Summary of WEBSENSE INC - Yahoo! Finance

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

The following discussion and analysis should be read in conjunction with the financial statements and related notes contained elsewhere in this report. See "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 revenues and billings;

• 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 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 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.

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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 cloud-based service (software-as-a-service or "SaaS") offering or in a hybrid hardware/SaaS 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 original equipment manufacturers ("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 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.

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 three and nine months ended September 30, 2012 and 2011, we derived approximately 50% of our revenues from international sales. Revenues from the United Kingdom comprised approximately 11% of our total revenues in the three and nine months ended September 30, 2012 and 2011.
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. 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. We plan to increase headcount in our sales force as part of our strategy to expand our subscription business to existing customers and to grow sales to new customers.
We sell subscriptions for our software and SaaS 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 SaaS 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.

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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. Our primarily subscription-based business model operates such that 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 United States generally accepted accounting principles ("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 decreased 3% to $81.5 million during the third quarter of 2012 from $84.3 million during the third quarter of 2011, primarily due to the negative impact of currency exchange rates on billings as well as fewer customer upgrades in the United States in the third quarter of 2012 compared with the third quarter of 2011. Our appliance billings decreased from $8.0 million in the third quarter of 2011 to $6.9 million in the third quarter of 2012, primarily due to reduced software billings as software sales are the general driver of our appliance sales.
Billings from our TRITON content security solutions accounted for 61% of total billings in the third quarter of 2012 and grew approximately 9% to $49.4 million, from $45.3 million in the third quarter of 2011, whereas billings from our non-TRITON solution products declined 18% to $32.1 million in the third quarter of 2012 from $39.0 million in the third quarter of 2011. 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-based security solutions. Our non-TRITON solutions include our Web filtering products, such as our Websense Web Filter, Web Security Suite, server-based email security and related hardware. We expect the proportion of billings from our TRITON solutions to increase slightly as a percentage of total billings in the fourth quarter of 2012 compared with the fourth quarter of 2011.
Our international billings represented $42.2 million, or 52% of our total billings, for the third quarter of 2012, compared with $37.1 million, or 44% of total billings, for the third quarter of 2011, reflecting our maturing and stabilized international sales force.
Our average contract duration increased to 24.1 months for the third quarter of 2012, from 23.1 months for the third quarter of 2011 with approximately 49% of our billings in 12 month contracts, 7% in 24 month contracts and 44% in contracts with durations of 36 months or more. The average contract duration increased compared with the third quarter of 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 the third quarter of 2012 increased by 9% from 132 transactions to 144 transactions compared with the third quarter of 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. As a trend, the percentage of billings from subscriptions to our TRITON content security solutions, including those pre-installed on appliances is increasing, and the percentage of billings from our legacy filtering products is declining.
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 is derived from software and SaaS 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 SaaS subscriptions, including any related technical support and professional services, 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.

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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.
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.
During the three and nine months ended September 30, 2012, we recognized $8.1 million and $23.8 million, respectively, in revenues from appliance sales, of which $6.6 million and $19.0 million, respectively, represented the immediate recognition of revenue upon shipment and the remaining $1.5 million and $4.8 million, respectively, represented primarily the ratable recognition of deferred revenue from appliance sales recorded prior to the adoption of the amended revenue recognition rules. We expect to recognize revenues of $1.2 million throughout the remainder of 2012 from appliance sales made prior to 2011 that are recorded in deferred revenue as of September 30, 2012. The amended revenue recognition standards are expected to continue to affect total revenues in future periods, although the impact on the timing and pattern of revenues will vary depending on the nature and volume of new or materially modified contracts in any given period.

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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.
As previously disclosed in our periodic reports filed with the Securities and Exchange Commission, during the first quarter of 2010 the U.S. Internal Revenue Service ("IRS") completed its audit for the tax years ended December 31, 2005 through December 31, 2007 and issued us a letter which outlined all of its proposed audit adjustments. The adjustments related primarily to the cost sharing arrangement between Websense, Inc. and its Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax initially proposed by the IRS for the audited years totaled approximately $19.0 million, of which $14.8 million related to the amount of the cost sharing buy-in, $2.5 million related to research and development credits and $1.7 million related to equity compensation awarded to certain executive officers. The total additional tax proposed excluded interest, penalties, state income taxes and a potential reduction in tax on the Irish subsidiary. We disagreed with all of the proposed adjustments and submitted a formal protest to the IRS for each matter. In the third quarter of 2011, the IRS withdrew the proposed adjustment relating to equity compensation.

In the first quarter of 2012, we reached an agreement in principle with the IRS Appeals Office to settle the remaining audit adjustments related to the cost sharing buy-in and research and development tax credits. Due to these negotiations, we recorded a tax provision of $8.8 million in the quarter ended March 31, 2012. As a result of the final settlement with the IRS under a closing agreement we entered into on September 20, 2012, we made payments in the aggregate amount of $14.7 million in the third quarter of 2012, consisting of
(i) $7.1 million in U.S. federal tax related to the proposed adjustments, (ii) $5.4 million in state tax and accumulated interest related to the additional federal and state taxes and (iii) $2.2 million of U.S. federal tax related to the payment of $23.4 million owed to Websense, Inc. by its Irish subsidiary which will be settled through an intercompany loan agreement.

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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.
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.
Performance-based restricted stock units have performance-based vesting components that vest only if performance criteria are met for each respective performance period. If the performance criteria are not met for a performance period, then the related performance awards that would have vested are forfeited. Certain performance criteria allow for different vested amounts based on the level of achievement of the performance criteria. Once the performance based vesting criteria is met, the awards are then subject to time-based vesting. Fair value is measured on the grant date and is recognized over the expected vesting period, provided we determine it is probable that the performance criteria will be met.
At September 30, 2012, there was $39.0 million of total unrecognized compensation cost related to share-based compensation arrangements granted under all equity compensation plans (excluding tax effects). This total unrecognized compensation cost will be adjusted for estimated forfeitures as well as for future changes in estimated forfeitures. We expect to recognize this cost over a weighted-average period of approximately 2.1 years.
We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions described below. We estimate the expected . . .