10-K 1 wbsn2012123110k.htm 10-K WBSN 2012.12.31 10K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from                      to                     
Commission File Number 000-30093
__________________________________________ 
Websense, Inc.
(Exact name of registrant as specified in its charter)
Delaware
51-0380839
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
10240 Sorrento Valley Road
San Diego, California 92121
858-320-8000
(Address of principal executive offices, zip code and telephone number, including area code)
__________________________________________
Securities registered pursuant to section 12(b) of the Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common stock, $0.01 par value
NASDAQ Global Select Market
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ý No  o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10‑K or any amendment to this Form 10‑K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
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Accelerated filer
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Non-accelerated filer
o
Smaller reporting company
o
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):    Yes o No ý
The aggregate market value of the Common Stock held by non-affiliates of the registrant, as of June 29, 2012 was approximately $676.2 million (based on the closing price for shares of the registrant's Common Stock as reported by the NASDAQ Stock Market for that date). Shares of Common Stock held by each officer, director and holder of 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. The identification of 10% or greater stockholders as of June 29, 2012 is based on Schedule 13G and/or Schedule 13D reports publicly filed before June 29, 2012. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management or policies of the registrant, or that such person is controlled by or under common control with the registrant.
The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of February 13, 2013 was 36,559,257.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be delivered to stockholders in connection with the 2013 Annual Meeting of Stockholders are incorporated by reference into Part III of this report. Such Definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the registrant's fiscal year ended December 31, 2012.



Websense, Inc.
Form 10-K
For the Fiscal Year Ended December 31, 2012
TABLE OF CONTENTS
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 


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PART I
Forward-Looking Statements
This report on Form 10-K may contain “forward-looking statements” within the meaning of the federal securities laws 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 “may,” “will,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” or other words indicating future results. Such statements may include, but are not limited to, statements concerning the following:
anticipated trends in revenues and billings, including plans to increase headcount of our sales force;
management’s plans, strategies and objectives for future operations;
growth opportunities in domestic and international markets;
reliance on indirect channels of distribution;
anticipated product enhancements or releases;
customer acceptance and satisfaction with our products, services and fee structures;
expectations regarding competitive products and pricing;
risks associated with launching new product offerings;
changes in domestic and international market conditions;
risks associated with fluctuations in exchange rates of the foreign currencies in which we conduct business;
the impact of macroeconomic conditions on our customers;
expected trends in expenses;
anticipated cash levels and intentions regarding usage of cash;
risks related to compliance with the covenants in our credit agreement;
changes in effective tax rates, laws and interpretations and statements related to tax audits;
risks related to changes in accounting interpretations or accounting guidance;
the volatile and competitive nature of the Internet and security industries; and
the success of our marketing programs and brand development efforts.
These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part I, Item 1A “Risk Factors,” that could cause actual results to differ materially from those anticipated as of the date of this report. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report.
Websense®, our corporate logo, TRITONTM, V‑SeriesTM, V5000TM, V10000TM, X-SeriesTM, ThreatSeeker®, Security LabsTM, PreciseIDTM and SurfControl® are trademarks of Websense. All other brand names or trademarks appearing in this report are the property of their respective holders.
In this report, “Websense,” the “Company,” “we,” “us” and “our” refer to Websense, Inc., and our wholly owned subsidiaries, unless the context otherwise provides.

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Item 1.
Business
Overview
We are a global provider of unified Web, email, mobile and data security solutions designed to protect an organization's data and users from external and internal threats, including modern cyber-threats, advanced malware attacks, information leaks, legal liability and productivity loss. Our customers deploy our subscription software solutions on standard servers or other information technology (“IT”) hardware, including our optimized appliances, as a software-as-a-service (otherwise referred to as a cloud-based or “Cloud” service) offering, or in a hybrid hardware/Cloud configuration. Our products and services are sold worldwide to provide content security to enterprise customers, small and medium sized businesses (“SMBs”), public sector entities, and Internet service providers through a network of distributors, value-added resellers and original equipment manufacturers (“OEMs”).
Organizations rely on the Internet and email to conduct business, and frequently send critical or confidential information outside their network perimeters as part of their established business processes. Accelerating use of rich Web-based applications with real-time interaction, social Web sites with user-generated content, and the rise of Cloud services, are increasing the volume and value of information transmitted across the Internet. At the same time, the cost and number of security breaches involving data loss has increased, and regulatory compliance requirements have become more stringent. These trends support the need for unified, organization-wide Web and email security solutions that include data loss prevention capabilities and address the dynamic nature of both Web content and cyber-threats.
Websense has evolved from a reseller of network security products to a leading developer and provider of IT security software solutions. Our first commercial software product was released in 1996 and controlled employee access to inappropriate Web sites. Since then, we have focused on developing our Web security and content classification capabilities to address changes in the Internet and the external threat environment. These changes include the rise of Web-based social and business applications and the growing incidence of sophisticated, timed and targeted cyber-attacks designed to steal valuable information. In 2008, we introduced the first products under our TRITON security architecture, the Websense Web Security Gateway with dynamic content classification and advanced malware protection, and the Websense Data Security Suite for monitoring and protecting an organization's valuable data assets. Since then, we have extended the TRITON platform with the introduction of the Websense Email Security Gateway and the Websense TRITON Security Gateway (combined Web, email and data security), incorporated our enterprise data loss prevention engine and policy controls in all three TRITON security gateways, added deployment options with the V10000, V5000 and X10G appliances and integrated Cloud capabilities. Our TRITON content security solutions utilize a common management and reporting console that unifies security policies and enforcement across an organization and reduces the total management burden on IT departments.
Our products use our deep content inspection, advanced content classification, and policy management technologies to:
prevent access to undesirable and dangerous elements on the Web, including Web pages that download viruses, spyware, keyloggers, hacking tools and an ever-increasing variety of malicious code, and Web sites that contain inappropriate content;
identify and remove malware from incoming Web content;
manage the use of social Web sites;
manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;
prevent misuse of computing resources, including unauthorized downloading of high-bandwidth content;
inspect the content of encrypted Web traffic to prevent data loss, malware and access to Web sites with inappropriate content;
filter spam, viruses and malicious attachments from incoming email and instant messages;
protect against data theft and loss by identifying and categorizing sensitive or confidential data and enforcing pre-determined policies regarding its use and transmission within and outside an organization; and
enable the secure use of mobile smartphones and tablets within an organization’s network by providing protection from Web-based malware, malicious apps, data loss and theft of intellectual property, and by providing mobile device management features that keep mobile devices secure, minimize risk and maintain compliance.
We operate in one industry segment, as defined by U.S. generally accepted accounting principles (“GAAP”).

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We commenced operations in 1994 as NetPartners Internet Solutions, Inc. and in 1999, we changed our name to Websense, Inc. Our principal offices are located at 10240 Sorrento Valley Road, San Diego, California 92121.
Industry Background
Many organizations use the Internet as an integral part of their computing infrastructure, expanding their use of the Web to enable mission-critical applications such as customer relationship management, accounting, employee benefits, collaborative research and development and more. Many employees also use their organization's computing resources for recreational “Web-surfing,” social networking, peer-to-peer file sharing, instant messaging and other personal matters.
As organizations create collaborative social networks with their customers, suppliers, technology partners and other stakeholders, the value and volume of confidential and sensitive data that travels across these networks increases. The growing adoption of Cloud IT architectures, Cloud offerings, and mobile devices further obscures the boundaries of organizations' networks and increases the amount of sensitive data stored outside an organization's network. Steady growth in business use of social networking sites, which are characterized by dynamic user-managed content that is vulnerable to malware injection, increases exposure to cyber-threats. At the same time, cyber-attacks targeting data have increased in sophistication, as well as scale and frequency. Securing confidential data in this environment has become a top priority for IT executives. The success of recent high-profile cyber-attacks demonstrates that traditional security solutions that are focused on broadly known threats are ineffective.
To build a sound defense against modern threats, organizations must implement security that monitors both inbound and outbound network traffic (Web pages, emails, and attached documents) for content, context and data, as well as the behavior of any embedded applications. Real-time analysis and dynamic classification of internal data, Web content, email content, and embedded applications are necessary to keep up with the social Web, newly created internal information, and mutating cyber-threats that are timed and targeted. Enforcement policies must be user-, content- and destination-aware to provide adequate protection without hindering established business processes, and policies must extend across both the Web and email communication channels. As a result, we believe there is a significant opportunity for IT security solutions that unify Web security, email security and data loss prevention technologies to continuously monitor network traffic and apply policies based on deep content analysis and dynamic classification.
Our Products and Services
Overview of our Solutions
Our products are designed to provide content security by protecting an organization's data and users from modern cyber-threats and advanced malware attacks, information leaks, legal liability and productivity loss, and can be grouped into four categories:
Web security and filtering solutions that protect against Web-based malware and targeted cyber-attacks, and prevent access to inappropriate content;
email security solutions that filter phishing, spam, malicious links, inappropriate images and malware from inbound email;
mobile security solutions that protect against data loss and the theft of intellectual property, through a Cloud security service that analyzes inbound and outbound data communications; and
data security solutions that discover the location of sensitive data within the network, monitor and prevent the movement of sensitive data in outbound Web and email traffic and at the desktop or laptop to enforce policies and prevent information leaks.
We released our first Web filtering software product in 1996 and have continually refined our Web security solution throughout the years to provide organizations the ability to restrict access to inappropriate Web content and to Web sites identified as security risks. Our Web security solution is highly scalable and utilizes the same database and classification technologies that can be found in our more advanced and integrated content security solutions. In 2007, we expanded our portfolio of software products to include email and data security offerings, establishing Websense as a leading provider of content security software solutions.
In April 2010, we integrated the management of our advanced Web, email and data security solutions on the TRITON management console to deliver unified visibility and policy management across Web, email and internal network communications. Collectively, these products allow IT administrators to protect against modern cyber-threats, targeted cyber-attacks, and information leaks, as well as mitigate the risks of legal liability and productivity loss associated with unmanaged Web use.

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Our Web and email security software solutions are available installed on standard servers or other IT hardware, including pre-installed on a Websense-optimized appliance, as Cloud offerings, and in hybrid hardware/Cloud configurations. Our data security technologies are available as functionality integrated within our TRITON Web and email security gateways and Cloud offerings, or may be implemented separately as server-based software. All Websense security solutions include several reporting modules to meet the information needs of different management groups.
We sell subscriptions to our software and Cloud products generally in 12, 24 or 36 month durations, based on the number of seats or devices managed. Our TRITON content security solutions, including our TRITON security gateways, our data loss prevention products, Cloud offerings and related appliances, accounted for 63% of billings in 2012, compared with 54% in 2011 and 40% in 2010. Billings from subscriptions to our legacy Web filtering solutions, including the Websense Web Filter and Websense Web Security Suite, accounted for 37% and 46% of billings in 2012 and 2011, respectively, compared with 60% of billings in 2010. We expect sales of our TRITON solutions will be the primary driver of our billings and revenue growth for several years, while the percentage of our billings derived from our Web filtering products will continue to decline. Billings represent the amount of subscription contracts, OEM royalties and appliance sales billed to customers during the applicable period. See “Item 7 - Managements' Discussion and Analysis of Financial Condition and Results of Operation” for further detail regarding our use of the billings measurement.
Websense TRITON Solutions
Our TRITON security platform provides advanced content security by integrating our Web, email and data security technologies in a single unified security architecture designed to reduce security risks, improve compliance, protect data, improve productivity and mitigate legal liability at a reduced overall cost of ownership. At the core of the TRITON architecture is the Advanced Classification Engine (ACE), which analyzes inbound and outbound Web and email traffic using advanced analytics and contextual awareness to identify and classify security threats, sensitive internal data, and inappropriate content in real-time. The TRITON management console unifies policies and enforcement across an organization for Web, email and internal network traffic, creating a consistent security profile and reducing the overall cost of management.
Our TRITON content security solutions include Web, email and combined security gateways with or without integrated data loss prevention, along with functionally equivalent Cloud solutions, Websense-optimized appliances for mid-sized and enterprise-class organizations, and stand-alone enterprise data security solutions.
TRITON Web Security
Websense Web Security Gateway is a Web security solution that combines traditional Web filtering with dynamic content scanning and classification using our ACE Classification Engine. The ACE Classification Engine uses analytics generated by our ThreatSeeker Network, which scans billions of Web sites, emails and other content to identify new threats. The analytics used by the ACE Classification Engine detect and block new and uncategorized threats and inappropriate content. Additionally, our Websense Security Labs technology populates our master database of uniform record locators (“URLs”), protocols, applications and malware using a proprietary process of automatic content assessment and classification, with manual verification as necessary. With our Web Security Gateway, customers can proactively discover and mitigate new security risks, block dangerous malware, prevent access to inappropriate content, and manage social networking use, while still enabling the use of Web-based tools and applications for business and other productive use.
Our Web Security Gateway can be deployed on standard servers or other IT hardware or on a Websense-optimized appliance. Websense Web Security Gateway Anywhere expands our Web Security Gateway product with the addition of our enterprise data loss prevention security engine and hybrid Cloud deployment options, all managed from the TRITON management console. Hybrid hardware and Cloud deployment allows IT administrators to implement policies across the organization, regardless of the location of the user or mobile device.
TRITON Email Security
Websense Email Security Gateway is an appliance-based gateway solution that scans outbound and inbound email traffic to perform content filtering and policy enforcement within an organization. Our email software blocks threats such as spam, phishing attacks and viruses, and protects confidential data within email and attachments, providing compliance functionality and enterprise-grade data security, all managed from the TRITON management console. Integrated data security technology protects against data theft and leaks via email by monitoring outbound email traffic, including attachments, and enforcing customer-specific data security policies. Our Email Security Gateway can be deployed on standard servers or other IT hardware or on a Websense-optimized appliance. Websense Email Security Gateway Anywhere expands our Email Security Gateway product with the addition of our hybrid Cloud deployment options. Hybrid hardware and Cloud deployment allows IT administrators to prefilter inbound email traffic in the cloud for malware and spam, reducing bandwidth needs for inbound email, and filter outbound emails for content and data loss prevention.

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TRITON Cloud Security
The Cloud deployment model eliminates the need for customers to maintain an on-site server-based solution and provides centralized policy management for any type of IT environment, including environments with remote locations, home offices, and mobile devices. Websense Cloud Security provides real-time security scanning and content classification and is functionally equivalent to our server-based solutions. The services include advanced features such as clientless authentication for users, a lightweight endpoint client to prevent users from bypassing security controls. Our Web and email Cloud solutions are managed from the TRITON management console in the cloud and can be deployed as complete filtering and security solutions, or layered with existing server-based Web and email security solutions to provide additional protection from malware and undesirable content.
Websense Cloud Web Security. Websense Cloud Web Security directs customer Web traffic to our centralized servers and enforces the same security and acceptable use policies to mobile and remote users that are applied to server-based users.
Websense Cloud Web Security Gateway. Websense Cloud Web Security Gateway combines Web security with dynamic content scanning and classification by our ACE Classification Engine, with Cloud deployment to protect against both previously known and new unclassified threats. With Websense Cloud Web Security Gateway, customers can proactively discover and mitigate new security risks, block dangerous malware, prevent access to inappropriate content, and manage social networking use, while still enabling the use of Web-based tools and applications for business and other productive use.
Websense ACE in the Cloud. Websense ACE in the Cloud integrates our ACE Classification Engine with existing network defenses for added protection against advanced threats, phishing and targeted attacks, and provides online real-time ACE security defenses for Web requests via a simple proxy forwarding link from existing proxy gateways. This solution is deployed through a Cloud service and offers customers an additional layer of protection by providing contextual awareness, composite risk scoring and multi-layered, real-time analysis of Web threats.  Often potential customers are locked into existing networking equipment that is not due to be replaced for a year or more. With ACE in the Cloud these customers can deploy modern malware defenses by adding a Cloud security blanket.
Websense Cloud Email Security. Websense Cloud Email Security directs customer email traffic to our centralized servers. Incoming email traffic is scanned for phishing, spam, inappropriate content, malicious links and embedded malware without the need for a customer to install software on an on-premise server, eliminating undesirable content before it reaches a customer's network. Our service will also encrypt emails containing sensitive data before forwarding such email to its destination.
TRITON Mobile Security
Websense TRITON Mobile Security enables the secure use of mobile devices in an organization's network by providing Web security, mobile malware protection, application controls and reporting for mobile devices. This solution also has the ability to be paired with our email and data security solutions to protect against data loss and the theft of intellectual property.
TRITON Mobile Security provides organizations with:
real-time security protection from threats targeted at mobile devices;
mobile device management functions such as encryption, password enforcement, detection of privilege escalation, and remote lock and erase capabilities;
applications controls which provide the ability to push and pull corporate applications to and from mobile devices; and
support for separate policies for mobile corporate and personal devices.
Websense Data Security
Our data security solutions protect against the loss of confidential information and data due to internal threats, such as inadequate business process controls, employee error and malfeasance, and external threats, such as theft by undetected malicious code embedded in the network. In addition to offering stand-alone data security solutions, we have integrated our data security engine and policy controls with our Web and email security solutions under the TRITON architecture. This integrated approach allows managers to set comprehensive internal and external data use policies that enable critical business processes while preventing unauthorized transmission of sensitive data via email or the Web, or by download to devices utilizing the universal serial bus (“USB”) protocol or other exchange technologies.

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Websense Data Security Suite is an integrated data security solution that protects against data loss by identifying and categorizing sensitive or confidential data based on its characteristics, monitoring the movement of sensitive data throughout the network and enforcing pre-determined usage and movement policies. Additionally, the Websense Data Security Suite can be managed within the TRITON management console for an integrated content security solution that extends beyond the internal network. Customers can also purchase modules of the Websense Data Security Suite separately as they develop and deploy their data security policies.
Websense Data Security Suite:
discovers and identifies data stored on a network-connected device (data-at-rest);
monitors and prevents sensitive data from unauthorized distribution in outgoing and internal communications, including transmission through traditional and Web-based email, instant messaging and file and hypertext transfer protocols (data-in-motion);
automates enforcement of policies for data-in-motion to authorized recipients;
monitors and prevents unauthorized copying of highly sensitive files to USB devices and other portable media, or printing to hardcopy paper; and
audits and reports the distribution and use of confidential data against regulatory and internal security policy requirements.
Separate modules include:
Websense Data Discover. Websense Data Discover remotely scans specified network files, shared drives, databases, email servers, data repositories, and desktop computers to discover and classify confidential data, including Cloud sales force data. Data Discover enforces data protection policies by applying actions including encryption, file removal, file replacement, notification, auditing, logging, and custom scripts.
Websense Data Security Gateway. Websense Data Security Gateway offers network-based data loss protection, securing sensitive data from inadvertent or deliberate transmission outside the network. It monitors not only common network channels of communication such as Web and email, but also file transfer protocols, instant messaging, peer-to-peer communications, and other forms of communication for sensitive data.
Websense Data Endpoint. Websense Data Endpoint extends the visibility and control to client endpoints to identify what data is confidential, who is using the data, how it is being used and where the data is being transferred. Websense Data Endpoint enables organizations to enforce policies in the endpoint environment, on or off network, including fingerprint data.
The Websense Data Security Suite includes built-in policy templates for simple policy creation by the end users and a sophisticated policy engine to address the most common compliance requirements for United States federal and state regulations, as well as industry regulations such as the Payment Card Industry Data Security Standard (PCI DSS) and Check 21 Act, Canada's Personal Information Protection and Electronic Documents Act (PIPEDA), and international government and banking regulations for the European Union, United Kingdom, Israel, South Africa, Australia and Singapore. These templates are automatically updated as regulations change.
TRITON Combined Security Solutions
Websense TRITON Security Gateway Anywhere. Websense TRITON Security Gateway Anywhere combines the functionality of the Web and email security gateways into one consolidated gateway solution consisting of a unified platform, unified content analysis, and unified management capabilities. Security analytics powered by our ACE Classification Engine provides malware protection and data loss prevention. Websense TRITON Security Gateway Anywhere is available on our appliances and in a hybrid deployment which combines our optimized appliance and our Cloud platform to extend security policies to remote offices, users and devices efficiently.
Websense TRITON Enterprise. Websense TRITON Enterprise provides security to organizations seeking a highly flexible, scalable, and effective solution designed to provide Web, email and data security across the enterprise, from the desktop to mobile users. Websense TRITON Enterprise includes the entire Websense TRITON solution portfolio, including Web and email security gateways with built-in data loss prevention security, Cloud Web and email security offerings, and end-point data loss prevention.

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Appliances
V-Series. Our V-Series appliances, including our V10000 and V5000 appliances, are standard server platforms optimized for our security software products. They offer a combination of performance and flexibility that simplifies deployment of our solutions for our customers by consolidating multiple security functions in a single hardware platform. V-Series appliances significantly reduce deployment time and operational costs of the Websense TRITON Security Gateways, while meeting scalability requirements for small and mid-sized enterprises. V-Series appliances also integrate with our Cloud platform to offer customers the flexibility to combine server-based and Cloud solutions to maximize effectiveness for all users and devices, regardless of location.
X-Series. Our X-Series appliances utilize a modular chassis architecture to deliver very large enterprises a highly available and scalable system with the necessary real-time data-aware contextual defenses that defend against advanced malware and prevent data theft of intellectual property. X-Series appliances are interoperable with our V-Series appliances and can be synchronized with our Cloud platform to allow an organization to deploy security policies to off-site users and to connect remote offices. Our first X-Series appliance, the X10G, was introduced in the fourth quarter of 2011 and includes a 10 gigabit Ethernet interface and supports up to 16 blades and scales from 10,000 to 100,000 users per chassis.
Web Security and Filtering Solutions
Our Web security and filtering solutions mitigate the productivity loss and legal exposure associated with unmanaged employee Web use and prevent access to Web sites identified as security risks. These solutions are deployed in conjunction with an organization's network gateway platform (such as a proxy server or firewall) and manage employee Web use by applying pre-determined policies to Web content classified in more than 95 categories in our master database. The policy management software provides multiple options for monitoring, analyzing and reporting on Internet activity and the risks associated with employee computing.
Websense Web Security Suite
Websense Web Security Suite combines the functionality and database categories of the basic Websense Web Filter with additional security-specific categories, as well as several additional services, including Real Time Security Updates. Websense Web Security Suite enables organizations to manage acceptable use policies and block access to sites associated with spyware, phishing, keylogging and other threats. Additionally, advanced application and network protocol controls mitigate risks associated with social networking applications, peer-to-peer communications and instant messaging applications, among others.
Security Categories. Security categories augment the basic Web filtering database categories with categories for spyware and phishing Web sites, as well as sites compromised with malicious code. Beyond sites identified as hosting known and potential exploit code, these categories also include sites likely to contain little or no useful content, sites that camouflage their true nature or identity, and sites that employees can access to utilize hacking tools.
Real Time Security Updates. Real Time Security Updates use Cloud technology to deliver security category updates as new Web and application-based threats are identified and categorized by Websense Security Labs and our ThreatSeeker Network.
Websense Web Security Suite can be deployed on standard servers or other IT hardware, including Websense-optimized appliances, or as a Cloud offering. The Cloud deployment model eliminates the need for the customer to maintain an on-site server-based solution and provides centralized policy management for any type of IT environment, including environments with remote locations, home offices, and mobile devices.
Websense Web Filter
Websense Web Filter enables employers to proactively analyze, report and manage employee access to Web sites based on the content of the requested Web site. Our software application works in conjunction with network user directories and our database of categorized Web sites populated by our Security Labs technology and our Threatseeker Network to provide patented flexibility for managers when customizing, implementing and modifying Internet access policies for various groups, user types and individuals. A graphical user interface simplifies policy definition and implementation. Once policies have been established, the filtering software examines each Internet access request, determines the category of the requested Web site and applies the policies that have been defined by the customer. The breadth and specificity of our Web site categorization provide flexibility in selecting which types of material should be allowed, blocked or reported.

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Additional Websense Products and Services
SurfControl Products
Through our acquisition of SurfControl plc (“SurfControl”) in October 2007, we acquired certain products for which we do not have long-term plans.
We continue to sell renewal subscriptions to SurfControl Web Filter and SurfControl Mobile Filter, and have enhanced these solutions by supplementing the SurfControl URL database with additional Web filtering and security coverage provided by Websense Security Labs and ThreatSeeker technology. We no longer accept new subscriptions to these products from customers.
Additional Services
Standard Technical Support. Standard technical support is included with every software subscription and includes phone and email access to technical support engineers during normal business hours and unlimited access to My Websense, our secure Web portal, and the Websense Knowledgebase. The Knowledgebase includes constantly updated product-support related documentation, tutorials, articles and frequently asked questions, as well as on-line customer forums and technical and security alerts.
Premium Technical Support. Premium technical support augments standard technical support with access to global support centers twenty-four hours a day and seven days per week, via a dedicated telephone number and priority email support. This service targets one-hour response times for the highest severity issues. Premium technical support is required for Websense TRITON Solutions, Websense Web Security Gateways and Websense Data Security Suite purchases.
Mission Critical Support. Mission Critical Support combines all the benefits of premium technical support with superior technical response coordinated by a dedicated account manager. Mission critical support also includes architecture reviews, migration planning assistance, training recommendations and periodic account reviews.
Professional Services. Websense Professional Services assists customers through consulting engagements staffed by Websense certified engineers who assess, plan, design and optimize Websense Web, email, mobile or data security solutions for the customers' business environment.
Customers
Our customers range from companies with as few as 10 employees to large global organizations, government agencies and educational institutions in approximately 150 countries around the world. Ingram Micro, one of our broad-line distributors in North America, accounted for approximately 28% of our total revenues during 2012 and 2011 compared with 31% of our total revenues during 2010. Ingram Micro sold subscriptions through approximately 1,100 resellers in North America in 2012.
Sales, Marketing and Distribution
Sales. Our goal is to increase sales to new customers and increase subscription renewals, upgrades and other incremental business to existing customers by expanding our security offerings and increasing the number and productivity of the resellers and distributors who sell our products to end-user customers worldwide. In addition, we increased headcount in our sales force in the fourth quarter of 2012 and plan to further increase headcount in 2013 to expand sales capacity.
We sell our products and services primarily through multi-tiered indirect channels comprised of distributors and value-added resellers with substantial support from our internal sales team and sales engineers. For 2012, 2011 and 2010, indirect channel sales comprised approximately 95% of total billings and revenues. We expect that the large majority of our billings and revenues will continue to be derived from sales through indirect channels, including distributors and value-added resellers. We also have several arrangements with OEMs that grant the OEM customers the right to incorporate our products into their products for resale to end users.
In North America, we use Ingram Micro, Arrow Enterprise Computing Solutions and ComputerLinks to distribute our products and provide credit facilities, marketing support and other services to regional and local value-added resellers who sell to end-user customers. Our agreements with Ingram Micro, Arrow Enterprise Computing Solutions and ComputerLinks are not subject to any minimum sales obligations or obligations to market our products to existing customers. All agreements are non-exclusive and either party to each agreement may terminate the agreement at any time without cause.

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We sell our products internationally to distributors and resellers in approximately 130 countries, who in turn sell our products to customers in approximately 150 countries. No international distributor accounted for more than 10% of our revenues in 2012. In 2012 we derived 52% of our revenues from international sales compared with 50% in 2011 and 2010. Revenues generated in the United Kingdom comprised approximately 12%, 11% and 13% of our total revenues during 2012, 2011 and 2010, respectively. See Note 4 to the consolidated financial statements for further explanation of our revenues based on geography. We believe international markets represent a significant growth opportunity and we are continuing to expand our international operations, particularly in selected countries in the European, Asia/Pacific and Latin American markets. Our continuing reliance on sales in international markets exposes us to risks inherent in foreign sales. See “Item 1A. Risk Factors - Sales to customers outside the United States have accounted for a significant portion of our revenues, which exposes us to risks inherent in international sales” for further details on this exposure.
We also sell directly to resellers that specialize in security software through our Enterprise Alliance Partner program. These resellers work closely with a team of Websense territory managers and sales engineers to target potential customers and often build implementation services around our products, particularly our advanced TRITON content security solutions.
Our channel sales efforts are coordinated worldwide through an internal channel sales team located in our key markets. Our internal sales force supports our channel sales by generating leads and helping close sales. In addition, certain customers, who are typically large organizations, from time to time require that we sell directly to them. As part of our strategy to expand our subscription business to existing customers and to grow sales to new customers through expanded market coverage, we increased headcount in our sales force in the fourth quarter of 2012 and plan to further increase headcount in 2013.
Marketing.  Our marketing efforts are designed to increase recognition of Websense as a leading provider of unified Web, email, mobile and data security solutions, raise awareness of the potential risks to employees and sensitive data from unprotected use of the modern Web, and generate qualified sales leads for our channel partners. We provide potential customers and channel partners with free trials of our security software and appliances, typically for 30-day periods.
We focus our marketing activities to business executives, including IT and information system security professionals, upper level management and human resources personnel. We actively manage our public relations programs, communicating directly with technology professionals and the media in an effort to promote greater awareness of the growing problems caused by modern cyber-threats, such as advanced malware attacks, viruses, spyware, phishing, and keylogging, as well as internal security threats such as the loss of confidential data and employee misuse of the Internet and other computing resources at work.
Our marketing initiatives include:
jointly marketing with our distributors to recruit additional value-added resellers and to increase awareness for Websense solutions with existing resellers;
advertising online and in high-technology trade magazines, management journals and other business-oriented periodicals;
participating in and sponsorship of trade shows and industry events;
providing subscriptions to security alerts from Websense Security Labs, which inform subscribers of newly identified security threats;
holding seminars, webinars, and training sessions for our sales organization and reseller partners, as well as customers and prospective customers;
holding speaking engagements on topics of interest to our customers and prospective customers;
utilizing our Web site and other social media outlets to communicate with our customers and provide product and company information to interested parties; and
distributing materials about Websense and our products, solutions, technologies, partnerships and benefits.
Technology Integrations. Our solutions integrate with a variety of network and IT platforms and our objective is for Websense security solutions to be effective in any network environment desired by a customer.

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Customer Service, Training and Support
We believe that superior customer support is critical to retaining and expanding our customer base. Our technical support group provides dependable and timely resolution of customer technical inquiries and is available to customers by telephone, email and over the Web. We also proactively update customers on a variety of topics, including release dates of new products, updates to existing products and other technical alerts. We monitor the performance of our technology and support on an ongoing basis and seek to continuously enhance our performance levels.
Our training services group delivers education, training, certification and pre-sales support to our resellers and customers. We also offer the TRITON Solution Technical Enablement Program, an online and instructor-led training and certification program on TRITON content security solutions and Websense Web filtering, to enable our partners to deliver superior service and value to our joint customers.
Research and Development
We maintain research and development facilities in San Diego and Los Gatos, California; Reading, England; Beijing, China and Ra'anana, Israel. Our research and development department is divided into several groups, which include content operations, security research, software development, quality and assurance, and documentation. Individuals in different locations are grouped along product lines and work as part of cross-disciplinary teams designed to provide a framework for defining and addressing the activities required to bring product concepts and development projects to market successfully. In 2012, 2011 and 2010, we spent approximately $63 million, $58 million and $54 million, respectively, on research and development activities.
Competition
The market for our products is highly competitive, quickly evolving and subject to rapid technological change. Increased competition and pricing pressures generally could result in reduced sales, reduced renewals and/or declining seat counts from existing customers, reduced margins or failure of our products to achieve or maintain more widespread market acceptance. Competitors vary in size and in the scope and breadth of the products and services they offer. The competitive environments in which we operate and the principal competitors within each environment are described below.
TRITON Solutions for Content Security
Web Security. Our principal competitors offering Web security software solutions include companies such as McAfee (acquired by Intel), Symantec, Trend Micro, Check Point Software Technologies, Cisco Systems, Blue Coat Systems, Microsoft, Google, Webroot Software, SafeNet, Actiance, EdgeWave, FireEye, Trustwave, Clearswift, Sophos, Kaspersky Lab, AhnLab, IBM, Panda Security, F-Secure, Commtouch, CA Technologies, Juniper Networks, Palo Alto Networks, Black Box Network Services and Barracuda Networks.
Email Security. Our principal competitors offering messaging or email security solutions include companies such as McAfee, Symantec/Message Labs, Google, Cisco Systems, Barracuda Networks, SonicWALL, Trend Micro, Microsoft, Axway, Sophos, Proofpoint, Clearswift, Commtouch, Zix, WatchGuard Technologies, Trustwave, Webroot Software, EdgeWave, Zscaler and Fortinet.
Mobile Security. Our principal competitors offering mobile security solutions include companies such as Symantec, McAfee, AirWatch, Good Technology and MobileIron.
Data Security. Our principal competitors offering data loss prevention solutions include companies such as Symantec, Verdasys, Trustwave, EMC, McAfee, IBM, Trend Micro, Proofpoint, Palisade Systems, CA Technologies, Raytheon, Intrusion, Fidelis Security Systems (acquired by General Dynamics), GTB Technologies, Workshare, Check Point Software Technologies and Code Green Networks; and companies offering desktop security solutions, such as Check Point Software Technologies, Cisco Systems, McAfee, Microsoft, Symantec, CA Technologies, Sophos, Webroot Software, IBM and Trend Micro.
Web Filtering Solutions
Our principal competitors offering Web filtering solutions, including through specialized security appliances, include companies such as McAfee, Symantec, Trend Micro, Check Point Software Technologies, Cisco Systems, Blue Coat Systems, Microsoft, Google, Webroot Software, SafeNet, Actiance, EdgeWave, FireEye, Trustwave, Clearswift, Sophos, Kaspersky Lab, AhnLab, IBM, Panda Security, F-Secure, Commtouch, CA Technologies, Palo Alto Networks, Fortinet, Barracuda Networks and SonicWALL.

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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, enhance, develop and/or bundle products to include functions that are currently provided primarily by network security software. We compete against and expect increased competition from anti-virus software developers, firewall providers, traditional network management software developers, Web management service providers and providers of other software-based compliance solutions.
We believe that the principal competitive factors affecting the markets for our products include, but are not limited to:
• performance
 
• innovation
• quality
 
• customer support
• introduction of new products
 
• frequency of upgrades and updates
• brand name recognition and reputation
 
• lower cost of ownership
• price
 
• integration and manageability of products
• functionality
 
• threat research
We believe that we compete effectively in each of these areas. However, many of our current and potential competitors, such as Symantec, McAfee, Trend Micro, Cisco Systems, Check Point Software Technologies, Google and Microsoft, have significantly greater financial, technical, marketing or other resources. They may have significantly greater name recognition, established marketing and channel relationships, both in the United States and internationally, better access to SMB and enterprise customers, and a larger installed base of users. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the functionality of their products to address customer needs or may be acquired by a corporation with significantly greater resources. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
Intellectual Property Rights
Our intellectual property rights are important to our business. We rely on a combination of trademark, copyright, patent 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 the Websense brands. We generally distribute our products under subscription agreements that grant customers a right to use our products and receive daily database updates for a specified time period and contain terms and conditions prohibiting the unauthorized reproduction or transfer of our products. In addition, our policy is to enter into confidentiality and invention assignment agreements with all employees and consultants, and nondisclosure agreements with all other parties to whom we disclose confidential information. These protections, however, may not be adequate to protect our intellectual property rights.
We have registered our Websense trademark in the United States, Japan, the European Union, Canada, Australia, China, Switzerland, Norway, Mexico, Colombia, Argentina, Singapore, South Africa, Taiwan, Brazil, Iceland, India, Morocco, Peru, Chile, Hong Kong, Jordan, New Zealand, Russia and Turkey. In addition, we have registrations for other Websense trademarks pending in several countries. Effective trademark protection may not be available in every country where our products are available.
We seek to protect the source code of our products as trade secrets and as unpublished copyrighted works. We currently have 40 patents issued in the United States, 37 patents issued internationally, 32 patent applications pending in the United States and 79 pending international patent applications that seek to protect our proprietary database and certain Web filtering technologies, ThreatSeeker Web security technology, our ACE Classification Engine and data loss prevention and content distribution technology, including our PreciseID digital fingerprinting. No assurance can be given that any pending patent applications will result in issued patents. Our patents cover features of our product offerings that we believe help differentiate our products.
Employees
As of December 31, 2012, we had 1,609 employees worldwide, including 267 in cost of revenue departments, 665 in selling and marketing, 545 in research and development and 132 in administration. We have not experienced any work stoppages, and we consider our relations with our employees to be good.
Web Site Access to Securities and Exchange Commission Filings
We maintain a Web site at www.websense.com. The content of our Web site is not part of this Annual Report on Form 10-K. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), available free of charge on our Web site as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (the “SEC”).

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Executive Officers of the Registrant
Our executive officers and their ages as of February 13, 2013 are as follows:
Name
 
 
 
Age
 
Position(s)
John McCormack
 
53
 
Chief Executive Officer
Michael A. Newman
 
43
 
Executive Vice President, Chief Financial Officer
Didier Guibal
 
50
 
Executive Vice President, Worldwide Sales
Russ Dietz
 
49
 
Executive Vice President, Chief Technology Officer
Christian Waage
 
46
 
Vice President, General Counsel and Corporate Secretary
John McCormack became Websense's Chief Executive Officer in January 2013. Mr. McCormack previously served as Websense's President from April 2009 to January 2013 and as Senior Vice President, Product Development of Websense from July 2006 to April 2009. He has been a director of Websense since January 2013. Prior to joining Websense, Mr. McCormack was Vice President of Engineering for Symantec, a publicly-traded security software company. Mr. McCormack joined Symantec through the acquisition of Sygate Technologies, Inc., a provider of network access software, where he was Senior Vice President of Product Development from May 2004 to October 2005. From 1997 to 2004, Mr. McCormack served in various capacities for Cisco Systems, Inc., a publicly-traded computer hardware and software company, lastly as General Manager of the Secure Managed Networks Business Unit. Mr. McCormack received his M.S. in Information Management from the Engineering Management School of the George Washington University and a B.S. in Computer Science from the University of New Hampshire.

Michael Newman was appointed Executive Vice President, Chief Financial Officer of Websense in April 2012. Mr. Newman previously served as Senior Vice President, General Counsel, Chief Administrative Officer and Corporate Secretary of Websense since December 2010 and as interim Chief Financial Officer since September 2011. From August 2007 to December 2010, Mr. Newman served as Websense's Senior Vice President, General Counsel and Corporate Secretary and, from September 2002 to August 2007, as Websense's Vice President and General Counsel. From April 1999 to September 2002, Mr. Newman served in the legal department of Gateway, Inc., a publicly-traded personal computer manufacturer, and prior to that, Mr. Newman practiced as an attorney with Cooley LLP and Latham & Watkins LLP, two of California's leading law firms. Mr. Newman received his B.S. in Business Administration from Georgetown University, and a J.D. from Harvard Law School.

Didier Guibal has served as Websense's Executive Vice President, Worldwide Sales, since July 2009. Mr. Guibal was previously President of Panda Security, a provider of IT security solutions from April 2008 to October 2008. At Panda Security, Mr. Guibal was responsible for overseeing all aspects of the company's fully owned subsidiary which sells and supports both corporate and consumer security products to the US market. From May 2000 to January 2007, Mr. Guibal was a Vice President of Sales at Rightnow Technologies, Inc., a provider of Cloud enterprise solutions. From April 1996 to April 2000, Mr. Guibal was employed by McAfee, Inc., ultimately serving as Vice President of Sales-Americas. Mr. Guibal received his Master's degree in Business from Sup de Co-Business School in Montpellier, France.

Russ Dietz has served as Websense's Executive Vice President, Chief Technology Officer, since November 2012. Mr. Dietz was previously Corporate Vice President and Chief Technology Officer of SafeNet, Inc., a worldwide provider of data protection software, from February 2009 to November 2012. At SafeNet, Mr. Dietz led global research and development operations and the strategic positioning and migration of new technologies into the company's portfolio. From August 2000 to January 2009, Mr. Dietz served as Vice President and Chief Technology Officer of Hifn, Inc. a semiconductor manufacturer of security processors that was subsequently acquired by Exar Corporation in April 2009. At Hifn, Mr. Dietz developed and implemented strategic plans for network and storage, capacity optimization and other security processing solutions. From October 1995 to August 2000, Mr. Dietz served as Vice President and Chief Technology Officer of Apptitude, Inc., a provider of embedded Internet traffic analysis solutions that was subsequently acquired by Hifn. From April 1989 to October 1995, Mr. Dietz served as Vice President of Engineering for Technically Elite, Inc., a network management and monitoring solutions and services company.

Christian Waage has served as Vice President, General Counsel and Corporate Secretary of Websense since July 2012. From March 2008 to July 2012, Mr. Waage served as Vice President, General Counsel and Corporate Secretary of Ardea Biosciences, Inc., a biotechnology company. At Ardea Biosciences, Mr. Waage was responsible for all legal affairs, including SEC reporting and compliance, corporate governance, corporate development and licensing operations, and also oversaw the strategic acquisition of the organization by AstraZeneca PLC. From September 1997 to February 2008, Mr. Waage practiced as a corporate and securities attorney with DLA Piper US LLP, one of the world's leading law firms. Mr. Waage received his B.A. in Economics from the University of California, San Diego, and a J.D. from the University of San Diego School of Law.


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Item 1A.
Risk Factors
In addition to the other information in this report, including the important information in “Forward-Looking Statements,” you should carefully consider the following information in evaluating our business and our prospects. 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. In addition to these risks, our business may be subject to risks currently unknown to us. If any of these or other risks actually occur, our business, financial condition, results of operations and cash flows may be adversely affected, the trading price of our common stock could decline, and you may lose all or part of your investment in Websense.
Our future success depends on our ability to sell new, renewal and upgraded subscriptions for our security products.
We expect that a majority of our billings for 2013 will be derived from our TRITON content security solutions, including the TRITON security gateways, our data loss prevention products, related appliances and Cloud offerings sold with or without appliances. We also expect the percentage of our billings derived from our legacy Web filtering products will decline in 2013, relative to 2012, as many of our customers transition to our TRITON products or to lower-priced products sold by our competitors. Our billings and revenue growth are dependent on sales of security products to new customers and to customers who upgrade products upon renewal, which must also offset declines in sales from the renewals of Web filtering subscriptions. We also depend upon enterprise customers for a substantial portion of our sales. If we cannot sufficiently increase our customer base with the addition of new customers and upgrade subscriptions for additional product offerings from existing customers or renew a sufficient number of customers, we will not be able to grow our business to meet expectations.
Subscriptions to our software and Cloud products generally have durations of 12, 24 or 36 months. Our billings and revenues depend upon maintaining a high rate of sales of renewal subscriptions and upselling additional product offerings to existing customers as well as new customer sales. Our customers have no obligation to renew their subscriptions upon expiration, and if they renew, they may elect to renew for a shorter duration than the previous subscription period. For example, our customers may elect to renew subscriptions for shorter durations and may reduce their subscribed products due to contractions of work forces of their respective organizations as a result of adverse macroeconomic conditions. This may require us to undertake increasingly costly sales efforts targeting senior management and other management personnel associated with our customers’ Internet and security infrastructure. We may not be able to maintain or continue to generate increasing revenues from existing customers.
Volatility in the global economy and macroeconomic conditions may adversely impact our business, results of operations, financial condition or liquidity.
The global economy has experienced periods of significant volatility characterized by the bankruptcy, failure, collapse or sale of various financial institutions and the intervention from governments and regulatory agencies worldwide. We believe that financial distress and associated headcount reductions implemented by certain of our end user customers in response to this volatility have caused these customers to choose shorter contract durations and/or reduce the number of seats under subscription and in some cases, have caused customers not to renew contracts at all. While the number of distressed customers appears to have stabilized, we expect this trend to continue until and unless there is a broad worldwide economic recovery and positive job growth. These trends, most recently in continental Europe, have negatively impacted the duration and scope of contract renewals in certain countries or regions in the world and, in some cases, resulted in customer losses. Our average contract duration may be volatile as we seek contract renewals without eroding our average contract price for our products and seek to sell subscriptions to our TRITON and gateway security products which may have longer durations and may depend on product mix. Credit markets may also adversely affect our resellers through whom our distributors distribute products and limit the credit value-added resellers may extend to their customers. The volatility of currency exchange rates can also significantly affect sales of our products denominated in foreign currencies. In addition, events in the global financial markets may make it difficult for us to access the credit markets or to obtain additional financing or refinancing, if needed, on satisfactory terms or at all.

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If our security gateway products, data loss prevention products, Cloud offerings and our appliance platforms are unable to achieve more widespread market acceptance our business will be seriously harmed, particularly as Web filtering products continue to commoditize.
Our ability to generate revenue growth depends on our ability to continue to diversify our offerings by successfully developing, introducing and gaining customer acceptance of our new products and services, particularly our TRITON security gateway offerings as our Web filtering products have become more of a commodity. We sell our Websense Web Security Gateway products as well as our V-Series and X-Series appliances pre-loaded with our software to address emerging Web threats. We also sell the Websense Data Security Suite, our data loss prevention offering, Websense Cloud Web Security and Websense Cloud Email Security, our Cloud offerings, TRITON Mobile Security, our mobile device security solution released in 2012, and Websense Email Security, our email filtering solution. We offer our products with TRITON, our unified Web, email, mobile and data security solution, which combines our products into a single platform. We may not be successful in achieving market acceptance of these or any new products that we develop and may be unsuccessful in obtaining incremental sales as a result. If our products fail to meet the needs of our existing and target customers, or if they do not compare favorably in price, features and performance to competing products, our operating results and our business will be significantly impaired. If we fail to continue to upgrade and diversify our products, we could lose revenues from renewal subscriptions for our Web filtering products as these products continue to suffer from commoditization.
Our V-Series and X-Series appliance platforms expose us to risks inherent with the sale of hardware such as product delays and pricing fluctuations.
The hardware for our appliances is primarily manufactured by a single third-party manufacturer, and a single third-party logistics company provides related logistical services, including product configuration and shipping. Our ability to deliver our appliances to our customers could be delayed if we fail to effectively manage our third-party relationships or if our hardware manufacturer or logistics provider experiences delays, disruptions or quality control problems in manufacturing, configuring or shipping the appliances. If our third-party providers fail for any reason to assemble and deliver the appliances with acceptable quality, in the required volumes, and in a cost-effective and timely manner, it could be costly to us, as well as disruptive to product shipments. In addition, supply disruptions or cost increases could increase our cost of goods sold and negatively impact our financial performance. If we are required to change our third-party hardware manufacturer and/or logistics provider, we may be unable to deliver our appliances to our customers on a timely basis which could result in loss of sales and existing or potential customers and could adversely affect our business and operating results. Our appliance platforms may also face greater obsolescence risks than our pure software products.
Our revenues are derived almost entirely from sales through indirect channels and we depend upon these channels to create and capitalize on demand for our products.
Our revenues have been derived almost entirely from sales through multi-tiered indirect channels, including value-added resellers, distributors and OEM customers that sell our products to end users, providers of managed Internet services and other resellers. Ingram Micro, one of our broad-line distributors in North America, accounted for approximately 28% of our revenues during the year ended December 31, 2012. Should Ingram Micro or any of our other distributors experience financial difficulties, difficulties in collecting their accounts receivable or otherwise delay or prevent our collection of accounts receivable from them, our revenues and cash flow would be adversely affected. Also, should our resellers be subject to credit limits or have financial difficulties that limit financing terms available to them, our revenues and cash flow could be adversely affected. Our indirect sales model involves a number of additional risks, including:
our resellers and distributors are not subject to minimum sales requirements or any obligation to market our products to their customers;
we cannot control the level of effort our resellers and distributors expend or the extent to which any of them will be successful in marketing and selling our products;
we cannot ensure that our channel partners will market and sell our newer product offerings such as our X-Series appliances or our mobile security solutions;
providers of networking hardware, OEM customers and other value-added resellers that incorporate our products into, or bundle our products with, their products may fail to provide, or restrict us from providing, adequate support services to end users of these integrated product offerings, harming our reputation and brand, or may decide to develop or sell competing products instead of our products;
our reseller and distributor agreements are generally nonexclusive and may be terminated at any time without cause; and

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our resellers and distributors frequently market and distribute competing products and may, from time to time, place greater emphasis on the sale of these products due to pricing, promotions and other terms offered by our competitors.
Our ability to increase meaningfully the amount of our products sold through our sales channels also depends on our ability to support these channel partners adequately and efficiently with, among other things, appropriate financial incentives to encourage pre-sales investment and development of sales tools, such as sales training, technical training and product materials needed to support their existing and prospective customers. The diversity and sophistication of our product offerings have required us to focus on additional sales and technical training, and we are making increased investments in this area. Additionally, we are continually evaluating the changes to our internal ordering and partner management systems in order to effectively execute our multi-tiered distribution strategy. Any failure to support our sales channels properly and efficiently could result in lost sales opportunities.
We also depend significantly upon our internal sales force to generate sales leads and assist in the sale of products through the reseller network. Our ability to grow our revenues from sales of TRITON solutions to new and renewing customers will depend on the success of our sales team in executing on new customer opportunities while upgrading our renewing customer base to TRITON solutions with higher subscription values. In order to execute successfully on our strategy, we have to recruit and retain qualified sales personnel who can sell our sophisticated security solutions in organizations with complex information technology infrastructures. Our failure to recruit or retain sales personnel may adversely affect our sales to new customers and our sales for renewals and upgrades within our existing customer base.
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. Many of these variations come from macroeconomic and cyclical changes causing fluctuations in our billings, revenues, operating expenses, cash flows and tax provisions. Our billings depend in part on the number of subscriptions up for renewal each quarter and are affected by cyclical variations, with the fourth quarter generally being our strongest quarter in billings, and the first quarter generally being our lowest quarter for billings, each fiscal year. Although a significant portion of our revenues in any quarter comes from previously deferred revenue, a portion of our revenues in any quarter depends on the number, size and length of subscriptions to our products that are sold in that quarter as well as our appliance sales which are, following January 1, 2011, fully recognized in the quarter in which they are sold. In addition, we have become increasingly dependent upon large orders which have a significant effect on our operating results during the quarter in which we receive them. The timing of such orders or the loss of an order is difficult to predict and sales expected in a quarter may not be completed until a subsequent quarter. The unpredictability of quarterly fluctuations is further increased by the fact that a significant portion of our quarterly sales have historically been generated during the last month of each fiscal quarter, with most of the largest enterprise customers purchasing subscriptions to our products nearer to the end of the last month of each quarter.
Our operating expenses may increase in the future if we expand our selling and marketing activities, increase our research and development efforts or hire additional personnel which could impact our margins. 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 report:
changes in currency exchange rates impacting our international operating expenses;
timing of marketing expenses for activities such as trade shows and advertising campaigns;
quarterly variations in general and administrative expenses, such as recruiting expenses and professional services fees;
increased research and development costs prior to new or enhanced product launches; and
fluctuations in expenses associated with commissions paid on sales of subscriptions to our products which generally increase with billings growth in the short term because such expenses are recognized immediately upon sales of subscriptions while revenues are recognized ratably over the subscription term.
Consequently, these factors limit our ability to accurately predict our results of operations and the expectations of current or potential investors may not be met. If this occurs, the price of our common stock may decline.

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Our worldwide income tax provisions and other tax accruals may be insufficient if any taxing authorities assume taxing positions that are contrary to our positions and those contrary positions are sustained.
Significant judgment is required in determining our worldwide provision for income taxes and for our accruals for state, federal and international income taxes together with transaction taxes such as sales tax, value added tax and goods and services tax. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of intercompany arrangements to share revenues and costs. In such arrangements there are uncertainties about the amount and manner of such sharing, which could ultimately result in changes once the arrangements are reviewed by taxing authorities. Although we believe that our approach to determining the amount of such arrangements is consistent with prevailing legislative interpretation, no assurance can be given that the final tax authority review of these matters will agree with our historical income tax provisions and other tax accruals. Such differences could have a material effect on our income tax provisions or benefits, or other tax accruals, in the period in which such determination is made, and consequently, on our results of operations for such period.
From time to time, we are audited by various federal, state and non- U.S. tax authorities. Generally, the tax years 2005 through 2011 could be subject to examination by U.S. federal and most state tax authorities. We are currently under examination for tax years 2008 and 2009 in the United States and for 2006 through 2010 in Israel. We also have various other on-going audits in various stages of completion. No outcome for a particular audit can be determined with certainty prior to the conclusion of the audit and any appeals process.
As each audit progresses and is ultimately concluded, adjustments, if any, will be recorded in our financial statements from time to time in light of prevailing facts based on our and the taxing authority’s respective positions on any disputed matters. We provide for potential tax exposures by accruing for uncertain tax positions based on judgment and estimates including historical audit activity. If the reserves are insufficient or we are not able to establish a reserve under GAAP prior to completion or during the progression of any audits, there could be an adverse impact on our financial position and results of operations when an audit assessment is made. In addition, our external costs of contesting and settling any dispute with the tax authorities could be substantial and adversely impact our financial position and results of operation.
Fluctuations in foreign currency exchange rates could materially affect our financial results.
A significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies, so if the U.S. dollar weakens, our consolidated operating expenses would increase. Conversely, our operating expenses would be lower if the U.S. dollar strengthens. These currency changes have the opposite impact on our billings from international sales. Should the U.S. dollar strengthen, our products may become more expensive for our international customers with subscription contracts denominated in U.S. dollars. If this causes a decrease in international sales, our results of operations and net cash flows from international operations may be adversely affected.
Changes in currency rates also impact our future revenues under subscription contracts that are not denominated in U.S. dollars, as we bill certain international customers in Euros, British Pounds, Australian Dollars, Japanese Yen and Chinese Renminbi. Our revenue and deferred revenue for these currencies are recorded in U.S. dollars when the subscription begins based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. This accounting policy increases our risks associated with fluctuations in currency exchange rates since we cannot be assured of receiving the same U.S. dollar equivalent as when we bill exclusively in U.S. dollars. For example, if there is a strong U.S. dollar at the time a subscription begins, we record a lower subscription amount in U.S. dollars relative to the foreign currency in which the subscription was priced to the customer. As a result, the strengthening of the U.S. dollar for current sales would reduce our future revenues from these contracts, even though these foreign currencies may strengthen during the term of these subscriptions. Because currency exchange rates remain volatile, our future revenues could be adversely affected by currency fluctuations.
We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss. If we fail to properly forecast our billings, expenses and currency exchange rates these hedging activities could have a negative impact.
We face increasing competition from much larger software and hardware companies, which places pressure on our pricing and which could prevent our revenues from increasing. In addition, as we increase our emphasis on our security-oriented products, we face competition from better-established security 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 Web filtering competitors frequently offer their products at a significantly lower price than our products, which has resulted in pricing pressures on sales of our basic Web filtering products and email filtering products. We depend on our more advanced security solutions, such as our TRITON content security solutions, to replace and grow revenues from Web filtering subscriptions that are not renewed.

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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, enhance, develop and/or bundle products to include functions that are currently provided primarily by network security software. If network security functions become standard features of computer hardware or of operating system software or other software, our products may become obsolete and unmarketable, particularly if the quality of these network security features is comparable to that of our products. Furthermore, even if the network security and/or management functions provided as standard features by hardware providers or operating systems or other software is more limited than that of our products, our customers might accept this limited functionality in lieu of purchasing additional software. Sales of our products would suffer materially if we were then unable to develop new Web, email, mobile and data loss prevention products to further enhance operating systems or other software and to replace any obsolete products.
Increased competition may also cause price reductions or a loss of market share, either of which could have a material adverse effect on our business, results of operations and financial condition. If we are unable to maintain the current pricing on sales of our products or increase our pricing in the future, our results of operations could be negatively impacted. Even if our products provide greater functionality and are more effective than certain other competitive products, potential customers might accept this limited functionality. In addition, our own indirect sales channels may decide to develop or sell competing products instead of our products. Pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of our products to achieve or maintain widespread market acceptance, any of which could have a material adverse effect on our business, results of operations and financial condition. The competitive environments in which we operate and the principal competitors within each environment are described below.
TRITON Solutions for Content Security
Web Security. Our principal competitors offering Web security software solutions include companies such as McAfee, Symantec, Trend Micro, Check Point Software Technologies, Cisco Systems, Blue Coat Systems, Microsoft, Google, Webroot Software, SafeNet, Actiance, EdgeWave, FireEye, Trustwave, Clearswift, Sophos, Kaspersky Lab, AhnLab, IBM, Panda Security, F-Secure, Commtouch, CA Technologies, Juniper Networks, Palo Alto Networks, Black Box Network Services and Barracuda Networks.
Email Security. Our principal competitors offering messaging or email security solutions include companies such as McAfee, Symantec/Message Labs, Google, Cisco Systems, Barracuda Networks, SonicWALL, Trend Micro, Microsoft, Axway, Sophos, Proofpoint, Clearswift, Commtouch, Zix, WatchGuard Technologies, Trustwave, Webroot Software, EdgeWave, Zscaler and Fortinet.
Mobile Security. Our principal competitors offering mobile security solutions include companies such as Symantec, McAfee, AirWatch, Good Technology and MobileIron.
Data Security. Our principal competitors offering data loss prevention solutions include companies such as Symantec, Verdasys, Trustwave, EMC, McAfee, IBM, Trend Micro, Proofpoint, Palisade Systems, CA Technologies, Raytheon, Intrusion, Fidelis Security Systems, GTB Technologies, Workshare, Check Point Software Technologies and Code Green Networks; and companies offering desktop security solutions, such as Check Point Software Technologies, Cisco Systems, McAfee, Microsoft, Symantec, CA Technologies, Sophos, Webroot Software, IBM and Trend Micro.
Web Filtering Solutions
Our principal competitors offering Web filtering solutions, including through specialized security appliances, include companies such as McAfee, Symantec, Trend Micro, Check Point Software Technologies, Cisco Systems, Blue Coat Systems, Microsoft, Google, Webroot Software, SafeNet, Actiance, EdgeWave, FireEye, Trustwave, Clearswift, Sophos, Kaspersky Lab, AhnLab, IBM, Panda Security, F-Secure, Commtouch, CA Technologies, Palo Alto Networks, Fortinet, Barracuda Networks and SonicWALL.
As we develop and market our products with an increasing security-oriented emphasis, we also face growing competition from security solutions providers. Many of our competitors within the Web security market, such as Symantec, McAfee, Trend Micro, Cisco Systems, Check Point Software Technologies, Google and Microsoft enjoy substantial competitive advantages, including:
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.

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As a result, we may be unable to gain sufficient traction as a provider of advanced content security solutions, and our competitors may be able to respond more quickly and effectively than we can to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, marketing, promotion and sale of their products than we can. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the functionality and market acceptance of their products or may be acquired by a corporation with significantly greater resources. In addition, our competitors may be able to replicate our products, make more attractive offers to existing and potential employees and strategic partners, develop new products or enhance existing products and services more quickly. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share. In addition, many of our competitors made recent acquisitions in some of our product areas, and, we expect competition to increase as a result of this industry consolidation. Through an acquisition, a competitor could bundle separate products to include functions that are currently provided primarily by our Web, email, mobile and data security solutions and sell the combined product at a lower cost which could essentially include, at no additional cost, the functionality of our stand-alone solutions. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.
The covenants in our credit facility restrict our financial and operational flexibility, including our ability to complete additional acquisitions and invest in new business opportunities.
In October 2010, we entered into the 2010 Credit Agreement. Under the 2010 Credit Agreement, we can borrow up to $120 million and use proceeds to fund share repurchases or other corporate purposes. We may increase the maximum aggregate commitment under the 2010 Credit Agreement to up to $200 million if certain conditions are satisfied, including that we are not in default under the 2010 Credit Agreement at the time of the increase. If we should need to increase the aggregate commitment, it may not be possible to satisfy these conditions.
The 2010 Credit Agreement contains affirmative and negative covenants, including an obligation to maintain a certain consolidated leverage ratio and consolidated interest coverage ratio and restrictions on our ability to borrow money, to incur liens, to enter into mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. An event of default under the 2010 Credit Agreement could allow the lenders to declare all amounts outstanding with respect to the agreement to be immediately due and payable. The 2010 Credit Agreement is secured by substantially all of our assets, including pledges of stock of certain of our subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by our domestic subsidiaries. If the amount outstanding under the 2010 Credit Agreement is accelerated, the lenders could proceed against those assets and stock. Any event of default, therefore, could have a material adverse effect on our business.
In addition to the risk of default, we face certain other risks as a result of entering into the 2010 Credit Agreement, including the following:
it may be difficult for us to satisfy our obligations under the 2010 Credit Agreement, including certain financial ratios that can be affected by events beyond our control;
we may be less able to obtain other debt financing in the future;
we could be less able to take advantage of significant business opportunities, including acquisitions or divestitures, as a result of the covenants under the 2010 Credit Agreement;
our vulnerability to general adverse economic and industry conditions could be increased;
we could be at a competitive disadvantage to competitors with less debt; and
we may be unable to repurchase our securities due to certain financial ratios set forth in the 2010 Credit Agreement.
Our international operations involve risks that could increase our expenses, adversely affect our operating results and require increased time and attention of our management.
We have significant operations outside of the United States, including research and development, sales and customer support. We have engineering operations in Reading, England; Beijing, China and Ra’anana, Israel.
We plan to continue to expand our international operations, but such expansion is contingent upon the financial performance of our existing international operations as well as our identification of growth opportunities. Our international operations are subject to risks in addition to those faced by our domestic operations, including:
difficulties associated with managing a distributed organization located on multiple continents in greatly varying time zones;

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potential loss of proprietary information due to misappropriation or foreign laws that may be less protective of our intellectual property rights;
requirements of foreign laws and other governmental controls, including trade and labor restrictions and related laws that reduce the flexibility of our business operations;
potential failures of our foreign employees or partners to comply with U.S. and foreign laws, including antitrust laws, trade regulations, the Foreign Corrupt Practices Act, the U.K. Bribery Act and other anti-bribery and corruption laws;
political unrest, war or terrorism, particularly in areas in which we have facilities;
difficulties in staffing, managing, and operating our international operations, including difficulties related to administering our stock plans in some foreign countries;
difficulties in coordinating the activities of our geographically dispersed and culturally diverse operations;
restrictions on our ability to repatriate cash from our international subsidiaries or to exchange cash in international subsidiaries into cash available for use in the United States; and
costs and delays associated with developing software in multiple languages.
Sales to customers outside the United States have accounted for a significant portion of our revenues, 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 52% of our total revenues generated during the year ended December 31, 2012. As a key component of our business strategy to generate new business sales, we intend to continue to expand our international sales, but success cannot be assured. In addition to the risks associated with our domestic sales, our international sales are subject to the following risks:
our ability to adapt to sales and marketing practices and customer requirements in different cultures;
our ability to successfully tailor software products for a significant number of international markets;
laws in foreign countries may not adequately protect our intellectual property rights;
the significant presence of some of our competitors in some international markets;
laws and business practices favoring local competitors;
dependence on foreign distributors and their sales channels;
longer payment cycles for sales in foreign countries and difficulties in collecting accounts receivable;
compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations and consumer protection and privacy laws; and
regional economic and political conditions, including civil unrest and adverse economic conditions in emerging markets with significant growth potential.
These factors could have a material adverse effect on our international sales. Any 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.
Security threats to our IT infrastructure could expose us to liability and damage our reputation and business.
It is essential to our business strategy that our technology and network infrastructure remain secure and is perceived by our customers, distributors and resellers to be secure. Despite security measures, however, any network infrastructure may be vulnerable to cyber-attacks by hackers and other security threats. As a provider of security solutions designed to provide content security by protecting an organization’s data and users, we may face cyber-attacks that attempt to penetrate our network security, including our data centers, to sabotage or otherwise disable our products and services, misappropriate our or our customers’ proprietary information, which may include personally identifiable information, or cause interruptions of our internal systems and services. If successful, any of these attacks could negatively affect our reputation as a provider of security solutions, damage our network infrastructure and our ability to deploy our products and services, harm our relationship with customers that are affected and expose us to financial liability.

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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 our products are designed to operate with a variety of network hardware and software platforms, we need to continuously modify and enhance our products to keep pace with changes in Internet-related hardware (including mobile devices), software, communication, browser and database technologies. We may not be successful in either developing such products or introducing them to the market in a timely fashion. In addition, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technologies 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.
We rely upon a combination of automated filtering technology and human review to categorize URLs and executable files in our proprietary databases. Our customers may not agree with our determinations that particular URLs and executable files should be included or excluded in specific categories of our databases. In addition, it is possible that our filtering processes may place objectionable or security risk material in categories that are generally unrestricted by our users’ Internet and computer access policies, which could result in such material not being blocked from the network. Any errors in categorization could result in customer dissatisfaction and harm our reputation. Any failure to effectively categorize and filter URLs and executable files according to our customers’ expectations could impair the growth of our business. Our databases and database technologies may not be able to keep pace with the growth in the number of URLs and executable files, especially the growing amount of content utilizing foreign languages and the increasing sophistication of malicious code and the delivery mechanisms associated with spyware, phishing and other hazards associated with the Internet. The success of our dynamic Web categorization capabilities may be critical to our customers’ long-term acceptance of our products.
We may spend significant time and money on research and development to enhance our TRITON management console, appliances, content gateway products, mobile device solutions, data loss prevention products and our Cloud offerings. If these products fail to achieve broad market acceptance in our target markets, we may be unable to generate significant revenues from our research and development efforts. As a result, our business, results of operations and financial condition would be adversely impacted.
Because our products primarily manage access to URLs and executable files included in our databases, if our databases do not contain a meaningful portion of relevant content, the effectiveness of our Web filtering products will be significantly diminished. Any failure of our databases to keep pace with the rapid growth and technological change of the Internet, such as the increasing amount of multimedia content on the Internet that is not easily classified, will impair the market acceptance of our products.
If we fail to maintain adequate operations infrastructure, we may experience disruptions of our Cloud offerings.
Any disruption to our technology infrastructure or the Internet could harm our operations and our reputation among our customers. Our technology and network infrastructure is extensive and complex, and could result in inefficiencies or operational failures. These potential inefficiencies or operational failures could diminish the quality of our products, services, and user experience, resulting in damage to our reputation and loss of current and potential subscribers, and could harm our operating results and financial condition. Any disruption to our computer systems could adversely impact the performance of our Cloud offerings and hybrid service offerings, our customer service, our delivery of products or our operations and result in increased costs and lost opportunities for business.
Failure of our products to work properly or misuse of our products could impact sales, increase costs, and create risks of potential negative publicity and legal liability.
Our products are complex, are deployed in a wide variety of network environments and manage content in a dramatically changing world. Our products may have errors or defects that users identify after deployment, which could harm our reputation and our business. In addition, 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 our products, and we expect to find such errors in the future. Because customers rely on our products to manage employee behavior to protect against security risks and prevent the loss of sensitive data, including confidential and proprietary information, any significant defects or errors in our products may result in negative publicity or legal claims. For example, an actual or perceived breach of network or computer security at one of our customers, regardless of whether the breach is attributable to our products, could adversely affect the market’s perception of our security products. Moreover, any actual security breach could result in product liability and related claims. Our subscription agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, however, it is possible, that such provisions may not be effective under the laws of certain jurisdictions, particularly in circumstances involving subscriptions without signed agreements from our customers.

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In addition to the risks above, parties whose Web sites or executable files are placed in security-risk categories or other categories with negative connotations may seek redress against us for falsely labeling them or for interfering with their business. 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 or legal problems.
Our products may also be misused or abused by customers or non-customer third parties who obtain access to our products. These situations may arise where an organization uses our products in a manner that impacts their end users’ or employees’ privacy or where our products are misappropriated to censor private access to the Internet. Any of these situations could result in negative press coverage and negatively affect our reputation.
Third parties claiming that we infringe their proprietary rights could cause us to incur significant legal expenses that reduce our operating margins and/or prevent us from selling our products.
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 we expand our product offerings in the data loss and security area where larger companies with large patent portfolios compete, the possibility of an intellectual property claim against us grows. We may receive claims that we have infringed the intellectual property rights of others, including claims regarding patents, copyrights and trademarks. Any such claim, with or without merit, could result in costly litigation and distract management from day-to-day operations and may result in us deciding to enter into license agreements to avoid ongoing patent litigation costs. For example, on July 12, 2010, Finjan, Inc. filed a lawsuit against us in the United States District Court for the District of Delaware alleging that certain of our products infringed a patent owned by Finjan. Although the jury delivered a verdict in our favor, finding that none of the accused products infringed the Finjan patent and that the Finjan patent was invalid, we have expended significant time and resources defending the claim and will continue to incur costs associated with filing and responding to post-trial motions. If we are not successful in defending other claims of infringement, we could be required to stop selling our products, redesign our products, pay monetary amounts as damages, enter into royalty or licensing arrangements, or satisfy indemnification obligations that we have with some of our customers. Such arrangements may cause our operating margins to decline.
We face risks related to customer outsourcing to system integrators.
Some of our customers have outsourced the management of their IT departments to large system integrators. If this trend continues, our established customer relationships could be disrupted and our products could be displaced by alternative system and network protection solutions offered by system integrators. Significant product displacements could impact our revenues and have a material adverse effect on our business.
Any failure to protect our proprietary technology would negatively impact our business.
Intellectual property is critical to our success, and we rely upon patent, 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 brands. While we require employees, collaborators and consultants to enter into confidentiality agreements and include provisions in our subscription agreements with customers that prohibit the unauthorized reproduction or transfer of our products, we cannot ensure that these agreements will not be breached or that we will have adequate remedies for any breach.
We rely on trade secrets to protect technology where we believe patent protection is not appropriate or obtainable and protect the source code of our products as trade secrets and as unpublished copyrighted works. We may not be able to adequately protect our trade secrets or other proprietary information in the event of any unauthorized use or disclosure, or the lawful development by others of such information. Any unauthorized disclosure of our source code or other trade secrets could result in the loss of future trade secret protection for those items. Additionally, any intentional disruption and/or the unauthorized use or publication of our trade secrets and other confidential business information, via theft or a cyber-attack, could adversely affect our competitive position, reputation, brands and future sales of our products.
We have registered our trademarks in various countries and have registrations for the Websense trademark pending in several countries. Effective trademark protection may not be available in every country where our products are available. Furthermore, any of our trademarks may be challenged by others or invalidated through administrative process or litigation.
We currently have 40 patents issued in the United States and 37 patents issued internationally, and we may be unable to obtain further patent protection in the future. We also have pending patent applications in the United States and in other countries. We cannot ensure that:
we were the first to conceive the inventions covered by each of our pending patent applications;
we were the first to file patent applications for these inventions;

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any of our pending patent applications are not obvious or anticipated such that they will not result in issued patents or if issued, will not be nullified when challenged for being obvious;
others will not independently develop similar or alternative technologies or duplicate any of our technologies;
any patents issued to us will provide us with any competitive advantages or will not be challenged by third parties;
we will develop additional proprietary technologies that are patentable; or
the patents of others will not have a negative effect on our ability to do business.
Our patents and claims in pending patent applications cover features or technology used in certain of our products but do not cover all of the technology utilized in any such product or preclude our competitors from offering competing products. Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain and can change over time. 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 U.S. 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 databases of URLs and executable files, and our ability to police that misappropriation or infringement is uncertain, particularly in countries outside of the United States. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition.
Because we recognize revenues from subscriptions for our software products ratably over the term of the subscription, downturns in software subscription sales may not be immediately reflected in our revenues.
Most of our revenues come from the sale of subscriptions to our software products, including our Cloud offerings. Upon execution of a subscription agreement or receipt of royalty reports from OEM customers, we invoice our customers for the full term of the subscription agreement or for the period covered by the royalty report from OEM customers. We then recognize revenue from customers daily over the terms of their subscription agreements, or performance period under the OEM contract, as applicable, which, in the case of subscriptions, typically have durations of 12, 24 or 36 months. Even though revenue recognition rules require us to recognize revenue from hardware sales in the current period that the sale is concluded, a majority of the revenues we report in each quarter will continue to be derived from deferred revenue from software subscription agreements and OEM contracts entered into and paid for during previous quarters. Because of this financial model, the revenues we report in any quarter or series of quarters may mask significant downturns in sales and the market acceptance of our products, before these downturns are reflected by declining revenues.
Acquired companies or technologies can be difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results.
We may acquire additional companies, services and technologies in the future as part of our efforts to expand and diversify our business. Although we review the records of companies or businesses we are interested in acquiring, even an in-depth review may not reveal existing or potential problems or permit us to become familiar enough with a business to assess fully its capabilities and deficiencies. Integration of acquired companies may disrupt or slow the momentum of the activities of our business. As a result, if we fail to properly evaluate, execute and integrate future acquisitions, our business and prospects may be seriously harmed.
Acquisitions involve numerous risks, including:
difficulties in integrating operations, technologies, services and personnel of the acquired company;
potential loss of customers and OEM relationships of the acquired company;
diversion of financial and management resources from existing operations and core businesses;
risks associated with entrance into new markets;
potential loss of key employees of the acquired company;
integrating personnel with diverse business and cultural backgrounds;
preserving the development, distribution, marketing and other important relationships of the companies;
assuming liabilities of the acquired company, including debt and litigation;

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inability to generate sufficient revenues from newly acquired products and/or cost savings needed to offset acquisition related costs; and
the continued use by acquired companies of accounting policies that differ from GAAP.
Acquisitions may also cause us to:
issue equity securities that would dilute our current stockholders’ percentage ownership;
assume certain liabilities, including liabilities that were not detected at the time of the acquisition;
incur additional debt;
make large and immediate one-time write-offs for restructuring and other related expenses;
become subject to intellectual property or other litigation; and
create goodwill and other intangible assets that could result in significant impairment charges and/or amortization expense.
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:
deteriorating or fluctuating world economic conditions;
announcements of technological innovations or new products or services by our competitors;
demand for our products, including fluctuations in subscription renewals;
changes in the pricing policies of our competitors; and
changes in government regulations.
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; and
quarterly variations in our revenues and operating expenses.
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. 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 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 personnel and our ability to recruit new personnel to executive and key management positions. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. Our employment agreements with our executive officers, key management or development personnel do not prevent them from terminating their employment with us at any time. 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.

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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. Competition for these personnel is intense and 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. In order to attract and retain personnel in a competitive marketplace, we believe that we must provide a competitive compensation package, including cash and equity-based compensation. The volatility of our stock price and our results of operations may from time to time adversely affect our ability to recruit or retain employees. 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 revenues may be negatively impacted and our business and future growth prospects could be severely harmed.
If our internal controls are not effective, current and potential stockholders could lose confidence in our financial reporting.
Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to conduct a comprehensive evaluation of their internal control over financial reporting. To comply with this statute, we are required to document and test our internal control over financial reporting; our management is required to assess and issue a report concerning our internal control over financial reporting; and our independent registered public accounting firm is required to attest to and report on the effectiveness of internal control over financial reporting.
In our annual and quarterly reports (as amended) for the periods from December 31, 2008 through September 30, 2009, we reported material weaknesses in our internal control over financial reporting which related to our revenue recognition under OEM contracts and our computation of our income tax benefit for the year ended December 31, 2008. We took a number of actions to remediate these material weaknesses. As a result of an error in identifying a variance in our deferred tax assets in the fourth quarter of 2010, we reassessed the effectiveness of our disclosure controls and procedures for the year ended December 31, 2009 and the period from January 1, 2010 through September 30, 2010 and concluded that we continued to have a material weakness in the internal controls over the computation of our income tax provision. In the fourth quarter of 2010, we took additional remediation measures and concluded that the material weakness described above had been remediated as of December 31, 2010.
Although we believe we have taken appropriate actions to remediate the material weaknesses, we cannot assure you that we will not discover other material weaknesses applicable to both future and past reporting periods. The existence of one or more material weaknesses could result in errors in our financial statements, and substantial costs and resources may be required to rectify these or other internal control deficiencies. If we cannot produce reliable financial reports, investors could lose confidence in our reported financial information, the market price of our common stock could decline significantly, and our business and financial condition could be harmed.
Compliance with new or changing regulations relating to corporate governance, accounting principles and public disclosure may result in additional expenses.
Compliance with laws, regulations and standards relating to corporate governance, accounting principles and public disclosure, including the Sarbanes-Oxley Act of 2002, Dodd-Frank Wall Street Reform and Consumer Protection Act, and listing rules of the NASDAQ Stock Market, Inc., have caused us to incur higher compliance costs and we expect to continue to incur higher compliance costs as a result of our increased global reach and obligation to ensure compliance with these laws as well as local laws in the jurisdictions where we do business. These laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time. Further guidance by regulatory and governing bodies can result in continuing uncertainty regarding compliance matters and higher costs related to the ongoing revisions to accounting, disclosure and governance practices. Our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed.
If we cannot effectively manage our internal growth, our business revenues, results of operations and prospects may suffer.
If we fail to manage our internal growth in a manner that minimizes strains on our resources, we could experience disruptions in our operations that could negatively affect our revenues, billings and results of operations. We are pursuing a strategy of organic growth through introduction of new products, leveraging our multi-tier distribution channels, international expansion and increasing the size of our international sales force. Each of these initiatives requires an investment of our financial and employee resources and involves risks that may result in a lower return on our investments than we expect. These initiatives also may limit the opportunities we pursue or investments we would otherwise make, which may in turn impact our prospects.

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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 amended and restated certificate of incorporation and amended and restated 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 amended and restated certificate of incorporation provides that stockholders may not call stockholder meetings or act by written consent. Our amended and restated bylaws provide that stockholders may not fill board of director vacancies and 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 of directors or initiate actions that are opposed by the then current board of directors. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board of directors to issue up to 5,000,000 shares of 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 has an anti-takeover effect with respect to transactions not approved in advance by our board of directors, including discouraging attempts that might result in a premium over the market price of the shares of common stock held by our stockholders.
Our repayment obligations under the 2010 Credit Facility accelerate and borrowings become payable in full upon a change of control, which is defined generally as a person or group acquiring 35% of our voting securities or a proxy contest that results in changing a majority of our board of directors. These consequences may discourage third parties from attempting to acquire us.
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, pay down the 2010 Credit Facility and repurchase shares of our common stock, and therefore do not expect to pay any cash dividends in the foreseeable future. Moreover, we are not permitted to pay cash dividends under the terms of the 2010 Credit Facility.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Properties
Our corporate headquarters and principal offices are located at a 122,000 square foot facility we lease in San Diego, California. The lease expires in July 2018, however, we have an option to extend the lease for an additional five years. Our international headquarters and offices are located in Dublin, Ireland. We lease additional office space in Los Gatos, California; Reading, England; Ra'anana, Israel; Sydney, Australia and Shanghai, Guangzhou and Beijing, China. We also have executive suite arrangements on monthly or annual terms, depending on the local market, relating to office space in the United Kingdom, Brazil, Dubai, France, Germany, Hong Kong, India, Italy, Japan, Singapore, Spain, Sweden, the Netherlands and Turkey.
Item 3.
Legal Proceedings
On July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that by making, using, importing, selling and/or offering for sale Websense Web Filter, Websense Web Security and Websense Web Security Gateway, the Company infringes U.S. Patent No. 6,092,194 (“194 Patent”). Since filing the complaint, Finjan withdrew its contention that Web Filter and Web Security infringes the 194 Patent. Finjan has also accused additional products of infringing the 194 Patent in response to discovery and in expert reports, namely TRITON Enterprise, TRITON Security Gateway Anywhere, Websense Web Security Gateway Anywhere, Websense Web Security Gateway Hosted and the Websense V-Series appliances. Finjan seeks an injunction from further infringement of the 194 Patent and damages. The jury trial commenced on November 30, 2012 and a favorable verdict was returned on December 20, 2012. The jury found that none of the accused Websense products infringe the 194 Patent and that the 194 Patent is invalid. Post-trial motions have been filed by the parties and are currently pending before the Court. We intend to vigorously defend the jury verdict in post-trial motions and, if necessary, on appeal.

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We are involved in various other legal actions in the normal course of business. Based on current information, including consultation with our lawyers, we cannot currently determine the potential amount of, and have not accrued for, any liability that may result from any of our pending legal actions because we are unable to predict or reasonably estimate the possible losses, if any, relating to such actions. Our evaluation of the likely impact of these actions could change in the future, we may determine that we are required to accrue for potential liabilities in one or more legal actions and unfavorable outcomes and/or defense costs, depending upon the amount and timing, which could have a material adverse effect on our results of operations or cash flows in a future period. If we later determine that we are required to accrue for potential liabilities resulting from any of these legal actions, it is reasonably possible that the ultimate liability for these matters will be greater than the amount for which we have accrued at that time.
Item 4.
Mine Safety Disclosures
Not Applicable.

28



PART II
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is traded on the NASDAQ Global Select Market under the symbol “WBSN.” The following table sets forth the range of high and low sale prices for our common stock for the periods indicated, as reported by the NASDAQ Global Select Market. Such quotations represent prices without retail markups, markdowns or commissions.
 
Years Ended December 31,
 
2012
 
2011
 
High
 
Low
 
High
 
Low
First Quarter
$
21.69

 
$
16.85

 
$
27.96

 
$
18.89

Second Quarter
22.15

 
17.12

 
26.25

 
22.55

Third Quarter
19.25

 
14.26

 
27.85

 
17.00

Fourth Quarter
16.13

 
12.70

 
20.13

 
15.50

To date, we have neither declared nor paid any cash dividends on our common stock. We currently intend to retain all future cash flows from operations, if any, for use in the operation and development of our business, for debt repayment and stock repurchases and, therefore, do not expect to declare or pay any cash dividends on our common stock in the foreseeable future. Moreover, we are not permitted to pay cash dividends under the terms of the 2010 Credit Agreement, subject to certain exceptions.
Holders
As of February 13, 2013, there were 18 holders of record of our common stock and we estimate that there were approximately 4,700 beneficial owners of our common stock that hold our shares in “street name” through brokerage firms, banks, dealers or similar organizations.
Issuer Purchases of Equity Securities
The following table sets forth information about purchases of our common stock during the quarter ended December 31, 2012:
Month
 
Total Number of Shares Purchased During Month (1)
 
Average Price Paid Per Share
 
Cumulative Number of Shares Purchased as Part of Publicly Announced Plan (2)
 
Number of Shares that May Be Purchased Under the Plan (2)
October 1 - October 31, 2012
 
10,000

 
13.14

 
22,690,517

 
1,309,483

November 1 - November 30, 2012
 
157,672

 
13.29

 
22,848,189

 
1,151,811

December 1 - December 31, 2012
 
187,888

 
14.76

 
23,036,077

 
963,923

Total
 
355,560

 
14.06

 
23,036,077

 
963,923

(1)
All share purchases were made in open market transactions under Rule 10b5-1 stock repurchase plans.
(2)
Our board of directors has authorized us to repurchase up to 24 million shares of our common stock under a stock repurchase program. The stock repurchase program does not have an expiration date, does not require us to purchase a specific number of shares and may be modified, suspended or terminated at any time by our board of directors. Effective July 17, 2012, the board of directors suspended the stock repurchase program, after repurchasing approximately $2.9 million of our common stock in the third quarter of 2012, to better align with third quarter cash flow. In October 2012 the board of directors resumed the stock repurchase program and authorized management to repurchase up to $5.0 million of our common stock per calendar quarter beginning in the fourth quarter of 2012.
Since October 2009, all share purchases under the stock repurchase program have been made in open market transactions at prevailing market prices in accordance with certain timing conditions set forth in Rule 10b5-1 stock repurchase plans. Depending on market conditions and other factors, including compliance with covenants in the 2010 Credit Agreement, purchases by our agent under the current Rule 10b5-1 stock repurchase plan may be suspended at any time, or from time to time. We repurchased an aggregate of 2,624,256 shares in 2012. The remaining number of shares authorized for repurchase under our stock repurchase program as of December 31, 2012 was 963,923.

29


Item 6.
Selected Financial Data
The following table summarizes certain historical financial information at the dates and for the periods indicated prepared in accordance with GAAP. The consolidated statement of operations data for each of the years ended December 31, 2012, 2011 and 2010, and the consolidated balance sheet data as of December 31, 2012, and 2011, have been derived from our consolidated financial statements audited by Ernst & Young LLP, an independent registered public accounting firm, included elsewhere in this Annual Report on Form 10-K. The consolidated statement of operations data for each of the years ended December 31, 2009 and 2008 and the consolidated balance sheet data as of December 31, 2010, 2009 and 2008 have been derived from our financial statements not included herein. The selected consolidated financial data should be read in conjunction with “Management's Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto, which are included elsewhere in this Annual Report on Form 10-K. Our historical results are not necessarily indicative of operating results to be expected in the future.
 
Years Ended December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
(In thousands, except for per share data)
Statement of Operations Data:
 
 
 
 
 
 
 
 
 
Revenues:
 
 
 
 
 
 
 
 
 
Software and service
$
328,276

 
$
325,373

 
$
320,544

 
$
311,476

 
$
288,274

Appliance
33,188

 
38,810

 
12,218

 
2,237

 

Total revenues
361,464

 
364,183

 
332,762

 
313,713

 
288,274

Cost of revenues:
 
 
 
 
 
 
 
 
 
Software and service
45,560

 
41,563

 
45,681

 
48,653

 
48,160

Appliance
13,646

 
18,056

 
7,409

 
2,153

 

Total cost of revenues
59,206

 
59,619

 
53,090

 
50,806

 
48,160

Gross Profit
302,258

 
304,564

 
279,672

 
262,907

 
240,114

Operating expenses:
 
 
 
 
 
 
 
 
 
Selling and marketing
155,254

 
161,039

 
157,758

 
166,910

 
175,365

Research and development
63,305

 
58,247

 
54,325

 
52,643

 
53,274

General and administrative
42,161

 
40,863

 
36,779

 
40,295

 
45,343

Total operating expenses
260,720

 
260,149

 
248,862

 
259,848

 
273,982

Income (loss) from operations
41,538

 
44,415

 
30,810

 
3,059

 
(33,868
)
Interest expense
(2,586
)
 
(1,635
)
 
(3,715
)
 
(7,084
)
 
(13,134
)
Other income (expense), net
92

 
1,239

 
(834
)
 
384

 
739

Income (loss) before income taxes
39,044

 
44,019

 
26,261

 
(3,641
)
 
(46,263
)
Provision (benefit) for income taxes
20,695

 
13,025

 
7,609

 
7,056

 
(19,484
)
Net income (loss)
$
18,349

 
$
30,994

 
$
18,652

 
$
(10,697
)
 
$
(26,779
)
Net income (loss) per share:
 
 
 
 
 
 
 
 
 
Basic net income (loss) per share
$
0.50

 
$
0.78

 
$
0.44

 
$
(0.24
)
 
$
(0.59
)
Diluted net income (loss) per share
$
0.49

 
$
0.76

 
$
0.43

 
$
(0.24
)
 
$
(0.59
)
Weighted average shares - basic
36,908

 
39,711

 
42,409

 
44,262

 
45,190

Weighted average shares - diluted
37,526

 
40,739

 
43,438

 
44,262

 
45,190


30


 
As of December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
(In thousands)
Balance Sheet Data:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents (including restricted cash) and marketable securities
$
65,246

 
$
76,829

 
$
78,080

 
$
83,296

 
$
66,811

Total assets
624,461

 
634,438

 
661,943

 
695,846

 
718,848

Deferred revenue
401,057

 
393,034

 
394,304

 
380,112

 
341,784

Secured loan, current portion

 

 

 
12,429

 
4,112

Secured loan, long term potion
68,000

 
73,000

 
67,000

 
74,571

 
120,888

Long term liabilities
239,696

 
232,493

 
229,744

 
233,929

 
261,965

Total stockholders' equity
94,749

 
99,745

 
131,663

 
156,915

 
170,845


Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report on Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. Factors that might cause such a difference include, but are not limited to, those discussed below and elsewhere, including under Part I, Item 1A “Risk Factors” of this report on Form 10-K. The cautionary statements made in this report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this report on Form 10-K.
Overview
We are a global provider of unified Web, email, mobile and data security solutions designed to protect an organization’s data and users from external and internal threats, including modern cyber-threats, advanced malware attacks, information leaks, legal liability and productivity loss. Our customers deploy our subscription software solutions on standard servers or other IT hardware, including our optimized appliances, as a Cloud offering or in a hybrid hardware/Cloud configuration. Our products and services are sold worldwide to provide content security to enterprise customers, small and medium sized businesses, public sector entities and Internet service providers through a network of distributors, value-added resellers and OEMs. Our products use our advanced content classification, deep content inspection and policy enforcement technologies to:
prevent access to undesirable and dangerous elements on the Web, including Web pages that download viruses, spyware, keyloggers, hacking tools and an ever-increasing variety of malicious code, including Web sites that contain inappropriate content;
identify and remove malware from incoming Web content;
manage the use of social Web sites;
manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;
prevent misuse of computing resources, including unauthorized downloading of high-bandwidth content;
inspect the content of encrypted Web traffic to prevent data loss, malware and access to Web sites with inappropriate content;
filter spam, viruses and malicious attachments from incoming email and instant messages;
protect against data theft and loss by identifying and categorizing sensitive or confidential data and enforcing pre-determined policies regarding its use and transmission within and outside the organization; and
enable the secure use of mobile smartphones and tablets within an organization’s network by providing protection from Web-based malware, malicious apps, data loss and theft of intellectual property, and by providing mobile device management features that keep mobile devices secure, minimize risk and maintain compliance.

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Since we commenced operations in 1994, Websense has evolved from a reseller of network security products to a leading developer and provider of IT security software solutions. Our first commercial software product was released in 1996 and controlled employee access to inappropriate Web sites. Since then, we have focused on developing our Web filtering and content classification capabilities to address changes in the Internet and the external threat environment, including the rise of Web-based social and business applications and the growing incidence of sophisticated, targeted cyber-attacks designed to steal valuable information.
During the year ended December 31, 2012 we derived 52% of our revenues from international sales compared with 50% in 2011 and 2010. Revenues from the United Kingdom comprised approximately 12%, 11% and 13% of our total revenues for the years ended December 31, 2012, 2011 and 2010, respectively.
We utilize a multi-tiered distribution strategy globally to sell our products through indirect distributors and value-added reseller channels. Sales through indirect channels currently account for approximately 95% of our revenues, which is consistent with previous periods. In North America, we use Ingram Micro, Arrow Enterprise Computing Solutions and ComputerLinks to distribute our products and provide credit facilities, marketing support and other services to regional and local value-added resellers who sell to end-user customers. Ingram Micro accounted for approximately 28% of our revenues during 2012 and 2011 compared with 31% of revenues in 2010 and distributed our products to approximately 1,100 resellers in North America in 2012. We also have several arrangements with OEMs that grant them the right to incorporate our products into their products for resale to end users. Our sales force supports our channel sales by generating leads and helping close sales. As part of our strategy to expand the subscriptions of existing customers and to grow sales to new customers, we increased headcount in our sales force in the fourth quarter of 2012 and plan to further increase headcount in 2013.
We sell subscriptions for our software and Cloud products, generally in 12, 24 or 36 month contract durations, based on the number of seats or devices managed. As described elsewhere in this report, we recognize revenues from subscriptions for our software and Cloud products on a daily straight-line basis, commencing on the day the term of the subscription begins, over the term of the subscription agreement. We recognize revenues associated with OEM contracts ratably over the contractual period for which we are obligated to provide our services. We generally recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription agreement and are fully expensed in the period the product and/or software activation key is delivered.
Billings represent the amount of subscription contracts, OEM royalties and appliance sales billed to customers during the applicable period. Any excess of billings booked in a period compared with revenue recognized in that same period results in an increase in deferred revenue at the end of the period compared with the beginning of the period. Subscription billings are recorded initially to our balance sheet as deferred revenue and then recognized to our statement of operations as revenue ratably over the subscription term or, in the case of OEM arrangements, over the contractual obligation period. Our billings are not a numerical measure that can be calculated in accordance with GAAP. We provide this measurement (net of distributor marketing payments, channel rebates and adjustments to the allowance for doubtful accounts) in reporting financial performance because this measurement provides a consistent basis for understanding our sales activities each period. We believe the billings measurement is useful because the GAAP measurements of revenue and deferred revenue in the current period include subscription contracts commenced in prior periods.
Total billings increased 2% to $369.5 million during 2012 from $362.9 million in 2011, primarily due to the growing strength of our TRITON products across all global markets. Our appliance billings remained relatively consistent at $28.5 million in 2012 compared with $28.6 million in 2011.
Billings from our TRITON content security solutions accounted for 63% of total billings in 2012 and grew 21% year-over-year to $232.9 million, from $192.6 million in 2011, whereas billings from our non-TRITON solution products declined 20% year-over-year to $136.6 million in 2012 from $170.3 million in 2011. The increase in TRITON billings reflects sales to new customers, the ongoing migration to TRITON solutions by customers of non-TRITON products and the expansion of subscriptions of existing customers. The decrease in non-TRITON billings reflects the ongoing migration of existing customers to our more advanced TRITON security solutions, and to a lesser extent, customer losses to lower priced competitive solutions. Our TRITON solutions include our TRITON family of security gateways for Web, email, mobile and data security (including related appliances and technical support subscriptions), our standalone data security suite and our Cloud security solutions. Our non-TRITON solutions include our Web filtering products, such as our Websense Web Filter, Web Security Suite, legacy server-based email security and related hardware. We expect the proportion of billings from our TRITON solutions to continue to increase as a percentage of total billings in 2013.
International billings represented $195.5 million, or 53% of our total billings in 2012, compared with $189.6 million, or 52% of total billings in 2011, reflecting our maturing and stabilized international sales force.

32


Average contract duration increased to 25.0 months in 2012, from 23.7 months in 2011 with approximately 47% of our billings in 12 month contracts, 7% in 24 month contracts and 46% in contracts with durations of 36 months or more. The average contract duration increased compared with 2011 due to the increase in sales of TRITON solutions and sales to new customers, which tend to have longer average contract durations. The number of transactions valued at over $100,000 in 2012 increased by 15% from 563 transactions to 648 transactions compared with 2011.
Our billings depend in part on the number of subscriptions up for renewal each quarter and are affected by cyclical variations, with the highest billings occurring in the fourth quarter and the lowest billings occurring in the first quarter.
Critical Accounting Policies and Estimates
Critical accounting policies are those that may have a material impact on our financial statements and also require management to exercise significant judgment due to a high degree of uncertainty at the time the estimate is made. Our senior management has discussed the development and selection of our accounting policies, related accounting estimates and disclosures with the audit committee of our board of directors. 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. The majority of our revenues are derived from software and Cloud products sold on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats. We recognize revenues for the software and Cloud subscriptions, including any related technical support, on a daily straight-line basis, commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver software access codes to customers and then promptly invoice customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of the invoice date.
In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product’s essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to:
provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; and
require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE nor TPE is available.
We adopted the amended standards as of January 1, 2011 on a prospective basis for transactions entered into or materially modified after December 31, 2010.
A portion of our revenues is generated from the sale of appliances, which are standard server platforms optimized for our software products. These appliances contain software components, such as operating systems, that operate together with the hardware platform to provide the essential functionality of the appliance. Based on accounting standards, when sold in a multiple element arrangement that includes software deliverables, our hardware appliances are considered non-software deliverables. When appliance orders are taken, we ship the product, invoice the customer and recognize revenues when title/risk of loss passes to the buyer (typically upon delivery to a common carrier) and the other criteria of revenue recognition are met. The revenues recognized are based upon BESP, as outlined further below.
For transactions entered into prior to the adoption of amended revenue standards on January 1, 2011, all elements in a multiple element arrangement containing software were treated as a single unit of accounting as we did not have adequate support for VSOE of undelivered elements. As a result, we deferred revenue on our multiple element arrangements until only the post-contract customer support (database updates and technical support) or other services not essential to the functionality of the software remained undelivered. At that point, the revenue was amortized over the remaining life of the software subscription or estimated delivery term of the services, whichever was longer.

33


For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, we allocate the arrangement fee to the software-related elements and the non-software-related elements based upon the relative selling price of such element. When applying the relative selling price method, we determine the selling price for each element using BESP, because VSOE and TPE are not available. The revenues allocated to the software-related elements are recognized based on the industry-specific software revenue recognition guidance that remains unchanged. The revenues allocated to the non-software-related elements are recognized based on the nature of the element provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged.
We determine BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. We estimate the selling price by considering internal factors such as historical pricing practices and gross margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands and geography. As there is a significant amount of judgment when determining BESP, we review all of our assumptions and inputs around BESP on a quarterly basis and maintain internal controls over the establishment and updates of these estimates.
For our OEM contracts, we grant our OEM customers the right to incorporate our products into the OEMs’ products or services for resale to end users. The OEM customers generally pay us a royalty fee for each resale of our product to an end user over a specified period of time. We recognize revenues associated with the OEM contracts ratably over the contractual period for which we are obligated to provide our services to the OEMs, which will vary for each OEM depending on the information available, such as underlying end user subscription periods. To the extent we provide any custom software and engineering services in connection with an OEM arrangement, we defer recognition of all revenue until acceptance of the custom software.
We record distributor marketing payments and channel rebates as an offset to revenues, unless we receive an identifiable benefit in exchange for the consideration and we can estimate the fair value of the benefit received. We recognize distributor marketing payments as an offset to revenues in the period the marketing service is provided, and we recognize channel rebates as an offset to revenues generally on a straight-line basis over the term of the underlying subscription sale.
Income Taxes. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes may be due. These reserves for tax contingencies are established when we believe that certain positions might be challenged despite our belief that our tax return positions are consistent with prevailing law and practice. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. The provision for income taxes includes the impact of these reserves and changes to the reserves that are considered appropriate.
We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which require periodic adjustments and which may not accurately anticipate actual outcomes.
Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent we believe it is more likely than not that all or a portion of the deferred tax assets will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience and expectations of future taxable income by taxing jurisdiction, the carry-forward periods available for tax reporting purposes and other relevant factors.
Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the acquisition method of accounting, in accordance with GAAP accounting rules for business combinations, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair value of net assets acquired is recorded as goodwill.

34


We review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. We review for impairment by analyzing facts and circumstances, either external or internal, indicating that we may not recover the carrying value of the asset. We measure impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. We measure fair value generally based on the estimated future cash flows generated by the asset. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets.
Share-Based Compensation. We account for share-based compensation under the fair value method. Share-based compensation expense related to stock options and employee stock purchase plan share grants is recorded based on the fair value of the award on its grant date. We estimate the fair value using the Black-Scholes option valuation model. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the date of grant.
The determination of fair value using the Black-Scholes option valuation model requires the use of certain estimates and highly judgmental assumptions that affect the amount of share-based compensation expense recognized in our consolidated statements of operations. These include estimates of the expected volatility of our stock price, expected life of an award, expected dividends and the risk-free interest rate. We estimate the expected term of options granted based on the history of grants and exercises in our option database. We estimate the volatility of our common stock at the date of grant based on both the historical volatility as well as the implied volatility of publicly traded options for our common stock. We base the risk-free interest rate on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon bond issues with equivalent remaining terms. We have never paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero. We amortize the fair value ratably over the vesting period of the awards. We use historical data to estimate pre-vesting option forfeitures and record share-based expense only for those awards that are expected to vest. We may elect to use different assumptions under the Black-Scholes option valuation model in the future or select a different option valuation model altogether, which could materially affect our results of operations in the future.
Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because our employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although the fair value of employee stock options is determined using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
Allowance for Doubtful Accounts and Other Loss Contingencies. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to pay their invoices. We establish this allowance using estimates that we make based on factors such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, changes to customer creditworthiness, current economic trends and other facts and circumstances of our existing customers. 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. Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires significant judgment by management based on the facts and circumstances of each matter.

35


Results of Operations
The following table summarizes our operating results as a percentage of total revenues for each of the periods shown.
 
Years Ended December 31,
 
2012
 
2011
 
2010
Revenues:
 
 
 
 
 
Software and service
91%

 
89%

 
96%

Appliance
9

 
11

 
4

Total revenues
100%

 
100%

 
100%

Cost of revenues:
 
 
 
 
 
Software and service
12

 
11

 
14

Appliance
4

 
5

 
2

Total cost of revenues
16

 
16

 
16

Gross profit
84

 
84

 
84

Operating expenses:
 
 
 
 
 
Selling and marketing
43

 
44

 
48

Research and development
18

 
16

 
16

General and administrative
12

 
11

 
11

Total operating expenses
73

 
71

 
75

Income from operations
11

 
13

 
9

Interest expense
(1
)
 
(1
)
 
(1
)
Other income (expense), net

 

 

Income before income taxes
10

 
12

 
8

Provision for income taxes
5

 
4

 
2

Net income
5%

 
8%

 
6%

Year ended December 31, 2012 compared with the year ended December 31, 2011
Revenues
Software and service revenues. Software and service revenues increased to $328.3 million in 2012 from $325.4 million in 2011. The increase in 2012 software and service revenues compared with 2011 was primarily the result of year-over-year growth in billings for TRITON software and service, which resulted in higher beginning current deferred software and service revenue and higher revenues recognized in 2012 compared with 2011. Because we recognize software and service revenues ratably over the term of the subscription, growth in software and service revenues reflect changes in current deferred revenue at the beginning of the period compared with the prior period, as well as the change in current period billings.
Software and service revenues generated in the United States accounted for $159.6 million, or 44% of 2012 revenues, compared with $161.8 million, or 44% of revenues in 2011. International software and service revenues accounted for $168.7 million, or 47% of 2012 revenues, compared with $163.6 million, or 45% of revenues in 2011.
Current deferred software and service revenue was $241.3 million as of December 31, 2012, compared with $244.6 million as of December 31, 2011, and we had total deferred revenue relating to software and service revenues of $396.0 million as of December 31, 2012, compared with $383.3 million as of December 31, 2011. Of the $241.3 million in current deferred software and service revenue as of December 31, 2012, $77.3 million is expected to be recognized as revenue in the first quarter of 2013.
We expect our software and service revenues in 2013 to remain relatively flat compared with our software and service revenues in 2012 due to subscriptions that are scheduled for renewal that are expected to be renewed and upgraded, and expected new business for which some revenues will be recognized during 2013. These trends are anticipated to be partially offset by an expected decline in revenue from OEM arrangements. Our software and service revenues are impacted by the duration of contracts billed, the timing of sales of renewal and new subscriptions, the average annual contract value and per seat price, the volume of OEM sales activity and the effect of currency exchange rates on new and renewal subscriptions in international markets.

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Appliance revenues. Appliance revenues decreased to $33.2 million in 2012 from $38.8 million in 2011. Appliance revenues of $33.2 million for 2012 consisted of $27.3 million in revenue from sales of appliances sold in 2012 and $5.9 million recognized primarily from deferred revenue for sales of appliances recorded prior to the adoption of the amended revenue recognition rules, as described previously. This compares with $38.8 million in 2011, which included $27.4 million in revenue from appliances sold in 2011 and $11.4 million recognized primarily from deferred revenue. The decrease in total appliance revenues was primarily the result of the decline in appliance revenues recognized from deferred revenue in 2012 compared with 2011, due to the amended revenue recognition rules. As of December 31, 2012, deferred appliance revenue was $2.7 million for sales recorded prior to the adoption of the amended revenue recognition rules.
Appliance revenues generated in the United States accounted for $15.6 million, or 4% of 2012 revenues, compared with $19.4 million, or 5% of revenues, in 2011. Appliance revenues generated internationally accounted for $17.6 million, or 5% of 2012 revenues, compared with $19.4 million, or 5% of revenues, in 2011.
For 2013, we expect our appliance revenues to decrease in both absolute dollars and as a percentage of total revenues as compared with 2012 primarily as a result of the decline in deferred revenue to be recognized in 2013 from appliance sales recorded prior to January 1, 2011. For 2013, we expect to recognize $2.2 million from deferred revenue for appliance sales recorded prior to January 1, 2011.
Cost of Revenues
Software and service cost of revenues. Software and service cost of revenues consists of the costs of Web content analysis, amortization of acquired technology, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our Cloud offerings. Software and service cost of revenues increased to $45.6 million in 2012 from $41.6 million in 2011. The $4.0 million increase was primarily due to increased costs of operating our infrastructure for our Cloud offerings, partially offset by decreased amortization of acquired technology of $0.4 million. Our full-time employee headcount in cost of revenues departments remained consistent at an average of 262 employees during 2011 and 2012. The headcount is expected to remain relatively flat in 2013. As a percentage of software and service revenues, software and service cost of revenues were 14% for 2012, compared with 13% for 2011.
We expect software and service cost of revenues will increase in absolute dollars in 2013 due to higher expected software and service billings, and increase as a percentage of software and service revenues in 2013 as compared with 2012 due to our continued investment in our Cloud infrastructure.
Appliance cost of revenues. Appliance cost of revenues consists of the costs associated with the sale of our appliance products, primarily the cost of the hardware platform and software installation costs. Appliance cost of revenues decreased to $13.6 million in 2012, from $18.1 million in 2011. As described previously, the $4.5 million decrease was primarily the result of the decline in appliance costs recognized from deferred costs in 2012 compared with 2011, due to the adoption of amended revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues for 2012, we recognized $2.6 million of the ratable cost of appliances sold prior to 2011 and the remaining $11.0 million represents costs of appliances sold in 2012. As a percentage of appliance revenues, appliance cost of revenues decreased to 41% in 2012 from 47% in 2011.
We expect appliance cost of revenues will decrease in absolute dollars in 2013 as compared with 2012 due to the decline in deferred costs to be recognized in 2013 from appliance sales recorded prior to January 1, 2011. During 2013, we expect to recognize $1.0 million in deferred cost of revenues related to sales recorded prior to January 1, 2011.
Gross Profit
Gross profit decreased to $302.3 million in 2012 from $304.6 million in 2011, primarily as a result of decreased appliance revenues from appliances sold prior to 2011 and increased cost of revenues related to our expanding Cloud infrastructure. As a percentage of total revenues, our gross profit was 84% for 2012 and 2011. We expect that gross profit as a percentage of revenue will remain in excess of 80% of revenue for 2013.
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, costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships and other allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates as those are recorded as an offset to revenue.

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Selling and marketing expenses decreased to $155.3 million, or 43% of revenues, in 2012 from $161.0 million, or 44% of revenues, in 2011. The $5.7 million decrease in total selling and marketing expenses was primarily due to a reduction in the amortization of acquired intangible assets (customer relationships) of $6.6 million, partially offset by an increase in personnel costs of $1.4 million resulting from higher average headcount. Our headcount in sales and marketing increased from an average of 614 employees during 2011 to an average of 626 employees during 2012, due primarily to the expansion of our sales force beginning in the fourth quarter of 2012. Headcount is expected to increase in 2013 as we continue to expand our sales team.
We expect overall selling and marketing expenses to increase in absolute dollars in 2013 as compared with 2012 primarily due to additional sales and marketing personnel to support our expanding selling and marketing efforts worldwide, partially offset by a reduction of amortization of acquired intangible assets, compared with 2012, from the SurfControl acquisition. We expect selling and marketing expenses as a percentage of revenues will increase in 2013 compared with 2012. Because commission expenses are recognized in the period incurred, while a substantial portion of revenues are recognized in future periods, if our 2013 billings growth exceeds expectations, our selling and marketing expenses as a percentage of revenues could further increase in 2013 compared with 2012. Based on the existing sales and marketing related intangible assets as of December 31, 2012, we expect amortization of sales and marketing related acquired intangibles of $5.4 million for 2013, which would be a reduction of approximately $0.6 million from 2012. Fluctuations in foreign currencies may also impact our selling and marketing expenses in 2013.
Research and development. Research and development expenses consist primarily of salaries and benefits for software developers and allocated costs. Research and development expenses increased to $63.3 million, or 18% of revenues, in 2012 from $58.2 million, or 16% of revenues, in 2011. The increase of $5.1 million in research and development expenses was primarily due to increased personnel costs of $3.7 million and increased allocated costs of $1.5 million. We allocate the costs for human resources, employee benefits, payroll taxes, IT, facilities and fixed asset depreciation to each of our functional areas based on headcount data. Although our headcount increased in research and development from an average of 493 employees during 2011 to an average of 527 employees during 2012, the impact of the higher headcount was partially mitigated by an increase in the number of employees in relatively low cost foreign locations.
We expect research and development expenses to increase in absolute dollars in 2013 as compared with 2012 due to higher personnel costs resulting from higher average headcount in 2013 compared with 2012. Fluctuations in foreign currencies may also impact our research and development expenses in 2013. We are managing the increase in our absolute research and development expenses by operating research and development facilities in multiple international locations, including facilities in Beijing, China and Ra'anana, Israel, that have lower costs than our operations in the United States. We also have research and development facilities in Los Gatos and San Diego, California and Reading, England. We expect that research and development expenses as a percentage of revenues will increase in 2013 compared with 2012.
General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and administrative personnel, third-party professional service fees and allocated costs. General and administrative expenses increased to $42.2 million, or 12% of revenues, in 2012 from $40.9 million, or 11% of revenues, in 2011. The $1.3 million increase in general and administrative expenses was primarily due to an increase in third-party professional service fees of $2.4 million and increased allocated costs of $0.7 million, offset by decreased share based compensation costs of $1.5 million.
We expect general and administrative expenses to decrease in absolute dollars and as a percentage of revenue in 2013 compared with 2012 due to decreased third-party professional fees.
Interest Expense
Interest expense increased to $2.6 million in 2012 compared with $1.6 million in 2011. The increase was primarily due to additional interest expense recognized on our interest rate swap that became effective on December 31, 2011.
Our weighted average interest rate was 3.1% in 2012 and is expected to remain consistent in 2013 resulting in total interest expense in 2013 being consistent with 2012. See “Liquidity and Capital Resources” for a description of the 2010 Credit Agreement.
Other Income (Expense), Net
Other income decreased to $0.1 million in 2012, compared with other income of $1.2 million in 2011, reflecting foreign exchange related net losses of $0.3 million in 2012 compared with net gains of $1.0 million in 2011 as a result of movements in the currency exchange rates during 2012 and 2011.
We expect our net other income in 2013 to remain consistent with 2012 levels; however, fluctuations in foreign currencies may also impact our other income (expense).

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Provision for Income Taxes
In 2012, we recognized an income tax expense of $20.7 million compared with an income tax expense of $13.0 million for 2011. The annual effective income tax rate for 2012 was 53.0% compared with 29.6% for 2011. For 2012, the effective tax rate variance from the U.S. federal statutory rate was primarily the result of our agreement with the IRS Appeals Office to settle certain outstanding tax matters for years 2005 through 2007, which is discussed more fully in Note 11 to the consolidated financial statements, as well as the unfavorable impact of foreign withholding taxes and non-deductible share-based payments, partially offset by the favorable impact from earnings in lower tax rate jurisdictions. For 2011, the effective tax rate variance from the U.S. federal statutory rate was primarily attributable to a net tax benefit recognized for the year of approximately $5.5 million, offset partially by the unfavorable impact of foreign withholding taxes and non-deductible share-based compensation expense. Approximately $2.8 million of the net tax benefit recognized for 2012 resulted from our global distribution restructuring which was completed during 2010 and became effective in January 2011. This amount relates primarily to the non-recurring tax effect from the transfer of customer relationship intangible assets and the related deferred tax liabilities from a higher tax rate jurisdiction to a lower tax rate jurisdiction. This entire tax benefit was recorded in the first quarter of 2011 upon completion of our global distribution restructuring and is not expected to recur. The remaining net tax benefit recognized for the year of approximately $2.7 million relates to the reversal of previously established reserves for uncertain tax positions due to the settlement of a tax inquiry in the United Kingdom in the fourth quarter of 2011. This entire net tax benefit was recorded in the fourth quarter of 2011, the period in which the settlement occurred, and is not expected to recur.
Our effective tax rate may change in future periods due to differences in the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules. Effective January 2011, we completed a global restructuring of our international distribution operations, which we anticipate will reduce the complexity and compliance risks associated with our global distribution activities. We expect that the restructuring will also reduce our GAAP effective tax rate relative to the GAAP effective tax rate that would have applied absent the restructuring because we expect to reduce our taxable income in certain foreign jurisdictions having high tax rates and expect to increase our taxable income in a foreign jurisdiction with a lower tax rate where we streamlined and consolidated the ownership of our intellectual property and distribution rights. The restructuring did not materially impact our U.S. business operations or the relative amount of taxable income in the U.S. versus outside the U.S. While we anticipate that our GAAP effective tax rate will be lower than it would have been without the global distribution restructuring, we cannot predict whether the GAAP effective tax rate in any particular period will be less than the GAAP effective tax rate in the immediately preceding prior period or in the comparable period of the prior fiscal year. The actual impact of the restructuring on our GAAP effective tax rate is highly dependent on our future results of operations, including the jurisdictions where our revenue is generated.
We assess, on a quarterly basis, the ultimate realization of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items for the fiscal year ended December 31, 2012, specifically the expected reversal of existing taxable temporary differences and a history of generating taxable income in applicable tax jurisdictions, we believe that it is more-likely-than-not that we will fully realize the balance of the deferred tax assets currently reflected on our consolidated balance sheets.
The American Taxpayer Relief Act of 2012, which was signed into law on January 2, 2013, included the retroactive reinstatement of the federal research and development tax credit from January 1, 2012, through December 31, 2013.  Our provision for income taxes for the year ended December 31, 2012, does not include the impact of the federal research credit generated in 2012 since the law was enacted subsequent to our reporting period.  Had the legislation been enacted in 2012, our provision for income taxes for the year ended December 31, 2012, would have been reduced by approximately $0.6 million.  Our provision for income taxes in the first quarter of 2013 will include the tax benefit as a result of the retroactive reinstatement of the federal research credit for 2012.

Year ended December 31, 2011 compared with the year ended December 31, 2010
Revenues
Software and service revenues. Software and service revenues increased to $325.4 million in 2011 from $320.6 million in 2010. The increase in 2011 software and service revenues compared with 2010 was primarily the result of increased incremental billings to new customers and upgrades to existing customers, as well as higher OEM revenues in 2011 as compared with 2010. Software and service revenues generated in the United States accounted for $161.8 million, or 44% of 2011 revenues, compared with $158.5 million, or 47% in 2010. Software and service revenues generated internationally accounted for $163.6 million, or 45% of 2011 revenues, compared with $162.1 million, or 49%, in 2010. We had current deferred revenue relating to software and service revenues of $244.6 million as of December 31, 2011, compared with $240.5 million as of December 31, 2010, and we had total deferred revenue relating to software and service revenues of $383.3 million as of December 31, 2011, compared with $374.3 million as of December 31, 2010.

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Appliance revenues. Appliance revenues increased to $38.8 million in 2011 from $12.2 million in 2010. The increase was primarily a result of increased appliance sales in 2011 and our adoption of amended revenue recognition rules starting January 1, 2011. Accordingly, $11.4 million of the revenue recognized in 2011, represented primarily the ratable recognition of deferred revenue for sales of appliances recorded prior to the adoption of the amended revenue recognition rules, and the remaining $27.4 million represented revenues from sales of appliances sold in 2011. As of December 31, 2011, we had $8.6 million of remaining deferred revenue for sales recorded prior to the adoption of the amended revenue recognition rules. Appliance revenues generated in the United States accounted for $19.4 million, or 5% of 2011 revenues, compared with $6.8 million, or 2% of revenues, in 2010. Appliance revenues generated internationally accounted for $19.4 million, or 5% of 2011 revenues, compared with $5.4 million, or 2% of revenues, in 2010.
Cost of Revenues
Software and service cost of revenues. Software and service cost of revenues decreased to $41.6 million in 2011 from $45.7 million in 2010. The $4.1 million decrease was primarily due to decreased amortization of acquired technology of $6.0 million and decreased allocated costs of $0.7 million, offset by increased personnel costs of $2.1 million. Amortization of acquired technology was $3.0 million in 2011 compared with $9.0 million in 2010. The decrease of $6.0 million in amortization of acquired technology from 2010 to 2011 was primarily due to certain acquired technology being fully amortized in 2010. As of December 31, 2011, the remaining acquired technology is being amortized over a remaining weighted average period of 3.2 years. Our full-time employee headcount in cost of revenues departments decreased from an average of 266 employees during 2010 to an average of 261 employees during 2011. As a percentage of software and service revenues, software and service cost of revenues was 13% for 2011, compared with 14% for 2010.
Appliance cost of revenues. Appliance cost of revenues increased to $18.1 million in 2011, from $7.4 million in 2010. As described previously, the $10.7 million increase was primarily due to increased appliance sales in 2011 and our adoption of amended revenue recognition rules. In appliance cost of revenues for 2011, we recognized $5.2 million of the ratable cost of appliances sold prior to 2011 that were recognized in revenues in 2011 and the remaining $12.9 million represents costs of appliances sold in 2011. As a percentage of appliance revenues, appliance cost of revenues decreased to 47% in 2011 from 61% in 2010.
Gross Profit
Gross profit increased to $304.6 million in 2011 from $279.7 million in 2010, primarily as a result of increased revenues. As a percentage of total revenues, our gross profit was 84% for both 2011 and 2010.
Operating Expenses
Selling and marketing. Selling and marketing expenses increased to $161.0 million, or 44% of revenues, in 2011 from $157.8 million, or 48% of revenues, in 2010. The $3.2 million increase in total selling and marketing expenses was primarily due to increased personnel costs of $6.2 million resulting from higher average head count and costs associated with changes to our internal sales team during 2011 and increased allocated costs of $1.7 million, partially offset by a reduction in the amortization of acquired intangible assets (customer relationships) of $4.9 million. Our headcount in sales and marketing increased from an average of 583 employees during 2010 to an average of 614 employees during 2011.
Research and development. Research and development expenses increased to $58.2 million, or 16% of revenues, in 2011 from $54.3 million, or 16% of revenues, in 2010. The increase of $3.9 million in research and development expenses was due to increased personnel costs of $2.4 million and increased allocated costs of $1.5 million. Although our headcount increased in research and development from an average of 454 employees during 2010 to an average of 493 employees during 2011, the impact of the higher headcount was partially mitigated by an increase in the number of employees in relatively low cost foreign locations.
General and administrative. General and administrative expenses increased to $40.9 million, or 11% of revenues, in 2011 from $36.8 million, or 11% of revenues, in 2010. The $4.1 million increase in general and administrative expenses was primarily due to an increase in third-party professional service fees, which were largely related to the global restructuring of our international distribution operations, and increased personnel costs. Our headcount remained consistent in general and administrative departments with an average of 120 employees during 2010 to an average of 121 employees during 2011.
Interest Expense
Interest expense decreased to $1.6 million in 2011 compared with $3.7 million in 2010. The decrease was partially due to a lower average outstanding loan balance on our secured loan of $67.8 million during 2011, compared with an average loan balance of $73.0 million during 2010. In addition, the effective interest rate was lower in 2011 compared with 2010 primarily due to the expiration of an unfavorable fixed rate swap agreement which expired on September 30, 2010 and more favorable interest rate terms under our 2010 Credit Facility. Also included in the interest expense is amortization of deferred financing fees of $0.2 million and $1.0 million for 2011 and 2010, respectively, that were capitalized as part of the 2010 Credit Facility and a senior secured credit facility entered into in October 2007, as applicable.

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Other Income (Expense), Net
Other income increased to $1.2 million in 2011, compared with other expense of $0.8 million in 2010, reflecting foreign exchange related net gains of $1.0 million in 2011 compared with net losses of $1.3 million in 2010 as a result of movements in the currency exchange rates during 2011 and 2010.
Provision for Income Taxes
In 2011, we recognized an income tax expense of $13.0 million compared with an income tax expense of $7.6 million for 2010. The annual effective income tax rate for 2011 was 29.6 % compared with 29.0% for 2010. For 2011, the effective tax rate variance from the U.S. federal statutory rate was primarily attributable to a net tax benefit recognized for the year of approximately $5.5 million offset partially by the unfavorable impact of foreign withholding taxes and non-deductible share-based compensation expense. Approximately $2.8 million of the net tax benefit recognized for the year resulted from our global distribution restructuring which was completed during 2010 and became effective in January 2011. This amount relates primarily to the non-recurring tax effect from the transfer of customer relationship intangible assets and the related deferred tax liabilities from a higher tax rate jurisdiction to a lower tax rate jurisdiction. This entire tax benefit was recorded in the first quarter of 2011 upon completion of our global distribution restructuring. The remaining net tax benefit recognized for the year of approximately $2.7 million relates to the reversal of previously established reserves for uncertain tax positions due to the settlement of a tax inquiry in the United Kingdom in the fourth quarter of 2011. This entire net tax benefit was recorded in the fourth quarter of 2011, the period in which the settlement occurred. For 2010, the effective tax rate variance from the U.S. federal statutory rate was primarily related to earnings recognized in lower tax jurisdictions, and the reduction of a valuation allowance related to net operating losses for one of our subsidiaries in the United Kingdom, partially offset by the write-down of a deferred tax asset relating to the net operating losses in the United Kingdom.
Liquidity and Capital Resources
As of December 31, 2012, we had cash and cash equivalents of $64.6 million and retained earnings of $90.6 million. Of the $64.6 million of cash and cash equivalents held as of December 31, 2012, $27.8 million was held by our foreign subsidiaries, and we plan to indefinitely reinvest the undistributed foreign earnings into our foreign operations. During 2012, we primarily used cash in excess of cash required for operations, to repurchase $49.1 million of our common stock and to make principal payments of $5.0 million under the 2010 Credit Agreement.
Net cash provided by operating activities was $48.9 million in 2012, compared with $79.2 million in 2011. The decrease in cash flow from operations for 2012 compared with 2011 was primarily a result of higher cash taxes in 2012 due to a settlement of certain tax obligations with the IRS related to prior years which resulted in $14.7 million in cash tax payments in the third quarter of 2012. Our operating cash flow is typically significantly influenced by the timing of new and renewal subscriptions, accounts receivable collections and cash expenses. A decrease in sales of new and/or renewal subscriptions or accounts receivable collections, or an increase in our cash expenses, would negatively impact our operating cash flow.
Net cash used in investing activities was $12.6 million in 2012, compared with $9.9 million in 2011. The $2.7 million increase in net cash used in investing activities was primarily due to increased purchases of property and equipment during 2012 compared with 2011 related to our expanding Cloud infrastructure.
Net cash used in financing activities was $47.9 million in 2012, compared with $70.4 million in 2011. The $22.5 million decrease in cash used in financing activities was driven primarily by a reduction in repurchases of our common stock during 2012 compared with 2011, partially offset by a reduction in the proceeds from exercises of stock options and reduced borrowings on our secured loan. In 2012, we used approximately $49.1 million to repurchase our common stock and made principal payments of $5.0 million under the 2010 Credit Agreement.
In October 2010, we entered into the 2010 Credit Agreement. The 2010 Credit Agreement provides for a secured revolving credit facility that matures on October 29, 2015 with an initial maximum aggregate commitment of $120 million, including a $15 million sublimit for issuances of letters of credit and a $5 million sublimit for swing line loans. We may increase the maximum aggregate commitment under the 2010 Credit Agreement to up to $200 million if certain conditions are satisfied, including that we are not in default under the 2010 Credit Agreement at the time of the increase. Loans under the 2010 Credit Agreement are designated, at our election, as either base rate or Eurodollar rate loans. Base rate loans bear interest at a rate equal to (i) the highest of (a) the federal funds rate plus 0.5%, (b) the Eurodollar rate plus 1.00%, and (c) Bank of America’s prime rate, plus (ii) a margin set forth below. Eurodollar rate loans bear interest at a rate equal to (i) the Eurodollar rate, plus (ii) a margin set forth below. As of December 31, 2012, the total amount outstanding under the 2010 Credit Facility was $68.0 million and the weighted average interest rate was 3.1%.

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The applicable margins are determined by reference to our leverage ratio, as set forth in the table below:
Consolidated Leverage Ratio
 
Eurodollar Rate
    Loans    
 
Base Rate
    Loans    
<1.25:1.0
 
1.75%
 
0.75%
≥1.25:1.0
 
2.00%
 
1.00%
Indebtedness under the 2010 Credit Agreement is secured by substantially all of our assets, including pledges of stock of certain of our subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by our domestic subsidiaries. The 2010 Credit Agreement contains affirmative and negative covenants, including an obligation to maintain a certain consolidated leverage ratio and consolidated interest coverage ratio and restrictions on our ability to borrow money, to incur liens, to enter into mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. The 2010 Credit Agreement does not require us to use excess cash to pay down debt.
The 2010 Credit Agreement provides for acceleration of our obligations thereunder upon certain events of default. The events of default include, without limitation, failure to pay loan amounts when due, any material inaccuracy in our representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against us or our subsidiaries involving an aggregate liability of $10 million or more, the security interest or guarantee ceasing to be in full force and effect, any person becoming the beneficial owner of more than 35% of our outstanding common stock, or our board of directors ceasing to consist of a majority of Continuing Directors (as defined in the 2010 Credit Agreement).
Obligations and commitments. The following table summarizes our contractual payment obligations and commitments as of December 31, 2012 (in thousands):
 
Payment Obligations by Year
 
2013
 
2014
 
2015
 
2016
 
2017
 
Thereafter
 
Total
2010 Credit Agreement:
 
 
 
 
 
 
 
 
 
 
 
 
 
Contractual principal payments
$

 
$

 
$
68,000

 
$

 
$

 
$

 
$
68,000

Estimated interest and fees
2,314

 
2,314

 
1,914

 

 

 

 
6,542

Operating leases
5,717

 
4,784

 
3,310

 
2,556

 
2,629

 
1,576

 
20,572

Other commitments
1,101

 
2,322

 
27

 

 

 

 
3,450

Total
$
9,132

 
$
9,420

 
$
73,251

 
$
2,556

 
$
2,629

 
$
1,576

 
$
98,564

Obligations under our 2010 Credit Agreement represent the future minimum principal debt payments due under this facility. Estimated interest and fees expected to be incurred on the 2010 Credit Facility are based on known rates and scheduled principal payments, as well as the interest rate swap agreement, as of December 31, 2012 (see Note 6 to the consolidated financial statements).
We lease our facilities under operating lease agreements that expire at various dates through 2018. Approximately 63% of our operating lease commitments are related to our corporate headquarters lease in San Diego, which has escalating rent payments through 2018. The San Diego lease expires in July 2018; however, we have an option to extend the lease for an additional five years. The rent expense related to our worldwide office space leases is recorded monthly on a straight-line basis in accordance with GAAP.
Included in other commitments above are contractual commitment obligations as of December 31, 2012 for inbound software licenses, equipment maintenance, royalty agreements and automobile leases.
Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at December 31, 2012, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $8.9 million of gross unrecognized tax benefits (as more fully described in Note 11 to the consolidated financial statements) have been excluded from the contractual payment obligations table above.

Our board of directors has authorized us to repurchase up to 24 million shares of our common stock under a stock repurchase program. The stock repurchase program does not have an expiration date, does not require us to purchase a specific number of shares and provides the board of directors with authority to modify, suspend or terminate the program at any time. Effective July 17, 2012, the board of directors suspended the stock repurchase program, after repurchasing approximately $2.9 million of our common stock in the third quarter of 2012, to better align with third quarter cash flow. In October 2012, the board of directors resumed the stock repurchase program and authorized management to repurchase up to $5.0 million of our common stock per calendar quarter beginning in the fourth quarter of 2012.

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Since October 2009, all share purchases under the stock repurchase program have been made in open market transactions at prevailing market prices in accordance with certain timing conditions set forth in Rule 10b5-1 stock repurchase plans. Depending on market conditions and other factors, including compliance with covenants in the 2010 Credit Agreement, purchases by our agent under the current Rule 10b5-1 stock repurchase plan may be suspended at any time, or from time to time. We repurchased an aggregate of 2,624,256 shares in 2012 for an aggregate of approximately $47.9 million at an average price of $18.26 per share. As of December 31, 2012, we had repurchased a total of 23,036,077 shares of our common stock under this stock repurchase program, for an aggregate of $457.7 million at an average price of $19.87 per share. The 2010 Credit Agreement permits us to repurchase our securities so long as we are not in default under the 2010 Credit Agreement, have complied with all of our financial covenants, and have liquidity of at least $20 million; provided, however, if, after giving effect to any repurchase, our consolidated leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10.0 million in the aggregate in any fiscal year.

We believe that our cash and cash equivalents balances, accounts receivable, revolving credit balances and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures, debt repayment obligations and stock repurchases, if any, for at least the next 12 months. Our cash requirements may increase if, as part of our growth strategy, we make acquisitions that increase our cash requirements, or for reasons we do not currently foresee. We may elect to borrow under the 2010 Credit Agreement, raise funds for these purposes or reduce our cost of capital through capital markets transactions or debt or private equity transactions as appropriate. We intend to continue to invest our cash in excess of current operating and capital requirements in interest-bearing, investment-grade money market funds.
Off-Balance Sheet Arrangements
As of December 31, 2012 and 2011, we did not have any relationships with unconsolidated entities or financial partners, including entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
Our market risk exposures are related to our cash and cash equivalents and the 2010 Credit Facility. We invest our excess cash in highly liquid short-term investments such as money market funds. 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 the interest expense incurred on our secured loan and therefore impact our cash flows and results of operations.
We are exposed to changes in interest rates primarily from our money market funds and from our borrowings at variable rates under the 2010 Credit Facility. In connection with the 2010 Credit Agreement, we entered into an interest rate swap agreement to pay a fixed rate of interest (1.778% per annum) and receive a floating rate interest payment (based on the three-month LIBOR) on a principal amount of $50 million. The $50 million swap agreement became effective on December 30, 2011 and expires on October 29, 2015.
A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would materially affect our interest expense. However, the impact of this type of adverse movement would be partially mitigated by our interest rate swap agreement that became effective on December 30, 2011. Based on our revolving credit balance at December 31, 2012 and taking into consideration our interest rate swap agreement, our interest expense would increase on a pre‑tax basis by approximately $200,000 during the next 12 months if a 100 basis point adverse move in the interest rate yield curve occurred.
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 investments at December 31, 2012. Changes in interest rates over time will, however, affect our interest income.
Foreign Currency Exchange Rate Risk
We sell our products through an international distribution network in approximately 130 countries, and we bill certain international customers in Euros, British Pounds, Australian Dollars, Japanese Yen and Chinese Renminbi. Additionally, a significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies. As a result, our financial results could be significantly affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we sell our products.

43


To mitigate the effect of changes in currency exchange rates, we utilize foreign currency forward contracts and zero‑cost collar contracts to hedge foreign currency market exposures of underlying assets, liabilities and expenses. We also keep working funds necessary to facilitate the short-term operations of our subsidiaries in the local currencies in which they do business. As exchange rate fluctuations can significantly vary our sales and expense results when converted to U.S. dollars, our objective is to reduce the risk to earnings and cash flows associated with changes in currency exchange rates. We do not use foreign currency contracts for speculative or trading purposes.
The notional and fair values of foreign currency contracts are summarized as follows (in thousands):
 
December 31, 2012
 
December 31, 2011
 
Notional
Value
Local
Currency
 
Notional
Value
USD
 
Fair
Value
USD
 
Notional
Value
Local
Currency
 
Notional
Value
USD
 
Fair
Value
USD
Contracts not designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
 
Euro
9,400

 
$
12,197

 
$
12,401

 
11,000

 
$
14,909

 
$
14,266

British Pound
6,000

 
$
9,653

 
$
9,759

 

 
$

 
$

Australian dollar
2,500

 
$
2,585

 
$
2,595

 

 
$

 
$

Contracts designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
 
Israeli Shekel
17,971

 
$
4,649

 
$
4,799

 

 
$

 
$

All of the Euro, British Pound and Australian Dollar foreign currency contracts in place as of December 31, 2012 are scheduled to be settled before April 2013. All Israeli Shekel hedging contracts in place as of December 31, 2012 are scheduled to be settled before November 2013.
A significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies and if the U.S. dollar weakens, our consolidated operating expenses would increase. Should the U.S. dollar strengthen, our products may become more expensive for our international customers with subscription contracts denominated in U.S. dollars. Changes in currency rates also impact our future revenues under subscription contracts that are not denominated in U.S. dollars. Our revenues and deferred revenue for these foreign currencies are recorded in U.S. dollars when the subscription is entered into based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss.

44



Item 8.
Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Websense, Inc.
We have audited the accompanying consolidated balance sheets of Websense, Inc. as of December 31, 2012 and 2011 and the related consolidated statements of operations, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Websense, Inc. at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, Websense changed its method of accounting for revenue recognition effective January 1, 2011.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Websense, Inc.'s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 20, 2013 expressed an unqualified opinion thereon.
 
/s/ Ernst & Young LLP
San Diego, California
 
February 20, 2013
 


45


Websense, Inc.
Consolidated Balance Sheets
(In thousands, except par value amounts)
 
December 31,
 
2012
 
2011
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
64,584

 
$
76,201

Accounts receivable, net of allowance for doubtful accounts of $2,066 and $979 as of December 31, 2012 and 2011, respectively
89,071

 
80,147

Income tax receivable / prepaid income tax
3,989

 
738

Current portion of deferred income taxes
28,933

 
30,021

Other current assets
13,249

 
13,793

Total current assets
199,826

 
200,900

Cash and cash equivalents – restricted
662

 
628

Property and equipment, net
18,901

 
16,832

Intangible assets, net
17,940

 
26,412

Goodwill
372,445

 
372,445

Deferred income taxes, less current portion
7,335

 
8,599

Deposits and other assets
7,352

 
8,622

Total assets
$
624,461

 
$
634,438

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
7,941

 
$
9,026

Accrued compensation and related benefits
24,981

 
22,770

Other accrued expenses
12,413

 
16,534

Current portion of income taxes payable
694

 
3,187

Current portion of deferred tax liability
42

 
86

Current portion of deferred revenue
243,945

 
250,597

Total current liabilities
290,016

 
302,200

Other long term liabilities
2,044

 
2,600

Income taxes payable, less current portion
10,514

 
11,955

Secured loan
68,000

 
73,000

Deferred tax liability, less current portion
2,026

 
2,501

Deferred revenue, less current portion
157,112

 
142,437

Total liabilities
529,712

 
534,693

Stockholders’ equity:
 
 
 
Common stock - $0.01 par value; 100,000 shares authorized; 36,484 and 38,048 shares issued and outstanding at December 31, 2012 and 2011, respectively
580

 
568

Additional paid-in capital
443,100

 
415,573

Treasury stock, at cost
(436,426
)
 
(385,544
)
Retained earnings
90,596

 
72,247

Accumulated other comprehensive loss
(3,101
)
 
(3,099
)
Total stockholders’ equity
94,749

 
99,745

Total liabilities and stockholders’ equity
$
624,461

 
$
634,438

See accompanying notes to consolidated financial statements

46


Websense, Inc.
Consolidated Statements of Operations
(In thousands, except per share amounts)
 
Years Ended December 31,
 
2012
 
2011
 
2010
Revenues:
 
 
 
 
 
Software and service
$
328,276

 
$
325,373

 
$
320,544

Appliance
33,188

 
38,810

 
12,218

Total revenues
361,464

 
364,183

 
332,762

Cost of revenues:
 
 
 
 
 
Software and service
45,560

 
41,563

 
45,681

Appliance
13,646

 
18,056

 
7,409

Total cost of revenues
59,206

 
59,619

 
53,090

Gross profit
302,258

 
304,564

 
279,672

Operating expenses:
 
 
 
 
 
Selling and marketing
155,254

 
161,039

 
157,758

Research and development
63,305

 
58,247

 
54,325

General and administrative
42,161

 
40,863

 
36,779

Total operating expenses
260,720

 
260,149

 
248,862

Income from operations
41,538

 
44,415

 
30,810

Interest expense
(2,586
)
 
(1,635
)
 
(3,715
)
Other income (expense), net
92

 
1,239

 
(834
)
Income before income taxes
39,044

 
44,019

 
26,261

Provision for income taxes
20,695

 
13,025

 
7,609

Net income
$
18,349

 
$
30,994

 
$
18,652

Net income per share:
 
 
 
 
 
Basic net income per share
$
0.50

 
$
0.78

 
$
0.44

Diluted net income per share
$
0.49

 
$
0.76

 
$
0.43

Weighted average shares — basic
36,908

 
39,711

 
42,409

Weighted average shares — diluted
37,526

 
40,739

 
43,438

See accompanying notes to consolidated financial statements

47


Websense, Inc.
Consolidated Statements of Comprehensive Income
(In thousands)
 
Years Ended December 31,
 
2012
 
2011
 
2010
Net income
$
18,349

 
$
30,994

 
$
18,652

Other comprehensive income (loss) before tax:
 
 
 
 
 
Foreign currency translation adjustments
44

 
(538
)
 

Unrealized gains (losses) on derivative contracts, net
(175
)
 
(2,940
)
 
1,991

Other comprehensive income (loss) before tax
(131
)
 
(3,478
)
 
1,991

Income tax benefit (provision) related to components of other comprehensive income
129

 
1,176

 
(794
)
Other comprehensive income (loss), net of tax
(2
)
 
(2,302
)
 
1,197

Comprehensive income
$
18,347

 
$
28,692

 
$
19,849

See accompanying notes to consolidated financial statements

48


Websense, Inc.
Consolidated Statements of Stockholders' Equity
(In thousands)
 
 
 
 
 
Additional paid-in capital
 
Treasury stock
 
Retained earnings
 
Accumulated other comprehensive loss
 
Total stockholders' equity
 
Common stock
 
 
 
 
 
 
Shares
 
Amount
 
 
 
 
 
Balance at January 1, 2010
43,410

 
$
529

 
$
330,451

 
$
(194,672
)
 
$
22,601

 
$
(1,994
)
 
$
156,915

Issuance of common stock upon exercise of options
973

 
10

 
15,982

 

 

 

 
15,992

Issuance of common stock for ESPP purchase
440

 
5

 
5,986

 

 

 

 
5,991

Issuance of common stock from restricted stock units, net
268

 
4

 

 
(2,900
)
 

 

 
(2,896
)
Share-based compensation expense

 

 
22,565

 

 

 

 
22,565

Tax shortfall from share-based compensation

 

 
(1,755
)
 

 

 

 
(1,755
)
Purchase of treasury stock
(4,090
)
 

 

 
(84,998
)
 

 

 
(84,998
)
Net income

 

 

 

 
18,652

 

 
18,652

Other comprehensive income

 

 

 

 

 
1,197

 
1,197

Balance at December 31, 2010
41,001

 
548

 
373,229

 
(282,570
)
 
41,253

 
(797
)
 
131,663

Issuance of common stock upon exercise of options
1,026

 
10

 
16,890

 

 

 

 
16,900

Issuance of common stock for ESPP purchase
473

 
5

 
6,609

 

 

 

 
6,614

Issuance of common stock from restricted stock units, net
335

 
5

 

 
(2,984
)
 

 

 
(2,979
)
Share-based compensation expense

 

 
18,976

 

 

 

 
18,976

Tax shortfall from share-based compensation

 

 
(131
)
 

 

 

 
(131
)
Purchase of treasury stock
(4,787
)
 

 

 
(99,990
)
 

 

 
(99,990
)
Net income

 

 

 

 
30,994

 

 
30,994

Other comprehensive loss

 

 

 

 

 
(2,302
)
 
(2,302
)
Balance at December 31, 2011
38,048

 
568

 
415,573

 
(385,544
)
 
72,247

 
(3,099
)
 
99,745

Issuance of common stock upon exercise of options
157

 
2

 
2,281

 

 

 

 
2,283

Issuance of common stock for ESPP purchase
521

 
5

 
6,747

 

 

 

 
6,752

Issuance of common stock from restricted stock units, net
382

 
5

 

 
(2,972
)
 

 

 
(2,967
)
Share-based compensation expense

 

 
20,110

 

 

 

 
20,110

Tax shortfall from share-based compensation

 

 
(1,611
)
 

 

 

 
(1,611
)
Purchase of treasury stock
(2,624
)
 

 

 
(47,910
)
 

 

 
(47,910
)
Net income

 

 

 

 
18,349

 

 
18,349

Other comprehensive loss

 

 

 

 

 
(2
)
 
(2
)
Balance at December 31, 2012
36,484

 
$
580

 
$
443,100

 
$
(436,426
)
 
$
90,596

 
$
(3,101
)
 
$
94,749

See accompanying notes to consolidated financial statements

49


Websense, Inc.
Consolidated Statements of Cash Flows
(In thousands)
 
Years Ended December 31,
 
2012
 
2011
 
2010
Operating activities:
 
 
 
 
 
Net income
$
18,349

 
$
30,994

 
$
18,652

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
Depreciation and amortization
20,351

 
26,286

 
37,873

Share-based compensation
20,110

 
18,976

 
22,565

Deferred income taxes
2,036

 
5,423

 
(264
)
Unrealized loss (gain) on foreign exchange
279

 
(137
)
 
490

Excess tax benefit from share-based compensation
(555
)
 
(2,596
)
 
(1,552
)
Changes in operating assets and liabilities:
 
 
 
 
 
Accounts receivable
(7,836
)
 
957

 
1,712

Other assets
835

 
2,251

 
(5,121
)
Accounts payable
(2,135
)
 
1,667

 
2,346

Accrued compensation and related benefits
1,877

 
449

 
(274
)
Other liabilities
(3,635
)
 
(4,161
)
 
(2,246
)
Deferred revenue
8,021

 
(1,246
)
 
14,191

Income taxes payable and receivable/prepaid
(8,765
)
 
328

 
1,747

Net cash provided by operating activities
48,932

 
79,191

 
90,119

Investing activities:
 
 
 
 
 
Change in restricted cash and cash equivalents
(21
)
 
31

 
(199
)
Purchase of property and equipment
(12,546
)
 
(9,117
)
 
(9,259
)
Purchase of intangible assets

 
(765
)
 

Net cash used in investing activities
(12,567
)
 
(9,851
)
 
(9,458
)
Financing activities: