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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2002

OR

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

For the Transition Period from ___ to ___

Commission File Number 000-30093

Websense, Inc.
(Exact name of registrant as specified in its charter)

10240 Sorrento Valley Road
San Diego, California 92121
858-320-8000
(Address of principal executive offices, zip code and telephone number)

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. (1) Yes [X] No [   ] (2) Yes [X] No [   ]

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 31, 2002 was 21,454,914.

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Websense, Inc.
Form 10-Q
For the Period Ended September 30, 2002

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Part I — Financial Information

Item 1. Consolidated Financial Statements (Unaudited)

Websense, Inc.
Consolidated Balance Sheets
(In thousands)

See accompanying notes.

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

See accompanying notes.

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Websense, Inc.
Consolidated Statement of Stockholders’ Equity
(Unaudited and in thousands)

See accompanying notes.

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

See accompanying notes.

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WEBSENSE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1. Basis of Presentation

     The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and of the results for the interim periods presented.

     These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2001, included in Websense, Inc.’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. Operating results for the three and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2002. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

2. Net Income Per Share

     Basic net income per common share (“Basic EPS”) excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share (“Diluted EPS”) reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted into common stock. The computation of Diluted EPS does not assume exercise or conversion of securities that would have an anti-dilutive effect on net income per common share.

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2. Net Income Per Share (continued)

     Following is a reconciliation of the numerator and denominator of Basic EPS to the numerator and denominator of Diluted EPS for all periods presented:

     For the three months ended September 30, 2002 and 2001, there were outstanding options to purchase 1,669,000 and 493,000 shares, respectively, that had an exercise price greater than the average market price of the common shares for the respective quarters. Therefore, these shares would have had an anti-dilutive effect on EPS.

     For the nine months ended September 30, 2002 and 2001, there were outstanding options to purchase 1,065,000 and 392,000 shares, respectively, that had an exercise price greater than the average market price of the common shares for the respective nine months. Therefore, these shares would have had an anti-dilutive effect on EPS.

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3. Amortization of Stock-based Compensation

     For the three and nine-month periods ended September 30, 2002 and 2001, the Company recorded amortization of stock-based compensation. The allocation of the expense by operating expense category is as follows (in thousands):

4. Comprehensive Income

     Components of comprehensive income were as follows (in thousands):

     Accumulated other comprehensive income totaled $526,000 and $60,000 at September 30, 2002 and December 31, 2001, respectively.

5. New Accounting Pronouncements

     In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS No. 146 addresses the recognition, measurement and reporting costs that are associated with exit or disposal activities. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect that the adoption of SFAS No. 146 will have a material effect on its financial statements.

6. Reclassifications

     Certain reclassifications have been made for consistent presentation.

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

     The following discussion and analysis should be read in conjunction with the financial statements and related notes contained elsewhere in this report. See “Risks and Uncertainties” regarding certain factors known to us that could cause reported financial information not to be necessarily indicative of future results.

Forward Looking Statements

     From time to time we have made and may continue to make “forward looking statements” within the meaning of the federal securities laws. This report on Form 10-Q may contain forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements, which represent our expectations or beliefs concerning various future events, may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or other words indicating future results. Such statements include but are not limited to statements concerning the following:

	•		anticipated trends in revenue;
	•		growth opportunities in domestic and international markets;
	•		customer acceptance and satisfaction with our products;
	•		expected trends in operating expenses; and
	•		anticipated cash and intentions regarding usage of cash.

     Actual results may differ materially from results anticipated in such forward-looking statements. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report.

Overview

     We provide Employee Internet Management, or EIM, solutions that enable businesses to monitor, report and manage how their employees use the Internet. Our Websense Enterprise solution supports an organization’s efforts to improve employee productivity, conserve network bandwidth, mitigate potential legal liability and enhance network security. In 1996, we released our first software product, Websense Internet Screening System, and since that time, we have focused our business on developing and selling EIM solutions. In December 1999, we released v4.0, a redesigned version of Websense Enterprise with our most recent version released in April 2002. We expect to launch sales of the next generation of Websense software — Websense Enterprise v5.0 — in the first quarter of 2003, including enhanced EIM capabilities and enabling application modules. We currently derive nearly all of our revenue from subscriptions to the Websense Enterprise solution and expect this trend to continue in the future.

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     During the nine months ended September 30, 2002, we derived approximately 31% of revenue from international sales compared to approximately 33% for the nine months ended September 30, 2001. Despite the decline year-over-year as a percentage of total revenue, we believe international markets represent a significant growth opportunity and are continuing to expand our international operations, particularly in selected countries in the European and Asia/Pacific markets.

     We currently sell Websense Enterprise through both indirect and direct channels; however, sales through indirect channels currently account for more than 75% of our revenue and our strategy is to continue to rely on indirect sales channels for a significant majority of our sales.

     As described below, we recognize revenue from subscriptions to Websense Enterprise on a monthly straight-line basis over the term of the subscription. However, we recognize operating expenses as they are incurred. These operating expenses include commissions relating to the sale of new subscriptions, which are based on the total amount of the subscription contract and are fully expensed in the current period. Operating expenses have continued to increase as compared to prior periods due to expanded selling and marketing efforts, continued product research and development and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.

Critical Accounting Policies

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. When a purchase decision is made, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and for a fixed number of users. We promptly invoice customers for the full amount of their subscriptions at the time a subscription is activated. Payment is due for the full term of the subscription generally within 30 days of the invoice. We recognize revenue on a monthly straight-line basis over the term of the subscription agreement. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. Upon expiration of the subscription, customers who wish to resubscribe typically must do so at then current rates to continue using Websense Enterprise. Our revenue is significantly influenced by subscription renewals, and a decrease in subscription renewals amounts could negatively impact our revenue.

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

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Deferred Tax Assets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future expected taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase our income or additional paid-in capital in the period such determination was made. Should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged against income in the period such determination was made. As of December 31, 2001, we had $14.3 million in gross deferred tax assets, which were fully offset by a valuation allowance.

Results of Operations

Three months ended September 30, 2002 compared to the three months ended September 30, 2001

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

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Revenue

     Revenue increased from $9.5 million in the third quarter of 2001 to $16.0 million in the third quarter of 2002. This increase was primarily a result of the addition of new customers. Approximately 51% of subscription revenue recognized in the third quarter of 2002 was derived from sales to first-time customers, who initially purchased one-, two-, or three-year subscriptions to Websense Enterprise in 2002 or prior years. The remaining 49% of subscription revenue was generated from renewal business with existing customers.

Cost of Revenue

     Cost of revenue consists of the costs of Web site review, technical support and infrastructure costs associated with maintaining our database. Cost of revenue increased from $911,000 in the third quarter of 2001 to $1.1 million in the third quarter of 2002. The increase was primarily due to the costs associated with additional personnel in our technical support group. We expect cost of revenue to increase in the future as we support the growth and maintenance of our database as well as the technical support needs of our customers. As a percentage of revenue, cost of revenue decreased from 10% in the third quarter of 2001 to 7% in the third quarter of 2002. This decrease was primarily due to benefits derived from the automation of database search and support processes as well as the leveraging of database and technical support costs over a larger revenue base. We expect that cost of revenue, as a percentage of revenue, will remain below 10% of revenue for the foreseeable future.

Gross Margin

Gross margin increased from $8.6 million in the third quarter of 2001 to $14.9 million in the third quarter of 2002. The increase was primarily due to increased revenue. As a percentage of revenue, gross margin increased from 90% in the third quarter of 2001 to 93% in the third quarter of 2002. This increase was primarily due to benefits derived from the automation of database search and support processes as well as the leveraging of database and technical support costs over a larger revenue base. We expect that gross margin, as a percentage of revenue, will remain in excess of 90% of revenue for the foreseeable future.

Operating Expenses

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to public relations, investor relations, advertising, promotions and travel as well as allocated facilities costs and depreciation expenses. Selling and marketing expenses increased from $4.5 million in the third quarter of 2001 to $6.6 million in the third quarter of 2002. The increase in selling and marketing expenses of $2.1 million was primarily due to increased headcount costs and increased advertising and promotional activities in North America, Europe and Asia. We expect selling and marketing expenses to increase in the future as more personnel are added to support our globally expanding selling and marketing efforts.

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Research and development. Research and development expenses consist primarily of salaries and benefits for software developers, contract programmers, and allocated facilities costs and depreciation expenses. Research and development expenses increased from $1.8 million in the third quarter of 2001 to $3.1 million in the third quarter of 2002. The increase of $1.3 million in research and development expenses was primarily a result of personnel and consultants added since the third quarter of 2001 to support our expanded list of technology partners, the growing enhancements of Websense Enterprise, including the development of Websense Enterprise v5.0, and additional products. We expect research and development expenses to increase in the future, as more personnel are added to support additional technology partners, growth of the enhancements of Websense Enterprise and expansion of our product offerings.

General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance, human resources and administrative personnel, third party professional service fees and allocated facilities costs and depreciation expenses. General and administrative expenses increased from $1.2 million in the third quarter of 2001 to $1.5 million in the third quarter of 2002. The $300,000 increase in general and administrative expenses is primarily a result of personnel added since the third quarter of 2001 to support our growing operations, both domestically and internationally, as well as higher infrastructure costs in Europe. We expect general and administrative expenses to increase in future periods, reflecting growth in operations and increasing expenses associated with being a public company and expansion of our international operations.

Amortization of stock-based compensation. Amortization of stock-based compensation decreased from $210,000 in the third quarter of 2001 to $95,000 in the third quarter of 2002. The decrease in the amortization expense is primarily due to the accelerated method of amortization used. We expect amortization of stock-based compensation to decrease in future periods as a result of using the accelerated method of amortization.

Interest Income, Net

     Net interest income decreased from $1.0 million in the third quarter of 2001 to $665,000 in the third quarter of 2002. The decrease is due to lower interest rates earned by our cash, cash equivalents and marketable securities despite increased balances as of September 30, 2002 as compared to September 30, 2001.

Provision for Income Taxes

     In the third quarter of 2001, our provision for income taxes related only to our wholly-owned subsidiary in the United Kingdom. Our provision for income taxes in the third quarter of 2002 relates to our wholly-owned subsidiaries in the United Kingdom, Japan and Australia as well as domestic state income taxes in several states. Beyond these domestic state income taxes, we did not provide for any other income taxes during the third quarter of 2002 related to our operations in the United States due to the partial utilization of our deferred tax assets that we recorded in prior periods. We expect our effective U.S. tax rate to be less than both the federal and state statutory rates in 2002 due to the continued utilization of our deferred tax assets; however, we expect our provision for income taxes to increase in 2002 as compared to 2001. We expect the provision for income taxes to increase significantly in 2003 to approximate statutory rates. Subsequent to 2003, the provision for income taxes should decrease over time due to benefits derived from lower tax rates associated with foreign income.

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Nine months ended September 30, 2002 compared to the nine months ended September 30, 2001

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

Revenue

     Revenue increased from $24.6 million in the first nine months of 2001 to $43.6 million in the first nine months of 2002. This increase was primarily a result of the addition of new customers. Approximately 53% of subscription revenue recognized in the first nine months of 2002 was derived from sales to first-time customers, who initially purchased one-, two-, or three-year subscriptions to Websense Enterprise in 2002 or prior years. The remaining 47% of subscription revenue was generated from renewal business with existing customers.

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Cost of Revenue

     Cost of revenue increased from $2.6 million in the first nine months of 2001 to $3.1 million in the first nine months of 2002. The increase of $500,000 was primarily due to the costs associated with additional personnel in our technical support group. We expect cost of revenue to increase in the future as we support the growth and maintenance of our database as well as the technical support needs of our customers. As a percentage of revenue, cost of revenue decreased from 10% in the first nine months of 2001 to 7% in the first nine months of 2002. This decrease was primarily due to benefits derived from the automation of database search and support processes as well as the leveraging of database and technical support costs over a larger revenue base. We expect that cost of revenue, as a percentage of revenue, will remain below 10% of revenue for the foreseeable future.

Gross Margin

     Gross margin increased from $22.0 million in the first nine months of 2001 to $40.5 million in the first nine months of 2002. The increase was primarily due to increased revenue. As a percentage of revenue, gross margin increased from 90% in the first nine months of 2001 to 93% in the first nine months of 2002. This increase was primarily due to benefits derived from the automation of database search and support processes as well as the leveraging of database and technical support costs over a larger revenue base. We expect that gross margin, as a percentage of revenue, will remain in excess of 90% of revenue for the foreseeable future.

Operating Expenses

Selling and marketing. Selling and marketing expenses increased from $13.8 million in the first nine months of 2001 to $18.8 million in the first nine months of 2002. The increase in selling and marketing expenses of $5.0 million was primarily due to increased headcount costs and increased advertising and promotional activities in North America, Europe and Asia. We expect selling and marketing expenses to increase in the future as more personnel are added to support our globally expanding selling and marketing efforts.

Research and development. Research and development expenses increased from $5.5 million in the first nine months of 2001 to $7.9 million in the first nine months of 2002. The increase of $2.4 million in research and development expenses was primarily a result of personnel added since the first nine months of 2001 to support our expanded list of technology partners, the growing enhancements of Websense Enterprise, including the development of Websense Enterprise v5.0, and additional products. We expect research and development expenses to increase in the future, as more personnel are added to support additional technology partners, growth of the feature set of Websense Enterprise and expansion of our product offerings.

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General and administrative. General and administrative expenses increased from $3.9 million in the first nine months of 2001 to $4.6 million in the first nine months of 2002. The $700,000 increase in general and administrative expenses is primarily due to higher state sales tax expenses, higher foreign income tax consulting expenses, higher personnel expenses to support our growing operations, both domestically and internationally, and higher infrastructure costs in Europe. We expect general and administrative expenses to increase in future periods, reflecting growth in operations and increased expenses associated with being a public company and expansion of our international operations.

Amortization of stock-based compensation. Amortization of stock-based compensation decreased from $655,000 in the first nine months of 2001 to $380,000 in the first nine months of 2002. The decrease in the amortization expense is primarily due to the accelerated method of amortization used. We expect amortization of stock-based compensation to decrease in future periods as a result of using the accelerated method of amortization.

Interest Income, Net

     Net interest income decreased from $3.3 million in the first nine months of 2001 to $2.1 million in the first nine months of 2002. The decrease is due to lower interest rates earned by our cash, cash equivalents and marketable securities despite increased balances as of September 30, 2002 as compared to September 30, 2001.

Provision for Income Taxes

     In the first nine months of 2001, our provision for income taxes related only to our wholly-owned subsidiary in the United Kingdom. Our provision for income taxes in the first nine months of 2002 relates to our wholly-owned subsidiaries in the United Kingdom, Japan and Australia as well as domestic state income taxes in several states. Beyond these domestic state income taxes, we did not provide for any other income taxes during the first nine months of 2002 related to our operations in the United States due to the partial utilization of our deferred tax assets that we recorded in prior periods. We expect our effective U.S. tax rate to be less than both the federal and state statutory rates in 2002 due to the continued utilization of our deferred tax assets; however, we expect our provision for income taxes to increase in 2002 as compared to 2001. We expect the provision for income taxes to increase significantly in 2003 to approximate statutory rates. Subsequent to 2003, the provision for income taxes should decrease over time due to benefits derived from lower tax rates associated with foreign income.

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Liquidity and Capital Resources

     From our inception through March 2000, we financed our operations primarily through the sale of preferred equity securities. In total, we raised approximately $15.5 million, net of fees and expenses, through the sale of preferred equity securities. In March 2000, we closed our initial public offering with proceeds, net of underwriting fees and offering expenses, of approximately $65.7 million. In the past, we have also utilized available financing for the purchase of capital equipment.

     As of September 30, 2002, we had cash and cash equivalents of $56.7 million and investments in marketable securities of $71.8 million and an accumulated deficit of $7.5 million.

     Net cash provided by operating activities was $23.2 million in the first nine months of 2002 and $12.1 million in the first nine months of 2001. In the first nine months of 2002, cash provided by operating activities was primarily due to net income from operations and an increase in our subscriptions (which are initially recorded as deferred revenue). In the first nine months of 2001, cash provided by operating activities was primarily due to an increase in our subscriptions (which are initially recorded as deferred revenue). Our operating cash flow and revenue are significantly influenced by subscription renewals, and a decrease in subscription renewals could negatively impact our operating cash flow and revenue.

     Net cash provided by investing activities was $6.5 million in the first nine months of 2002 compared to net cash used in investing activities of $14.8 million in the first nine months of 2001. The increase in cash provided by investing activities in the first nine months of 2002 is primarily due to maturities of marketable securities.

     Net cash provided by financing activities was $3.2 million in the first nine months of 2002 compared to $1.1 million in the first nine months of 2001. Cash provided by financing activities in the first nine months of 2002 and the first nine months of 2001 was due to proceeds received from the exercise of stock options and the issuance of common stock related to the Company’s employee stock option and stock purchase plans.

     At September 30, 2002, existing or future letters of credit totaled $350,000. We have operating lease commitments of $116,000 during the remaining quarter of 2002, $1.2 million in 2003, $1.2 million in 2004, $1.2 million in 2005, $1.2 million in 2006 and $1.3 million in 2007. A significant majority of our operating lease commitments are related to our corporate headquarters lease, which was renewed in April 2002. The lease renewal incentives result in no rent payments in the third and fourth quarters of 2002 and escalating rent payments from 2004 to 2007. The rent expense related to our corporate headquarters lease renewal will be recorded monthly on a straight-line basis in accordance with generally accepted accounting principles.

     We believe that our cash and cash equivalents balances and investments in marketable securities will be sufficient to satisfy our cash requirements for at least the next 12 months. We intend to continue to invest our cash in excess of current operating requirements in interest bearing, investment-grade securities. If existing cash is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities. The sale of additional equity or convertible debt securities would result in additional dilution to our stockholders. Additional debt would result in increased expenses and could result in covenants that would restrict our operations. We have not made arrangements to obtain additional financing and there is no assurance that financing, if required, will be available in amounts or on terms acceptable to us, if at all.

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Risks and Uncertainties

You should carefully consider the following information in addition to other information in this report before you decide to purchase our common stock. The risks and uncertainties described below are those that we currently deem to be material and that we believe are specific to our company and our industry. If any of these or other risks actually occurs, the trading price of our common stock could decline, and you may lose all or part of your investment.

Our future success depends on our existing customers renewing and purchasing additional subscriptions to Websense Enterprise.

Our future success depends on achieving substantial revenue from customer renewals for subscriptions to Websense Enterprise. Subscriptions for Websense Enterprise typically have durations of 12, 24 or 36 months. Our customers have no obligation to renew their subscriptions upon expiration. We may be unable to generate significant revenue from renewals. In order to maintain our revenue we must be successful in selling renewal subscriptions.

Our future success also depends on our ability to sell further subscriptions to existing customers in order to obtain additional seats within their respective organizations. As a result, to increase our revenue we must sell our existing customers additional subscriptions for Websense Enterprise to get greater coverage of their workforces. This may require increasingly sophisticated and costly sales efforts targeting senior management and other management personnel associated with our customers’ Internet infrastructure.

Because we expect to derive substantially all of our future revenue from subscription fees for Websense Enterprise, any failure of this product to satisfy customer demands or to achieve more widespread market acceptance will seriously harm our business.

Substantially all of our revenue comes from subscriptions to Websense Enterprise and we expect this trend will continue for the foreseeable future. As a result, if for any reason revenue from Websense Enterprise declines or does not grow as rapidly as we anticipate, our operating results and our business will be significantly impaired. If Websense Enterprise fails to meet the needs of our existing and target customers, or if it does not compare favorably in price and performance to competing products, our growth will be limited. Many of our competitors are seeking to compete with us by aggressively reducing the price of their products. Websense Enterprise may not achieve continued market acceptance. Our future financial performance also will depend, in part, on our ability to diversify our offerings by successfully developing, introducing and gaining customer acceptance of new products and enhanced versions of Websense Enterprise. We may not be successful in achieving market acceptance of any new products that we develop or of enhanced versions of Websense Enterprise. Any failure or delay in diversifying our existing offerings could harm our business, results of operations and financial condition.

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We face increasing competition, which has placed pressure on our pricing and which could prevent us from increasing revenue or maintaining profitability. In addition, we may face competition from better-established companies that have significantly greater resources.

The market for our products is intensely competitive and is likely to become even more so in the future. Our current principal competitors frequently offer their products at a significantly lower price than Websense Enterprise, which has resulted in pricing pressures on sales of our product and potentially could result in the commoditization of EIM products. If we are unable to maintain the current pricing on sales of Websense Enterprise and increase our pricing in the future, our profitability could be negatively impacted. In addition, pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of Websense Enterprise to achieve or maintain more widespread market acceptance, any of which could have a material adverse effect on our business, results of operations and financial condition. Our current principal competitors include:

•		companies offering network filtering products, such as SurfControl plc, Secure Computing, Symantec Corporation, N2H2 Incorporated, Elron Software, Inc. and 8e6 Technologies; and
•		companies offering network reporting products, such as the WebTrends business acquired by NetIQ in 2001 and Wavecrest Computing.

We also face current and potential competition from vendors of Internet servers, operating systems and networking hardware, many of which now, or may in the future, develop and/or bundle Employee Internet Management, or EIM, products with their products. We also compete against, and expect increased competition from, anti-virus software developers, traditional network management software developers and Web management service providers. If EIM functions become standard features of Internet-related hardware or software, the demand for Websense Enterprise will decrease. Furthermore, even if Websense Enterprise provides greater functionality and is more effective than the products offered by vendors of Internet-related hardware or software, potential customers might accept this limited functionality in lieu of purchasing Websense Enterprise. In addition, our own indirect sales channels may decide to develop or sell competing products instead of Websense Enterprise. Many of our potential competitors enjoy substantial competitive advantages, such as:

•		greater name recognition and larger marketing budgets and resources;
•		established marketing relationships and access to larger customer bases; and
•		substantially greater financial, technical and other resources.

As a result, they may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or customer requirements. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.

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Sales to customers outside the United States have accounted for a significant portion of our revenue, and we expect this trend to continue, which exposes us to risks inherent in international sales.

We market and sell our products outside the United States through value-added resellers, distributors and other resellers. International sales represented approximately 31% of our total revenue in the first nine months of 2002 and approximately 33% in the first nine months of 2001, although international sales have increased 66% in absolute dollars in the first nine months of 2002 over the first nine months of 2001. As a key component of our business strategy, we intend to expand our international sales but, as evidenced by the recent decline of our international sales as a percentage of our total sales mix, success cannot be assured. In addition to the risks associated with our domestic sales, our international sales are subject to the following risks:

•		dependence on foreign distributors and their sales channels;
•		localization of our Websense Enterprise products and our products’ ability to properly categorize and filter Web sites containing foreign languages;
•		laws and business practices favoring local competitors;
•		compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations;
•		foreign currency fluctuations;
•		longer accounts receivable payment cycles and other collection difficulties; and
•		regional economic and political conditions.

Such factors could have a material adverse effect on our future international sales. Any further reduction in international sales, or our failure to further develop our international distribution channels, could have a material adverse effect on our business, results of operations and financial condition. Our international revenue is currently denominated in U.S. dollars. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make Websense Enterprise more expensive for international customers, which could harm our business. We do not currently engage in currency hedging activities to limit the risk of exchange rate fluctuation.

The market for EIM products continues to emerge, and if we are not successful in promoting awareness of the need for Websense Enterprise and of our Websense brand, our growth may be limited.

Based on our experience with potential customers, we believe that many corporations do not recognize or acknowledge the existence or scope of problems caused by employee misuse of the Internet. In addition, there may be a time-limited opportunity to achieve and maintain a significant share of the market for EIM products due in part to the emerging nature of this market and the substantial resources available to our existing and potential competitors. If employers do not recognize or acknowledge these problems, then the market for Websense Enterprise may develop more slowly than we expect, which could adversely affect our operating results. Developing and maintaining awareness of our Websense brand is critical to achieving widespread acceptance of our existing and future EIM products. Furthermore, we believe that the importance of brand recognition will increase as competition in our market develops. Successful promotion of our Websense brand will depend largely on the effectiveness of our marketing efforts and on our ability to develop reliable and useful products at competitive prices. If we fail to successfully promote our Websense brand, or if our expenses to promote and maintain our Websense brand are greater than anticipated, our results of operations and financial condition could suffer.

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Because we recognize revenue from subscriptions for Websense Enterprise ratably over the term of the subscription, downturns in sales may not be immediately reflected in our revenue.

We expect that nearly all of our revenue for the foreseeable future will come from subscriptions to Websense Enterprise. Upon execution of a subscription agreement, we invoice our customers for the full term of the subscription agreement. We then recognize revenue from customers monthly over the terms of their subscription 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 deferred revenue from subscription agreements entered into and paid for during previous quarters. Because of this financial model, the revenue we report in any quarter or series of quarters may mask significant downturns in sales and the market acceptance of Websense Enterprise.

We may not be able to develop acceptable new products or enhancements to our existing products at a rate required by our rapidly changing market.

Our future success depends on our ability to develop new products or enhancements to our existing products that keep pace with rapid technological developments and that address the changing needs of our customers. Although Websense Enterprise is designed to operate with a variety of network hardware and software platforms, we will need to continuously modify and enhance Websense Enterprise to keep pace with changes in Internet-related hardware, software, communication, browser and database technologies. We may not be successful in either developing such products or timely introducing them to the market. In addition, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technology, could increase our research and development expenses. The failure of our products to operate effectively with the existing and future network platforms and technologies will limit or reduce the market for our products, result in customer dissatisfaction and seriously harm our business, results of operations and financial condition.

If we acquire any companies or technologies in the future, they could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results.

We may acquire or make investments in complementary companies, services and technologies in the future. We have not made any acquisitions or investments to date, and therefore our ability as an organization to make acquisitions or investments is unproven.

Acquisitions and investments involve numerous risks, including:

•		difficulties in integrating operations, technologies, services and personnel;
•		diversion of financial and management resources from existing operations;
•		risk of entering new markets;
•		potential loss of key employees; and
•		inability to generate sufficient revenue to offset acquisition or investment costs.

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

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We must develop and expand our indirect sales channels to increase revenue and improve our operating results.

We currently sell a significant majority of our products indirectly. We intend to continue to rely on our indirect sales channels for a significant majority of revenue. We depend on our indirect sales channels, including value-added resellers, distributors, and providers of managed Internet services, to offer Websense Enterprise to a larger customer base than can be reached through a direct sales effort. We will need to expand our existing relationships and enter into new relationships to increase our current and future market share and revenue. We may be unable to maintain and expand our existing relationships or enter into new relationships on commercially reasonable terms or at all. If we are unable to maintain and expand our existing relationships or enter into new relationships, we would lose customer introductions and co-marketing benefits and our operating results could suffer.

Our reliance on indirect sales channels could result in reduced revenue growth because we have little control over our value-added resellers, distributors and original equipment manufacturers.

Our indirect sales channels accounted for more than 75% of our revenue in the first nine months of 2002 and for more than 90% of our revenue in the first nine months of 2001. We anticipate that sales from our various indirect sales channels, including value-added resellers, distributors, providers of managed Internet services and others, will continue to account for a significant majority of our total revenue in future periods. None of these parties is obligated to continue selling our products or to make any purchases from us. Our ability to generate increased revenue depends significantly upon the ability and willingness of our indirect sales channels to market and sell our products to organizations worldwide. If they are unsuccessful in their efforts, our operating results will suffer. We cannot control the level of effort these parties expend or the extent to which any of them will be successful in marketing and selling our products. A number of our value-added resellers and distributors have been adversely affected by the current global economic downturn and we believe that their financial difficulties may negatively impact their ability to sell and market Websense Enterprise. Some of our indirect sales channels also market and sell products that compete with Websense Enterprise or may decide to do so in the future. We may not be able to prevent these parties from devoting greater resources to support our competitors’ products and/or eliminating their efforts to sell Websense Enterprise.

We have a history of losses and, because we expect our operating expenses to increase in the future, we may not be able to maintain profitability.

In 2001, we achieved profitability for the first time since 1996. Prior to the third quarter of 2001, we had experienced net losses in each of our previous 21 fiscal quarters, and as of September 30, 2002, we had an accumulated deficit of $7.5 million. We may be unable to maintain profitability unless our revenue continues to increase at a greater rate than our operating expenses. We currently expect our operating expenses to increase substantially, as we, among other things:

•		expand our domestic and international selling and marketing activities;
•		expand our product offerings;
•		increase our research and development efforts to upgrade our existing products and develop new products and technologies;
•		develop and expand our proprietary database and systems;
•		upgrade our operational and financial systems, procedures and controls; and
•		hire additional personnel, including sales and marketing personnel, engineers and other technical staff.

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We will need to increase our revenue to maintain profitability. If we fail to increase revenue from subscription fees for Websense Enterprise, we may experience losses in future quarters. If we continue to grow, we also may fail to accurately estimate and assess the associated increase in our operating expenses. If our operating expenses exceed our expectations, our financial performance will be adversely affected.

We are an early-stage company with an unproven business model, which makes it difficult to evaluate our current business and future prospects.

We have only a limited operating history upon which to base an evaluation of our current business and future prospects. We began offering our EIM software in September 1996, but only since May 1998, when we released our first version of Websense Enterprise as a significant enhancement to our original product, have we directed a majority of our focus on this market. We introduced the most recent version of Websense Enterprise in April 2002 and expect to release the next version in the first quarter of 2003. As a result, the revenue and income potential of our business and our market are unproven. In addition, we have very limited historical data with respect to subscription renewals because we sell subscriptions that range from one to three years in length and have been selling Websense Enterprise for five years. Further, because of our limited operating history and because the market for EIM products is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. In making an investment decision with respect to our stock, you should carefully consider the risks, uncertainties and difficulties frequently encountered by early-stage companies in new and rapidly evolving markets such as ours. We may not be able to successfully address any or all of these risks. Failure to adequately do so could cause our business, results of operations and financial condition to suffer.

Negative economic conditions in the United States and in the other countries and geographic areas in which we offer our products may negatively impact our ability to maintain profitability.

During 2001 and 2002, the United States and other international markets in which we offer our products experienced a significant economic downturn. In addition, the United States and other countries suffered significant acts of hostility and terror. These or similar acts in the future may increase or prolong the negative economic conditions. The economic downturn may impact our ability to sustain profitability by:

•		negatively affecting demand for our products and services;
•		decreasing the renewal rate of subscriptions by our existing customers; and
•		decreasing the strength of our indirect sales channels.

In addition, the economic downturn may force companies to prioritize expenditures, and these companies may decide not to purchase our product in a slowing economy. There can be no certainty as to the degree or severity of the duration of this downturn. We also cannot predict the extent and timing of the impact of the economic downturn in the United States and in other countries and geographic regions in which we conduct our business.

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Any failure to protect our intellectual property rights could impair our ability to protect our proprietary technology and establish our Websense brand.

Intellectual property is critical to our success, and we rely upon trademark, copyright and trade secret laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology and our Websense brand. Any of our trademarks may be challenged by others or invalidated through administrative process or litigation. We currently have no issued patents and may be unable to obtain patent protection in the future. In addition, any issued patents may not provide us with any competitive advantages, or may be challenged by third parties. Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our products are available. The laws of some foreign countries may not be as protective of intellectual property rights as United States laws, and mechanisms for enforcement of intellectual property rights may be inadequate. As a result our means of protecting our proprietary technology and brands may not be adequate. Furthermore, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property, including the misappropriation or misuse of the content of our proprietary database of websites. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition.

We may be sued by third parties for alleged infringement of their proprietary rights.

The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of patent infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies and products may not be able to withstand any third-party claims or rights against their use. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle, and could divert management attention from executing our business plan.

Our database categories and our process for classifying Web sites within those categories are subjective, and we may not be able to categorize Web sites in accordance with our customers’ expectations.

We may not succeed in accurately categorizing Internet content to meet our customers’ expectations. We rely upon a combination of automated filtering technology and human review to categorize Web sites in our proprietary database. Our customers may not agree with our determinations that particular Web sites should be included or not included in specific categories of our database. In addition, it is possible that our filtering processes may place objectionable material in categories that are generally unrestricted by our users’ Internet access policies, which could result in employees having access to such material in the workplace. Any miscategorization could result in customer dissatisfaction and harm our reputation. Furthermore, we select our categories based on Web site content we believe employers want to manage. We may not now, or in the future, succeed in properly identifying the categories of Web site content that employers want to manage. Any failure to effectively categorize and filter Web sites according to our customers’ expectations will impair the growth of our business and our efforts to increase brand acceptance.

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Our database may fail to keep pace with the rapid growth and technological change of the Internet.

The success of Websense Enterprise depends on the breadth and accuracy of our database. Although our database currently catalogs 3.9 million Web sites, it contains only a fraction of the material available on the Internet. In addition, the total number of Web sites is growing rapidly, and we expect this rapid growth rate to continue in the future. Our database and database technologies may not be able to keep pace with the growth in the number of Web sites, especially the growing number of Web sites containing foreign languages. Further, the ongoing evolution of the Internet will require us to continually improve the functionality, features and reliability of our database. Because Websense Enterprise can only manage access to Web sites included in our database, if our database does not contain a meaningful portion of relevant Web sites, the effectiveness of Websense Enterprise will be significantly diminished. Any failure of our database to keep pace with the rapid growth and technological change of the Internet will impair the market acceptance of Websense Enterprise, which in turn will harm our business, results of operations and financial condition.

Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.

Our quarterly operating results have varied significantly in the past, and will likely vary in the future primarily as the result of fluctuations in our operating expenses. We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our research and development efforts and hire additional personnel. In addition, our operating expenses historically have fluctuated, and may continue to fluctuate in the future, as the result of the factors described below and elsewhere in this quarterly report:

•		concentration of marketing expenses for activities such as trade shows and advertising campaigns;
•		concentration of general and administrative expenses, such as recruiting expenses and professional services fees;
•		concentration of research and development costs; and
•		concentration of expenses associated with commissions paid on sales of subscriptions to Websense Enterprise.

As a result, it is possible that in some future periods, our results of operations may not meet the expectations of current or potential investors. If this occurs, the price of our common stock may decline.

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

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

•		announcements of technological innovations or new products or services by our competitors;
•		demand for Websense Enterprise, including fluctuations in subscription renewals;
•		fluctuations in revenue from our indirect sales channels;
•		changes in the pricing policies of our competitors; and
•		changes in government regulations.

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

•		announcements of technological innovations or new products or services by us;
•		changes in our pricing policies;
•		quarterly variations in our operating expenses; and
•		our technological capabilities to accommodate the future growth in our operations or our customers.

Further, the stock market has experienced significant price and volume fluctuations that have particularly affected the market price of the stock of many Internet-related companies, and that often have been unrelated or disproportionate to the operating performance of these companies. A number of publicly traded Internet-related companies have current market prices below their initial public offering prices. Market fluctuations such as these may seriously harm the market price of our common stock. In the past, securities class action suits have been filed following periods of market volatility in the price of a company’s securities. If such an action were instituted, we would incur substantial costs and a diversion of management attention and resources, which would seriously harm our business, results of operations and financial condition.

We may need to raise additional funds in the future, which may not be available on acceptable terms or at all and which may cause dilution.

We expect that our operating expenses will increase substantially over at least the next 12 months. In addition, we may experience a material decrease in liquidity due to unforeseen capital requirements or other events and uncertainties. As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, if at all. An additional equity financing would reduce the percentage of ownership of our existing stockholders, and debt financing, if available, may involve restrictive covenants, which may limit our operating flexibility. Stockholders may experience additional dilution in net book value per share and any additional equity securities may have rights, preferences and privileges senior to those of the holders of our common stock. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our software applications or database, execute on our business plan, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements. This may seriously harm our business, results of operations and financial condition.

Future sales of our common stock may cause our stock price to decline.

The market price of our common stock could decline as a result of sales by our existing stockholders of large numbers of shares of our common stock or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

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Our systems may be vulnerable to security risks or service disruptions that could harm our business.

Our servers are vulnerable to physical or electronic break-ins and service disruptions, which could lead to interruptions, delays, loss of data or the inability to process customer requests. Such events could be very expensive to remedy, could damage our reputation and could discourage existing and potential customers from using our products. We may experience break-ins in the future. Any such events could substantially harm our business, results of operations and financial condition.

Because our products are complex and are deployed in a wide variety of complex network environments, they may have errors or defects that users identify after deployment, which could harm our reputation and our business.

Products as complex as ours frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found errors in versions of Websense Enterprise, and we may find such errors in the future. The occurrence of errors could adversely affect sales of our products, divert the attention of engineering personnel from our product development efforts and cause significant customer relations problems.

Evolving regulation of the Internet may affect us adversely.

As Internet commerce continues to evolve, increasing regulation by federal, state or foreign agencies becomes more likely. Such regulation is likely in the areas of user privacy, pricing, content and quality of products and services. Taxation of Internet use or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Laws and regulations applying to the solicitation, collection or processing of personal or consumer information could affect our activities. Furthermore, any regulation imposing fees for Internet use could result in a decline in the use of the Internet and the viability of Internet commerce, which could have a material adverse effect on our business, results of operations and financial condition.

The success of our business depends on the continued growth and acceptance of the Internet as a business tool.

Expansion in the sales of Websense Enterprise depends on the continued acceptance of the Internet as a communications and commerce platform for enterprises. The Internet may not prove to be a viable commercial medium due to inadequate development of the necessary infrastructure, such as a reliable network backbone, or timely development of complementary products, such as high-speed modems. Additionally, the Internet could lose its viability as a business tool due to delays in the development or adoption of new standards and protocols to handle increased demands of Internet activity, security, reliability, cost, ease-of-use, accessibility, and quality-of-service. If the Internet does not continue to become a widespread communications medium and commercial platform, the demand for Websense Enterprise could be significantly reduced, which could have a material adverse effect on our business, results of operations and financial condition.

Our products create risks of potential negative publicity and legal liability.

Because customers rely on Websense Enterprise to provide EIM, any significant defects or errors in our products may result in negative publicity or legal claims. Negative publicity or legal claims could seriously harm our business, results of operations and financial condition. In addition, Websense Enterprise’s capability to report Internet data retrieval requests and the workstations from which they originated may result in negative publicity or legal claims based on potential privacy violations.

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

Our success depends largely upon the continued services of our executive officers and other key management and development personnel. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. We do not have employment agreements with a majority of our executive officers, key management or development personnel and, therefore, they could terminate their employment with us at any time without penalty. We do not maintain key person life insurance policies on any of our employees. The loss 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 be unable to recruit personnel to replace these individuals in a timely manner, or at all, on acceptable terms.

Our growth could strain our personnel and infrastructure resources, and if we are unable to implement appropriate controls and procedures to manage our growth, we may not be able to successfully implement our business plan.

We are currently experiencing a period of rapid growth in our operations, which has placed, and will continue to place, a significant strain on our management, administrative, operational and financial infrastructure. Our future success will depend in part upon the ability of our senior management to manage growth effectively. This will require us to hire and train additional personnel to manage our expanding operations. In addition, we will be required to continue to improve our operational, financial and management controls and our reporting systems and procedures. If we fail to successfully manage our growth, we will be unable to execute our business plan.

Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth.

To execute our growth plan, we must attract and retain highly qualified personnel. We need to hire additional personnel in virtually all operational areas, including selling and marketing, research and development, operations and technical support, customer service and administration. Competition for these personnel is intense, especially for engineers with high levels of experience in designing and developing software and Internet-related products. We may not be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. If we fail to attract new personnel or retain and motivate our current personnel, our business and future growth prospects could be severely harmed.

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

Some provisions of our certificate of incorporation and bylaws, as well as some provisions of Delaware law, may discourage, delay or prevent third parties from acquiring us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides for a classified board, with each board member serving a staggered three-year term. It also provides that stockholders may not fill board vacancies, call stockholder meetings or act by written consent. Our bylaws further provide that advance written notice is required prior to stockholder proposals. Each of these provisions makes it more difficult for stockholders to obtain control of our board or initiate actions that are opposed by the then current board. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board to issue preferred stock with voting or other rights and preferences that could impede the success of any attempted change of control. Delaware law also could make it more difficult for a third party to acquire us. Section 203 of the Delaware General Corporation Law may have an anti-takeover effect with respect to transactions not approved in advance by our board, including discouraging attempts that might result in a premium over the market price of the shares of common stock held by our stockholders.

We do not intend to pay dividends.

We have not declared or paid any cash dividends on our common stock since we have been a publicly-traded company. We currently intend to retain any future cash flows from operations to fund growth and, therefore, do not expect to pay any dividends in the foreseeable future.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

We are exposed to changes in interest rates primarily from our available-for-sale investments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at September 30, 2002. Declines in interest rates over time will, however, reduce our interest income.

We mitigate our foreign currency risks principally by contracting primarily in U.S. dollars and maintaining only nominal foreign currency cash balances. Working funds necessary to facilitate the short term operations of our subsidiaries are kept in the local currencies in which they do business. For the quarter ended September 30, 2002, all of our billings, including those billed by our operations in Ireland, were denominated in our functional currency, which is the U.S. dollar.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the Securities and Exchange Commission (SEC), and to record, process, summarize and report this information within the time periods specified in the rules of the SEC. Based on their evaluation of our disclosure controls and procedures which took place as of a date within 90 days of the filing date of this report, our Chief Executive and Chief Financial Officers have concluded that these controls and procedures are effective.

We also maintain a system of internal controls designed to provide reasonable assurance that transactions are executed in accordance with management’s general or specific authorization and that transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles, and (2) to maintain accountability for assets. Access to assets is permitted only in accordance with management’s general or specific authorization, and the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

Since the date of the most recent evaluation of our internal controls by our Chief Executive and Chief Financial Officers, there have been no significant changes in our internal controls or in other factors that could significantly affect our internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

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Part II — Other Information

Item 1. Legal Proceedings

None.

Item 2. Changes in Securities and Use of Proceeds

(a)  Not applicable.

(b)  Not applicable.

(c)  Not applicable.

(d)  On March 28, 2000, we completed our initial public offering for the sale of 4,000,000 shares of common stock at a price to the public of $18 per share, which resulted in net proceeds of $65.7 million after payment of the underwriters’ commissions and deductions of offering expenses. The registration statement (No. 333-95619) relating to our initial public offering was declared effective on March 28, 2000. Subsequent to our initial public offering, a portion of the offering proceeds were used to repay the $1.4 million balance of our fixed term loan agreements with financial institutions. The remaining proceeds have conformed with our intended use outlined in the prospectus related to such offering. We currently have approximately $64.3 million remaining from our IPO proceeds.

Item 3. Defaults upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

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Item 6. Exhibits and Reports on Form 8-K and S-8

(a)  Exhibits

99.1

Certifications Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)  Reports on Form 8-K

     No reports on Form 8-K were filed by the Registrant during the quarter ended September 30, 2002.

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