 30, 2006, there was $68.2 million oftotal unrecognized compensation cost related to share-based compensationarrangements granted under all equity compensation plans (excluding taxeffects). That total unrecognized compensation cost will be adjusted for estimatedforfeitures as well as for future changes in estimated forfeitures. We expectto recognize that cost over a weighted average period of approximately 3 years.

We estimate the fair value of options granted usingthe Black-Scholes option valuation model and the assumptions described below.We estimate the expected term of options granted based on the history of grantsand exercises in our option database. We estimate the volatility of our commonstock at the date of grant based on both the historical volatility as well asthe implied volatility of publicly traded options on our common stock,consistent with SFAS No. 123(R) and Securities and Exchange Commission StaffAccounting Bulletin No. 107 (SAB No. 107). We base the risk-free interestrate that is used in the Black-Scholes option valuation model on the impliedyield in effect at the time of option grant on U.S. Treasury zero-coupon issueswith equivalent remaining terms. We have never paid any cash dividends on ourcommon stock and do not anticipate paying any cash dividends in the foreseeablefuture. Consequently, we use an expected dividend yield of zero in theBlack-Scholes option valuation model. We amortize the fair value ratably overthe vesting period of the awards, which is typically four years. We usehistorical data to estimate pre-vesting option forfeitures and recordshare-based expense only for those awards that are expected to vest. Forpurposes of calculating pro forma information under SFAS No. 123 for periodsprior to January 1, 2006, we accounted for forfeitures as they occurred. We mayelect to use different assumptions under the Black-Scholes option valuationmodel in the future or select a different option valuation model altogether,which could materially affect our net income or loss and net income or loss pershare in the future.

We determine the fair value of share-based paymentawards on the date of grant using an option-pricing model that is affected byour stock price as well as assumptions regarding a number of complex andsubjective variables.  These variablesinclude, but are not limited to our expected stock price volatility over theterm of the awards, and actual and projected employee stock option exercisebehaviors.  Option-pricing models weredeveloped for use in estimating the value of traded options that have novesting or hedging restrictions and are fully transferable.  Because our employee stock options havecertain characteristics that are significantly different from traded options,and because changes in the subjective assumptions can materially affect theestimated value, in management’s opinion, the exiting valuation models may notprovide an accurate measure of the fair value of our employee stockoptions.  Although the fair value ofemployee stock options is determined in accordance with SFAS No. 123(R) and SABNo. 107 using an option-pricing model, that value may not be indicative of thefair value observed in a willing buyer/willing seller market transaction.

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*Deferred Tax Assets.* As requiredby SFAS No. 109, we recognize tax assets on the balance sheet if it is “morelikely than not” that they will be realized on future tax returns.  At June 30, 2006, we had deferred tax assetsof $24.2 million.  We believe that it ismore likely than not that our deferred tax assets will be realized. Factorsconsidered by us included: our earnings history, projected earnings based oncurrent operations, and projected future taxable income in excess of stockoption deductions. However, should we determine that we would not be able torealize all or part of our deferred tax assets in thefuture, anadjustment to the deferred tax assets would be charged against income in theperiod such determination was made.

*Income Tax Provision and TaxContingency Reserve*. Significant judgment isrequired in determining our consolidated income tax provision and evaluatingour U.S. and foreign tax positions. It is our policy to maintain taxcontingency reserves for tax audit issues that are probable to occur and canreasonably be estimated.  We review thereserves as circumstances warrant and adjust the reserves as events occur thataffect our potential liability for additional taxes, such as lapsing ofapplicable 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.

***Allowance for Doubtful Accounts.***We maintain an allowance for doubtful accounts for estimated lossesresulting from the inability or unwillingness of our customers to pay theirinvoices. If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

# **Results of Operations**

***Three months ended June 30, 2006 compared with the threemonths ended June 30, 2005***

The following table summarizes our operating resultsas a percentage of total revenue for each of the periods shown.
| ** **                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** |
| ** **                  | ** ** | **(Unaudited)**                  | ** ** |
|                        |       |                             |       |   |   |
| Revenue                     |       | 100                              | %          | 100 | % |
|                        |       |                             |       |   |   |
| Cost of revenue             |       | 8                                | *          | 7 |   |
|                        |       |                             |       |   |   |
| Gross margin                |       | 92                               |       | 93 |   |
|                        |       |                             |       |   |   |
| Operating expenses:         |       |                             |       |   |   |
| Selling and marketing       |       | 43                               | *          | 39 |   |
| Research and development    |       | 13                               | *          | 11 |   |
| General and administrative  |       | 12                               | *          | 8 |   |
| Total operating expenses    |       | 68                               |       | 58 |   |
|                        |       |                             |       |   |   |
| Income from  operations     |       | 24                               |       | 35 |   |
|                        |       |                             |       |   |   |
| Other income,  net          |       | 6                                |       | 3 |   |
|                        |       |                             |       |   |   |
| Income before  income taxes |       | 30                               |       | 38 |   |
|                        |       |                             |       |   |   |
| Provision for  income taxes |       | 11                               |       | 13 |   |
| Net income                  |       | 19                               | %          | 25 | % |

----

*                   Includesshare-based compensation expense. Total share-based compensation was $5.0million, or 11% of revenue, for the three months ended June 30, 2006.

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# **Revenue**

Revenue increased to $44.1 million in the secondquarter of 2006, from $36.0 million in the second quarter of 2005. The increasewas primarily a result of the addition of new, renewed and upgradedsubscriptions from our customers that resulted in a 2.5 million increase in thenumber of seats under subscription from June 30, 2005 to June 30, 2006.Approximately 65% of subscription revenue recognized in the second quarters of2006 and 2005 was derived from renewal business.  We expect total revenue growth amounts in2006 to exceed total revenue growth in 2005, although the percentage revenuegrowth rate may be lower in 2006 than in 2005 as a result of the increasingoverall revenue base and sales execution issues in North America, principallywith respect to new business, that we experienced in the first six months of2006.

# **Cost ofRevenue**

Cost of revenue consists of the costs of contentreview, technical support and infrastructure costs associated with maintainingour databases. Cost of revenue increased to $3.7 million in the second quarterof 2006, from $2.5 million in the second quarter of 2005. The increase of $1.2million was due to the costs associated with share-based compensation expenseof $0.4 million relating to our adoption of SFAS No. 123(R) on January 1, 2006,as well as additional personnel in our technical support and database groupsand allocated costs. We allocate the total costs for human resources, employeebenefits, payroll taxes, information technology, facilities, fixed assetdepreciation and legal costs to each of our functional areas based on salariesand headcount data. We expect cost of revenue to increase in the future due toshare-based compensation expense and to support the growth and maintenance ofour databases as well as the technical support needs of our customers. As apercentage of revenue, cost of revenue increased to 8% during the secondquarter of 2006 from 7% in 2005. We expect that cost of revenue, as apercentage of revenue, will remain below 10% of revenue for the foreseeablefuture.

# **GrossMargin**

Gross margin increased to $40.4 million in the secondquarter of 2006, from $33.5 million in the second quarter of 2005. The increasewas due to increased revenue. As a percentage of revenue, gross margindecreased to 92% in the second quarter of 2006 from 93% in the second quarterof 2005. We expect that gross margin, as a percentage of revenue, will remainin excess of 90% of revenue for the foreseeable future.

# **Operating Expenses**

# *Sellingand marketing*. Selling and marketing expenses consist primarilyof salaries, commissions and benefits related to personnel engaged in selling,marketing and customer support functions, along with costs related to publicrelations, advertising, promotions and travel as well as allocated costs.Selling and marketing expenses increased to $18.9 million in the second quarterof 2006, from $13.9 million in the second quarter of 2005. The increase inselling and marketing expenses of $5.0 million was due to share-basedcompensation expenses of $2.1 million relating to our adoption of SFAS No.123(R) on January 1, 2006, as well as increased personnel costs and relatedtravel, and allocated costs. We expect selling and marketing expenses toincrease in absolute dollars in the future driven primarily by share-based

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#  

# compensation expense and as more personnelare added to support our expanding selling and marketing efforts worldwide andas increased sales result in higher overall sales commission expenses.

# *Research and development.* Research and development expensesconsist primarily of salaries and benefits for software developers andallocated costs. Research and development expenses increased to $5.5 million inthe second quarter of 2006, from $4.0 million in the second quarter of 2005.The increase of $1.5 million in research and development expenses was primarilya result of share-based compensation expense of $0.9 million relating to our adoption ofSFAS No. 123(R) on January 1, 2006, as well as increased personnelneeded to support our expanding list of technology partners, the enhancementsof Websense Enterprise and additional products, and allocated costs. We expectresearch and development expenses to increase in absolute dollars in futureperiods driven primarily by share-based compensation expense and as a result ofour continued enhancements of our products as well as the development of newproducts.

*General and administrative*. General andadministrative expenses consist primarily of salaries, benefits and relatedexpenses for our executive, finance, administrative personnel, third partyprofessional service fees, and allocated costs. General and administrativeexpenses increased to $5.2 million in the second quarter of 2006, from $2.9million in the second quarter of 2005. The $2.3 million increase in general andadministrative expenses was primarily a result of share-based compensationexpense of $1.7 million relating to our adoption of SFAS No. 123(R) on January1, 2006, as well as additional personnel needed to support our growingoperations, and allocated costs. We expect general and administrative expensesto increase in absolute dollars in future periods driven primarily byshare-based compensation expense, growth in operations, increasing expenses associatedwith being a public company and expansion of our international operations.

# **OtherIncome, Net**

Other income, net increased to $2.8 million in thesecond quarter of 2006, from $1.2 million in the second quarter of 2005. Theincrease was due primarily to higher interest rates realized on our increasedbalances of cash, cash equivalents and marketable securities as of June 30,2006 compared with June 30, 2005. The majority of our investments of cash andcash equivalents and marketable securities are tax-exempt. We expect that themajority of our cash and cash equivalents and marketable securities willcontinue to be held in tax-exempt investments during the foreseeable future.

# **Provisionfor Income Taxes**

In the second quarter of 2006, United States and foreignincome tax expense was $5.2 million, compared to $5.0 million for the secondquarter of 2005.  The effective incometax rate increased to 38% in the second quarter of 2006 from 36% in the secondquarter of 2005. The increase in the tax rate was primarily driven by thenon-availability for tax deduction of certain share-based compensation expensesunder SFAS No. 123(R). The increase in the tax rate was partially offset by ahigher percentage of income earned by our international operations, for which lowerincome tax rates apply, and an increase in tax-exempt interest income. Oureffective tax rate may change in future periods due to the composition oftaxable income between domestic and international operations along withpotential changes or interpretations in tax rules and legislation, orcorresponding accounting rules.

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#  

***Six months ended June 30, 2006 compared with the six monthsended June 30, 2005***

The following table summarizes our operating resultsas a percentage of total revenue for each of the periods shown.
| ** **                  | ** ** | **Six Months Ended** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **June 30, 2006**    | ** ** | **June 30, 2005** | ** ** |
| ** **                  | ** ** | **(Unaudited)**                | ** ** |
|                        |       |                           |       |   |   |
| Revenue                     |       | 100                            | %          | 100 | % |
|                        |       |                           |       |   |   |
| Cost of revenue             |       | 8                              | *          | 7 |   |
|                        |       |                           |       |   |   |
| Gross margin                |       | 92                             |       | 93 |   |
|                        |       |                           |       |   |   |
| Operating expenses:         |       |                           |       |   |   |
| Selling and marketing       |       | 43                             | *          | 37 |   |
| Research and development    |       | 13                             | *          | 12 |   |
| General and administrative  |       | 12                             | *          | 8 |   |
| Total operating expenses    |       | 68                             |       | 57 |   |
|                        |       |                           |       |   |   |
| Income from  operations     |       | 24                             |       | 36 |   |
|                        |       |                           |       |   |   |
| Other income,  net          |       | 6                              |       | 3 |   |
|                        |       |                           |       |   |   |
| Income before  income taxes |       | 30                             |       | 39 |   |
|                        |       |                           |       |   |   |
| Provision for  income taxes |       | 11                             |       | 14 |   |
|                        |       |                           |       |   |   |
| Net income                  |       | 19                             | %          | 25 | % |

----

*                   Includesshare-based compensation expense. Total share-based compensation was $9.7million, or 11% of revenue, for the six months ended June 30, 2006.

# **Revenue**

Revenue increased to $86.6 million in the first six monthsof 2006, from $70.2 million in the first six months of 2005. The increase wasprimarily a result of the addition of new, renewed and upgraded subscriptionsfrom our customers. Approximately 65% of subscription revenue recognized in thefirst six months of 2006 and 2005 was derived from renewal business.

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# **Cost ofRevenue**

Cost of revenue increased to $7.1 million in the firstsix months of 2006, from $5.0 million in the first six months of 2005. Theincrease of $2.1 million was due to the costs associated with share-basedcompensation expense of $0.7 million relating to our adoption of SFAS No.123(R) on January 1, 2006, as well as additional personnel in our technicalsupport and database groups and allocated costs. We allocate the total costsfor human 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. As a percentage of revenue, costsof revenue increased to 8% during the first six months of 2006 from 7% in 2005.

# **GrossMargin**

Gross margin increased to $79.5 million in the firstsix months of 2006, from $65.2 million in the first six months of 2005. Theincrease was due to increased revenue. As a percentage of revenue, gross margindecreased to 92% in the first six months of 2006 from 93% in the first sixmonths of 2005.

# **Operating Expenses**

# *Sellingand marketing*. Selling and marketing expenses increased to $36.9million in the first six months of 2006, from $26.2 million in the first sixmonths of 2005. The increase in selling and marketing expenses of $10.7 millionwas due to share-based compensation expenses of $4.0 million relating to ouradoption of SFAS No. 123(R) on January 1, 2006, as well as increased personnelcosts and related travel, and allocated costs.

# *Research and development.* Research and development expensesincreased to $11.0 million in the first six months of 2006, from $8.0 millionin the first six months of 2005. The increase of $3.0 million in research anddevelopment expenses was primarily a result of share-based compensation expense of $1.7 millionrelating to our adoption of SFAS No. 123(R) on January 1, 2006, as wellas increased personnel needed to support our expanding list of technology partners,the enhancements of Websense Enterprise and additional products, and allocatedcosts.

*General and administrative*. General andadministrative expenses increased to $10.4 million in the first six months of2006, from $5.8 million in the first six months of 2005. The $4.6 millionincrease in general and administrative expenses was primarily a result ofshare-based compensation expense of $3.3 million relating to our adoption ofSFAS No. 123(R) on January 1, 2006, as well as additional personnel needed to supportour growing operations, and  allocatedcosts.

# **OtherIncome, Net**

Other income, net increased to $5.5 million in thefirst six months of 2006, from $2.2 million in the first six months of 2005.The increase was due primarily to higher interest rates realized on ourincreased balances of cash, cash equivalents and marketable securities as ofJune 30, 2006 compared with June 30, 2005. The majority of our investments ofcash and cash equivalents and marketable securities are tax-exempt.

# **Provisionfor Income Taxes**

In the first six months of 2006, United States andforeign income tax expense increased to $10.0 million compared to $9.8 millionin 2005. The effective income tax rate increased to 38% in the first six monthsof 2006 from 36% in the first six months of 2005. The increase in the tax ratewas primarily driven by the non-availability for tax deduction of certainshare-based compensation expenses under SFAS No. 123(R). The increase in thetax rate was partially offset by a higher percentage of income 

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#  

# earned by our international operations, for whichlower income tax rates apply, and an increase in tax-exempt interest income.

**Liquidity and Capital Resources**

As of June 30, 2006, we had cash and cash equivalentsof $20.6 million, investments in marketable securities of $317.8 million andretained earnings of $73.0 million. As of December 31, 2005, we had cash andcash equivalents of $61.6 million, investments in marketable securities of$258.8 million and retained earnings of $56.4 million.

Net cash provided by operating activities was $42.1million in the first six months of 2006, compared with $49.0 million in thefirst six months of 2005. The $6.9 million decrease in cash provided byoperating activities in the first six months of 2006 was primarily due todecreased growth in deferred revenue (subscription amounts in excess ofrecognizable revenue are recorded as deferred revenue) compared to the firstsix months of 2005. Our operating cash flow is significantly influenced bysubscription renewals and accounts receivable collections, and deferredrevenue.  A decrease in  subscription renewals or accounts receivablecollections or a lower deferred revenue balance, would negatively impact ouroperating cash flow.

Net cash used in investing activities was $61.1million in the first six months of 2006, compared with net cash used ininvesting activities of $49.7 million in the first six months of 2005. The$11.4 million increase of cash used in investing activities for the first sixmonths of 2006 was primarily due to purchases of marketable securities withfewer maturities and sales of marketable securities to offset the purchases.

Net cash used by financing activities was $22.1million in the first six months of 2006, compared with net cash used by financingactivities of $5.0 million in the first six months of 2005. The $17.1 millionincrease in net cash used by financing activities in the first six months of2006 was primarily due to share repurchases of 1,300,000 shares of our commonstock for $33.1 million in the first six months of 2006, compared with 650,000shares for $17.3 million in the first six months of 2005, and fewer proceedsfrom exercises of employee stock options.

We have an operating lease commitment of approximately$1.0 million during the remainder of 2006, $1.9 million in 2007, and $0.3million in 2008. A majority of our operating lease commitments are related toour corporate headquarters lease, which extends through 2008. Our corporateheadquarters lease includes escalating rent payments from 2006 to 2008,although the lease permits us to cancel the 2008 year commitment of the leaseprior to December 31, 2006, at our option in exchange for a payment ofapproximately $0.3 million. The rent expense related to our corporateheadquarters lease is recorded monthly on a straight-line basis in accordancewith generally accepted accounting principles.

Future minimum annual payments under non-cancelableoperating leases at June 30, 2006 are as follows (in thousands):
| ** ** | ** ** | **Operating  Leases** | ** ** |
|------------|------------|-----------------------|------------|
|       |       |                  |       |
| 2006       |       | $                     | 951        |   |
| 2007       |       | 1,937                 |       |
| 2008       |       | 325                   |       |
|       |       | $                     | 3,213      |   |

 

As of June 30, 2006 and 2005, we did not have anyrelationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other 

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contractually narrow or limitedpurposes. As such, we are not exposed to any financing, liquidity, market orcredit risk that could arise if we had engaged in such relationships.

On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million shares ofour common stock.  On August 15, 2005, weannounced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 8 million shares. On July 25, 2006, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 12 million shares. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may be commenced orsuspended at any time, or from time to time, without prior notice. As of June30, 2006, we had repurchased 5,170,060 shares of our common stock under thisprogram, for an aggregate of $112.1 million at an average price of $21.68 pershare. We plan on spending at least $50 million on stock repurchases during thethird quarter of 2006.

As of December 31, 2004, we retired all 2,012,000shares of our common stock that had been repurchased prior to that date.  In accordance with APB 6, *Status of Accounting Research Bulletins*, the treasury stockretirement was effected by reducing the following on our Consolidated BalanceSheet:  treasury stock by $30.7 million,common stock by $0.1 million, additional paid-in capital by $6.4 million andretained earnings by $24.2 million. There was no effect to our overall equityposition as a result of the retirement. We do not expect to retire shares of our common stock that werepurchased during 2005 or 2006 in the foreseeable future.

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

 

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**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk

Our market risk exposures are related to our cash,cash equivalents 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 primarilyfrom our short-term available-for-sale investments. Under our current policies,we do not use interest rate derivative instruments to manage exposure tointerest rate changes. A hypothetical 100 basis point adverse move in interestrates along the entire interest rate yield curve would not materially affectthe fair value of our interest sensitive financial instruments at June 30,2006. Changes in interest rates over time will, however, affect our interestincome.

We utilize foreign currency forward contracts andzero-cost collar contracts to hedge foreign currency market exposures ofunderlying assets and liabilities.  InApril 2005, we began billing customers in Euro-denominated countries in theEuro.  In addition, working fundsnecessary to facilitate the short-term operations of our subsidiaries are keptin the local currencies in which they do business. Our objective is to reducethe risk to earnings and cash flows associated with changes in foreign currencyexchange rates. We do not use foreign currency contracts for speculative ortrading purposes.

Notional and fair values of our hedging positions at June 30, 2006 and 2005 are presented in the table below (in thousands):
| ** **    | ** ** | **June 30, 2006**          | ** ** | **June 30, 2005** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**    | ** ** | **Fair  Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair  Value  USD** | ** ** |
|          |       |                                 |       |                        |       |   |   |   |   |   |   |   |   |
| Euro          |       | €                               | 785        |                        | $          | 1,004 |   | $ | 1,003 |   | € | — |   | $ | — |   | $ | — |   |
| British Pound |       | £                               | 900        |                        | 1,581      |   | 1,626 |   | £ | 2,300 |   | 4,212 |   | 4,101 |   |
| Total         |       |                                 |       | $                           | 2,585      |   | $ | 2,629 |   |   |   | $ | 4,212 |   | $ | 4,101 |   |

 

The $1.0 million notional increase in our Euro hedgedposition is primarily due to increased Euro-based billings of customers inEuro-denominated countries. All of the Euro hedging contracts will be settledbefore August 31, 2006.  For both thethree and six months ended June 30, 2006, approximately 10% of our total billingswere denominated in the Euro. We do not expect foreign currency billings torepresent more than 15% of our total billings during 2006.

The $2.6 million notional decrease in our BritishPound hedged position is primarily due to a shortening of the period hedged aswell as a decrease in the percentage of working funds hedged. All of theBritish Pound hedging contracts will be settled before September 30, 2006.  In 2006, we expect an increase in BritishPound expenditures and our corresponding hedged commitments to be consistentwith our increase in overall operating expenditures.

**Given our foreign exchangeposition, a 10% change in foreign exchange rates upon which these foreignexchange contracts are based would result in exchange gains and losses. In allmaterial aspects, these exchange gains and losses would be fully offset byexchange gains and losses on the underlying net monetary exposures for whichthe contracts are designated as hedges. We do not expect material exchange rategains and losses from unhedged foreign currency exposures.**

26

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** **

**Item 4.**                          Controlsand Procedures

**Disclosure Controls and Procedures**

**We maintain disclosure controlsand procedures (as defined in Rules 13a — 15(e) and 15d — 15(e) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) designed toensure that we are able to collect the information we are required to disclosein the reports we file under the Exchange Act, and to record, process,summarize and report this information within the time periods specified in therules 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.

**Changes In Internal Control Over Financial Reporting**

There have been no significant changes in our internalcontrol over financial reporting or in other factors that could significantlyaffect our internal control over financial reporting, including any correctiveactions with regard to significant deficiencies and material weaknesses, duringthe period covered by this report.

27

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**Part II — OtherInformation**

**Item 1.**                          LegalProceedings

None.

**Item 1A.**                 Risk Factors

Risks and uncertainties that could impact ourbusiness, consolidated financial position, results of operations and cash flowsand cause future results to differ from our expectations include the following:customer acceptance of our products, including the quantity of new customersales; the success of our sales execution plans and strategies (includingperformance of our expanded and enhanced indirect sales channels); the mix ofdomestic versus international sales;  thesuccess of our brand development efforts; the volatile and competitive natureof the internet industry; changes in domestic and international marketconditions and the entry into and development of international markets for ourproducts; risks relating to intellectual property ownership; and the risks anduncertainties identified in our 2005 Annual Report and other filings with theSecurities and Exchange Commission. There have been no material changes in our “Risk Factors” as previouslydisclosed in our 2005 Annual Report.

**Item 2.**                          UnregisteredSales of Equity Securities and Use of Proceeds

**(a) Not applicable.**

**(b) Not applicable.**

**(c) Issuer Purchases of Equity 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) | ** ** |
|------------|------------|-------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| April 2006 |       | —                                                      |       | —                                       |       | 4,170,060                                                                                                      |       | 3,829,940                                                                                                           |       |
| May 2006   |       | 1,000,000                                                   |       | $                                            | 24.17      |                                                                                                           | 5,170,060  |                                                                                                                | 2,829,940  |   |
| June 2006  |       | —                                                      |       | —                                       |       | 5,170,060                                                                                                      |       | 2,829,940                                                                                                           |       |
| Total      |       | 1,000,000                                                   |       | $                                            | 24.17      |                                                                                                           | 5,170,060  |                                                                                                                | 2,829,940  |   |

----

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

**(2)**          On April 3, 2003, we announced that ourBoard of Directors authorized a stock repurchase program of up to 4 millionshares of our common stock. On August 15, 2005, we announced that our Board ofDirectors increasedthe size of the stock repurchase program by an additional 4 million shares ofour common stock, for a total program size of up to 8 million shares of ourcommon stock.  On July 25, 2006, we announced that ourBoard of Directors increasedthe size of the stock repurchase program by an additional 4 million shares ofour common stock, for a total program size of up to 12 million shares of ourcommon stock.

**Item 3.**                          Defaultsupon Senior Securities

**None.**

28

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** **

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

**The Annual Meeting of Stockholders was held on Tuesday,June 6, 2006.  The following matters werevoted upon at the meeting and were adopted by the margins indicated:**

**1.**               The stockholders elected three Directors to hold office for a termexpiring upon the 2009 Annual Meeting of Stockholders.
| ** **                                  | ** ** | **Number of Shares** | ** ** |
|---------------------------------------------|------------|--------------------------------|------------|
| **Name of Director Elected** | ** ** | **For**                        | ** ** | **Withheld** | ** ** |
|                                        |       |                           |       |   |   |
| Bruce T. Coleman                            |       | 44,103,806                     |       | 2,808,375 |   |
| Gene Hodges                                 |       | 46,602,374                     |       | 309,807 |   |
| John F. Schaefer                            |       | 45,550,787                     |       | 1,361,394 |   |

** **

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

**Thefollowing individuals are continuing directors with terms expiring upon the2008 Annual Meeting of Stockholders: Mark S. St.Clare and Peter C. Waller.**

**2. Thestockholders ratified the appointment of Ernst & Young LLP as ourindependent auditors for the fiscal year ending December 31, 2006.**

** **
| For     |   | 46,844,366 |
|---------|--------|------------|
| Against |   | 62,129     |
| Abstain |   | 5,686      |

** **

**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.                                                                                                                                                     |
|   |   |                                                                                                                                                                                             |
| 10.1   |   | 2000 Stock Incentive Plan, Form of Deferred Issuance  Stock Issuance Agreement.                                                                                                                  |
|   |   |                                                                                                                                                                                             |
| 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). |

29

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**(1)**            Previously filed as an exhibit toour Registration Statement on Form S-1, as amended, (File No 333-95619) andincorporated herein by reference.

30

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#####  

##### **SIGNATURES**

Pursuant to the requirements of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                       |       | **WEBSENSE, INC.** |
|-----------------------|------------|--------------------|
|                  |       |               |   |   |
| Date: August 8, 2006  |       | By:                |   | /s/ GENE HODGES |
|                  |       |               |   | Gene Hodges |
|                  | * *   | * *           | * * | *President and* |
|                  | * *   | * *           | * * | *Chief Executive Officer* |
|                  |       |               |   |   |
|                  |       |               |   |   |
| Date: August 8,  2006 |       | By:                |   | /s/ DOUGLAS C. WRIDE |
| ** **            |       |               |   | Douglas C. Wride |
| ** **            | * *   | * *           | * * | *Chief Financial Officer* |
| ** **            |       |               |   |   |
| ** **            | ** ** | ** **         | ** ** | ** ** |

 

 

31

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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.                                                                                                                                                |
| 10.1            |       | 2000 Stock Incentive Plan, Form of Deferred Issuance  Stock Issuance Agreement.                                                                                                             |
| 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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