**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 September 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 RoadSan Diego, California 92121858-320-8000**

(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 October 31, 2006 was 44,694,330.

 

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**Websense, Inc.**

**Form 10-Q**

**For the Period Ended September 30, 2006**

**TABLE OFCONTENTS**
|                                | ** ** | ** ** | ** ** | ** **                                                                                         | ** ** | **Page** |
|--------------------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------|------------|----------|
| Part I.  Financial Information |       |       |
|                           |       |       |       |                                                                                               |       |     |
|                           |       | Item  1.   |       | Consolidated Financial  Statements (Unaudited)                                                     |       |     |
|                           |       |       |       | Consolidated Balance Sheets as of  September 30, 2006 and December 31, 2005                        |       | 1        |
|                           |       |       |       | Consolidated Statements of  Income for the three and nine months ended September 30, 2006 and 2005 |       | 2        |
|                           |       |       |       | Consolidated Statement of  Stockholders’ Equity for the nine months ended September 30, 2006  |       | 3        |
|                           |       |       |       | Consolidated Statements of Cash Flows  for the nine months ended September 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        |       | 15       |
|                           |       | 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                                       |       | 38       |
|                           |       | Item  3.   |       | Defaults  upon Senior Securities                                                                   |       | 38       |
|                           |       | Item  4.   |       | Submission  of Matters to a Vote of Security Holders                                               |       | 38       |
|                           |       | Item 5.    |       | Other  Information                                                                                 |       | 38       |
|                           |       | Item 6.    |       | Exhibits                                                                                           |       | 39       |
|                           |       |       |       |                                                                                               |       |     |
| Signatures                     |       | 40         |
|                                |            |            |            |                                                                                                    |            |          |  |  |  |  |

 

i

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**Part I – FinancialInformation**

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

**Websense,Inc.**Consolidated BalanceSheets(Unaudited and in thousands)
| ** **                                                   | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | ** **                   | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                                   |       |                         |       |                        |       |
| Current assets:                                              |       |                         |       |                        |       |
| Cash and cash  equivalents                                   |       | $                            | 46,033     |                        | $          | 61,629 |   |
| Marketable  securities                                       |       | 254,323                      |       | 258,760                     |       |
| Accounts  receivable, net of allowance for doubtful accounts |       | 40,673                       |       | 50,570                      |       |
| Prepaid income  taxes                                        |       | —                       |       | 1,962                       |       |
| Current portion  of deferred income taxes                    |       | 15,815                       |       | 15,772                      |       |
| Other current  assets                                        |       | 4,598                        |       | 3,467                       |       |
| Total current  assets                                        |       | 361,442                      |       | 392,160                     |       |
|                                                         |       |                         |       |                        |       |
| Property and equipment,  net                                 |       | 5,656                        |       | 4,923                       |       |
| Deferred income taxes,  less current portion                 |       | 10,146                       |       | 6,043                       |       |
| Deposits and other  assets                                   |       | 1,739                        |       | 549                         |       |
| Total assets                                                 |       | $                            | 378,983    |                        | $          | 403,675 |   |
|                                                         |       |                         |       |                        |       |
| **Liabilities and stockholders’  equity**               |       |                         |       |                        |       |
| Current liabilities:                                         |       |                         |       |                        |       |
| Accounts payable                                             |       | $                            | 2,140      |                        | $          | 2,073 |   |
| Accrued payroll  and related benefits                        |       | 8,647                        |       | 8,476                       |       |
| Other accrued  expenses                                      |       | 7,191                        |       | 5,085                       |       |
| Income taxes  payable                                        |       | 2,847                        |       | 2,305                       |       |
| Current portion  of deferred revenue                         |       | 127,295                      |       | 119,118                     |       |
| Total current  liabilities                                   |       | 148,120                      |       | 137,057                     |       |
|                                                         |       |                         |       |                        |       |
| Deferred revenue, less  current portion                      |       | 62,104                       |       | 60,807                      |       |
|                                                         |       |                         |       |                        |       |
| Stockholders’ equity:                                   |       |                         |       |                        |       |
| Common stock                                                 |       | 507                          |       | 500                         |       |
| Additional  paid-in capital                                  |       | 226,514                      |       | 197,826                     |       |
| Treasury stock                                               |       | (139,744                     | )          | (48,340                     | )          |
| Retained  earnings                                           |       | 81,550                       |       | 56,449                      |       |
| Accumulated  other comprehensive loss                        |       | (68                          | )          | (624                        | )          |
| Total  stockholders’ equity                             |       | 168,759                      |       | 205,811                     |       |
|                                                         |       |                         |       |                        |       |
| Total  liabilities and stockholders’ equity             |       | $                            | 378,983    |                        | $          | 403,675 |   |

 

See accompanyingnotes.

1

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**Websense,Inc.Consolidated Statements of Income(Unaudited) (in thousands, except per share amounts)**
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Revenue                                |       | $                                | 46,068     |                            | $          | 38,300 |   | $ | 132,651 |   | $ | 108,508 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Cost of revenue                        |       | 3,873                            |       | 2,829                           |       | 10,955 |   | 7,830 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Gross margin                           |       | 42,195                           |       | 35,471                          |       | 121,696 |   | 100,678 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                   |       |                             |       |                            |       |   |   |   |   |
| Selling and marketing                  |       | 21,309                           |       | 13,770                          |       | 58,245 |   | 39,970 |   |
| Research and development               |       | 5,954                            |       | 4,091                           |       | 16,932 |   | 12,122 |   |
| General and administrative             |       | 5,535                            |       | 3,145                           |       | 15,968 |   | 8,954 |   |
| Total operating expenses               |       | 32,798                           |       | 21,006                          |       | 91,145 |   | 61,046 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Income from  operations                |       | 9,397                            |       | 14,465                          |       | 30,551 |   | 39,632 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Other income,  net                     |       | 2,784                            |       | 1,535                           |       | 8,240 |   | 3,690 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Income before  income taxes            |       | 12,181                           |       | 16,000                          |       | 38,791 |   | 43,322 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Provision for  income taxes            |       | 3,647                            |       | 5,889                           |       | 13,690 |   | 15,665 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Net income                             |       | $                                | 8,534      |                            | $          | 10,111 |   | $ | 25,101 |   | $ | 27,657 |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Net income per  share:                 |       |                             |       |                            |       |   |   |   |   |
|                                   |       |                             |       |                            |       |   |   |   |   |
| Basic net income per share             |       | $                                | 0.19       |                            | $          | 0.21 |   | $ | 0.53 |   | $ | 0.58 |   |
| Diluted net income per share           |       | $                                | 0.18       |                            | $          | 0.21 |   | $ | 0.52 |   | $ | 0.56 |   |
| Weighted average shares – basic   |       | 45,796                           |       | 47,326                          |       | 47,102 |   | 47,446 |   |
| Weighted average shares – diluted |       | 46,401                           |       | 48,904                          |       | 47,926 |   | 49,294 |   |

 

See accompanyingnotes.

2

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**Websense,Inc.**Consolidated Statement of Stockholders’ Equity(Unaudited and in thousands)
| ** **                                                                                        | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------|------------|----------------|------------|--------------------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                        | ** ** | **Shares**       | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**                          | ** ** | **loss**                      | ** ** | **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                                                 |       | 784              |       | 6              |       | 8,780                    |       | —       |       | —                                |       | —                        |       | 8,786 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of common stock for ESPP Purchase                                                        |       | 101              |       | 1              |       | 1,987                    |       | —       |       | —                                |       | —                        |       | 1,988 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Share-based compensation expense                                                                  |       | —           |       | —         |       | 15,032                   |       | —       |       | —                                |       | —                        |       | 15,032 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Excess tax benefit of share-based compensation                                                    |       | —           |       | —         |       | 2,889                    |       | —       |       | —                                |       | —                        |       | 2,889 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Purchase of treasury stock                                                                        |       | (4,300           | )          | —         |       | —                   |       | (91,404      | )          | —                                |       | —                        |       | (91,404 | ) |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net income                                                                                        |       | —           |       | —         |       | —                   |       | —       |       | 25,101                                |       | —                        |       | 25,101 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in unrealized loss on marketable  securities, net of tax                               |       | —           |       | —         |       | —                   |       | —       |       | —                                |       | 480                           |       | 480 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in unrealized loss on fair market  valuation of foreign currency contracts, net of tax |       | —           |       | —         |       | —                   |       | —       |       | —                                |       | 76                            |       | 76 |   |
|                                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Comprehensive income                                                                              |       |             |       |           |       |                     |       |         |       |                                  |       |                          |       | 25,657 |   |
| Balance at  September 30, 2006                                                                    |       | 44,527           |       | $              | 507        |                     | $          | 226,514      |       | $                                     | (139,744   | )                             | $          | 81,550 |   | $ | (68 | ) | $ | 168,759 |   |

 

See accompanying notes.

3

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**Websense,Inc.Consolidated Statements of Cash Flows(Unaudited and in thousands)**
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                         | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| **Operating  activities:**                                                         |       |                            | ** ** |   |   |
| Net income                                                                         |       | $                               | 25,101     |   | $ | 27,657 |   |
|                                                                               |       |                            |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                            |       |   |   |
|                                                                               |       |                            |       |   |   |
| Depreciation and amortization                                                      |       | 2,432                           |       | 1,924 |   |
| Share-based compensation                                                           |       | 15,032                          |       | - |   |
| Deferred revenue                                                                   |       | 9,474                           |       | 20,172 |   |
| Unrealized gain (loss) on foreign exchange contracts                               |       | 76                              |       | (84 | ) |
| Tax benefit from exercise of stock options                                         |       | —                          |       | 9,586 |   |
| Excess tax benefit from share-based compensation                                   |       | (2,889                          | )          | — |   |
| Changes in operating assets and liabilities:                                       |       |                            |       |   |   |
| Accounts receivable                                                                |       | 9,897                           |       | 13,320 |   |
| Prepaid income taxes                                                               |       | 1,962                           |       | 1,501 |   |
| Other current assets                                                               |       | (1,131                          | )          | (2,780 | ) |
| Deposits and other assets                                                          |       | (23                             | )          | (79 | ) |
| Deferred income taxes                                                              |       | (4,146                          | )          | — |   |
| Accounts payable                                                                   |       | 67                              |       | 205 |   |
| Accrued payroll and related benefits                                               |       | 171                             |       | (104 | ) |
| Other accrued expenses                                                             |       | 2,106                           |       | 951 |   |
| Income taxes payable                                                               |       | 3,431                           |       | 1,248 |   |
| Net cash  provided by operating activities                                         |       | 61,560                          |       | 73,517 |   |
|                                                                               |       |                            |       |   |   |
| **Investing  activities:**                                                         |       |                            | ** ** |   |   |
| Purchase of  intangible assets                                                     |       | (1,200                          | )          | — |   |
| Purchases of  property and equipment                                               |       | (3,132                          | )          | (2,444 | ) |
| Purchases of  marketable securities                                                |       | (472,950                        | )          | (299,074 | ) |
| Maturities of  marketable securities                                               |       | 477,867                         |       | 247,314 |   |
| Sales of  marketable securities                                                    |       | —                          |       | 1,042 |   |
| Net cash  provided by (used in) investing activities                               |       | 585                             |       | (53,162 | ) |
|                                                                               |       |                            |       |   |   |
| **Financing  activities:**                                                         |       |                            | ** ** |   |   |
| Proceeds from  exercise of stock options                                           |       | 8,786                           |       | 12,716 |   |
| Proceeds from  issuance of common stock for stock purchase plan                    |       | 1,988                           |       | 1,647 |   |
| Excess tax  benefit from share-based compensation                                  |       | 2,889                           |       | — |   |
| Purchases of  treasury stock                                                       |       | (91,404                         | )          | (41,855 | ) |
| Net cash used in  financing activities                                             |       | (77,741                         | )          | (27,492 | ) |
|                                                                               |       |                            |       |   |   |
| Decrease in cash  and cash equivalents                                             |       | (15,596                         | )          | (7,137 | ) |
|                                                                               |       |                            |       |   |   |
| Cash and cash  equivalents at beginning of period                                  |       | 61,629                          |       | 38,878 |   |
|                                                                               |       |                            |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                               | 46,033     |   | $ | 31,741 |   |
| ** **                                                                         |       |                            |       |   |   |
| **Supplemental  disclosures of cash flow information:**                            |       |                            |       |   |   |
| Income taxes  paid                                                                 |       | $                               | 11,908     |   | $ | 3,001 |   |
| Unrealized gain  (loss) on marketable securities                                   |       | $                               | 480        |   | $ | (53 | ) |

 

See accompanyingnotes.

 

4

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**Websense,Inc.**

**NotesTo Consolidated Financial Statements (Unaudited)**

1. *Basis of Presentation*

The accompanyingunaudited consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States for interimfinancial statements and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information or footnote disclosuresnormally included in complete financial statements prepared in accordance withaccounting principles generally accepted in the United States have beencondensed or omitted pursuant to the rules and regulations of the Securitiesand Exchange Commission. In the opinion of management, the statements includeall adjustments necessary, which are of a normal and recurring nature, for thefair presentation of our financial position and of the results for the interimperiods presented. 

These financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto for the year ended December 31, 2005,included in Websense, Inc.’s Annual Report on Form 10-K filed with theSecurities and Exchange Commission. Operating results for the three and ninemonths ended September 30, 2006 are not necessarily indicative of the resultsthat may be expected for any other interim period or for the year endingDecember 31, 2006. The balance sheet at December 31, 2005 has been derived fromthe audited financial statements at that date but does not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements.

2. *Net Income Per Share*

Websense computes net income per share as permitted by the FinancialAccounting Standards Board (FASB) with Statement of Financial AccountingStandards (SFAS) No. 128, *Earnings Per Share*(EPS) (SFAS No. 128). Under the provisions of SFAS No. 128, basic netincome per share is computed by dividing the net income for the period by theweighted average number of common shares outstanding during the period. Dilutednet income per share is computed by dividing the net income for the period bythe weighted average number of common and common equivalent shares outstandingduring the period. Common equivalent shares consist of dilutive stock optionsand restricted stock units for 2006. Common equivalent shares consist of onlydilutive stock options for 2005. Dilutive securities include both dilutivestock options and dilutive restricted stock units and are calculated based onthe average share price for each fiscal period using the treasury stock method.Under the treasury stock method, the amount the employee must pay forexercising stock options or acquiring restricted stock units, the amount ofcompensation cost for future service that the Company has not yet recognized,and the amount of tax benefits that would be recorded in additional paid-incapital when the award becomes deductible are assumed to be used to repurchaseshares.

During the quarters endedSeptember 30, 2006 and 2005, the difference between the weighted average sharesused in determining basic EPS versus diluted EPS related to dilutive stockoptions totaling 605,000 and 1,578,000 shares, respectively. Potentially dilutivesecurities totaling 5,604,000 and 628,000 shares for the quarters endedSeptember 30, 2006 and 2005, respectively, were excluded from historical basicand diluted earnings per share because of their anti-dilutive effect.

During the first ninemonths of 2006 and 2005, the difference between the weighted average sharesused in determining basic EPS versus diluted EPS related to dilutive stockoptions totaling 824,000 and 1,848,000 shares, respectively. Potentiallydilutive securities totaling 4,412,000 and 152,000 shares for the first ninemonths of 2006 and 2005, respectively, were excluded from historical basic anddiluted earnings per share because of their anti-dilutive effect.

5

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The following is areconciliation of the numerator and denominator used in calculating basic EPSto the numerator and denominator used in calculating diluted EPS for allperiods presented:
| ** **                       | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **September  30, 2006:**         | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 8,534      |              | 45,796     |               | $          | 0.19 |   |
| Effect of stock options          |       | —                                                                |       | 605               |       | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 8,534      |              | 46,401     |               | $          | 0.18 |   |
| ** **                       |       |                                                                  |       |              | ** ** | ** **         | ** ** |
| **September  30, 2005:**         |       |                                                                  |       |              | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 10,111     |              | 47,326     |               | $          | 0.21 |   |
| Effect of stock options          |       | —                                                                |       | 1,578             |       | (0.00              | )          |
| Diluted EPS                      |       | $                                                                     | 10,111     |              | 48,904     |               | $          | 0.21 |   |
| ** **                       | ** ** | ** **                                                            |       |              | ** ** | ** **         | ** ** |
| **For the  Nine Months Ended:**  | ** ** | ** **                                                            |       |              | ** ** | ** **         | ** ** |
| **September  30, 2006:**         | ** ** | ** **                                                            |       |              | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 25,101     |              | 47,102     |               | $          | 0.53 |   |
| Effect of stock options          |       | —                                                                |       | 824               |       | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 25,101     |              | 47,926     |               | $          | 0.52 |   |
| ** **                       | ** ** | ** **                                                            |       |              | ** ** | ** **         | ** ** |
| **September 30, 2005:**          | ** ** | ** **                                                            |       |              | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 27,657     |              | 47,446     |               | $          | 0.58 |   |
| Effect of stock options          |       | —                                                                |       | 1,848             |       | (0.02              | )          |
| Diluted EPS                      |       | $                                                                     | 27,657     |              | 49,294     |               | $          | 0.56 |   |
| ** **                       |       |                                                                  |       |              |       |               |       |

 

3. *Comprehensive Income*

The components of comprehensive income, as required tobe reported by SFAS No. 130, *Reporting ComprehensiveIncome*, were as follows (in thousands): 

 
| ** **                                                                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
| Net income                                                                                                |       | $                                | 8,534      |                            | $          | 10,111 |   | $ | 25,101 |   | $ | 27,657 |   |
| Net change in  unrealized gain (loss) on marketable securities, net of tax                                |       | 278                              |       | (16                             | )          | 480 |   | (53 | ) |
| Net change in  unrealized gain (loss) on fair market valuation of foreign currency  contracts, net of tax |       | (40                              | )          | 34                              |       | 76 |   | (84 | ) |
| Comprehensive income                                                                                      |       | $                                | 8,772      |                            | $          | 10,129 |   | $ | 25,657 |   | $ | 27,520 |   |

 

6

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4.*Stockholder’s Equity*

**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 nine months ended September 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 nine months ended September 30, 2005 as the purchase price of the stock wasnot less than 85% of the lower of the fair market value of the common stock atthe beginning of each offering period or at the end of each purchase period. Nevertheless,through December 31, 2005 in accordance with SFAS No. 123 and SFAS No. 148, *Accounting for Stock-Based Compensation - Transition and Disclosure*(SFAS No. 148), the Company disclosed net income or loss and net income or lossper share as if the fair value-based method was applied in measuringcompensation expense for 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 customarily employedfor at least five months per calendar year. Employees who participate in anoffering may have up to 15% of their earnings withheld pursuant to the PurchasePlan. The amount withheld is then used to purchase shares of common stock onspecified dates. The price of common stock purchased pursuant to the PurchasePlan will be equal to 85% of the lower of the fair market value of the commonstock at the commencement date of each offering period or the relevant purchasedate. Employees may end their participation in the offering at any time duringthe offering period, and participation ends automatically on termination ofemployment. At September 30, 2006, 1,579,013 shares were available for issuanceunder the Purchase Plan.

During the nine months ended September 30, 2006 andSeptember 30, 2005, the Company issued 100,816 and 217,880 shares,respectively, under the 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 and non-statutorystock options, restricted stock units and rights to purchase stock toemployees, directors or consultants of the Company. The 2000 Plan provides thatincentive stock options will be granted only to employees and are subject tocertain limitations as to fair value during a calendar year.

7

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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 September 30, 2006, a total of 19,558,162 shares have beenauthorized for issuance under the 2000 Plan, of which 717,578 remain availablefor grant.

The exercise price of bothincentive and non-statutory stock options and the issuance price of commonstock under the 2000 Plan must equal at least the fair value on the date ofgrant or issuance, as the case may be. Through April 2005, the option grantswere generally exercisable for a period of ten years, and beginning in May2005, the option grants are generally exercisable for a period of seven yearsafter the date of grant and generally vest 25% one year from date of grant andratably each month thereafter for a period of 36 months. Unvested common sharesobtained through early exercise of stock options are subject to repurchase bythe Company at the original issue price. Restricted stock units are subject tovesting and the holders of the restricted stock units are entitled to deliveryof the underlying common stock on the applicable vesting date without anypayment. To date, the Company has awarded restricted stock units as part ofcompetitive hiring packages to replace foregone compensation. The vestingschedules, including acceleration events, for restricted stock units may varyin the individual cases. To date, only non-statutory stock options andrestricted stock units have been granted under the 2000 Plan. Through September30, 2006, the Company granted 120,000 restricted stock units. The unvestedrestricted stock units have a weighted average grant date fair value of $29.39and an aggregate intrinsic value of $2.6 million as of September 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 either partygives notice of termination. On January 9, 2006, Mr. Hodges was granted non-qualifiedstock options to purchase an aggregate of 1,200,000 shares of the Company’scommon stock outside the Company’s 2000 Plan (the “Options”) with an exerciseprice per share equal to the fair market value of the Company’s common stock onthat date. On April 13, 2006, at the request of the Company, Mr. Hodges agreedto the cancellation of the Options and the immediate re-grant under the 2000Plan of non-qualified stock options to purchase an aggregate of 1,200,000shares of the Company’s common stock with identical option terms, exerciseprices, vesting schedules and vesting commencement dates as the originalOptions. The Company requested the cancellation and re-grant to bring theOptions under the 2000 Plan for U.S. federal income tax reasons. Mr. Hodgesreceived no income tax or other personal benefit from the cancellation and re-grant.

8

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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                        |       | 4,560,930                        |       | 28.31                                  |       |
| Exercised                      |       | (784,110                         | )          | 11.25                                  |       |
| Cancelled/forfeited/expired    |       | (1,894,338                       | )          | 28.69                                  |       |
| Balance at September  30, 2006 |       | 7,097,184                        |       | 22.42                                  |       |
|                                |            |                                  |            |                                        |            |  |

 

Theweighted average fair value of stock options granted during the nine monthsended September 30, 2006 was $13.18 per share based on the grant date fairvalue of the stock options estimated in accordance with the provisions of SFAS No. 123(R),excluding Mr. Hodges’ April 2006 re-granted stock options described above. Thefair value of the April 2006 re-granted stock options to Mr. Hodges was lessthan the original stock option grants in January 2006 as the market price ofthe Company’s common stock declined from January 2006 to April 2006. TheCompany will continue to amortize the higher fair value associated with Mr.Hodges’ original stock option grants in January 2006 rather than the lower fairvalue associated with the April 2006 re-granted stock options.

Thetotal intrinsic value of stock options exercised during the nine months endedSeptember 30, 2006 was $11.2 million.

The following table summarizes all stock options outstanding andexercisable by price range as of September 30, 2006: 

|                          | ** ** | **Options Outstanding** | ** ** | ** **                | ** ** |
|--------------------------|------------|------------------------------|------------|---------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**              | ** ** | ** ** | ** ** | **Options Exercisable** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**               | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Remaining**             | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **Number of**           | ** ** | **Contractual Life** | ** ** | **Average** | ** ** | **Number of** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **Shares**                   | ** ** | **In Years**         | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $0.25-$16.03             |       | 1,431,941                    |       | 5.72                      |       | $ | 9.97 |   | 1,201,546 |   | $ | 9.88 |   |
| $16.12-$21.77            |       | 2,035,594                    |       | 7.12                      |       | 20.06 |   | 318,330 |   | 18.40 |   |
| $21.81-$25.85            |       | 1,429,723                    |       | 6.46                      |       | 24.78 |   | 384,281 |   | 25.01 |   |
| $25.89-$32.24            |       | 2,018,526                    |       | 7.44                      |       | 30.99 |   | 156,966 |   | 27.71 |   |
| $32.42-$33.85            |       | 181,400                      |       | 6.77                      |       | 33.14 |   | — |   | — |   |
|                     |       |                         |       |                      |       |   |   |   |   |   |   |
|                     |       | 7,097,184                    |       | 6.79                      |       | 22.42 |   | 2,061,123 |   | 15.38 |   |
|                          |            |                              |            |                           |            |  |  |  |  |  |  |  |  |

 

The Company defines in-the-moneystock options at September 30, 2006 as stock options that had exercise pricesthat were lower than the $21.61 market price of our common stock at that date.The weighted-average remaining contractual term of options currentlyexercisable is 6.22 years. The aggregate intrinsic value of all exercisable andnon-exercisable stock options outstanding and in-the-money at September 30,2006 was $20.0 million. The aggregate intrinsic value of only exercisable stockoptions outstanding and in-the-money at September 30, 2006 was $15.1 million.There were 2.6 million stock options in-the-money at September 30, 2006, ofwhich 1.5 million stock options were exercisable.

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Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No.123(R), using the modified prospective transition method. Under that transitionmethod, compensation expense that the Company recognized beginning on that dateincludes: (a) compensation expense for all share-based awards grantedprior to, but not yet vested as of January 1, 2006, based on the grant datefair value estimated in accordance with the original provisions of SFAS No.123, and (b) compensation expense for all share-based awards granted on orafter January 1, 2006, based on the grant date fair value estimated inaccordance with the provisions of SFAS No. 123(R). Results for prior periodswill 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 nine months ended September 30, 2005 (in thousands,except per share amounts): 
| ** **                                                                                                  | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                  | ** ** | **September 30,  2005** | ** ** | **September 30,  2005** | ** ** |
| Net income as reported                                                                                      |       | $10,111                 |       | $27,657                 |       |
| Deduct: share-based compensation expense determined under fair value  method for all awards, net of tax (1) |       | (2,802                  | )          | (7,874                  | )          |
| Pro forma net income                                                                                        |       | $7,309                  |       | $19,783                 |       |
|                                                                                                        |       |                    |       |                    |       |
| Basic net income per share as reported                                                                      |       | $0.21                   |       | $0.58                   |       |
| Pro forma basic net income per share                                                                        |       | $0.15                   |       | $0.42                   |       |
|                                                                                                        |       |                    |       |                    |       |
| Diluted net income per share as reported                                                                    |       | $0.21                   |       | $0.56                   |       |
| Pro forma diluted net income per share                                                                      |       | $0.15                   |       | $0.40                   |       |

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(1)             TheCompany had an effective tax rate of 37% and 36% in the three and nine monthsended September 30, 2005, respectively.

The table below reflects net income and diluted netincome per share for the three and nine months ended September 30, 2006compared with the pro forma information for the three and nine months endedSeptember 30, 2005 (in thousands, except per share amounts):
| ** **                                                                                                             | ** ** | **Three Months Ended**   | ** ** | **Nine Months Ended**    | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                             | ** ** | **September 30,   2006** | ** ** | **September 30,   2005** | ** ** | **September 30,   2006** | ** ** | **September 30,   2005** | ** ** |
| Net income - as  reported for prior periods (1)                                                                        |       | N/A                                |       | $                                  | 10,111     |   | N/A |   | $ | 27,657 |   |
| Share-based  compensation expense related to employee stock options and employee stock  purchases, net of tax (2) |       | ($2,954                            | )          | ($2,802                            | )          | ($10,218 | ) | ($7,874 | ) |
| Net income,  including the effect of share-based compensation expense (3)                                              |       | $                                  | 8,534      |                               | $          | 7,309 |   | $ | 25,101 |   | $ | 19,783 |   |
| Diluted net  income per share - as reported for prior periods (1)                                                 |       | N/A                                |       | $                                  | 0.21       |   | N/A |   | $ | 0.56 |   |
| Diluted net income per  share, including the effect of share-based compensation expense (3)                            |       | $                                  | 0.18       |                               | $          | 0.15 |   | $ | 0.52 |   | $ | 0.40 |   |

 

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(1)             Net income and netincome per share did not include share-based compensation expense for employeestock options and employee stock purchases under SFAS No. 123 because theCompany did not adopt the recognition provisions of SFAS No. 123 prior toJanuary 1, 2006.

(2)             Share-basedcompensation expense prior to January 1, 2006 is calculated based on pro formainformation based on FAS 123.

(3)             Netincome and net income per share prior to January 1, 2006 represents pro formainformation based on FAS 123.

The results for the three and nine months endedSeptember 30, 2006 include share-based compensation expense of $5.3 million(excluding tax effects) and $15.0 million (excluding tax effects),respectively, in the following expense categories of the consolidated statementof income.
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
| Share-based  compensation in:                        |       |                             |       |                            |       |   |   |   |   |
| Cost of revenue                                      |       | $                                | 392        |                            | $          | — |   | $ | 1,088 |   | $ | — |   |
| Total share-based compensation in cost of revenue    |       | 392                              |       | —                          |       | 1,088 |   | — |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Selling and marketing                                |       | 2,204                            |       | —                          |       | 6,208 |   | — |   |
| Research and development                             |       | 927                              |       | —                          |       | 2,659 |   | — |   |
| General and administrative                           |       | 1,797                            |       | —                          |       | 5,077 |   | — |   |
| Total share-based compensation in operating expenses |       | 4,928                            |       | —                          |       | 13,944 |   | — |   |
| Total share-based  compensation                      |       | $                                | 5,320      |                            | $          | — |   | $ | 15,032 |   | $ | — |   |

 

At September 30, 2006, there was $66.0 millionof total unrecognized compensation cost related to share-based compensationarrangements granted under all equity compensation plans (excluding taxeffects). That total unrecognized compensation cost will be adjusted forestimated forfeitures as well as for future changes in estimated forfeitures.The Company expects to recognize that cost over a weighted average period ofapproximately 3 years.

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 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. The Company has never paid any cash dividendson its 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 thefollowing assumptions to estimate the fair value of stock options granted forthe three and nine months ended September 30, 2006 and 2005:
| ** **                          | ** ** | **Three Months Ended**   | ** ** | **Nine Months Ended**    | ** ** |
|-------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **September 30,   2006** | ** ** | **September 30,   2005** | ** ** | **September 30,   2006** | ** ** | **September 30,   2005** | ** ** |
| Average expected  life (years)      |       | 3.9                                |       | 5.0                                |       | 4.3 |   | 5.0 |   |
| Average expected  volatility factor |       | 47.54                              | %          | 37.87                              | %          | 54.61 | % | 42.79 | % |
| Average risk-free  interest rate    |       | 4.91                               | %          | 4.19                               | %          | 4.79 | % | 3.93 | % |
| Average expected  dividend yield    |       | —                             |       | —                             |       | — |   | — |   |

 

11

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The Company used thefollowing assumptions to estimate the fair value of the semi-annual employeestock purchase plan share grant during the nine months ended September 30, 2006and 2005:

|                                     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,  2006**    | ** ** | **September 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’sdetermination of fair value of share-based payment awards on the date of grantusing an option-pricing model is affected by the Company’s stock price as wellas assumptions regarding a number of complex and subjective variables. Thesevariables include, but are not limited to the Company’s expected stock pricevolatility over the term of the awards, and actual and projected employee stockoption exercise behaviors. Option-pricing models were developed for use inestimating the value of traded options that have no vesting or hedgingrestrictions and are fully transferable. Because the Company’s employee stockoptions have certain characteristics that are significantly different fromtraded options, and because changes in the subjective assumptions canmaterially affect the estimated value, in management’s opinion, the existingvaluation models may not provide an accurate measure of the fair value of theCompany’s employee stock options. Although the fair value of employee stockoptions is determined in accordance with SFAS No. 123(R) and SAB No. 107 usingan option-pricing model, that value may not be indicative of the fair valueobserved in a willing buyer/willing seller market transaction.

**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. On July 25,2006, the Company announced that its Board of Directors increased the size ofthe stock repurchase program by an additional 4 million shares, for a totalprogram size of up to 12 million shares. The repurchases will be made from timeto time on the open market at prevailing market prices or in privatelynegotiated transactions. Depending on market conditions and other factors,purchases under this program may commence or be suspended at any time, or fromtime to time, without prior notice. As of September 30, 2006, the Company hadrepurchased 8,170,060 shares of its common stock under this program, for anaggregate of $170.4 million at an average price of $20.86 per share.

As ofDecember 31, 2004, the Company retired all 2,012,000 shares of its common stockthat 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 the Company’s ConsolidatedBalance Sheet: treasury stock by $30.7 million, common stock by $0.1 million,additional paid-in capital by $6.4 million and retained earnings by $24.2million. There was no effect to the Company’s overall equity position as aresult of the retirement. The Company does not expect to retire shares of itscommon stock that it repurchased during 2005 or 2006 in the foreseeable future.

5.*Foreign Currency Hedges*

TheCompany uses derivatives to manage foreign currency risk and not forspeculative 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 from changes in the fair values of 

12

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those derivative instrumentswill be recorded to earnings or other comprehensive income depending on the useof the derivative instrument and whether it qualifies for hedge accounting. 

During 2005 and 2006, the Company utilized Euro foreign currency forward contracts to hedge anticipated Euro denominated accounts receivable. During 2005, the Company utilized British Pound foreign currency forward contracts to hedge anticipated operating expenses. During 2006, the Company utilized British Pound zero-cost collar contracts to hedge anticipated operating expenses. All such contracts entered into were designated as either fair value hedges or cash flow hedges and were considered effective, if applicable, as defined by SFAS No. 133,*Accounting for Derivative Instruments and Hedging Activities* (SFAS No. 133), as amended. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as fair value hedges settled during 2006 are included in other income, net, in the accompanying consolidated income statements and amounted to approximately $45,000 and $177,000 for the three and nine months ended September 30, 2006, respectively. There were no such gains or losses in 2005. Net realized gains related to the contracts designated as cash flow hedges settled during 2006 are included in the respective operating categories the Company hedges its British Pound expenditures against. These net realized gains amounted to approximately $57,000 and $106,000 for the three and nine months ended September 30, 2006, respectively. Net realized losses related to the contracts designated as cash flow hedges settled during 2005 are included in other income, net, in the accompanying consolidated income statements and amounted to approximately $43,000 and $114,000 for the three and nine months ended September 30, 2005, respectively.

Notional and fair values of the Company’s hedging position at September 30, 2006 and 2005 are presented in the table below (in thousands):
| ** **    | ** ** | **September 30, 2006**     | ** ** | **September 30, 2005** | ** ** |
|---------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**         | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,200      |                             | $          | 2,818 |   | $ | 2,841 |   | € | — |   | $ | — |   | $ | — |   |
| British Pound |       | £                               | 1,000      |                             | 1,871      |   | 1,858 |   | £ | 1,150 |   | 2,103 |   | 2,026 |   |
| Total         |       |                                 |       | $                                | 4,689      |   | $ | 4,699 |   |   |   | $ | 2,103 |   | $ | 2,026 |   |

 

Euroforward contracts at September 30, 2006 were designated as fair value hedgesand were not required to be tested for effectiveness as hedge accounting wasnot selected. All Euro contracts will be settled before November 30, 2006.Realized gains or losses related to the settlements, if any, will be recordedin other income, net at the time of settlement.

AllBritish Pound contracts were designated as cash flow hedges and were determinedeffective as of September 30, 2006 and 2005. All British Pound contracts willbe settled before December 31, 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 on Cash and Marketable Securities*

The Company’s interest on cash and marketablesecurities, included as a component of other income, net, is $2.8 million and$1.6 million for the three months ended September 30, 2006 and 2005, respectively.Interest on cash and marketable securities amounted to $8.3 million and $4.0million for the nine months ended September 30, 2006 and 2005, respectively.

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7. *Tax Matters*

From time to time, the Company is audited by variousstate, federal, and international authorities relating to tax matters. TheCompany’s audits are in various stages of completion; however, no outcome for aparticular audit can be determined with certainty prior to the conclusion ofthe audit and appeals process. Adjustments, if any, are appropriately recordedin the Company’s financial statements in the period they become probable andestimable. During the current quarter, the Company received a favorable IRS privateletter ruling related to the tax treatment of stock options. In addition, theCompany settled its UK income tax audit resulting in a reversal of previouslyrecorded tax contingency reserves.

*8. Legal Proceedings*

 

On September 24, 2006, Jason Tauber filed a purportedclass action against the Company and other unidentified individuals inCalifornia Superior Court for the County of San Diego, captioned *Tauber v. Websense*. The complaint alleges that the plaintiff and a putative class of certainsoftware engineers and computer professionals who worked for the Company asexempt employees during the period from September 15, 2002 through the presentshould have been classified as non-exempt employees under California law andshould have been paid for overtime.  Thecomplaint also alleges related wage and hour violations of the California LaborCode arising from the alleged misclassification and that the failure to payovertime constitutes an unfair business practice under California Business andProfessions Code § 17200.  The complaintseeks unspecified damages for unpaid overtime, prejudgment interest, attorneys’fees and other costs, statutory penalties for alleged violations, and otherproper relief.  The case is at a veryearly stage and discovery has not commenced. The Company denies all material allegations and intends to defend theaction vigorously.

The Company is involved in various legal actions inthe normal course of business.  Based oncurrent information, including consultation with the Company lawyers, theCompany believes that any ultimate liability that may result from theseactions, including *Tauber v. Websense*,would not materially affect the Company’s consolidated financial positions,results of operation or cash flows.  TheCompany’s evaluation of the likely impact of these actions could change in thefuture and unfavorable outcomes and/or defense costs, depending upon the amountand timing, could have a material adverse effect on the Company’s results ofoperations or cash flows in a future period.

9. *Recently Issued Accounting Standards*

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 derecognition, 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.

In September 2006, the FASBissued SFAS No. 157 *Fair Value Measurement*(SFAS No. 157), which provides guidance for using fair value to measure assetsand liabilities. In addition, SFAS No. 157 also provides guidance for expandedinformation about the extent to which companies measure assets and liabilitiesat fair value, the information used to measure fair value, and the effect offair value measurements on earnings. SFAS No. 157 applies whenever otherstandards require (or permit) assets or liabilities to be measured at fairvalue, but does not expand the use of fair value in any new circumstances. Theaccounting provisions of SFAS No. 157 will be effective for the Companybeginning January 1, 2008. The Company is in the process of determining theeffect the adoption of SFAS No. 157 will have on its financial statements.

In September 2006, the SEC released Staff AccountingBulletin No. 108 (SAB No. 108), *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*. SAB No. 108 provides interpretive guidance onthe SEC’s views regarding the process of quantifying materiality of financialstatement misstatements. SAB No. 108 is effective for fiscal years endingafter November 15, 2006, with early application for the first interimperiod ending after November 15, 2006. The Company does not believe theapplication of SAB No. 108 will have a material effect on the results ofits financial statements.

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

**The following discussion andanalysis should be read in conjunction with the financial statements andrelated notes contained elsewhere in this report. See “Risk Factors” under PartII, Item 1A below regarding certain factors known to us that could causereported financial information not to be necessarily indicative of futureresults.**

**Forward Looking Statements**

**Thisreport on Form 10-Q may contain “forward-looking statements” within the meaningof the federal securities laws made pursuant to the safe harbor provisions ofthe Private Securities Litigation Reform Act of 1995. These statements, whichrepresent our expectations or beliefs concerning various future events, maycontain words such as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,”“believes,” “estimates,” or other words indicating future results. Suchstatements may include but are not limited to statements concerning thefollowing:**

·                  anticipated trends in revenue;

·                  growth opportunities in domestic andinternational markets;

·                  new and enhanced channels ofdistribution;

·                  customer acceptance and satisfactionwith our products;

·                  expected trends in operating andother expenses;

·                  anticipated cash and intentionsregarding usage of cash;

·                  changes in effective tax rates; and

·                  anticipatedproduct enhancements or releases.

**These forward-looking statementsare subject to risks and uncertainties, including those risks and uncertaintiesdescribed herein under Part II, Item 1A “Risk Factors”, that could cause actualresults to differ materially from those anticipated as of the date of this report.We assume no obligation to update any forward-looking statements to reflectevents or circumstances arising 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® software application,which serves as a central policy engine and management and reporting consoleand enables the extended functionality of our add-on products.  Websense Enterprise gives organizations theability to enhance network security, improve employee productivity, mitigatepotential legal liability and conserve network bandwidth by allowingorganizations to identify potential risk areas and implement Web access andapplication usage policies that reduce these risks. Over the past 10 years, ourproducts have evolved from software that prevents employees from downloadingunacceptable content to products that prevent employee access to the mostundesirable and dangerous elements on the Internet, such as Websites thatcontain or will download viruses, spyware, keyloggers, phishing exploits and anever-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 Webfiltering and Web security solutions. Websense Enterprise and WebsenseEnterprise — Corporate EditionTM are our core Web filtering solutions, providingfully featured Web filtering and serving as management platforms for relatedWebsense add-on modules, such as our Security Filtering, Real Time SecurityUpdatesTM, Bandwidth OptimizerTM, Client Policy ManagerTM and Remote Filtering. Wehave also created suites of some of our products to address specific customerneeds, such as the Websense Web Security SuiteTM and Websense Web Security Suite—**

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**Lockdown EditionTM.  We currently derive all of our revenue fromsubscriptions to the Websense Enterprise-based solutions and expect this tocontinue in the future as more offerings are added to the Websense Enterpriseplatforms. **

**In October 2005, we announced anagreement with Nortel Networks to develop a mobile Web content filteringsolution to protect wireless Internet users from receiving and accessingunwanted content. Throughout 2006, we have engaged in development for mobilefiltering products with several third parties, and we expect to close our firsttransactions for the mobile filtering product in 2007.**

**During the nine months endedSeptember 30, 2006, we derived approximately 37% of revenue from internationalsales, compared with 33% for the nine months ended September 30, 2005, with theUnited Kingdom comprising approximately 10% of our total revenue in bothperiods. We believe international markets continue to represent a significantgrowth opportunity and we are continuing to expand our international operations,particularly in selected countries in the European, Asia/Pacific and LatinAmerican markets.**

**We sell Websense Enterprisethrough both indirect channels and directly, and are transitioning to a twotier distribution strategy in North America. Sales through indirect channelscurrently account for more than 80% of our revenue, and we plan to increase thepercentage of our revenue obtained through indirect channels. Our strategy isto increase new and renewal customer sales through independent softwaredistributors and resellers and increase the focus of our internal sales andmarketing force on supporting our channel strategy. As a result, we expect toincrease the proportion of our sales made through indirect channels.  On August 4, 2006, we announced that IngramMicro will distribute, market and support our Web security and Web filteringsoftware for our two tier distribution strategy in North America.  Ingram Micro will also focus its efforts onrecruiting new resellers and building awareness and demand within our existingNorth America channel partner base.  Thenew program is also intended to expand our presence in the growing small andmedium business Web filtering market.**

**As described elsewhere in thisreport, we recognize revenue from subscriptions to Websense Enterprise,including add-on modules, on a monthly straight-line basis over the term of thesubscription. We recognize the operating expenses related to these sales as theyare incurred. These operating expenses include sales commissions, which arebased on the total amount of the subscription contract and are fully expensedin the period the product is delivered. Operating expenses have continued toincrease as compared with prior periods due to expanded selling and marketingefforts, continued product research and development and investments inadministrative infrastructure to support subscription sales that we willrecognize as revenue in subsequent periods.**

**Critical Accounting Policies**

**We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our consolidated financial statements.**

***RevenueRecognition.***When a purchase decision is madefor Websense Enterprise, customers enter into a subscription agreement, whichis generally 12, 24 or 36 months in duration and for a fixed number of users.Other services such as upgrades/enhancements and standard post-contracttechnical support services are sold together with Websense Enterprise andprovided throughout the subscription term. We recognize revenue on a monthlystraight-line basis, commencing with the month the subscription begins, overthe term of the subscription agreement, provided collectibility is reasonablyassured. Upon entering into a subscription arrangement for a fixed ordeterminable fee, we electronically deliver access codes to users and thenpromptly invoice customers for the full amount of their subscriptions. Paymentis due for the full term of the subscription, generally within 30 to 60 days ofthe invoice. We record amounts billed to customers in excess of recognizablerevenue as deferred revenue on our balance sheet. Upon expiration of thesubscription, customers who wish to re-subscribe typically must do so at thethen current rates to continue using Websense Enterprise. Our revenue issignificantly influenced by new and renewal subscriptions, and a decrease insubscription amounts could negatively impact our future revenue.

*Accounting for Share-Based Compensation.*Through December 31, 2005, we accounted forshare-based employee compensation plans under the measurement and recognitionprovisions of

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Accounting Principles Board (APB) No. 25 (APB No. 25), and relatedInterpretations, as permitted by Financial Accounting Standards Board(FASB) SFAS No. 123 *Accounting for Stock-BasedCompensation* (SFAS No. 123). Accordingly, we recorded no share-basedemployee compensation expense for options granted under our Amended andRestated 2000 Stock Incentive Plan (2000 Plan) or predecessor plans (or optionsgranted as non-plan inducement options) during the nine months ended September30, 2005 as all other options granted had exercise prices equal to the fairmarket value of the common stock on the date of grant. We also recorded nocompensation expense in connection with the Employee Stock Purchase Plan as thepurchase price of the stock was not less than 85% of the lower of the fairmarket value of the common stock at the beginning of each offering period or atthe end of each 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 orloss and net income or loss per share as if the fair value-based method wasapplied in measuring compensation expense 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 nine monthsended September 30, 2006 include share-based compensation expense of $15.0million (excluding tax effects). Compensation expense related to share-basedawards is generally amortized over the vesting period in the related expensecategories of the consolidated statement of income.

At September 30, 2006, there was $66.0 millionof total unrecognized compensation cost related to share-based compensationarrangements granted under all equity compensation plans (excluding taxeffects). That total unrecognized compensation cost will be adjusted forestimated forfeitures as well as for future changes in estimated forfeitures.We expect to recognize that cost over a weighted average period ofapproximately 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.

Wedetermine the fair value of share-based payment awards on the date of grantusing an option-pricing model that is affected by our stock price as well asassumptions regarding a number of complex and subjective variables.  These variables include, but are not limitedto our expected stock price volatility over the term of the awards, and actualand projected employee stock option exercise behaviors.  Option-

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pricing models were developed for use in estimating the value of tradedoptions that have no vesting or hedging restrictions and are fullytransferable.  Because our employee stockoptions have certain characteristics that are significantly different fromtraded options, and because changes in the subjective assumptions canmaterially affect the estimated value, in management’s opinion, the exitingvaluation models may not provide an accurate measure of the fair value of ouremployee stock options.  Although thefair value of employee stock options is determined in accordance with SFAS No.123(R) and SAB No. 107 using an option-pricing model, that value may not beindicative of the fair value observed in a willing buyer/willing seller markettransaction.

*Deferred Tax Assets.* Asrequired by SFAS No. 109, we recognize tax assets on the balance sheet if it is“more likely than not” that they will be realized on future tax returns.  At September 30, 2006, we had deferred taxassets of $26.0 million.  We believe thatit is more likely than not that our deferred tax assets will be realized.Factors considered by us included: our earnings history, projected earningsbased on current operations, and projected future taxable income. However,should we determine that we would not be able to realize all or part of ourdeferred tax assets in thefuture, an adjustment to thedeferred tax assets would be charged against income in the period such determinationwas 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 of applicablestatutes of limitations, conclusion of tax audits, additional exposure based oncurrent calculations, identification of new issues or rendering of courtdecisions affecting a particular tax issue. Tax reserve contingencies andchanges to the reserves are evaluated and recorded in our tax provision in theperiod in which the above noted events occur. During the current quarter,the Company received a favorable IRS private letter ruling related to the taxtreatment of stock options that had a positive impact on the tax provision. Inaddition, the Company settled its UK income tax audit resulting in the reversalof previously recorded tax contingency reserves.

***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.

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# **Results of Operations**

***Three months ended September 30, 2006 compared with thethree months ended September 30, 2005***

Thefollowing table summarizes our operating results as a percentage of total revenuefor each of the periods shown.

|                             | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005** | ** ** |
| ** **                  | ** ** | **(Unaudited)**                  | ** ** |
|                        |       |                             |       |   |   |
| Revenue                     |       | 100                              | %          | 100 | % |
|                        |       |                             |       |   |   |
| Cost of revenue             |       | 8                                | *          | 7 |   |
|                        |       |                             |       |   |   |
| Gross margin                |       | 92                               |       | 93 |   |
|                        |       |                             |       |   |   |
| Operating expenses:         |       |                             |       |   |   |
| Selling and marketing       |       | 46                               | *          | 36 |   |
| Research and development    |       | 13                               | *          | 11 |   |
| General and administrative  |       | 12                               | *          | 8 |   |
| Total operating expenses    |       | 71                               | *          | 55 |   |
|                        |       |                             |       |   |   |
| Income from  operations     |       | 21                               | *          | 38 |   |
|                        |       |                             |       |   |   |
| Other income,  net          |       | 6                                |       | 4 |   |
|                        |       |                             |       |   |   |
| Income before  income taxes |       | 27                               | *          | 42 |   |
|                        |       |                             |       |   |   |
| Provision for  income taxes |       | 8                                |       | 16 |   |
|                        |       |                             |       |   |   |
| Net income                  |       | 19                               | %*         | 26 | % |

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* Includes share-based compensation expense. Totalshare-based compensation was $5.3 million, or 12% of revenue, for the threemonths ended September 30, 2006.

# **Revenue**

# Revenue increasedto $46.1 million in the third quarter of 2006, from $38.3 million in the thirdquarter of 2005. The increase was primarily a result of the addition of new,renewed and upgraded subscriptions from our customers that resulted in a 2.1million increase in the number of seats under subscription from September 30,2005 to September 30, 2006. Approximately 67% of subscription revenuerecognized in the third quarter of 2006 was derived from renewal businesscompared to 65% in the third quarter of 2005. We expect our fourth quarter revenue to increase over the fourth quarterof 2005, as a result of our renewal business, international growth and growthof new business.

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# **Cost ofRevenue**

Cost of revenue consistsof the costs of content review, technical support and infrastructure costsassociated with maintaining our databases. Cost of revenue increased to $3.9million in the third quarter of 2006, from $2.8 million in the third quarter of2005. The increase of $1.1 million was due to the costs associated withshare-based compensation expense relating to our adoption of SFAS No. 123(R) onJanuary 1, 2006, as well as additional personnel in our technical support anddatabase groups and allocated costs. We allocate the total costs for humanresources, employee benefits, payroll taxes, information technology,facilities, fixed asset depreciation and legal costs to each of our functionalareas based on salaries and headcount data. We expect cost of revenue toincrease in the future due to share-based compensation expense and to supportthe growth and maintenance of our databases as well as the technical supportneeds of our customers. As a percentage of revenue, cost of revenue increasedto 8% during the third quarter of 2006 from 7% in 2005. We expect that cost ofrevenue, as a percentage of revenue, will remain below 10% of revenue for theforeseeable future.

#  

# **GrossMargin**

Gross margin increased to$42.2 million in the third quarter of 2006, from $35.5 million in the thirdquarter of 2005. The increase was due to increased revenue. As a percentage ofrevenue, gross margin decreased to 92% in the third quarter of 2006 from 93% inthe third quarter of 2005. We expect that gross margin, as a percentage ofrevenue, will remain in excess of 90% of revenue for the foreseeable future.

#  

# **Operating Expenses**

*Sellingand marketing*. Selling and marketing expenses consistprimarily of salaries, commissions and benefits related to personnel engaged inselling, marketing and customer support functions, including our channelpartner and distribution programs, along with costs related to publicrelations, advertising, promotions and travel as well as allocated costs.Selling and marketing expenses increased to $21.3 million in the third quarterof 2006, from $13.8 million in the third quarter of 2005. The increase inselling and marketing expenses of $7.5 million was due to share-basedcompensation expenses relating to our adoption of SFAS No. 123(R) on January 1,2006, as well as additional expenses associated with our new channel strategy, increasedpersonnel costs and related travel, and allocated costs. We expect selling andmarketing expenses to increase in absolute dollars in the future drivenprimarily by share-based compensation expense and as more personnel are addedto support our expanding selling and marketing efforts worldwide and asincreased sales result in higher overall sales commission expenses.

* *

*Researchand development.* Researchand development expenses consist primarily of salaries and benefits forsoftware developers and allocated costs. Research and development expensesincreased to $6.0 million in the third quarter of 2006, from $4.1 million inthe third quarter of 2005. The increase of $1.9 million in research anddevelopment expenses was due to share-based compensation expense relating to ouradoption of SFAS No. 123(R) on January 1, 2006, as well as increasedpersonnel needed to support our expanding list of technology partners, theenhancements of Websense Enterprise and additional products, and allocatedcosts. We expect research and development expenses to increase in absolutedollars in future periods driven primarily by share-based compensation expenseand as more personnel are added to support our continued enhancements of ourproducts as well as the development of new products.

 

*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 $5.5 million in the third quarter of 2006, from $3.1million in the third quarter of 2005. The $2.4 million increase in general andadministrative expenses was primarily a result of share-based compensationexpense

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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 expensesassociated with being a public company and expansion of our internationaloperations.

# **OtherIncome, Net**

Other income, netincreased to $2.8 million in the third quarter of 2006, from $1.5 million inthe third quarter of 2005. The increase was due primarily to higher interestrates realized on our increased balances of cash, cash equivalents andmarketable securities as of September 30, 2006 compared with September 30,2005. The majority of our investments of cash and cash equivalents andmarketable securities are tax-exempt. We expect that the majority of our cashand cash equivalents and marketable securities will continue to be held intax-exempt investments during the foreseeable future.

#  

# **Provisionfor Income Taxes**

In the third quarter of2006, United States and foreign income tax expense was $3.6 million, comparedto $5.9 million for the third quarter of 2005. The effective income tax rate decreased to 30% in the third quarter of2006 from 37% in the third quarter of 2005. The decrease in the tax rate isprimarily related to a favorable IRS private letter ruling related to the taxtreatment of stock options. In addition, we settled our UK income tax auditresulting in a reversal of previously recorded tax contingency reserves. 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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***Nine months ended September 30, 2006 compared with the ninemonths ended September 30, 2005***

Thefollowing table summarizes our operating results as a percentage of totalrevenue for each of the periods shown.

|                             | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **September 30,  2006**    | ** ** | **September 30,  2005** | ** ** |
| ** **                  | ** ** | **(Unaudited)**                 | ** ** |
|                        |       |                            |       |   |   |
| Revenue                     |       | 100                             | %          | 100 | % |
|                        |       |                            |       |   |   |
| Cost of revenue             |       | 8                               | *          | 7 |   |
|                        |       |                            |       |   |   |
| Gross margin                |       | 92                              |       | 93 |   |
|                        |       |                            |       |   |   |
| Operating  expenses:        |       |                            |       |   |   |
| Selling and marketing       |       | 44                              | *          | 37 |   |
| Research and development    |       | 13                              | *          | 11 |   |
| General and administrative  |       | 12                              | *          | 8 |   |
| Total operating expenses    |       | 69                              | *          | 56 |   |
|                        |       |                            |       |   |   |
| Income from  operations     |       | 23                              | *          | 37 |   |
|                        |       |                            |       |   |   |
| Other income,  net          |       | 6                               |       | 3 |   |
|                        |       |                            |       |   |   |
| Income before  income taxes |       | 29                              | *          | 40 |   |
|                        |       |                            |       |   |   |
| Provision for  income taxes |       | 10                              |       | 14 |   |
|                        |       |                            |       |   |   |
| Net income                  |       | 19                              | %*         | 26 | % |

 

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*                    Includesshare-based compensation expense. Total share-based compensation was $15.0million, or 11% of revenue, for the nine months ended September 30, 2006.

# **Revenue**

Revenueincreased to $132.7 million in the first nine months of 2006, from $108.5million in the first nine months of 2005. The increase was primarily a resultof the addition of new, renewed and upgraded subscriptions from our customers.Approximately 65% of subscription revenue recognized in the first nine monthsof 2006 and 2005 was derived from renewal business.

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# ** **

# **Cost ofRevenue**

Cost of revenueincreased to $11.0 million in the first nine months of 2006, from $7.8 millionin the first nine months of 2005. The increase of $3.2 million was due to thecosts associated with share-based compensation expense relating to our adoptionof SFAS No. 123(R) on January 1, 2006, as well as additional personnel in ourtechnical support and database groups and allocated costs. We allocate thetotal costs for human resources, employee benefits, payroll taxes, informationtechnology, facilities, fixed asset depreciation and legal costs to each of ourfunctional areas based on salaries and headcount data. As a percentage ofrevenue, costs of revenue increased to 8% during the first nine months of 2006from 7% in 2005.

# **GrossMargin**

Gross margin increased to$121.7 million in the first nine months of 2006, from $100.7 million in thefirst nine months of 2005. The increase was due to increased revenue. As apercentage of revenue, gross margin decreased to 92% in the first nine monthsof 2006 from 93% in the first nine months of 2005.

#  

# **Operating Expenses**

*Sellingand marketing*. Selling and marketing expenses increased to$58.2 million in the first nine months of 2006, from $40.0 million in the firstnine months of 2005. The increase in selling and marketing expenses of $18.2million was due to share-based compensation expenses relating to our adoptionof SFAS No. 123(R) on January 1, 2006, as well as additional expensesassociated with our new channel strategy, increased personnel costs and relatedtravel, and allocated costs.

*Researchand development.* Researchand development expenses increased to $16.9 million in the first nine months of2006, from $12.1 million in the first nine months of 2005. The increase of $4.8million in research and development expenses was primarily a result ofshare-based compensation expense relating to our adoption of SFAS No. 123(R) onJanuary 1, 2006, as well as increased personnel needed to support ourexpanding list of technology partners, the enhancements of Websense Enterpriseand additional products, and allocated costs.

* *

*Generaland administrative*. General and administrative expensesincreased to $16.0 million in the first nine months of 2006, from $9.0 millionin the first nine months of 2005. The $7.0 million increase in general andadministrative expenses was primarily a result of share-based compensation expenserelating to our adoption of SFAS No. 123(R) on January 1, 2006, as well asadditional personnel needed to support our growing operations and allocatedcosts.

# ** **

# **OtherIncome, Net**

Other income, netincreased to $8.2 million in the first nine months of 2006, from $3.7 millionin the first nine months of 2005. The increase was due primarily to higherinterest rates realized on our increased balances of cash, cash equivalents andmarketable securities as of September 30, 2006 compared with September 30,2005. The majority of our investments of cash and cash equivalents andmarketable securities are tax-exempt.

# ** **

# **Provisionfor Income Taxes**

In the first nine monthsof 2006, United States and foreign income tax expense decreased to $13.7million compared to $15.7 million in the first nine months of 2005. Theeffective income tax rate decreased to 35% in the first nine months of 2006from 36% in the first nine months of 2005. The decrease in the tax rate isprimarily related to the settlement of a UK tax audit resulting in the reversalof a previously recorded tax contingency reserve, a higher percentage ofinternational income subject to lower tax rates, and an increase in tax exemptinterest income. The decrease in the tax rate was partially offset by thenon-availability for tax deduction of certain share-based compensation expensesunder SFAS No. 123(R).

 

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** **

**Liquidity and Capital Resources**

As of September 30, 2006, we had cash and cashequivalents of $46.0 million, investments in marketable securities of $254.3million and retained earnings of $81.6 million. As of December 31, 2005, we hadcash and cash equivalents of $61.6 million, investments in marketable securitiesof $258.8 million and retained earnings of $56.4 million.

**Net cashprovided by operating activities was $61.6 million in the first nine months of2006, compared with $73.5 million in the first nine months of 2005. The $11.9million decrease in cash provided by operating activities in the first ninemonths of 2006 was primarily due to decreased growth in deferred revenue(subscription amounts in excess of recognizable revenue are recorded asdeferred revenue) compared to the first nine months of 2005. Our operating cashflow is significantly influenced by subscription renewals and accountsreceivable collections, and deferred revenue. A decrease in subscription renewals or accounts receivable collections,or a lower deferred revenue balance, would negatively impact our operating cash flow.**

Net cash provided by investing activities was $0.6million in the first nine months of 2006, compared with net cash used ininvesting activities of $53.2 million in the first nine months of 2005. The$53.8 million increase of net cash provided by investing activities for thefirst nine months of 2006 was primarily due to fewer purchases to offset thematurities and sales of marketable securities.

Net cash used by financing activities was $77.7million in the first nine months of 2006, compared with net cash used byfinancing activities of $27.5 million in the first nine months of 2005. The$50.2 million increase in net cash used by financing activities in the firstnine months of 2006 was primarily due to share repurchases of 4,300,000 sharesof our common stock for $91.4 million in the first nine months of 2006,compared with 1,658,060 shares for $41.9 million in the first nine months of2005, and fewer proceeds from exercises of employee stock options.

We have an operating lease commitment of approximately$0.5 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 September 30, 2006 are as follows (in thousands):

|        | ** ** | **Operating  Leases** | ** ** |
|--------|------------|-----------------------|------------|
| 2006   |       | $                     | 479        |   |
| 2007   |       | 1,937                 |       |
| 2008   |       | 325                   |       |
|   |       | $                     | 2,741      |   |

 

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As of September 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 contractually narrow or limited purposes. As such,we are not exposed to any financing, liquidity, market or credit risk thatcould 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. Repurchasesmay be made from time to time on the open market at prevailing market prices orin privately negotiated transactions. Depending on market conditions and otherfactors, purchases under this program may be commenced or suspended at anytime, or from time to time, without prior notice. As of September 30, 2006, wehad repurchased 8,170,060 shares of our common stock under this program, for anaggregate of $170.4 million at an average price of $20.86 per share.

Asof December 31, 2004, we retired all 2,012,000 shares of our common stock thathad been repurchased prior to that date. In accordance with APB 6, *Status of AccountingResearch Bulletins*, the treasury stock retirement was effected byreducing the following on our Consolidated Balance Sheet:  treasury stock by $30.7 million, common stockby $0.1 million, additional paid-in capital by $6.4 million and retainedearnings by $24.2 million. There was no effect to our overall equity positionas a result of the retirement.  We do notexpect to retire shares of our common stock that we repurchased during 2005 or2006 in the foreseeable future.

We believe that our cash and cash equivalents balances, investments in marketable securities and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures and stock repurchases, if any, for at least the next 12 months.  Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements.  We may elect to raise funds for these purposes through capital markets transactions or debt or private equity transactions as appropriate.  We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

**Off-Balance Sheet Arrangements**

As of September 30, 2006, we did not have any material off-balance sheet arrangements as defined in Regulation S-K Item 303 (a)(4).

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**Item 3. Quantitative andQualitative Disclosures About Market Risk**

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

**We are exposed to changes in interest rates primarily fromour short-term available-for-sale investments. Under our current policies, wedo not use interest rate derivative instruments to manage exposure to interestrate changes. A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not materially affect the fairvalue of our interest sensitive financial instruments at September 30, 2006.Changes in interest rates over time will, however, affect our interest income.**

Weutilize foreign currency forward contracts and zero-cost collar contracts tohedge foreign currency market exposures of underlying assets andliabilities.  In April 2005, we beganbilling customers in Euro-denominated countries in the Euro.  In addition, working funds necessary tofacilitate the short-term operations of our subsidiaries are kept in the localcurrencies in which they do business. Our objective is to reduce the risk toearnings and cash flows associated with changes in foreign currency exchangerates. We do not use foreign currency contracts for speculative or tradingpurposes.

Notional and fair values of our hedging positions at September 30, 2006 and 2005 are presented in the table below (in thousands):

|               | ** ** | **September 30, 2006**     | ** ** | **September 30, 2005** | ** ** |
|---------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**         | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,200      |                             | $          | 2,818 |   | $ | 2,841 |   | € | — |   | $ | — |   | $ | — |   |
| British Pound |       | £                               | 1,000      |                             | 1,871      |   | 1,858 |   | £ | 1,150 |   | 2,103 |   | 2,026 |   |
| Total         |       |                                 |       | $                                | 4,689      |   | $ | 4,699 |   |   | ** ** | $ | 2,103 | ** ** | $ | 2,026 | ** ** |

 

The $2.8 million notional increase in ourEuro hedged position is primarily due to increased Euro-based billings ofcustomers in Euro-denominated countries. All of the Euro hedging contracts willbe settled before November 30, 2006.  Forboth the three and nine months ended September 30, 2006, less than  15% of our total billings were denominated inthe Euro. We do not expect foreign currency billings to represent more than 15%of our total billings during 2006.

**The $0.2 million notionaldecrease in our British Pound hedged position is primarily due to a decrease inthe percentage of working funds hedged. All of the British Pound hedgingcontracts will be settled before December 31, 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 exchange position, a 10% change in foreign exchangerates upon which these foreign exchange contracts are based would result inexchange gains and losses. In all material aspects, these exchange gains andlosses would be fully offset by exchange gains and losses on the underlying netmonetary exposures for which the contracts are designated as hedges. We do notexpect material exchange rate gains and losses from unhedged foreign currencyexposures.**

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**Item 4. Controls and 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 these controlsand procedures are effective as of the end of the period covered by thisQuarterly Report.

**Changes In Internal Control Over Financial Reporting**

There have been no significantchanges in our internal control over financial reporting or in other factorsthat could significantly affect our internal control over financial reporting,including any corrective actions with regard to significant deficiencies andmaterial weaknesses, during the period covered by this Quarterly Report.

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**Part II - Other Information**

** **

**Item 1. LegalProceedings**

 

On September 24, 2006, Jason Tauberfiled a purported class action against us and other unidentified  individuals in California Superior Court forthe County of San Diego, captioned *Tauber v. Websense*.  The complaint alleges that the plaintiff anda putative class of certain software engineers and computer professionals whoworked for us as exempt employees during the period from September 15, 2002through the present should have been classified as non-exempt employees underCalifornia law and should have been paid for overtime.  The complaint also alleges related wage andhour violations of the California Labor Code arising from the allegedmisclassification and that the failure to pay overtime constitutes an unfairbusiness practice under California Business and Professions Code § 17200.  The complaint seeks unspecified damages for unpaidovertime, prejudgment interest, attorneys’ fees and other costs, statutorypenalties for alleged violations, and other proper relief.  The case is at a very early stage anddiscovery has not commenced.  We deny allmaterial allegations and intend to defend the action vigorously.

 

We are involved in various legal actions in the normal courseof business.  Based on currentinformation, including consultation with our lawyers, we believe that anyultimate liability that may result from these actions, including *Tauber v. Websense*, would not materially affect ourconsolidated financial positions, results of operation or cash flows.  Our evaluation of the likely impact of theseactions could change in the future and unfavorable outcomes and/or defensecosts, depending upon the amount and timing, could have a material adverseeffect on our results of operations or cash flows in a future period.

 

**Item 1A. Risk Factors**

 

You should carefullyconsider the following information in addition to other information in thisreport before you decide to purchase our common stock.  The risks and uncertanties described beloware those that we currently deem to be material and that we believe arespecific to our company and our industry. In addition to these risks, our business may be subject to riskscurrently unknown to us.  If any of theseor other risks actually occur, our business may be adversely affected, thetrading price of our common stock could decline, and you may lose all or partof your investment in Websense.

 

We have marked with anasterisk (*) those risk factors that reflect changes from the risk factorsincluded in our Annual Report on Form 10-K filed with the Securities andExchange Commission on March 3, 2006.

 

*Our future success depends on our abilityto sell new, renewal and upgraded subscriptions to Websense Enterprise and therelated add-on products.**

 

All of our revenue comes from newand renewal subscriptions to Websense Enterprise and its related add-onproducts, and we expect this trend to continue through mid-2007 when we plan tolaunch an OEM data leakage product with Port Authority, Inc. Even after suchtime, we anticipate subscriptions to Websense Enterprise and related productswill account for the significant majority of our revenues in the foreseeablefuture. If Websense Enterprise or the add-on products**fail to meet the needs of our existing and targetcustomers, or if they do not compare favorably in price and performance tocompeting products, our operating results and our business will besignificantly impaired. If we cannot sufficiently increase our customer basewith the addition of new customers, we will not be able to grow our business tomeet expectations.

 

Subscriptions for WebsenseEnterprise typically have durations of 12, 24 or 36 months. Our customers haveno obligation to renew their subscriptions upon expiration. In order tomaintain our revenue we must be successful in selling renewal subscriptions andin selling further subscriptions to existing customers in order to addadditional seats or product offerings within their respective organizations.This may require increasingly costly sales efforts targeting senior managementand other

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management personnel associated with our customers’ Internetand security infrastructure. We may not be able to maintain or continue togenerate increasing revenue from existing customers.

 

*Failure of our add-on products,particularly our security products, to achieve more widespread marketacceptance will seriously harm our business.**

 

Our future financial performancedepends on our ability to diversify our offerings by successfully developing,introducing and gaining customer acceptance of our new products and services,particularly our security offerings. We currently have two platforms for ourcore software, Websense Enterprise and Websense Enterprise—Corporate Edition.We also sell a number of add-on products such as Security Filtering, RemoteFiltering, Client Policy Manager, Real-Time Security Updates and BandwidthOptimizer. In addition, we have developed security services that we includewithin our Websense Web Security Suites, such as ThreatWatcher, BrandWatcherand SiteWatcher. We may not be successful in achieving market acceptance ofthese or any new products that we develop or of enhanced versions of WebsenseEnterprise. Moreover, our recent increased emphasis on the development,marketing and sale of our security offerings could distract us from sales ofour core Websense Enterprise offering, negatively impacting our overall sales.Any failure or delay in diversifying our existing offerings, or diversificationat the detriment to our core Websense Enterprise offering, could harm ourbusiness, results of operations and financial condition.

 

*We face increasing competition,which places pressure on our pricing and which could prevent us from increasingrevenue or maintaining profitability. In addition, as we increase our emphasison our security-oriented products, we face competition from better-establishedsecurity companies that have significantly greater resources.**

 

The market for our products isintensely competitive and is likely to become even more so in the future,within both the Web filtering market as well as the Web security market. Ourcurrent principal Web filtering competitors frequently offer their products ata significantly lower price than our products, which has resulted in pricingpressures on sales of our product and potentially could result in thecommoditization of Web filtering products. We also face current and potentialcompetition from vendors of Internet servers, operating systems and networkinghardware, many of which now, or may in the future, develop and/or bundle Webfiltering or other competitive products with their products. If we are unableto maintain the current pricing on sales of our products or increase ourpricing in the future, our profitability could be negatively impacted. Even ifour products provide greater functionality and are more effective than certainother competitive products, potential customers might accept this limitedfunctionality in lieu of purchasing our products. In addition, our own indirectsales channels may decide to develop or sell competing products instead of ourproducts. Pricing pressures and increased competition generally could result inreduced sales, reduced margins or the failure of our products to achieve ormaintain more widespread market acceptance, any of which could have a materialadverse effect on our business, results of operations and financial condition.Our current principal competitors include:

 

·                  companiesoffering Web filtering products, such as SurfControl, Secure Computing,Symantec, Digital Arts, Computer Associates, Microsoft, St. Bernard Software, Finjan,Barracuda, ScanSafe, and Trend Micro;

·                  companiesintegrating Web filtering into specialized security appliances, such as 8e6Technologies, Blue Coat Systems, Cisco Systems, McAfee and SonicWALL;

·                  companiesoffering Web security solutions, such as McAfee, Microsoft, Symantec, JuniperNetworks, Message Labs and Trend Micro; 

·                  companiesoffering desktop security solutions such as Check Point Software, CiscoSystems, McAfee, Microsoft and Symantec; and

 

·                  companiesoffering proxy based solutions such as Blue Coat Systems and IronPort.

 

As we develop and market ourproducts with an increasing security-oriented emphasis, we also face increasingcompetition from security solutions providers. Many of our competitors withinthe Web security market, such as Symantec Corporation, McAfee, Inc., TrendMicro, Cisco Systems and Microsoft Corporation enjoy substantial competitiveadvantages, including:

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·                  greatername recognition and larger marketing budgets and resources;

 

·                  establishedmarketing relationships and access to larger customer bases; and

 

·                  substantiallygreater financial, technical and other resources.

 

As a result, we may be unable togain sufficient traction as a provider of Web security solutions, and ourcompetitors may be able to respond more quickly and effectively than we can tonew or changing opportunities, technologies, standards or customerrequirements. In addition, current and potential competitors have establishedor may establish cooperative relationships among themselves or with thirdparties to increase the functionality of their products to address customerneeds. Accordingly, new competitors or alliances among competitors may emergeand rapidly acquire significant market share. For all of the foregoing reasons,we may not be able to compete successfully against our current and futurecompetitors.

 

*The market for our productscontinues to emerge, and if we are not successful in promoting awareness of theneed for our products and of our Websense brand, our growth may be limited.*

 

Based on our experience withpotential customers, we believe that many corporations do not recognize oracknowledge the existence or scope of problems caused by misuse or abuse of theInternet or of network computers. In addition, there may be a time-limitedopportunity to achieve and maintain a significant share of the market for Websecurity solutions due in part to the emerging nature of these markets and thesubstantial resources available to our existing and potential competitors. Ifemployers do not recognize or acknowledge the problems associated withunrestricted employee access to the Internet, the gaps in their traditionalsecurity infrastructures and the ability of Websense security products toprovide an additional layer of protection, then the market for our products maydevelop more slowly than we expect, which could adversely affect our operatingresults. Developing and maintaining awareness of our Websense brand is criticalto achieving widespread acceptance of our existing and future products.Furthermore, we believe that the importance of brand recognition will increaseas competition in our market develops. Successful promotion of our Websensebrand will depend largely on the effectiveness of our marketing efforts and onour ability to develop reliable and useful products at competitive prices. Ifwe fail to successfully promote our Websense brand, or if our expenses topromote and maintain our Websense brand are greater than anticipated, ourresults of operations and financial condition could suffer.

 

*Because we recognize revenue fromsubscriptions for our products ratably over the term of the subscription,downturns in sales may not be immediately reflected in our revenue.*

 

We expect that nearly all of ourrevenue for the foreseeable future will come from subscriptions to WebsenseEnterprise and our add-on products. Upon execution of a subscription agreement,we invoice our customers for the full term of the subscription agreement. Wethen recognize revenue from customers monthly over the terms of theirsubscription agreements, which typically have durations of 12, 24 or 36 months.As a result, a majority of the revenue we report in each quarter is deferredrevenue from subscription agreements entered into and paid for during previousquarters. Because of this financial model, the revenue we report in any quarteror series of quarters may mask significant downturns in sales and the marketacceptance of our products.

 

*Sales to customers outside theUnited States have accounted for a significant portion of our revenue, and weexpect this trend to continue, which exposes us to risks inherent ininternational sales.**

 

We market and sell our productsoutside the United States through value-added resellers, distributors and otherresellers. International sales represented approximately 37% of our totalrevenue generated during the ninemonths ended September 30, 2006 compared with 33% of our total revenuein all of 2005. International sales also increased 33% in absolute dollars forthe nine month period ending September 30, 2006 compared with the nine monthperiod ending September 30, 2005. As a key component of our business strategy,we intend to expand our international sales, but success cannot be assured. Inaddition to the risks associated with our domestic sales, our internationalsales are subject to the following risks:

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·                  dependenceon foreign distributors and their sales channels;

 

·                  localizationof our products and our ability to properly categorize and filter Web sitescontaining foreign languages;

 

·                  laws andbusiness practices favoring local competitors;

 

·                  compliancewith multiple, conflicting and changing governmental laws andregulations,  including tax laws and regulations;

 

·                  foreigncurrency fluctuations;

 

·                  longeraccounts receivable payment cycles and other collection difficulties; and

 

·                  regionaleconomic and political conditions.

 

Such factors could have a materialadverse effect on our future international sales. Any reduction ininternational sales, or our failure to further develop our internationaldistribution channels, could have a material adverse effect on our business,results of operations and financial condition.

 

Our international revenue iscurrently primarily denominated in U.S. dollars. As a result, fluctuations inthe value of the U.S. dollar and foreign currencies may make our products moreexpensive for international customers, which could harm our business. In 2005,we began billing certain international customers in Euros. This may increaseour risks associated with fluctuations in foreign currency exchange rates sincewe cannot be assured of receiving the same U.S. dollar equivalent as when webill exclusively in U.S. dollars. We engage in currency hedging activitieswith the intent of limiting the risk of exchange rate fluctuation. Our hedgingactivities also involve inherent risks that could result in an unforeseen loss.If we fail to properly forecast rate fluctuations these activities could have anegative impact.

 

*We may not be able to developacceptable new products or enhancements to our existing products at a raterequired by our rapidly changing market.*

 

Our future success depends on ourability to develop new products or enhancements to our existing products thatkeep pace with rapid technological developments and that address the changingneeds of our customers. Although our products are designed to operate with avariety of network hardware and software platforms, we will need tocontinuously modify and enhance our products to keep pace with changes in Internet-relatedhardware, software, communication, browser and database technologies. We maynot be successful in either developing such products or introducing them to themarket in a timely fashion. In addition, uncertainties about the timing andnature of new network platforms or technologies, or modifications to existingplatforms or technology could increase our research and development expenses.The failure of our products to operate effectively with the existing and futurenetwork platforms and technologies will limit or reduce the market for ourproducts, result in customer dissatisfaction and seriously harm our business,results of operations and financial condition.

 

*If we acquire any companies ortechnologies in the future, they could prove difficult to integrate, disruptour business, dilute stockholder value and adversely affect our operatingresults.**

 

We may acquire complementarycompanies, services and technologies in the future. We have not made anyacquisitions to date, and therefore our ability as an organization to makeacquisitions is unproven. Although we review the records of companies orbusinesses we are interested in acquiring, even an in-depth review may notreveal existing or potential problems or permit us to become familiar enoughwith a business to assess fully its capabilities and deficiencies.

 

Acquisitions involve numerousrisks, including:

 

·                  difficultiesin integrating operations, technologies, services and personnel;

 

·                  diversionof financial and management resources from existing operations;

 

·                  risk ofentering new markets;

 

·                  potentialloss of key employees;

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·                  assumptionof liabilities of the acquired company, including debt and litigation; and

 

·                  inabilityto generate sufficient revenue to offset acquisition costs.

 

In addition, if we financeacquisitions by issuing convertible debt or equity securities, our existingstockholders may be diluted which could affect the market price of our stock.As a result, if we fail to properly evaluate and execute acquisitions, ourbusiness and prospects may be seriously harmed.

 

*Our quarterly operating results mayfluctuate significantly, and these fluctuations may cause our stock price tofall.*

 

Our quarterly operating resultshave varied significantly in the past, and will likely vary in the futureprimarily as the result of fluctuations in our billings, revenues, operatingexpenses and tax provisions. Although a significant portion of our revenue inany quarter comes from previously deferred revenue, a meaningful portion of ourrevenue in any quarter depends on subscriptions to our products that are soldin that quarter. The risk of quarterly fluctuations is increased by the factthat a significant portion of our quarterly sales have historically beengenerated during the last month of each fiscal quarter, with many of thelargest enterprise customers purchasing subscriptions to our products nearer tothe end of the last month of each quarter. Due to the unpredictability of theseend-of-period buying patterns, forecasts may not be achieved.

 

We expect that our operatingexpenses will increase substantially in the future as we expand our selling andmarketing activities, increase our research and development efforts and hireadditional personnel. In addition, our operating expenses historically havefluctuated, and may continue to fluctuate in the future, as the result of thefactors described below and elsewhere in this quarterly report:

 

·                  timing ofmarketing expenses for activities such as trade shows and advertising campaigns;

 

·                  quarterlyvariations in general and administrative expenses, such as recruiting expensesand professional services fees;

 

·                  increasedresearch and development costs prior to new or enhanced product launches; and

 

·                  timing ofexpenses associated with commissions paid on sales of subscriptions to ourproducts.

 

Consequently, our results ofoperations may not meet the expectations of current or potential investors. Ifthis occurs, the price of our common stock may decline.

 

*The market price of our common stockis likely to be highly volatile and subject to wide fluctuations.*

 

The market price of our commonstock has been and likely will continue to be highly volatile and could besubject to wide fluctuations in response to a number of factors that are beyondour control, including:

 

·                  announcementsof technological innovations or new products or services by our competitors;

 

·                  demand forour products, including fluctuations in subscription renewals;

 

·                  changes inthe pricing policies of our competitors; and

 

·                  changes ingovernment regulations.

 

In addition, the market price ofour common stock could be subject to wide fluctuations in response to:

 

·                  announcementsof technological innovations or new products or services by us;

 

·                  changes inour pricing policies; and

 

·                  quarterlyvariations in our revenues and operating expenses.

 

Further, the stock market hasexperienced significant price and volume fluctuations that have particularlyaffected the market price of the stock of many Internet-related companies, andthat often have

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been unrelated or disproportionate to the operatingperformance of these companies. A number of publicly traded Internet-relatedcompanies have current market prices below their initial public offeringprices. Market fluctuations such as these may seriously harm the market priceof our common stock. In the past, securities class action suits have been filedfollowing periods of market volatility in the price of a company’s securities.If such an action were instituted, we would incur substantial costs and adiversion of management attention and resources, which would seriously harm ourbusiness, results of operations and financial condition.

 

*We intend to develop and expand ourindirect sales channels including our new two tier distribution channel inNorth America, to increase revenue and improve our operating results.**

 

We depend on our indirect saleschannels, including value-added resellers, distributors, and providers ofmanaged Internet services, to offer our products to a larger customer base thancan be reached through a direct sales effort. We need to expand our existingindirect sales channel relationships and enter into new indirect sales channelrelationships to increase our current and future market share and revenue,particularly revenue from new customer sales in the small and medium businesssegment. On August 4, 2006, we announced that Ingram Micro, Inc. willdistribute, market and support our Web security and Web filtering software aspart of our new two tier distribution strategy in North America. We may beunable to maintain and expand our existing relationships or enter into newrelationships on commercially reasonable terms or at all. If we are unable tomaintain and expand our existing relationships, including our relationship withIngram Micro, or enter into new relationships, we would lose customerintroductions and co-marketing benefits and our operating results could suffer.Our ability to meaningfully increase the amount of our products sold throughour sales channels also depends on our ability to adequately and efficientlysupport these channel partners with, among other things, appropriate financialincentives to encourage pre-sales investment and sales tools, such as salestraining, technical training and product collateral needed to support theircustomers and prospects. Additionally, we must make significant changes to ourinternal ordering and partner management systems in order to effectivelyexecute our new two tier distribution strategy. Any failure to properly andefficiently support our sales channels will result in lost sales opportunities.

 

*Our reliance on indirect saleschannels could result in reduced revenue growth because we have little controlover our value-added resellers, distributors and original equipmentmanufacturers.**

 

We anticipate that sales from ourvarious indirect sales channels, including value-added resellers, distributors,providers of managed Internet services and others, will continue to account fora significant majority of our total revenue in future periods.  In addition, on August 4, 2006, we announcedthat Ingram Micro will distribute, market and support our Web security and Webfiltering software.  None of theseparties is obligated to sell our products or to make any purchases from us. Ourability to generate increased revenue depends upon the ability and willingnessof our indirect sales channels to market and sell our products. If they areunsuccessful in their efforts or are unwilling or unable to market and sell ournew product offerings such as our security-oriented offerings, our operatingresults will suffer. We cannot control the level of effort these parties expendor the extent to which any of them will be successful in marketing and sellingour products. Some of our indirect sales channels also market and sell productsthat compete with our products or may decide to do so in the future. We may notbe able to prevent these parties from devoting greater resources to support ourcompetitors’ products and/or eliminating their efforts to sell our products.

 

*Any failure to protect ourproprietary technology or establish our Websense brand would negatively impactour business.*

 

Intellectual property is critical toour success, and we rely upon trademark, copyright and trade secret laws in theUnited States and other jurisdictions as well as confidentiality procedures andcontractual provisions to protect our proprietary technology and our Websensebrand. We rely on trade secrets to protect technology where we believe patentprotection is not appropriate or obtainable. However, trade secrets aredifficult to protect. While we require employees, collaborators and consultantsto enter into confidentiality agreements, we cannot assure that theseagreements will not be breached or that we will have adequate remedies for anybreach. We may not be able to adequately protect our trade secrets or otherproprietary information in the event of any unauthorized use or disclosure orthe lawful development by others of such information.

 

We have registered our Websense andWebsense Enterprise trademarks in several countries and have registrations forthe Websense trademark pending in several other countries. Effective trademark

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protection may not be available in every country whereour products are available. Furthermore, any of our trademarks may bechallenged by others or invalidated through administrative process orlitigation.

 

We currently have only three issuedpatents in the United States and one corresponding issued patentinternationally, and we may be unable to obtain further patent protection inthe future. We have several pending patent applications in the United Statesand in other countries. We cannot ensure that:

 

·                  we werethe first to make the inventions covered by each of our pending patentapplications;

 

·                  we werethe first to file patent applications for these inventions;

 

·                  otherswill not independently develop similar or alternative technologies or duplicateany of our technologies;

 

·                  any of ourpending patent applications will result in issued patents;

 

·                  anypatents issued to us will provide us with any competitive advantages or willnot be challenged by third parties;

 

·                  we willdevelop additional proprietary technologies that are patentable; or

 

·                  thepatents of others will not have a negative effect on our ability to dobusiness.

 

Furthermore, legal standardsrelating to the validity, enforceability and scope of protection ofintellectual property rights are uncertain. Effective patent, trademark,copyright and trade secret protection may not be available to us in everycountry in which our products are available. The laws of some foreign countriesmay not be as protective of intellectual property rights as United States laws,and mechanisms for enforcement of intellectual property rights may beinadequate. As a result our means of protecting our proprietary technology andbrands may not be adequate. Furthermore, despite our efforts, we may be unableto prevent third parties from infringing upon or misappropriating ourintellectual property, including the misappropriation or misuse of the contentof our proprietary databases of universal resource locators (URLs) and softwareapplications. Any such infringement or misappropriation could have a materialadverse effect on our business, results of operations and financial condition.

 

*We may be sued by third parties foralleged infringement of their proprietary rights.*

 

The software and Internetindustries are characterized by the existence of a large number of patents,trademarks and copyrights and by frequent litigation based on allegations ofpatent infringement or other violations of intellectual property rights. As weexpand our product offerings in the security area where larger companies withlarge patent portfolios compete, the possibility of an intellectual propertyclaim against us grows. We may also incur more expense in our productdevelopment efforts if we need to license patents or design around patents toavoid infringement claims. Our technologies and products may not be able towithstand any third-party claims or rights against their use. Any intellectualproperty claims, with or without merit, could be time-consuming and expensiveto litigate or settle, and could divert management attention from executing ourbusiness plan.

 

*Our database categories and ourprocess for classifying URLs and software applications within those categoriesare subjective, and we may not be able to categorize URLs and softwareapplications in accordance with our customers’ expectations.*

 

We may not succeed in accuratelycategorizing Internet and application content to meet our customers’expectations. We rely upon a combination of automated filtering technology andhuman review to categorize URLs and software applications in our proprietarydatabases. Our customers may not agree with our determinations that particularURLs and software applications should be included or not included in specificcategories of our databases. In addition, it is possible that our filteringprocesses may place objectionable or security risk material in categories thatare generally unrestricted by our users’ Internet and computer access policies,which could result in such material not being blocked from the network. Anymiscategorization could result in customer dissatisfaction and harm ourreputation. Any failure to effectively categorize and filter URLs and softwareapplications according to our customers’ expectations will impair the growth ofour business and our efforts to increase brand acceptance.

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*Our databases may fail to keep pacewith the rapid growth and technological change of the Internet.**

 

The success of our products dependson the breadth and accuracy of our databases. Although our databases currentlycatalog more than 20 million URLs and over 1.9 million software applicationsand executable files, they contain only a portion of such material that exists.In addition, the total number of URLs and software applications is growingrapidly, and we expect this rapid growth rate to continue in the future. Inparticular, URLs and software applications that pose security risks tend todevelop and evolve at a much faster rate than other content that we identifyand categorize. Accordingly, we must identify and categorize content for oursecurity risk categories at an extremely rapid rate with our Real Time SecurityUpdates. Our databases and database technologies may not be able to keep pacewith the growth in the number of URLs and software applications, especially thegrowing amount of content utilizing foreign languages and the increasingsophistication of malicious code and the delivery mechanisms associated withspyware, phishing and other hazards associated with the Internet. Further, theongoing evolution of the Internet and computing environments will require us tocontinually improve the functionality, features and reliability of ourdatabases. Because our products primarily manage access to URLs and softwareapplications included in our databases, if our databases do not contain ameaningful portion of relevant content, the effectiveness of WebsenseEnterprise and our add-on products will be significantly diminished. Anyfailure of our databases to keep pace with the rapid growth and technologicalchange of the Internet will impair the market acceptance of our products, whichin turn will harm our business, results of operations and financial condition.

 

*Failure of our products to workproperly or misuse of our products could impact sales, increase costs, andcreate risks of potential negative publicity and legal liability.*

 

Our products are complex and aredeployed in a wide variety of complex network environments. Our products mayhave errors or defects that users identify after deployment, which could harmour reputation and our business. In addition, products as complex as oursfrequently contain undetected errors when first introduced or when new versionsor enhancements are released. We have from time to time found errors in versionsof our products, and we may find such errors in the future. Because customersrely on our products to manage employee behavior and to protect againstsecurity risks, any significant defects or errors in our products may result innegative publicity or legal claims. For example, an actual or perceived breachof network or computer security at one of our customers, regardless of whetherthe breach is attributable to our products, could adversely affect the market’sperception of our security products. Moreover, parties whose Web sites orsoftware applications are placed in security-risk categories or othercategories with negative connotations may seek redress against us for falselylabeling them or for interfering with their business. The occurrence of errorscould adversely affect sales of our products, divert the attention ofengineering personnel from our product development efforts and causesignificant customer relations or legal problems.

 

Our products may also be misused orabused by customers or non-customer third parties who obtain access and use ofour products. These situations may arise where an organization uses ourproducts in a manner that impacts their end users’ or employees’ privacy orwhere our products are misappropriated to censor private access to the Internet.Any of these situations could result in negative press coverage and negativelyaffect our reputation.

 

*Our worldwide income tax provisionsand other tax accruals may be insufficient if any taxing authorities assumetaxing positions that are contrary to our positions.*

 

Significant judgment is required indetermining our worldwide provision for income taxes and for our accruals forother state, federal and international taxes such as sales and VAT taxes. Inthe ordinary course of a global business, there are many transactions for whichthe ultimate tax outcome is uncertain. Some of these uncertainties arise as aconsequence of intercompany arrangements to share revenue and costs. In sucharrangements there are uncertainties about the amount and manner of suchsharing, which could ultimately result in changes once the arrangements arereviewed by taxing authorities. Although we believe that our approach todetermining the amount of such arrangements is reasonable, no assurance can begiven that the final tax authority review of these matters will not bematerially different than that which is reflected in our historical income taxprovisions and other tax accruals. Such differences could have a

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material effect on our income tax provisions orbenefits, or other tax accruals, in the period in which such determination ismade, and consequently, on our net income for such period.

 

From time to time, we are alsoaudited by various state, federal and international authorities relating to taxmatters. We fully cooperate with all audits. Our audits are in various stagesof completion; however, no outcome for a particular audit can be determinedwith certainty prior to the conclusion of the audit and appeals process. Aseach audit is concluded, adjustments, if any, are appropriately recorded in ourfinancial statements in the period determined. To provide for potential taxexposures, we maintain allowances for tax contingencies based on reasonableestimates of our potential exposure with respect to the tax liabilities thatmay result from such audits. However, if the reserves are insufficient uponcompletion of any audits, there could be an adverse impact on our financialposition and results of operations.

 

*We are subject to changes in financialaccounting standards, which may adversely affect our reported financial resultsor the way we conduct business.**

 

Accounting policies affectingsoftware revenue recognition have been the subject of frequent interpretations.Future changes in financial accounting standards, including pronouncementsrelating to revenue recognition, may have a significant effect on our reportedresults, including reporting of transactions completed before the effective dateof the changes.

 

In December 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards (SFAS) No. 123 (revised 2004), Share-Based Payment (SFASNo. 123R), which became effective in our first quarter of fiscal 2006.  Commencing with our first quarter of fiscal 2006, we adopted a fairvalue-based method for measuring the compensation expense related to employeestock awards; this has caused an additional compensation expense ofapproximately $15.0 million in the first nine months of fiscal 2006, therebyreducing net income and earnings per share. The adoption of this standard couldlimit our ability to continue to use stock options as an incentive andretention tool, which could, in turn, hurt our ability to recruit employees andretain existing employees. However, overall, our cash flows will be unaffected.

 

*We are dependent on our managementteam, and the loss of any key member of this team may prevent us fromimplementing our business plan in a timely manner.**

 

Our success depends largely uponthe continued services of our executive officers and other key managementpersonnel. We are also substantially dependent on the continued service of ourexisting engineering personnel because of the complexity of our products andtechnologies. We do not have employment agreements with a majority of ourexecutive officers, key management or development personnel and, therefore,they could terminate their employment with us at any time without penalty. Wedo not maintain key person life insurance policies on any of our employees. Theloss of one or more of our key employees could seriously harm our business,results of operations and financial condition. In such an event we may beunable to recruit personnel to replace these individuals in a timely manner, orat all, on acceptable terms.

 

*Our growth could strain ourpersonnel and infrastructure resources, and if we are unable to implementappropriate controls and procedures to manage our growth, we may not be able tosuccessfully implement our business plan.*

 

Wecontinue to experience rapid growth in our operations, which has placed, andwill continue to place, a significant strain on our management, administrative,operational and financial infrastructure. Our future success will depend inpart upon the ability of our senior management to manage growth effectively.This will require us to hire and train additional personnel to manage ourexpanding operations. In addition, we will be required to continue to improveour operational, financial and management controls and our reporting systemsand procedures. If we fail to successfully manage our growth, we will be unableto execute our business plan.

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*Because competition for our targetemployees is intense, we may not be able to attract and retain the highlyskilled employees we need to support our planned growth.*

 

To execute our growth plan, we mustattract and retain highly qualified personnel. We need to hire additionalpersonnel in virtually all operational areas, including selling and marketing,research and development, operations and technical support, customer serviceand administration. Competition for these personnel is intense, especially forengineers with high levels of experience in designing and developing software andInternet-related products. We may not be successful in attracting and retainingqualified personnel. We have from time to time in the past experienced, and weexpect to continue to experience in the future, difficulty in hiring andretaining highly skilled employees with appropriate qualifications. Many of thecompanies with which we compete for experienced personnel have greaterresources than we have. If we fail to attract new personnel or retain andmotivate our current personnel, our business and future growth prospects couldbe severely harmed.

 

*Our systems may be vulnerable tosecurity risks or service disruptions that could harm our business.*

 

Although we have taken measures tosecure our systems against security risks and other causes of disruption ofelectronic services, our servers are vulnerable to physical or electronicbreak-ins and service disruptions, which could lead to interruptions, delays,loss of data or the inability to process customer requests. Such events couldbe very expensive to remedy, could damage our reputation and could discourageexisting and potential customers from using our products.

 

*Evolving regulation of the Internetmay affect us adversely.*

 

As Internet commerce continues toevolve, increasing regulation by federal, state or foreign agencies becomesmore likely. Such regulation is likely in the areas of user privacy, pricing,content and quality of products and services. Taxation of Internet use or othercharges imposed by government agencies or by private organizations foraccessing the Internet may also be imposed. Laws and regulations applying tothe solicitation, collection or processing of personal or consumer informationcould affect our activities. Furthermore, any regulation imposing fees for Internetuse could result in a decline in the use of the Internet and the viability of Internetcommerce, which could have a material adverse effect on our business, resultsof operations and financial condition.

 

*It may be difficult for a thirdparty to acquire us, even if doing so would be beneficial to our stockholders.*

 

Some provisions of our certificateof incorporation and bylaws, as well as some provisions of Delaware law, maydiscourage, delay or prevent third parties from acquiring us, even if doing sowould be beneficial to our stockholders. For example, our certificate ofincorporation provides for a classified board, with each board member serving astaggered three-year term. It also provides that stockholders may not fillboard vacancies, call stockholder meetings or act by written consent. Ourbylaws further provide that advance written notice is required prior tostockholder proposals. Each of these provisions makes it more difficult forstockholders to obtain control of our board or initiate actions that areopposed by the then current board. Additionally, we have authorized preferredstock that is undesignated, making it possible for the board to issue up to5,000,000 shares of preferred stock with voting or other rights and preferencesthat could impede the success of any attempted change of control. Delaware lawalso could make it more difficult for a third party to acquire us.Section 203 of the Delaware General Corporation Law has an anti-takeovereffect with respect to transactions not approved in advance by our board,including discouraging attempts that might result in a premium over the marketprice of the shares of common stock held by our stockholders.

 

*We do not intend to pay dividends.*

 

Wehave not declared or paid any cash dividends on our common stock since we havebeen a publicly traded company. We currently intend to retain any future cashflows from operations to fund growth and, do not expect to pay any dividends inthe foreseeable future.

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**Item 2.    Unregistered Sales of Equity Securities andUse 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) | ** ** |
|----------------|------------|-------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| July 2006      |       | 187,500                                                     |       | $                                            | 18.55      |                                                                                                           | 5,357,560  |                                                                                                                | 6,642,440  |   |
| August 2006    |       | 2,812,500                                                   |       | $                                            | 19.50      |                                                                                                           | 8,170,060  |                                                                                                                | 3,829,940  |   |
| September 2006 |       | —                                                      |       | —                                       |       | 8,170,060                                                                                                      |       | 3,829,940                                                                                                           |       |
| Total          |       | 3,000,000                                                   |       | $                                            | 19.44      |                                                                                                           | 8,170,060  |                                                                                                                | 3,829,940  |   |

 

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1.                  Thepurchases were made in open-market transactions.

2.                  On April 3,2003, we announced that our Board of Directors authorized a stock repurchaseprogram of up to 4 million shares of our 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 of our common stock, for atotal program size of up to 8 million shares of our common stock.  On July 25, 2006, we announced that our Boardof Directors increased the size of the stock repurchase program by anadditional 4 million shares of our common stock, for a total program size of upto 12 million shares of our common stock.

 

**Item 3.    Defaults upon SeniorSecurities**

** **

**None.**

** **

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

** **

**None.**

** **

**Item5.    Other Information**

** **

**None.**

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** **

**Item6.    Exhibits**

** **

**Exhibits**

** **

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

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(1)             Filed as an Exhibitto our Registration Statement on Form S-1/A (No 333-95619) filed on March 3,2000.

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#####  

##### **SIGNATURES**

#####  

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|                         | **WEBSENSE, INC.** |
|-------------------------|--------------------|
|                    |               |   |   |
| Date: November 8,  2006 |               | By: |  /s/ GENE HODGES |   |
|                    |               |   |   | Gene Hodges |
|                    | * *           | * * | * * | *President and* |
|                    | * *           | * * | * * | *Chief Executive Officer* |
|                    |               |   |   |
| Date: November 8,  2006 |               | By: |  /s/ DOUGLAS C. WRIDE |   |
| ** **              |               |   |   | Douglas C. Wride |
| ** **              | * *           | * * | * * | *Chief Financial Officer* |
|                         |                    |  |  |  |  |  |

 

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

 

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**(1)**                Filed asan Exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed onMarch 3, 2000.

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