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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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 June 30, 2003

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.

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 [   ]

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

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of July 31, 2003 was 21,968,835.

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Websense, Inc.
Form 10-Q
For the Period Ended June 30, 2003

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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, 2002, included in Websense, Inc.’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. Operating results for the three and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2003. The balance sheet at December 31, 2002 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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     The 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 June 30, 2003 and 2002, there were outstanding options to purchase 2,407,000 and 1,019,000 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 six months ended June 30, 2003 and 2002, there were outstanding options to purchase 1,814,000 and 866,000 shares, respectively, that had an exercise price greater than the average market price of the common shares for the respective six 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 six month periods ended June 30, 2003 and 2002, 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 $66,000 and $476,000 at June 30, 2003 and December 31, 2002, respectively.

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5. Stock Based Compensation

     The Company accounts for its stock-based compensation plans under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. The pro forma information below is based on provisions of Statement of Financial Accounting Standard (“FAS”) No. 123, Accounting for Stock-Based Compensation, as amended by FAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure, issued in December 2002. The pro forma effects of stock-based compensation on net income and net income per share have been estimated at the date of grant using the Black-Scholes option pricing model based on the following weighted average assumptions since the Company’s initial public offering in March of 2000: risk free interest rates of 2.71% to 6.0%, dividend yields of 0%, expected volatility of 102% to 132%, and life of 5 years.

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

     For purposes of pro forma disclosures, the estimated fair value is amortized to expense over the options vesting period. The effect of applying SFAS 123 for purposes of providing pro forma disclosures may not be representative of the effects on our operating results in future years.

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6. New Accounting Pronouncements

     In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS No. 150). SFAS No. 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003 and must be applied to the Company’s existing financial instruments effective August 1, 2003, the beginning of the first fiscal period after June 15, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material effect on its results of operations or financial condition.

7. 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 analyze, report and manage how their employees use computing resources at work, including the Internet. Our primary product, Websense Enterprise®, gives organizations the ability to rapidly implement and configure Internet access policies in support of their 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 Websense Enterprise Version 4, which was sold through March 2003. We launched the next generation of Websense software — Websense Enterprise Version 5 — in March 2003, including enhanced EIM capabilities and new network and application management technology such as Client Application Manager™ and Bandwidth Optimizer™. We currently derive nearly all of our revenue from subscriptions to the Websense Enterprise solution and expect this trend to continue in the future as more offerings are added to the Websense Enterprise platform.

     During the six months ended June 30, 2003, we derived approximately 29% of revenue from international sales compared with approximately 32% for the six months ended June 30, 2002. Despite the decline year-over-year as a percentage of total revenue, international sales increased 25% in the second quarter of 2003 over the second quarter of 2002, and we believe international markets represent a significant growth opportunity and are continuing to expand our international operations, particularly in selected countries in the European, Latin American and Asia/Pacific markets.

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     We currently sell Websense Enterprise, including premium products and application modules, through both indirect and direct channels; however, sales through indirect channels currently account for more than 80% of our revenue and we expect this trend to continue.

     As described below, we recognize revenue from subscriptions to Websense Enterprise, including premium products and application modules, on a monthly straight-line basis over the term of the subscription. We recognize the operating expenses related to these sales as they are incurred. These operating expenses include commissions relating to the sale of new and renewal subscriptions, which are based on the total amount of the subscription contract and are fully expensed in the period a subscription key for the product is delivered. Operating expenses have continued to increase as compared with 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 future 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 renew 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 future 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.

     Deferred Tax Assets. As required by Statement of Financial Accounting Standards No. 109 (“SFAS 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. During 2002, we reassessed the valuation allowance previously established against U.S. deferred tax assets. Factors considered by us included: our earnings history, projected earnings based on current operations, and projected future taxable income in excess of stock option deductions. Based on this evidence, we concluded that it was more likely than not that the U.S. deferred tax assets would be realized. Accordingly, we released the valuation allowance of $14.3 million, which resulted in an income tax benefit of approximately $9.3 million. The remaining $5.0 million was credited to additional paid-in capital as it related to the tax benefit of stock option deductions. However, should we determine that we would not be able to realize all or part of our 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, 2002, we had $15.4 million in deferred tax assets.

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Results of Operations

     Three months ended June 30, 2003 compared with the three months ended June 30, 2002

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

Revenue

     Revenue increased to $19.5 million in the second quarter of 2003 from $14.6 million in the second quarter of 2002. This increase was primarily a result of the addition of new customers. Approximately 42% of subscription revenue recognized in the second quarter of 2003 was derived from sales to first-time customers, who initially purchased one-, two-, or three-year subscriptions to Websense Enterprise in 2003 or prior years. The remaining 58% of subscription revenue was generated from renewal business with existing customers. We expect revenue to grow at a slower rate in 2003 than 2002, principally as a result of the larger revenue base at June 30, 2003 compared with June 30, 2002 and uncertain global economic factors.

Cost of Revenue

     Cost of revenue consists of the costs of content review, technical support and infrastructure costs associated with maintaining our databases. Cost of revenue increased to $1.3 million in the second quarter

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of 2003 from $1.1 million in the second quarter of 2002. The increase was primarily due to the costs associated with additional personnel in our technical support and database groups. We expect cost of revenue to increase in the future as we support the growth and maintenance of our databases as well as the technical support needs of our customers. As a percentage of revenue, cost of revenue remained unchanged at 7% during the second quarters of 2003 and 2002. 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 to $18.2 million in the second quarter of 2003 from $13.5 million in the second quarter of 2002. The increase was primarily due to increased revenue. As a percentage of revenue, gross margin remained unchanged at 93% in the second quarters of 2003 and 2002. 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 to $7.5 million in the second quarter of 2003 from $6.3 million in the second quarter of 2002. The increase in selling and marketing expenses of $1.2 million was primarily due to increased headcount costs as well as higher commission expenses related to higher sales levels. We expect selling and marketing expenses to increase in the future as more personnel are added to support our expanding selling and marketing efforts worldwide.

     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 to $3.1 million in the second quarter of 2003 from $2.6 million in the second quarter of 2002. The increase of $500,000 in research and development expenses was primarily a result of personnel added since the second quarter of 2002 to develop and support our expanded list of technology partners, enhancements of Websense Enterprise, and additional products. We expect research and development expenses to increase in the future, as more personnel are added to support additional technology partners, product enhancements, and the 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, allocated facilities costs and depreciation expenses. General and administrative expenses increased to $1.7 million in the second quarter of 2003 from $1.4 million in the second quarter of 2002. The $300,000 increase in general and administrative expenses is primarily a result of an increase in personnel to support our growing operations, both domestically and internationally. 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 to $22,000 in the second quarter of 2003 from $125,000 in the second quarter of 2002. The decrease in the amortization expense is primarily due to the accelerated method of amortization that we have applied since our initial public offering. We expect amortization of stock-based compensation to decrease in future periods as a result of using the accelerated

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method of amortization. The deferred stock-based compensation balance of $18,000 will be completely amortized as of December 2003.

Other Income, Net

     Other income increased to $780,000 in the second quarter of 2003 from $688,000 in the second quarter of 2002. The increase is due primarily to realized gains related to the sale of taxable investments. During the third quarter of 2003, we intend to continue to sell taxable investments and use the proceeds to purchase tax-exempt investments. As of June 30, 2003, approximately 40% of our investments were tax exempt and we expect this percentage to increase significantly during the third quarter of this year. The increase was partially offset by lower interest income earned due to lower interest rates generated by our cash, cash equivalents and marketable securities despite increased balances as of June 30, 2003 as compared with June 30, 2002.

Provision for Income Taxes

     In the second quarter of 2002, our provision for income taxes related to our wholly-owned subsidiaries in the United Kingdom and Japan as well as domestic state income taxes. Beyond these domestic state income taxes, we did not provide for any other income taxes related to our U.S. operations due to the partial utilization of our deferred tax assets in the second quarter of 2002. Our provision for income taxes in the second quarter of 2003 relates to our wholly-owned subsidiaries in the United Kingdom, Japan, Australia, France and Germany as well as U.S. federal and state income taxes. We expect an effective tax rate of approximately 39% for 2003. Subsequent to 2003, our effective tax rate may decrease over time due to benefits derived from lower tax rates associated with foreign income.

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Six months ended June 30, 2003 compared to the six months ended June 30, 2002

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