Websense 10-Q 2007
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2007
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
(Exact name of registrant as specified in its charter)
10240 Sorrento Valley Road
San Diego, California 92121
(Address of principal executive offices, zip code and telephone number, including area code)
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 x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes o Nox
The number of shares outstanding of the registrants Common Stock, $.01 par value, as of April 30, 2007 was 44,973,164.
For the Period Ended March 31, 2007
TABLE OF CONTENTS
See accompanying notes.
See accompanying notes.
See accompanying notes.
See accompanying notes.
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and of the results for the interim periods presented.
These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2006, included in Websense, Inc.s (Websense or the Company) Annual Report on Form 10-K filed with the Securities and Exchange Commission. Operating results for the three months ended March 31, 2007 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2007. The balance sheet at December 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.
2. Net Income Per Share
Websense computes net income per share as permitted by the Financial Accounting Standards Board (FASB) with Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share (EPS) (SFAS No. 128). Under the provisions of SFAS No. 128, basic net income per share is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares consist of dilutive stock options and restricted stock units for 2007 and 2006. Dilutive securities include both dilutive stock options and dilutive restricted stock units and are calculated based on the average share price for each fiscal period using the treasury stock method.
During the three months ended March 31, 2007 and 2006, the difference between the weighted average shares used in determining basic EPS versus diluted EPS related to dilutive securities totaling 655,000 and 1,099,000 shares, respectively. Potentially dilutive securities totaling 5,378,000 and 3,367,000 shares for the three months ended March 31, 2007 and 2006, respectively, were excluded from historical basic and diluted earnings per share because of their anti-dilutive effect.
The following is a reconciliation of the numerator and denominator used in calculating basic EPS to the numerator and denominator used in calculating diluted EPS for all periods presented:
3. Comprehensive Income
The components of comprehensive income, as required to be reported by SFAS No. 130, Reporting Comprehensive Income, were as follows (in thousands):
4. Stockholders Equity
Employee Stock Purchase Plan
Shares available for issuance under the Companys Employee Stock Purchase Plan are as follows:
Employee Stock Option Plan
The Amended and Restated 2000 Stock Incentive Plan (the 2000 Plan) provides for the grant of stock options to the Companys directors, officers, employees and consultants. The 2000 Plan provides for the grant of incentive and non-statutory stock options, restricted stock units and rights to purchase stock to employees, directors or consultants of the Company. The 2000 Plan provides that incentive stock options will be granted only to employees and are subject to certain limitations as to fair value during a calendar year. To date, only non-statutory stock options and restricted stock units have been granted under the 2000 Plan. Through March 31, 2007, the Company has granted 120,000 restricted stock units.
The unvested restricted stock units have a weighted average grant date fair value of $28.69 and an aggregate intrinsic value (the amount by which the fair value exceeds the award price) of $2.2 million as of March 31, 2007.
In addition, the 2000 Plan provides for automatic annual increases in the number of shares authorized and reserved for issuance thereunder equal to the lesser of (i) 4% of the Companys outstanding shares on the last business day in December of the calendar year immediately preceding or (ii) 3,000,000 shares. At March 31, 2007, a total of 21,349,542 shares have been authorized for issuance under the 2000 Plan, of which 1,941,761 remain available for grant.
On January 8, 2007, the Compensation Committee of Websenses Board of Directors adopted the Websense, Inc. 2007 Stock Incentive Assumption Plan (the 2007 Plan). In connection with the acquisition of PortAuthority, the Company agreed to substitute unvested stock options to purchase PortAuthority common stock that were granted under PortAuthoritys 2004 Global Share Option Plan (the PortAuthority Option Plan) and outstanding immediately prior to the effective time of the acquisition with options to purchase an aggregate of 74,891 shares of Websense common stock (the Substitute Options). The Substitute Options have the same contractual lives and vesting periods as they did under the PortAuthority Option Plan. The number of shares and exercise prices of the Substitute Options were determined based on the conversion ratio as defined by the merger agreement with PortAuthority.
The results for the three months ended March 31, 2007 and 2006 include share-based compensation expense (excluding tax effects) of $5.2 million and $4.7 million, respectively, in the following expense categories of the consolidated statement of income (in thousands).
The Company used the following assumptions to estimate the fair value of stock options granted under the 2000 plan:
The Company used the following assumptions to estimate the fair value of the options granted under the 2007 Plan:
As of March 31, 2007, the Company had repurchased 8,170,060 shares of its common stock since April 2003 under the Board of Directors authorized stock repurchase program, for an aggregate of $170.4 million at an average price of $20.86 per share. Remaining shares authorized for repurchase under the Companys stock repurchase program as of March 31, 2007 are as follows:
5. Acquisition - PortAuthority
On January 8, 2007, the Company acquired all of the outstanding stock of PortAuthority Technologies Inc., a provider of information leak prevention technology. The Company acquired PortAuthority to combine the two companies technologies to help customers prevent unauthorized use or disclosure of confidential data while simultaneously protecting users and data from external malicious threats. The Company expects to benefit from the acquisition by expanding its current product offerings and increasing its revenues. These are among the factors that contributed to a purchase price for the PortAuthority acquisition that resulted in the recognition of goodwill of $73.4 million. PortAuthoritys operations were assumed as of the date of the acquisition and are included in the Companys results of operations beginning on January 9, 2007 and, as a result, are not reflected in the Companys results of operations for the three months ended March 31, 2006.
Pursuant to the terms of the agreement, signed on December 20, 2006, the Company acquired all of PortAuthoritys outstanding capital stock, for $88.2 million in cash, funded with existing cash resources. The purchase price includes $5.0 million which is held in an escrow account and will be available to satisfy any Company claims for indemnification from the former stockholders of PortAuthority until the escrow is released. The total purchase price, including transaction expenses of approximately $1.9 million, has been allocated to tangible and intangible assets acquired based on estimated fair market values, with the remainder classified as goodwill.
The total purchase price of the acquisition was as follows (in thousands):
The transaction costs incurred by the Company primarily consist of fees for attorneys, financial advisors, accountants, debt prepayment penalty and other advisors directly related to the transaction.
The total purchase price has been allocated as follows based on the assets and liabilities acquired as of January 8, 2007 (in thousands):
The $4.2 million of PortAuthority indebtedness assumed in the transaction was repaid in the first quarter of 2007.
The amount allocated to in-process technology represents the fair value of an acquired, to-be-completed research project. The estimated value of approximately $1.3 million of the research project was determined by estimating the costs to develop the acquired technology into a commercially viable product, estimating the future net cash flows from the project once commercially viable, and discounting the net cash flows to their present value. As of the acquisition date, this project was not expected to have reached technological feasibility and will have no alternative future use. Accordingly, the amount allocated to in-process technology was charged to Websenses statement of income for the three months ended March 31, 2007.
The accompanying consolidated statements of income reflect the operating results of the PortAuthority business since January 8, 2007. Assuming the acquisition of PortAuthority had occurred on January 1, 2007 and 2006, the pro forma unaudited results of operations would have been as follows (in thousands):
The above pro forma unaudited results of operations do not include pro forma adjustments relating to costs of integration or post-integration cost reductions that may be incurred or realized by the Company in excess of actual amounts incurred or realized through March 31, 2007.
6. Goodwill and Intangible Assets
As of March 31, 2007, the Companys goodwill balance of $73.4 million solely relates to the Companys acquisition of PortAuthority on January 8, 2007. The Company did not have any goodwill or intangible assets at March 31, 2006.
The Company records goodwill when the purchase price of net tangible and intangible assets acquired exceeds their fair value. In accordance with SFAS 142, Goodwill and Other Intangible Assets, the Company reviews goodwill that has an infinite useful life for impairment at least annually in its fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. Intangible assets are carried at cost less accumulated amortization. The Company amortizes the cost of identified intangible assets on a straight-line basis over their expected economic lives. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company reviews intangible assets that have finite useful lives when an event occurs indicating the potential for impairment.
The Company reviews for impairment by facts or circumstances, either internal or external, indicating that it may not recover the carrying value of the asset. The Company measures impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. The Company measures fair value under SFAS 144, which is generally based on the present value of estimated future discounted cash flows. The Companys analysis is based on available information and on assumptions and projections it considers to be reasonable and supportable. The discounted cash flow analysis considers the likelihood of possible outcomes and is based on the Companys best estimate of projected future cash flows. If necessary, the Company performs 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.
Intangible assets, subject to amortization, were as follows as of March 31, 2007 (in thousands):
Amortization expense, as of March 31, 2007, is expected to be as follows (in thousands):
7. Foreign Currency Hedges
The Company uses derivatives to manage foreign currency risk and not for speculative or trading purposes. The Companys objective is to reduce the risk to earnings and cash flows associated with changes in foreign currency exchange rates. Gains and losses resulting from changes in the fair values of those derivative instruments will be recorded to earnings or other comprehensive income depending on the use of the derivative instrument and whether it qualifies for hedge accounting.
During the three months ended March 31, 2007 and 2006, the Company utilized Euro foreign currency forward contracts to hedge anticipated Euro denominated accounts receivable. All such contracts entered into were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not elected. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as fair value hedges settled during 2007 and 2006 are included in other income, net, in the accompanying consolidated income statements and amounted to approximately $85,000 and $47,000 for the three months ended March 31, 2007 and 2006, respectively.
During the three months ended March 31, 2007 and 2006, the Company utilized British Pound zero-cost collar contracts to hedge anticipated operating expenses. All such contracts entered into were designated as cash flow hedges and were considered effective as defined by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133), as amended. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as cash flow hedges settled during the first quarters of 2007 and 2006 are included in the respective operating categories the Company hedges its British Pound expenditures against. These net realized losses amounted to approximately $23,000 and $20,000 for the three months ended March 31, 2007 and 2006, respectively.
Notional and fair values of the Companys hedging position at March 31, 2007 and 2006 are presented in the table below (in thousands):
Euro forward contracts at March 31, 2007 and 2006 were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not selected. All Euro contracts will be settled before June 30, 2007. Realized gains or losses related to the settlements, if any, will be recorded in other income, net at the time of settlement.
All British Pound contracts were designated as cash flow hedges and were determined effective as of March 31, 2007 and 2006. All British Pound contracts will be settled before June 30, 2007. Realized gains and losses related to the settlements, if any, will be recorded in the respective operating categories the Company hedges its British Pound expenditures against.
8. Tax Matters
The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (FIN 48), at the beginning of fiscal year 2007. As a result of the implementation the Company recognized a $1.2 million increase to reserves for uncertain tax positions. This increase was accounted for as an adjustment to the January 1, 2007 balance of additional paid in capital and retained earnings on the Consolidated Balance Sheet. Including the cumulative effect increase, at the beginning of 2007, the Company had approximately $9.2 million of total gross unrecognized tax benefits. Of this total, $5.8 million (net of federal, state and foreign tax benefits) represents the amount of unrecognized tax benefits that, if recognized, would decrease the effective income tax rate in future periods. In addition, consistent with the provisions of FIN 48, the Company determines the classification of uncertain tax liabilities as current or non-current based on anticipated payment date. Accordingly, the Company has reflected $9.2 million as non-current income taxes payable.
Estimated interest and penalties related to the underpayment of income taxes are classified as a component of Provision for Income Taxes in the Consolidated Statements of Income and totaled $51,000 in the quarter ended March 31, 2007. Accrued interest and penalties were $0.4 million as of January 1, 2007.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state and foreign jurisdictions. The Company has substantially concluded all U.S. federal and state income tax audits for years through 2002. Substantially all material foreign income tax audits have been concluded for years through 2002. California income tax returns for 2003 and 2004 are currently under examination. The Company does not anticipate that total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statute of limitations prior to March 31, 2008. At March 31, 2007, the Company had deferred tax assets of $34.8 million.
The Company has requested a ruling regarding unrecognized state income tax benefits. It is reasonably possible within 12 months of the reporting date that the uncertain tax position established for the 2006 tax year could be decided in the Companys favor resulting in the reduction of the gross uncertain tax liability in an amount up to $1.7 million.
On September 29, 2006, Jason Tauber filed a purported class action against the Company and other unidentified individuals in California Superior Court for the County of San Diego, captioned Tauber v. Websense. The complaint alleges that the plaintiff and a putative class of certain software engineers and computer professionals who worked for the Company as exempt employees during the period from September 15, 2002 through the present should have been classified as non-exempt employees under California law and should have been paid for overtime. The complaint also alleges related wage and hour violations of the California Labor Code arising from the alleged misclassification and that the failure to pay overtime constitutes an unfair business practice under California Business and Professions Code § 17200. The complaint seeks unspecified damages for unpaid overtime, prejudgment interest, attorneys fees and other costs, statutory penalties for alleged violations, and other proper relief. The Company denies all material allegations and intends to defend the action vigorously.
The Company is involved in various legal actions in the normal course of business. Based on current information, including consultation with the Companys lawyers, the Company believes that any ultimate liability that may result from these actions, including Tauber v. Websense, would not materially affect the Companys consolidated financial positions, results of operation or cash flows. The Companys evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on the Companys results of operations or cash flows in a future period.
10. Recently Issued Accounting Standards
In September 2006, the FASB issued SFAS No. 157 Fair Value Measurement (SFAS No. 157), which provides guidance for using fair value to measure assets and liabilities. In addition, SFAS No. 157 also provides guidance for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, but does not expand the use of fair value in any new circumstances. The accounting provisions of SFAS No. 157 will be effective for the Company beginning January 1, 2008. The Company is in the process of determining the effect the adoption of SFAS No. 157 will have on its financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an Amendment of FASB Statement No. 115(SFAS No. 159). This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in SFAS No. 159 are elective; however, the amendment to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities. The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. The accounting provisions of SFAS No. 159 will be effective for the Company beginning January 1, 2008. The Company is in the process of determining the effect the adoption of SFAS No. 159 will have on its financial statements.
11. Subsequent event
The Company announced on April 26, 2007 that it has made a pre-conditional cash offer to acquire all of the issued and to-be-issued ordinary shares, excluding treasury shares, of SurfControl plc, a provider of on-demand and software-based Web and email security solutions. Under the terms of the proposal, SurfControl shareholders will receive 700 pence (approximately $14) in cash for each SurfControl share. The proposal values SurfControls existing issued share capital at approximately £201 million (approximately $400 million). The Company is obligated to pay the purchase price in British Pounds and has purchased a currency hedge against £244 million at $2.10 for 15 months, corresponding to the funds certain period under the credit facilities described below and the long stop date under the transaction agreement with SurfControl.
The transaction is expected to close approximately four months following regulatory approval by United States (US) and United Kingdom (UK) agencies. The transaction is expected to be financed through a combination of the Companys cash resources at the close of the transaction and the new senior credit facility. The transaction, which has been unanimously approved by the boards of both companies, is subject to the conditions and the satisfaction or waiver of the Pre-Conditions which relate to the obtaining of regulatory clearances from the relevant UK and US regulatory authorities. As of March 31, 2007, the Company has incurred approximately $1.8 million of transaction costs in connection with this offer, which are reflected in the deposits and other assets and other accrued expenses line items on the Companys consolidated balance sheet.
In connection with the SurfControl announcement, the Company entered into an agreement with Morgan Stanley Senior Funding Inc. and Bank of America, National Association, for a $300 million senior credit facility. The senior facility will consist of up to a $285 million six-year term loan and a $15 million revolving credit facility. The Company currently expects to borrow approximately $180 million to $200 million of the available senior credit facility at the closing of the acquisition. The senior credit facility is only available for funding the acquisition and related transaction costs. At funding, the senior credit facility will be secured by substantially all of the Companys assets, including pledges of the Companys first tier subsidiaries stock (except for limits on the stock pledges of foreign subsidiaries) and will be guaranteed by the Companys domestic subsidiaries. Loans made under the term loan amortize at 1.0% per year for years one through five, with the remaining 95% due in the sixth year of the agreement. The Company is required to use up to 50% of excess cash flow to make mandatory prepayments of principal, which are not subject to any prepayment penalties. The Company will have the option to borrow at prime rate or at a Eurodollar base rate plus, in each case, an applicable margin based on the Companys corporate credit rating at the time of funding. The senior credit facility contains financial covenants, as defined per the senior credit agreement, comprised of a consolidated leverage ratio and a consolidated interest coverage ratio. The senior credit agreement also contains affirmative and negative covenants. In addition, the Company has entered into an interim credit facility with the same lenders that is collateralized by $217 million of the Companys cash, cash equivalents and marketable securities that are deposited in restricted accounts and not available to the Company for any other uses while the
acquisition of SurfControl is pending. The Company expects to use the restricted funds to pay for a portion of the purchase price of SurfControl. The interim credit facility was entered into as part of a funds certain process for cash acquisitions of UK public companies that are subject to the City Code. Under the City Code, Morgan Stanley as financial adviser has indicated that it is satisfied that sufficient financial resources will be made available to the Company to satisfy the maximum cash consideration that would be payable under the terms of the proposal. The Company does not expect to borrow any amounts under the interim credit agreement.
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.
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;
· growth opportunities in domestic and international markets;
· new and enhanced channels of distribution;
· customer acceptance and satisfaction with our products;
· expected trends in operating and other expenses;
· anticipated cash and intentions regarding usage of cash;
· 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.
Our products help organizations manage their networks and computing resources to provide a secure and productive computing environment. We provide Web filtering and Web security software products that enable organizations to protect employees and confidential information from external Web-based attacks such as spyware, and phishing, as well as analyze, report and manage how employees use computing resources and the Internet. In January 2007, we acquired our technology development partner for information leak prevention solutions, PortAuthority Technologies Inc. (PortAuthority). As a result, in addition to our Web filtering and Web security software products, we offer software that helps prevent the loss of confidential information from internal threats, such as ineffective business process controls, employee error and malfeasance.
At the foundation of our Web filtering and Web security product offering is the Websense Enterprise® software application, which serves as a central policy engine and management and reporting platform for our Web filtering and related add-on Web security products. Websense Enterprise gives organizations the ability to enhance network security, improve employee productivity, mitigate potential legal liability and conserve network bandwidth by allowing organizations to identify potential risk areas and implement and automate Web access and application usage policies that reduce these risks. When combined with our Web security products that utilize our ThreatSeeker technology including Security Filtering, Remote Filtering and Client Policy Manager, Websense Enterprise allows organizations to enhance network and content security by blocking access to malicious Web sites and preventing the transmission of data to known spyware destination sites. To simplify the purchase process for our value-added resellers and customers, we have created a suite of Websense Enterprise and our most popular add-on security products and services, known as the Websense® Web Security Suite. We currently derive a significant percentage of our revenue from subscriptions to the Websense Enterprise-based solutions and expect this to continue in the future.
The Websense Content Protection Suite is an integrated information leak prevention solution that protects organizations from information leaks and data loss by discovering the location of sensitive data inside the network, monitoring the data as it attempts to travel inside or outside the organization, and protecting the data, with policy-based controls that align to business processes. The Content Protection Suite provides protection for data at rest, data in use, and data in motion, and is available with two modules: the Content Auditor and the Content Enforcer. Content Auditor is a proactive solution that finds sensitive
data in the network and identifies who is using it and how it is being used. Content Enforcer adds the ability to enforce user-defined data security policies. Sales of our newly acquired information leak prevention products and other products under development will comprise only a very small portion of our overall sales in 2007.
We also have been developing Web content filtering and security solutions to protect Internet users from receiving and accessing unwanted or illegal content on their mobile phones and personal digital assistants (PDAs). We have engaged in discussions regarding mobile filtering solutions with several third parties, and we expect a market for our solutions to develop once the wireless carriers determine that there is a sufficient market need for security protection on wireless mobile devices. We cannot predict with certainty when we will begin to generate revenue from this business.
During the three months ended March 31, 2007, we derived 39% of revenue from international sales, compared with 35% for the three months ended March 31, 2006, with the United Kingdom comprising approximately 10% of our total revenue in both years. 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 and Latin American markets. On April 26, 2007, we announced that we are acquiring SurfControl plc (a London stock exchange listed company) through a pre-conditional cash offer to acquire all of the ordinary shares of SurfControl for 700 pence per share (or an aggregate of approximately $400 million based upon the current exchange rate) through a scheme of arrangement. SurfControl has substantial international operations, including in the United Kingdom, Australia, China and Israel and we expect the acquisition to accelerate our international growth.
We sell Websense Enterprise through both indirect channels and directly. Sales through indirect channels currently account for more than 85% of our revenue, and we plan to increase the percentage of our revenue obtained through indirect channels. Our strategy is to increase new and renewal customer sales through independent software distributors and resellers and increase the focus of our internal sales and marketing force on supporting our channel strategy. In August 2006, we announced a new two-tier distribution strategy in North America and entered into a relationship with Ingram Micro to distribute, market and support our Web security and Web filtering software in North America. Through joint marketing programs with Websense, Ingram Micro will focus its efforts on recruiting new resellers, especially resellers focused on selling to small and medium-sized businesses (SMB), and on building awareness and demand within our existing North America channel partner base.
As described elsewhere in this report, we recognize revenue from subscriptions to our products, including add-on modules, 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 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 product is delivered. Operating expenses have continued to increase as compared with prior periods due to expanded selling and marketing efforts, continued product research and development and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.
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 Websense Enterprise and provided throughout the subscription term. We recognize revenue on a daily straight-line basis, commencing with the day the subscription begins, over the term of the subscription agreement, provided collectibility 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. Taxes invoiced, collected and remitted to governmental authorities are presented on a net basis in our consolidated statements of income. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. Upon expiration of the subscription, customers who wish to re-subscribe typically must do so at the then current rates to continue using our products. Our revenue is significantly influenced by new and renewal subscriptions, and a decrease in subscription amounts could negatively impact our future revenue.
We record channel marketing payments and channel rebates as an offset to revenue. We recognize channel 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.
Goodwill and Intangible Assets. We record goodwill when the purchase price of net tangible and intangible assets we acquire exceeds their fair value. In accordance with SFAS 142, Goodwill and Other Intangible Assets, we review goodwill that has an infinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. Intangible assets are carried at cost, less accumulated amortization. We amortize the cost of identified intangible assets on a straight-line basis over their expected economic lives. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, 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 internal or external, 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 present value of estimated future discounted cash flows. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. The discounted cash flow analysis considers the likelihood of possible outcomes and is based on our best estimate of projected future cash flows. 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. On January 1, 2006, we adopted the provisions of Statement No. 123R and SAB No. 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 based on the provisions prescribed under Statement No. 123R and SAB No. 107. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the grant date.
Deferred Tax Assets. As required by SFAS No. 109, we recognize tax assets on the balance sheet if it is more likely than not that they will be realized on future tax returns. At March 31, 2007, we had deferred tax assets of $34.8 million. We believe that it is more likely than not that our deferred tax assets will be realized. Factors considered by us included: our earnings history, projected earnings based on current operations, and projected future taxable income. However, should we determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax assets would be charged against income in the period such determination was made.
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. In July 2006, the FASB issued Interpretation 48, Accounting for Uncertainty in Income Taxes (FIN 48), which became effective for us beginning in 2007. FIN 48 addressed 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 ultimate resolution. The impact of our reassessment of tax positions in accordance with FIN 48 did not have a material impact on the results of operations, financial condition or liquidity.
The following table summarizes our operating results as a percentage of total revenue for each of the periods shown.
Revenue increased to $49.7 million in the first quarter of 2007, from $42.1 million in the first quarter of 2006. The increase was primarily a result of the addition of new, renewed and upgraded subscriptions from our customers that resulted in a 1.5 million increase in the number of seats under subscription from March 31, 2006 to March 31, 2007. As a percentage of subscription revenue, new business increased to 39% in the first quarter of 2007 from 33% in the first quarter of 2006. We expect revenue to increase in the future as a result of our deferred revenue under existing subscriptions, our renewal business, our recently-acquired information leak prevention business and expected worldwide growth and expected growth in SMB business, partially offset by increased distributor marketing payments and channel payments.
Cost of Revenues
Cost of revenues. Cost of revenues consist of the costs of content review, technical support and infrastructure costs associated with maintaining our databases. Cost of revenues, excluding amortization of acquired technology, increased to $4.0 million in the first quarter of 2007 from $3.4 million in the first quarter of 2006. The increase of $0.6 million was primarily due to additional personnel in our technical support and database groups, and allocated costs. We allocate the total costs for human resources, employee benefits, payroll taxes, information technology, facilities, fixed asset depreciation and
legal costs to each of our functional areas based on salaries and headcount data. We expect cost of revenues to increase in the future to support the growth and maintenance of our databases as well as the technical support needs of our customers. As a percentage of revenue, cost of revenues, excluding amortization of acquired technology, remained the same during the first quarter of 2007 and 2006.
Amortization of acquired technology. Amortization of acquired technology primarily relates to the developed technology acquired from the PortAuthority acquisition in January 2007. The acquired technology is being amortized on a straight-line basis over its estimated economic life of six years.
Gross margin increased to $45.1 million in the first quarter of 2007 from $38.7 million in the first quarter of 2006. The increase was due to increased revenue. As a percentage of revenue, gross margin decreased to 91% in the first quarter of 2007 from 92% in the first quarter of 2006 primarily due to the increased costs as described in the Costs of Revenues section above.
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 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 $24.9 million, or 50% of revenue, in the first quarter of 2007, from $18.0 million, or 43% of revenue, in the first quarter of 2006. The increase in selling and marketing expenses of $6.9 million was primarily due to expenses associated with our new channel strategy, increased personnel costs and related travel, including new personnel added from the PortAuthority acquisition in January 2007, and allocated costs. We expect selling and marketing expenses to increase in absolute dollars in the future as more personnel are added to support our expanding selling and marketing efforts worldwide, including for our recently acquired information leak prevention products from PortAuthority, and as increased sales result in higher overall sales commission expenses.
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 $7.1 million, or 14% of revenue, in the first quarter of 2007 from $5.4 million, or 13% of revenue, in the first quarter of 2006. The increase of $1.7 million in research and development expenses was primarily due to increased personnel, including new personnel added from the PortAuthority acquisition in January 2007, needed to support our expanding list of technology partners, the enhancements of Websense Enterprise including our new SMB products under development and additional products, enhancements to our new information leak prevention products and allocated costs. We expect research and development expenses to increase in absolute dollars in the future due to our acquisition of PortAuthority and its engineering team, and as more personnel are added to support our continued enhancements of our existing products and new products.
General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance, administrative personnel, third party professional service fees, and allocated costs. General and administrative expenses increased to $7.2 million, or 15% of revenue, in the first quarter of 2007 from $5.2 million, or 12% of revenue, in the first quarter of 2006. The $2.0 million increase in general and administrative expenses was primarily due to additional personnel needed to support our growing operations, including the acquisition of PortAuthority in January 2007, and allocated costs. We expect general and administrative expenses to increase in absolute dollars in the future periods due to our growth in operations, increasing expenses associated with being a public company and expansion of our international operations.
Write off of in-process research and development. Write off of in-process research and development represents the fair value of an acquired, to be completed research project obtained from the PortAuthority acquisition that had not reached technological feasibility at the acquisition date and is not expected to have an alternative future use. Accordingly, the $1.3 million of in-process research and development was charged to our statement of income during the quarter ended March 31, 2007.
Other Income, Net
Other income, net decreased to $2.4 million in the first quarter of 2007 from $2.6 million in the first quarter of 2006.
The decrease was primarily due to lower cash, cash equivalents and marketable securities balances during the first quarter of 2007 compared to the first quarter of 2006, principally related to the acquisition of PortAuthority for approximately $90 million in January 2007 and partially offset by higher interest rates during the first quarter of 2007 compared to the first quarter of 2006. The majority of our investments of cash and cash equivalents and marketable securities are tax-exempt.
In connection with our recently announced acquisition of SurfControl, we entered into two new credit facilities with Morgan Stanley Senior Funding and Bank of America, NA, including a $207 million interim credit facility that was required to be entered into in order to satisfy the funds certain requirement for cash takeovers of UK public companies. The interim credit facility is collateralized with $217 million of our cash equivalents and marketable securities in restricted accounts, and we expect to use these restricted funds to fund a portion of the purchase price of SurfControl. We will continue to earn income on the restricted funds until the closing of the SurfControl acquisition. We expect that the majority of our cash, cash equivalents and marketable securities, including cash we continue to generate through operations, will continue to be held in tax-exempt investments during the foreseeable future.
Provision for Income Taxes
In the first quarter of 2007, United States and foreign income tax expense was $3.2 million, compared to $4.7 million for the first quarter of 2006. The effective income tax rate increased to 45% in the first quarter of 2007 from 37% in the first quarter of 2006. The increase in the tax rate is primarily related to a write-off in the current quarter of non-deductible in-process R&D acquired in the Port Authority acquisition, less tax exempt interest income and higher effective state income tax rate. Our effective tax rate may change in future periods due to the composition of taxable income between domestic and international operations along with potential changes or interpretations in tax rules and legislation, or corresponding accounting rules. We expect the effective income tax rate to decrease in the second quarter of 2007 compared to the first quarter of 2007 due to the non-recurrence of the write-off of non-deductible in-process R&D.
Liquidity and Capital Resources
As of March 31, 2007, we had cash and cash equivalents of $27.2 million, investments in marketable securities of $234.1 million and retained earnings of $86.2 million. As of December 31, 2006, we had cash and cash equivalents of $83.5 million, investments in marketable securities of $243.4 million and retained earnings of $82.7 million.
Net cash provided by operating activities was $21.3 million in the first three months of 2007 compared with $32.7 million in the first three months of 2006. The $11.4 million decrease in cash provided by operating activities was primarily due to decreased growth in deferred revenue as a result of higher growth in recognized revenue than growth in subscription amounts and increased accounts receivables from sales of our products compared to the first three months of 2006. Our operating cash flow is significantly influenced by subscription renewals and accounts receivable collections, and deferred revenue. A decrease in subscription renewals or accounts receivable collections, or a lower deferred revenue balance, would negatively impact our operating cash flow.
Net cash used in investing activities was $74.4 million in the first three months of 2007 compared with net cash used in investing activities of $70.2 million in the first three months of 2006. The $4.2 million increase of net cash used in investing activities was primarily due to cash used to purchase PortAuthority in January 2007 partially offset by cash provided by the net of purchases and maturities of marketable securities.
Net cash used in financing activities was $3.1 million in the first three months of 2007 compared with net cash used in financing activities of $3.6 million in the first three months of 2006. The $0.5 million decrease of net cash used in financing activities was primarily due to decreased proceeds of $2.8 million for exercises of stock options, decreased excess tax benefit from share-based compensation of $1.4 million, repayment of a $4.2 million loan acquired from PortAuthority offset by no purchases of treasury stock during the three months ended March 31, 2007 (compared to treasury stock purchases totaling $8.9 million during the three months ended March 31, 2006).
We have operating lease and software license commitments of approximately $19.9 million as of March 31, 2007. A majority of our operating lease commitments are related to our corporate headquarters lease, which extends through December 2013. Our corporate headquarters lease includes escalating rent payments from 2007 to 2013. The rent expense related to our worldwide office space leases are recorded monthly on a straight-line basis in accordance with generally accepted accounting principles. Future minimum annual payments under non-cancelable operating leases and software license agreements at March 31, 2007 are as follows (in thousands):
As of March 31, 2007 and 2006, we did not have any relationships with unconsolidated entities or financial partners, such as 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 exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
On April 3, 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 4 million shares of our common stock. On August 15, 2005, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 8 million shares. On July 25, 2006, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 12 million shares. Repurchases may be made from time to time on the open market at prevailing market prices or in privately negotiated transactions. Depending on market conditions and other factors, purchases under this program may be commenced or suspended at any time, or from time to time, without prior notice. As of March 31, 2007, we had repurchased 8,170,060 shares of our common stock under this program, for an aggregate of $170.4 million at an average price of $20.86 per share. Under the terms of our new senior credit facility, we are restricted from repurchasing our stock for a purchase price that exceeds 50% of our consolidated net income during the period from the effective date of the facility through the most recent quarter end for which we have filed quarterly financial statements.
On April 26, 2007, we entered into an agreement with Morgan Stanley Senior Funding Inc. and Bank of America, National Association for a $300 million senior credit facility. Our senior facility consists of up to a $285 million six-year term loan and a $15 million revolving credit facility. We intend to use the proceeds of the loan to fund, in part, the acquisition of SurfControl that we announced on April 26, 2007. We currently expect to borrow approximately $180 to $200 million of the available senior credit facility at the closing of the acquisition. The senior credit facility is not available for borrowing for any other purpose. At funding, the senior credit facility will be secured by substantially all of our assets, including pledges of our first tier subsidiaries stock (except for limits on the stock pledges of foreign subsidiaries) and is guaranteed by our domestic subsidiaries. Loans made under the term loan amortize at 1.0% per year for years one through five, with the remaining 95% due in the sixth year of the agreement. We are required to use up to 50% of excess cash flow to make mandatory prepayments of principal, which are not subject to any prepayment penalties. We will have the option to borrow at prime rate or at a Eurodollar base rate plus, in each case, an applicable margin based on our corporate credit rating at the time of funding The senior credit facility contains financial covenants, as defined per the senior credit agreement, comprised of a consolidated leverage ratio and a consolidated interest coverage ratio. In addition, we have entered into an interim credit facility with the same lenders that is collateralized by $217 million of our cash, cash equivalents and marketable securities that are deposited in restricted accounts and not available to us for any other uses while the acquisition of SurfControl is pending. We expect to use our restricted funds to pay for a portion of the purchase price of SurfControl. In connection with the financing for the acquisition, we purchased a currency hedge against £244 million for the 15 month period until the long stop date under the transaction agreement with SurfControl.
We believe that our unrestricted cash and cash equivalents balances, investments in marketable securities and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures and stock repurchases, if any, exclusive of the purchase price of SurfControl, for at least the next 12 months. We expect to fund the purchase of SurfControl from our $217 million in restricted cash equivalents and marketable securities, and proceeds from our senior credit facility. Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements. We may elect to raise funds for these purposes through capital markets transactions or debt or private equity transactions as appropriate, subject to the restrictions on incurring additional debt in our senior credit facility and our obligation to use all of the proceeds of any equity offering to make mandatory prepayments of principal under our senior credit facility. We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.
As of March 31, 2007, we did not have any material off-balance sheet arrangements as defined in Regulation S-K Item 303 (a)(4).
Our market risk exposures are related to our cash, cash equivalents and investments in marketable securities. We invest our excess cash in highly liquid short-term investments, municipal securities, commercial paper and corporate bonds. These investments are not held for trading or other speculative purposes. Changes in interest rates affect the investment income we earn on our investments and therefore impact our cash flows and results of operations.
We are exposed to changes in interest rates primarily from our short-term available-for-sale investments. If our acquisition of SurfControl closes, we will be subject to changes in interest rates for our borrowings under our variable rate senior credit facility. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at March 31, 2007. Changes in interest rates over time will, however, affect our interest income.
We utilize foreign currency forward contracts and zero-cost collar contracts to hedge foreign currency market exposures of underlying assets and liabilities. In addition, working funds necessary to facilitate the short-term operations of our subsidiaries are kept in the local currencies in which they do business. Our objective is to reduce the risk to earnings and cash flows associated with changes in foreign currency exchange rates. We do not use foreign currency contracts for speculative or trading purposes.
Notional and fair values of our hedging positions at March 31, 2007 and 2006 are presented in the table below (in thousands):
The $0.2 million notional decrease in our Euro hedged position at March 31, 2007 compared to March 31, 2006 is primarily due to increased spending in Euros which creates a natural hedge against Euro billings. All of the Euro hedging contracts will be settled before June 30, 2007. For the quarter ended March 31, 2007, less than 15% of our total billings were denominated in the Euro. We do not expect Euro billings to represent more than 15% of our total billings during 2007.
The $2.1 million notional decrease in our British Pound hedged position at March 31, 2007 compared to March 31, 2006 is primarily due to a decrease in the percentage of working funds hedged. All of the British Pound hedging contracts will be settled before June 30, 2007. We expect our British Pound hedge commitments to reduce as we begin billing in the British Pound, in the second quarter of 2007, and create a natural hedge against our British Pound expenditures.
The Company is obligated to pay the purchase price for SurfControl in British Pounds and has purchased a currency hedge against £244 million at $2.10 for 15 months, corresponding to the funds certain period under the credit facilities and the long stop date under the transaction agreement with SurfControl.
Given our foreign exchange position, a 10% change in foreign exchange rates upon which these foreign exchange contracts are based would result in exchange gains and losses. In all material aspects, these exchange gains and losses would be fully offset by exchange gains and losses on the underlying net monetary exposures for which the contracts are designated as hedges. We do not expect material exchange rate gains and losses from unhedged foreign currency exposures.
We maintain disclosure controls and procedures (as defined in Rules 13a 15(e) and 15d 15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act)) designed to ensure that we are able to collect the information we
are required to disclose in the reports we file under the Exchange Act, and to record, process, summarize and report this information within the time periods specified in the rules of the Securities and Exchange Commission. Our Chief Executive Officer and Chief Financial Officer evaluated our disclosure controls and procedures as of the end of the period covered by this report. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are effective as of the end of the period covered by this Quarterly Report.
There have been no significant changes in our internal control over financial reporting or in other factors that could significantly affect our internal control over financial reporting, including any corrective actions with regard to significant deficiencies and material weaknesses, during the period covered by this Quarterly Report.
On September 29, 2006, Jason Tauber filed a purported class action against us and other unidentified individuals in California Superior Court for the County of San Diego, captioned Tauber v. Websense. The complaint alleges that the plaintiff and a putative class of certain software engineers and computer professionals who worked for us as exempt employees during the period from September 15, 2002 through the present should have been classified as non-exempt employees under California law and should have been paid for overtime. The complaint also alleges related wage and hour violations of the California Labor Code arising from the alleged misclassification and that the failure to pay overtime constitutes an unfair business practice under California Business and Professions Code § 17200. The complaint seeks unspecified damages for unpaid overtime, prejudgment interest, attorneys fees and other costs, statutory penalties for alleged violations, and other proper relief. We deny all material allegations and intend to defend the action vigorously.
We are involved in various legal actions in the normal course of business. Based on current information, including consultation with our lawyers, we believe that any ultimate liability that may result from these actions, including Tauber v. Websense, would not materially affect our consolidated financial positions, results of operations or cash flows. Our evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on our results of operations or cash flows in a future period.
You should carefully consider the following information in addition to other information in this report before you decide to purchase our common stock. The risks and uncertainties described below are those that we currently deem to be material and that we believe are specific to our company and our industry. 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 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.
We have marked with an asterisk (*) those risk factors that reflect material changes from the risk factors included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 28, 2007.
We have experienced declining growth rates, particularly for Web filtering sales to large enterprises in North America and Western Europe, and therefore need to increase our sales to small and medium sized business customers.
During the first half of 2006, we were unable to sustain our growth rates for sales of Web filtering products to large enterprises, particularly for new sales to this market segment. During the second half of 2006, we expanded our focus on increasing sales to small and medium sized business (SMB) customers in North America and Western Europe while sales growth rates in the large enterprise market segment slowed down. Our growth plans for new sales in North America and Western Europe in 2007 are largely dependent on our ability to increase sales in the SMB segment. To be successful, we must develop products specifically targeted at the SMB segment. We are scheduled to release the first such product in July 2007. We will also need to increase our reliance on our new two-tier distribution channel in North America and establish similar two-tier distribution arrangements in Western Europe that target SMB customers. Numerous competitors target the SMB segment for Web filtering and security sales, many of whom are different competitors from our primary competitors in the large enterprise space. If we cannot develop new products for the SMB segment or compete effectively for volume business through our existing or a newly established two-tier distribution model, our financial results will be negatively affected.
We are moving towards a two-tier distribution channel in North America which is intended to increase the quantity of our indirect sales.
As we move toward a two-tier indirect sales model in North America, our revenue will be derived almost entirely from sales through indirect channels, including value-added resellers, distributors that sell our products to end-users, providers of managed Internet services and other resellers. Currently, Ingram Micro is our only broad-line distributor in North America, so the success of our North American sales efforts is reliant on Ingram Micros success in selling our products to their reseller network. Our indirect sales model involves a number of additional risks, including:
· our resellers and distributors, including Ingram Micro, 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 assure that our channel partners will market and sell our new product offerings such as our security-oriented offerings and our new information leak prevention offerings;
· our reseller and distributor agreements are generally nonexclusive and may be terminated at any time without cause; and
· 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 meaningfully increase the amount of our products sold through our sales channels also depends on our ability to adequately and efficiently support these channel partners with, among other things, appropriate financial incentives to encourage pre-sales investment and sales tools, such as sales training, technical training and product collateral needed to support their customers and prospects. Additionally, we are continually evaluating the changes to our internal ordering and partner management systems in order to effectively execute our new two-tier distribution strategy. Any failure to properly and efficiently support our sales channels will result in lost sales opportunities.
Our future success depends on our ability to sell new, renewal and upgraded Web filtering and Web security subscriptions.*
Substantially all of our revenue in 2006 and the first quarter of 2007 was derived from new and renewal subscriptions to our Web filtering and Web security products. We expect that a significant majority of our sales for the remainder of 2007 will continue to be derived from our Web filtering and security products and that sales of our newly acquired information leak prevention products and other products under development will comprise only a very small portion of our overall sales in 2007. If our Web filtering and security 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 cannot sufficiently increase our customer base with the addition of new customers, particularly in the SMB segment, and increase seats under subscriptions from existing customers, we will not be able to grow our business to meet expectations.
Subscriptions for our Web filtering and security products typically have durations of 12, 24 or 36 months. Our customers have no obligation to renew their subscriptions upon expiration. Our revenue also depends upon maintaining a high rate of sales of renewal subscriptions and in selling further subscriptions to existing customers in order to add additional
seats or product offerings within their respective organizations. This may require 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 revenue from existing customers.
Failure of our security products, including our information leak prevention products, to achieve more widespread market acceptance will seriously harm our business. *
Our future financial performance depends on our ability to diversify our offerings by successfully developing, introducing and gaining customer acceptance of our new products and services, particularly our security offerings. On January 8, 2007, we acquired PortAuthority Technologies, Inc., and as a result of that acquisition, we now sell information leak prevention products in the content security market. We may not be successful in achieving market acceptance of these or any new products that we develop. Moreover, our recent increased emphasis on the development, marketing and sale of our security offerings and information leak prevention products could distract us from sales of our core Web filtering and Web security offerings, negatively impacting our overall sales. Any failure or delay in diversifying our existing offerings, or diversification at the detriment to our core Web filtering and Web security offerings, could harm our business, results of operations and financial condition.
We face increasing competition from much larger software and hardware companies, which places pressure on our pricing and which could prevent us from increasing revenue or maintaining profitability. 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 product and potentially could result in the commoditization of products in our space. We also face current and potential competition from vendors of Internet servers, operating systems and networking hardware, many of which now, or may in the future, develop and/or bundle Web filtering or other competitive products with their products. Increased competition may 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 profitability 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 lieu of purchasing our products. 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 more widespread market acceptance, any of which could have a material adverse effect on our business, results of operations and financial condition.
Our current principal competitors include:
· companies offering Web security solutions, such as Microsoft, Symantec, McAfee, Juniper Networks, Message Labs, Trend Micro and Postini;
· companies offering Web filtering products, such as SurfControl, Secure Computing, Symantec, Digital Arts, Computer Associates, Microsoft, St. Bernard Software, Finjan, Barracuda, ScanSafe, Cisco Systems and Trend Micro;
· companies integrating Web filtering into specialized security appliances, such as 8e6 Technologies, Blue Coat Systems, Cisco Systems, McAfee, WatchGuard and SonicWALL;
· companies offering information leak protection solutions, such as Vontu, Verdasys, Vericept, Tablus, Symantec, Secure Computing, Reconnex, Provilla, Proofpoint, Palisade Systems, Orchestria, Oakley Networks, McAfee, Intrusion, Fidelis, Checkpoint and Code Green Networks;
· companies offering desktop security solutions such as Check Point Software, Cisco Systems, McAfee, Microsoft, Symantec, Computer Associates, Internet Security Systems (IBM) and Trend Micro; and
· companies offering proxy based solutions such as BlueCoat Systems, Cisco Systems and Juniper.
As we develop and market our products with an increasing security-oriented emphasis, we also face increasing competition from security solutions providers. Many of our competitors within the Web security market, such as Symantec Corporation, McAfee, Inc., Trend Micro, Cisco Systems and Microsoft Corporation 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.
As a result, we may be unable to gain sufficient traction as a provider of Web 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. 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, we also expect that competition will increase as a result of industry consolidation. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.
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 recently established engineering operations in Beijing, China, and acquired PortAuthority Technologies, Inc., whose engineering efforts are based in Israel. We intend to maintain our principal engineering efforts for our information leak prevention products in Israel. On April 26, 2007, we announced that we are acquiring SurfControl, which also has substantial operations outside the United States, including in the United Kingdom, Australia, China and 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 acquisition of SurfControl will also expand our international operations. 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;
· potential loss of proprietary information due to misappropriation or 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;
· 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;
· seasonal reductions in business activity in the summer months in Europe and in other periods in other countries;
· 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.
All of our foreign subsidiaries operating expenses are incurred in foreign currencies. As a result, should the dollar weaken, our foreign operating expenses would increase. Should foreign currency exchange rates fluctuate, our earnings and net cash flows from international operations may be adversely affected, especially if the trend continues of international sales growing as a percentage of our total sales.
Sales to customers outside the United States have accounted for a significant portion of our revenue, 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 39% of our total revenue generated during the quarter ended March 31, 2007 compared with 35% of our total revenue during the quarter ended March 31, 2006. As a key component of our business strategy to generate new business sales, we intend 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 localize software products for a significant number of international markets;
· 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.
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.
Our international revenue is currently primarily denominated in U.S. dollars. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make our products more expensive for international customers, which could harm our business. We currently bill certain international customers in Euros. This may increase our risks associated with fluctuations in foreign 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. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuation. Our hedging activities also involve inherent risks that could result in an unforeseen loss. If we fail to properly forecast rate fluctuations these activities could have a negative impact.
Acquired companies or technologies can be difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results.*
In January 2007, we acquired PortAuthority Technologies Inc., and on April 26, 2007 we announced that we are acquiring SurfControl. 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.
In the case of the SurfControl acquisition, we expect to achieve costs synergies from restructuring of the combined businesses following the closing. Our estimates of costs synergies are based upon our review of SurfControls business and our familiarity with the industry and markets. Our estimates are based upon numerous assumptions that are subject to risks and uncertainties and the actual amount of costs synergies achieved could deviate materially from our estimates. The timing of the achievement of synergies may also deviate from our estimates depending upon the success of the integration process. While we expect to satisfy the regulatory pre-conditions to acquiring SurfControl, the timing, costs and ultimate outcome of the regulatory processes are not in the Companys control, and can be extremely costly and time-consuming. A positive outcome in the regulatory processes cannot be assured. Also, while we expect the stockholders of SurfControl to approve the scheme of arrangement by the requisite vote, we have not obtained irrevocable undertakings from the stockholders of SurfControl, other than the members of SurfControls board of directors, to support the proposed acquisition. It is possible that SurfControl could receive a competing offer or the SurfControl stockholders could decline to support the transaction.
Acquisitions involve numerous risks, including:
· difficulties in integrating operations, technologies, services and personnel of the acquired company;
· diversion of financial and management resources from existing operations;
· risk of entering new markets;
· potential loss of key employees of the acquired company;
· potential loss of customers and original equipment manufacturing relationships of the acquired company;
· integrating personnel with diverse business and cultural backgrounds;
· preserving the development, distribution, marketing and other important relationships of the companies;
· assumption of liabilities of the acquired company, including debt and litigation; and
· inability to generate sufficient revenue and cost savings to offset acquisition costs.
Acquisitions may also cause us to:
· issue equity securities that would dilute our current stockholders percentage ownership;
· assume certain liabilities;
· incur additional debt;
· make large and immediate one-time write-offs and restructuring and other related expenses;
· become subject to intellectual property or other litigation; and
· create goodwill or other intangible assets that could result in significant impairment charges and/or amortization expense.
As a result, if we fail to properly evaluate, execute and integrate acquisitions such as PortAuthority and SurfControl, our business and prospects may be seriously harmed.
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 will need to continuously modify and enhance our products to keep pace with changes in Internet-related hardware, software, communication, browser and database technologies. We may not be successful in either developing such products or 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 technology could increase our research and development expenses. The failure of our products to operate effectively with the existing and future network platforms and technologies will limit or reduce the market for our products, result in customer dissatisfaction and seriously harm our business, results of operations and financial condition.
We may spend significant time and money on research and development to design and develop our information leak prevention products. If these products fail to achieve broad market acceptance in our target markets, we may be unable to generate significant revenue from our research and development efforts. Moreover, even if we are able to develop information prevention products, they may not be accepted in our target markets. As a result, our business, results of operations and financial condition would be adversely impacted.
Our products may fail to keep pace with the rapid growth and technological change of the Internet in accordance with our customers expectations.
The ongoing evolution of the Internet and computing environments will require us to continually improve the functionality, features and reliability of our databases. Because our products primarily manage access to URLs and software applications 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.
We rely upon a combination of automated filtering technology and human review to categorize URLs and software applications in our proprietary databases. Our customers may not agree with our determinations that particular URLs and software applications should be included or not included 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 miscategorization could result in customer dissatisfaction and harm our reputation. Any failure to effectively categorize and filter URLs and software applications according to our customers expectations will 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 software applications, 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.
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 and are deployed in a wide variety of complex network environments. 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 may 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, 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 markets perception of our security products. Moreover, parties whose Web sites or software applications 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 and use of 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.
We face risks related to customer outsourcing to system integrators.
Some of our customers have outsourced the management of their information technology 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 revenue and have a material adverse effect on our business.
Other vendors may include products similar to ours in their hardware or software and render our products obsolete.
In the future, vendors of hardware and of operating system software or other software may continue to enhance their products or bundle separate 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 filtering, security and information leak prevention products to further enhance operating systems or other software and to replace any obsolete products.
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.
Significant judgment is required in determining our worldwide provision for income taxes and for our accruals for other state, federal and international taxes such as sales and VAT taxes. 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 revenue 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 reasonable, no assurance can be given that the final tax authority review of these matters will not be materially different than that which is reflected in 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 also audited by various state, federal and international authorities relating to tax matters. We fully cooperate with all audits. Our audits are in various stages of completion; however, no outcome for a particular audit can be determined with certainty prior to the conclusion of the audit and appeals process. As each audit is concluded, adjustments, if any, are appropriately recorded in our financial statements in the period determined. To provide for potential tax exposures, we maintain allowances for tax contingencies based on reasonable estimates of our potential exposure with respect to the tax liabilities that may result from such audits. However, if the reserves are insufficient upon completion of any audits, there could be an adverse impact on our financial position and results of operations.
Any failure to protect our proprietary technology would negatively impact our business.*
Intellectual property is critical to our success, and we rely upon trademark, copyright and trade secret laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology and our Websense brand. We rely on trade secrets to protect technology where we believe patent protection is not appropriate or obtainable. However, trade secrets are difficult to protect. While we require employees, collaborators and consultants to enter into confidentiality agreements, we cannot assure that these agreements will not be breached or that we will have adequate remedies for any breach. 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.
We have registered our Websense and Websense Enterprise trademarks in several countries and have registrations for the Websense trademark pending in several other 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 only five issued patents in the United States and two patents issued internationally, and we may be unable to obtain further patent protection in the future. We have several pending patent applications in the United States and in other countries. We cannot ensure that:
· we were the first to make the inventions covered by each of our pending patent applications;
· we were the first to file patent applications for these inventions;
· others will not independently develop similar or alternative technologies or duplicate any of our technologies;
· any of our pending patent applications will result in issued patents;
· 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.
Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our products are available. The laws of some foreign countries may not be as protective of intellectual property rights as 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 universal resource locators (URLs) and software applications. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition.
Third parties claiming that we infringe their proprietary rights could cause us to incur significant legal expenses and 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 leakage and security area where larger companies with large patent portfolios compete, the possibility of an intellectual property claim against us grows. We could 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. If we are not successful in defending such claims, we could be required to stop selling 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.
Because we recognize revenue from subscriptions for our products ratably over the term of the subscription, downturns in sales may not be immediately reflected in our revenue.
We expect that nearly all of our revenue for the foreseeable future will come from subscriptions to Websense Enterprise and our add-on products. Upon execution of a subscription agreement, we invoice our customers for the full term of the subscription agreement. We then recognize revenue from customers daily over the terms of their subscription agreements, which typically have durations of 12, 24 or 36 months. As a result, a majority of the revenue we report in each quarter is derived from deferred revenue from subscription agreements entered into and paid for during previous quarters. Because of this financial model, the revenue we report in any quarter or series of quarters may mask significant downturns in sales and the market acceptance of our products, before these downturns result in declining revenues.
Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.*
Our quarterly operating results have varied significantly in the past, and will likely vary in the future primarily as the result of fluctuations in our billings, revenues, operating expenses and tax provisions. Although a significant portion of our revenue in any quarter comes from previously deferred revenue, a meaningful portion of our revenue in any quarter depends on the number, size and length of subscriptions to our products that are sold in that quarter. The risk of quarterly fluctuations is 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 many of the largest enterprise customers purchasing subscriptions to our products nearer to the end of the last month of each quarter. Due to the unpredictability of these end-of-period buying patterns, forecasts may not be achieved.
We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our research and development efforts and hire additional personnel which could impact our gross 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 quarterly report:
· 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
· timing of expenses associated with commissions paid on sales of subscriptions to our products.
Consequently, our results of operations may not meet the expectations of current or potential investors. If this occurs, the price of our common stock may decline.
The market price of our common stock is likely to be highly volatile and subject to wide fluctuations.
The market price of our common stock has been and likely will continue to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our control, including:
· announcements of technological innovations or new products or services by our competitors;
· demand for 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. A number of publicly traded Internet-related companies have current market prices below their initial public offering prices. Market fluctuations such as these may seriously harm the market price of our common stock. In the past, securities class action suits have been filed following periods of market volatility in the price of a companys 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. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. We do not have employment agreements with a majority of our executive officers, key management or development personnel and, therefore, they could terminate their employment with us at any time without penalty. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business, results of operations and financial condition. In such an event we may be unable to recruit personnel to replace these individuals in a timely manner, or at all, on acceptable terms.
Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth.
To execute our growth plan, we must attract and retain highly qualified personnel. We need to hire additional personnel in virtually all operational areas, including selling and marketing, research and development, operations and technical support, customer service and administration. Competition for these personnel is intense, especially for engineers with high levels of experience in designing and developing software and Internet-related products. We may not be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. 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 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 business and future growth prospects could be severely harmed.
Compliance with changing regulation of corporate governance, accounting principles and public disclosure may result in additional expenses.
Changing laws, regulations and standards relating to corporate governance, accounting principles and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ Global Select Market rules, are creating uncertainty for companies such as ours. These new or changed 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. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal controls over financial reporting and our external auditors audit of that assessment has required the commitment of significant financial and managerial resources. 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.
The covenants in our senior credit facility restrict our financial and operational flexibility, including our ability to complete additional acquisitions and invest in new business opportunities.*
Our senior credit facility contains covenants that restrict, among other things, our ability to borrow money, make particular types of investments, including investments in our subsidiaries, make other restricted payments, pay down subordinated debt, swap or sell assets, merge or consolidate or make acquisitions other than the pending acquisition of SurfControl. An event of default under our senior credit facility could allow the lenders to declare all amounts outstanding with respect to the senior credit facility to be immediately due and payable. A major event of default under the senior credit facility occurring between signing and the closing of the SurfControl acquisition, could allow the lenders not to fund the loan needed to close the acquisition of SurfControl. At funding of the loan, we will pledge substantially all of our consolidated assets and the stock of our subsidiaries (subject to limitations with respect to foreign subsidiaries) to secure the debt under our senior credit facility. If the amounts outstanding under the senior credit facility were accelerated, the lenders could proceed against those consolidated assets and the stock of our subsidiaries. Any event of default, therefore, could have a material adverse effect on our business. Our senior credit facility also requires us to maintain specified financial ratios. Our ability to meet these financial ratios can be affected by events beyond our control, and we cannot assure you that we will meet those ratios.
The amount of our debt expected to be outstanding as of the closing of the SurfControl acquisition may prevent us from taking actions we would otherwise consider in our best interest.*
The amount of our debt expected to be outstanding as of the closing of the SurfControl acquisition, the limitations our senior credit facility impose on us and the restrictions on $217 million of our cash resources pending the acquisition of SurfControl could have important consequences, including:
· it may be difficult for us to satisfy our obligations under the senior credit facility;
· we will have to use much of our cash flow for scheduled debt service rather than for potential investments;
· 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 divestiture, as a result of debt covenants;
· our vulnerability to general adverse economic and industry conditions could be increased; and
· we could be at a competitive disadvantage to competitors with less debt.
If we cannot effectively manage our internal growth and the integration of acquired businesses, our business revenues, profit margins and prospects may suffer. *
If we fail to manage our internal growth and the integration of acquired businesses in a manner that minimizes strains on our resources, we could experience disruptions in our operations that could negatively affect our revenue, billings or profitability. We are pursuing a strategy of organic growth through implementation of two-tier distribution, international expansion, introduction of new products and expansion of our product sales to the small and medium sized businesses. We also have pursued two strategic acquisitions, and are in the process of integrating PortAuthority and await regulatory approval to complete our acquisition of SurfControl. Finally, we have opened or acquired engineering centers in China and Israel. 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.
It may be difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.*
Some provisions of our certificate of incorporation and bylaws, as well as some provisions of Delaware law, may discourage, delay or prevent third parties from acquiring us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides for a classified board, with each board member serving a staggered three-year term. It also provides that stockholders may not fill board vacancies, call stockholder meetings or act by written consent. Our bylaws further provide that advance written notice is required prior to stockholder proposals. Each of these provisions makes it more difficult for stockholders to obtain control of our board or initiate actions that are opposed by the then current board. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board to issue 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, including discouraging attempts that might result in a premium over the market price of the shares of common stock held by our stockholders.
Our senior credit facility also accelerates and becomes payable in full upon our 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 and, 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 our senior credit facility.
(1) Filed as an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on January 12, 2007.
(2) Filed as an Exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 3, 2000.
(3) Filed as an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
(1) Filed as an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on January 12, 2007.
(2) Filed as an Exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 3, 2000.
(3) Filed as an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.