The following discussion and analysis should be read in conjunction with the financial statements and related notes contained elsewhere in this report. See "Risk Factors" under Part II, Item 1A below regarding certain factors known to us that could cause reported financial information not to be necessarily indicative of future results.

Forward-Looking Statements

This report on Form 10-Q 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 revenue;

† plans, strategies and objectives of management for future operations;

† growth opportunities in domestic and international markets;

† new and enhanced channels of distribution;

†          customer acceptance and satisfaction with our products;



†          risks associated with fluctuations in foreign currency exchange
rates;

† expected trends in operating and other expenses;

† anticipated cash and intentions regarding usage of cash;

† risks associated with integrating acquired businesses and launching new product offerings;

† changes in effective tax rates; and

† anticipated product enhancements or releases.

These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part II, 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.

Overview

Since we commenced operations in 1994 as a reseller of computer security products, Websense has evolved from a Web filtering company into a leading provider of integrated content security software solutions, including Web security, email and messaging security and data loss prevention ("DLP") solutions. Our customers use our software products to provide employees, business partners and customers with a secure and productive computing environment that protects essential information and enables safe Internet access, online collaboration and electronic commerce.

In today's computing environments, customers must deploy integrated Web, email and data security products to achieve effective protection against blended Web and email attacks, as well as from inadvertent data leaks due to faulty business processes. To meet our customers' requirements for comprehensive protection from these internal and external security risks, in 2006, we began expanding our product offering beyond Web filtering through both internal development and through acquisitions. In January 2007, we entered the emerging market for DLP through our acquisition of PortAuthority Technologies, Inc. ("PortAuthority"), a technology leader in the segment and our technology development partner for DLP solutions. In October 2007, we acquired SurfControl plc ("SurfControl"), a leading provider of Web and email security software solutions, which expanded our product portfolio to include email security software and hosted Web and email security solutions. Additionally, we have developed new Web security gateway software capable of dynamic Web content categorization and real-time detection and removal of malware from incoming Web traffic.

Today, we offer comprehensive suites of Web, email and data security products, available as layered software or hosted (on-demand) solutions. We have focused on integrating the intelligence and functionality from each of these product suites to provide more effective protection. Our products allow organizations to:

† prevent access to undesirable and dangerous elements on the Web, such as Web 2.0 sites that contain inappropriate content or sites that download an ever-increasing variety of malicious code;

†         filter unwanted emails or "spam" out of incoming email traffic;



†         filter viruses and other malicious attachments from email and instant
messages;

† manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;

† restrict the unauthorized use and loss of sensitive data, such as customer or employee information; and

† control misuse of an organization's valuable computing resources, including unauthorized downloading of high-bandwidth content.

Collectively, our software products secure an organization's confidential data and increase the productivity of its employees so they can safely conduct business electronically with partners and over the Internet. Fundamental to our products are:

† proactive discovery of Web and internal content, which is classified into highly granular database categories;

† proactive discovery and identification of Web-based threats, including spyware, hacking tools, keyloggers, phishing and pharming exploits;

† dynamic classification of uncategorized, high-risk Web content, including user-generated Web 2.0 content, based on our knowledge of the Web, email attack vectors and malicious code characteristics; and

† policy software that automates enforcement of pre-defined business policies regarding acceptable users and uses of various Web and internal content categories.

During the nine months ended September 30, 2008, we derived approximately 44% of our revenue from international sales, compared with approximately 40% for the nine months ended September 30, 2007, with the United Kingdom comprising approximately 14% and 10% of our total revenue for the nine months ended September 30, 2008 and 2007, respectively. We believe international markets continue to represent a significant growth opportunity and we are continuing to expand our international operations, particularly in selected countries in the European, Asia/Pacific, Latin American and Australian markets.

We sell our products primarily through two tier distribution channels. On occasion, we do sell products directly to value-added resellers or to customers, but sales through indirect channels currently account for more than 90% of our revenue.

As described elsewhere in this report, we recognize revenue from subscriptions to our products on a daily straight-line basis over the term of the subscription agreement, commencing on the first day of the subscription term. We 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 contract and are fully expensed in the period the subscription term begins. Operating expenses have continued to increase as compared with prior periods due to expanded selling and marketing efforts, continued product research and development and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.

In October 2007, we completed our acquisition of SurfControl. As a result of expenses related to the combination and certain accounting adjustments, we are incurring operating losses under U.S. generally accepted accounting principles ("GAAP"). Similar to Websense, SurfControl sold products primarily under subscriptions whereby revenues were initially recorded as deferred revenue and recognized ratably over the term of the agreement. Under GAAP purchase accounting, we wrote off $97.4 million of SurfControl's deferred revenue, leaving a balance of $19.7 million as the fair value of the obligation. This adjustment reflects the fair value of the post-contract technical support services that will be recognized daily in accordance with our revenue recognition policy. We did not expect to generate significant revenue from the installed SurfControl customer base until existing SurfControl subscriptions were renewed and we expected revenue from the SurfControl revenue base to increase over time as subscriptions were renewed. In connection with the acquisition, we have incurred restructuring costs primarily in connection with reducing SurfControl headcount and eliminating redundant facilities. We also started to incur the expenses of managing the SurfControl operations as well as recording the amortization of the acquired intangibles. As a result, we expect to continue to operate at a loss under GAAP until we generate sufficient revenue from the renewal of subscriptions of the installed SurfControl customer base. Given the average remaining term of the SurfControl subscriptions, we do not expect to operate at a profit under GAAP in fiscal year 2008. Our ability to retain SurfControl customers and maintain our overall pricing levels for our products will impact our results of operations and the timing of our return to profitability.

In connection with the acquisition of SurfControl, we approved plans to restructure the operations of the acquired company by terminating 320 of SurfControl's employees and exiting certain SurfControl facilities. As of September 30, 2008, all of the 320 employees that we identified as being subject to the involuntary termination have been terminated and all the severance costs have been paid. These workforce reductions were across all functions and geographies and affected employees were provided cash severance packages. Additionally, we have consolidated facilities and have exited, or will be exiting, leases in certain locations as well as reducing the square footage required to operate some locations. Our facility exit plans were finalized in September 2008. We have accrued the estimated costs associated with the employee severance and facility exit obligations as liabilities assumed in the acquisition of SurfControl and, accordingly, included the costs as part of the purchase price of SurfControl. Changes to the estimates of the facility exit costs after September 2008 will be recorded either as a reduction to goodwill or as an expense to the results of operations, as appropriate.

Critical Accounting Policies and Estimates

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

Revenue Recognition. When a purchase decision is made for our products, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and for a fixed number of users. Other services such as upgrades/enhancements and standard post-contract technical support services are sold together with our product subscription and provided throughout the subscription term. We recognize revenue 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 and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver access codes to users 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. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. For our U.S. dollar functional currency entities, when we enter into a subscription agreement that is denominated and paid in a currency other than U.S. dollars, we record the subscription billing and deferred revenue in U.S. dollars based upon the currency exchange rate in effect on the last day of the previous month before the subscription agreement is signed.

We record distributor marketing payments and channel rebates as an offset to revenue. We recognize distributor marketing payments as an offset to revenue as the marketing service is provided. We recognize channel rebates as an offset to revenue on a straight-line basis over the term of the subscription agreement.

Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the purchase method of accounting in accordance with SFAS No. 141, 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 values of net assets acquired is recorded as goodwill. The fair value of intangible assets, including acquired technology and customer relationships, is based on significant judgments made by management and accordingly we obtain the assistance from third party valuation specialists. The valuations and useful life assumptions are based on information available near the acquisition date and are based on expectations and assumptions that are considered reasonable

by management. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations.

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, 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. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), we review intangible assets that have finite useful lives when an event occurs indicating the potential for impairment. We review for impairment by facts or 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 under SFAS 144, which is generally based on the estimated future cash flows. 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. Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment("SFAS 123R") and Staff Accounting Bulletin No. 107 ("SAB 107") requiring the measurement and recognition of all share-based compensation under the fair value method. Share-based compensation expense related to stock options is recorded based on the fair value of the award on its grant date which we estimate using the Black-Scholes valuation model in accordance with the provisions prescribed under SFAS 123R and SAB 107. 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.

Income Tax Provision and Uncertain Tax Positions.Significant judgment is required in determining our consolidated income tax provision and evaluating our U.S. and foreign tax positions. We adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes ("FIN 48") beginning in 2007. FIN 48 addresses the determination of how tax benefits claimed, or expected to be claimed, on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon resolution. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.

Results of Operations

Three months ended September 30, 2008 compared with the three months ended September 30, 2007

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

                                             Three Months Ended
                                       September 30,    September 30,
                                           2008             2007
                                                (Unaudited)

Revenue                                          100 %            100 %

Cost of revenues:
Cost of revenues                                  12                9
Amortization of acquired technology                4                1
Total cost of revenues                            16               10

Gross margin                                      84               90

Operating expenses:
Selling and marketing                             56               50
Research and development                          17               17
General and administrative                        14               13
Total operating expenses                          87               80

(Loss) income from operations                     (3 )             10

Interest expense                                  (4 )              -
Other income, net                                  -                8

(Loss) income before income taxes                 (7 )             18

(Benefit) provision for income taxes              (2 )              5

Net (loss) income                                 (5 )%            13 %

Revenue

Revenue increased to $76.7 million in the third quarter of 2008 from $50.4 million in the third quarter of 2007. The increase was a result primarily of additional customer seats in new, renewed and upgraded subscriptions (including $18.7 million from new or renewed SurfControl seat subscriptions and $1.9 million of revenue recognized from the deferred revenue acquired from SurfControl in October 2007). The number of seats under subscription increased by 62% from September 30, 2007 to September 30, 2008 primarily due to the SurfControl acquisition. Revenue from DLP products initally acquired from PortAuthority contributed $1.2 million for the third quarter of 2008 compared to $0.6 million for the third quarter of 2007. For the remainder of 2008, we expect our revenue to increase over 2007 due to the addition of our acquired SurfControl business, our deferred revenue under existing subscriptions, our renewal business and planned growth in sales, partially offset by increased channel marketing payments and channel rebates, which are recorded as reductions to revenue.

Cost of Revenues

Cost of revenues. Cost of revenues consists of the costs of content review, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Cost of revenues increased to $9.2 million in the third quarter of 2008 from $4.5 million in the third quarter of 2007. The $4.7 million increase primarily consisted of $1.3 million related to increased personnel costs in our technical support and database groups, including the increased headcount attributable to the acquisition of SurfControl, $0.8 million related to the addition of hosted services through the acquisition of SurfControl and $1.4 million related to increased allocated costs. Our headcount in cost of revenue departments increased from 164 employees at September 30, 2007 to 239 employees at September 30, 2008. We allocate the costs for human resources, employee benefits, payroll taxes, information technology, facilities and fixed asset depreciation to

each of our functional areas based on headcount data. As a percentage of revenue, cost of revenues increased to 12% from 9% during the third quarter of 2008 compared to 2007. We expect cost of revenue to remain higher in absolute dollars for the remainder of 2008 as compared to 2007 in order to support the growth and maintenance of our databases and due to costs associated with providing our hosted security services as well as the technical support needs of our customers.

Amortization of acquired technology. Amortization of acquired technology primarily relates to the developed technology acquired from the PortAuthority acquisition in January 2007 and SurfControl acquisition in October 2007. The increase of $2.5 million in amortization of acquired technology from the third quarter of 2007 to the third quarter of 2008 was primarily due to the acquisition of SurfControl in October 2007. The acquired technology is being amortized over a weighted average period of 2.7 years. We expect to incur $3.1 million in amortization expense of acquired technology during the remainder of 2008.

Gross Margin

Gross margin increased to $64.4 million in the third quarter of 2008 from $45.3 million in the third quarter of 2007. As a percentage of revenue, gross margin decreased to 84% in the third quarter of 2008 from 90% in the third quarter of 2007 due to the increased costs described in the preceding Cost of Revenues section. We expect that gross margin as a percentage of revenue will remain in excess of 80% of revenue for the remainder of 2008.

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, including costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships as well as allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates. Selling and marketing expenses increased to $43.0 million, or 56% of revenue, in the third quarter of 2008, from $25.2 million, or 50% of revenue, in the third quarter of 2007. Approximately $9.3 million of the increase was due to the amortization of acquired intangibles (customer relationships) which resulted from the acquisition of SurfControl in October 2007. The acquired customer relationships intangible assets are being amortized over a weighted average period of approximately 5.8 years. In addition to the amortization of acquired intangible assets, the increase in selling and marketing expenses was primarily due to increased personnel costs of $6.2 million and related travel of $0.6 million, including new personnel added from the SurfControl acquisition in October 2007 and $1.6 million of increased allocated costs. Our headcount in sales and marketing increased from 400 employees at September 30, 2007 to 531 employees at September 30, 2008. We expect overall selling and marketing expenses to decrease in absolute dollars for the remainder of 2008 as compared to 2007 primarily due to a reduction of $3.7 million in the amount of amortization of acquired intangibles from the SurfControl acquisition due to the accelerated nature of the amortization, offset by having additional sales and marketing personnel to support our expanding selling and marketing efforts worldwide and increased sales resulting in higher overall sales commission expenses. We expect amortization of acquired intangibles of $9.4 million for the remainder of 2008 as a result of the amortization of acquired intangibles from the SurfControl and PortAuthority acquisitions.

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 $13.1 million, or 17% of revenue, in the third quarter of 2008 from $8.3 million, or 17% of revenue, in the third quarter of 2007. The increase of $4.8 million in research and development expenses was primarily due to $3.2 million of increased personnel cost, including adding new full time employees due to the SurfControl acquisition in October 2007, and increased hiring to support our release of our Web content gateway, data loss prevention endpoint module and enhancements to our other products as well as to support our expanding list of technology partners and $1.4 million of increased allocated costs. Our headcount increased in research and development from 211 employees at September 30, 2007 to 353 employees at September 30, 2008. We expect future research and development expenses to increase in absolute dollars for the remainder of 2008 as compared to 2007 due to having an expanded base of product offerings and the personnel and facilities required to develop and maintain the expanded product offerings. We are managing the increase in our absolute research and development expenses by operating research and development facilities in multiple international locations, including a facility in Beijing, China that we are in the process of expanding, that have lower costs than our operations in the United States. As a result of the PortAuthority and SurfControl acquisitions, we now have research and development facilities in Ra'anana, Israel; Sydney, Australia; Los Gatos, California and Reading, England, that have contributed to our increased research and development expenses.

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 $10.8 million, or 14% of revenue, in the third quarter of 2008 from $6.8

million, or 13% of revenue, in the third quarter of 2007. The $4.0 million increase in general and administrative expense was primarily due to $1.4 million of increased personnel costs needed to support our growing operations, including the acquisition of SurfControl in October 2007 and $0.8 million of increased allocated costs. Our headcount increased in general and administrative departments from 75 employees at September 30, 2007 to 115 employees at September 30, 2008. We expect general and administrative expenses to decrease in absolute dollars for the remainder of 2008 as compared to 2007 due to the reduction of the legacy SurfControl personnel in the general and administrative areas.

Interest Expense

Interest expense increased to $3.0 million in the third quarter of 2008 from zero in the third quarter of 2007. Interest expense represents the interest . . .