Websense 10-Q 2008
Washington, D.C. 20549
For the Transition Period from to
Commission File Number 000-30093
(Exact name of registrant as specified in its charter)
10240 Sorrento Valley Road
(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, a non-accelerated filer or a smaller reporting company. See the definition of large accelerated filer, accelerated filer and smaller reporting company 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 No x
The number of shares outstanding of the registrants Common Stock, $.01 par value, as of October 31, 2008 was 45,004,221.
For the Period Ended September 30, 2008
See accompanying notes.
(Unaudited) (in thousands, except per share amounts)
See accompanying notes.
(Unaudited and in thousands)
See accompanying notes.
(Unaudited and in thousands)
See accompanying notes.
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in conformity with United States generally accepted accounting principles (GAAP) 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 GAAP 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 results of operations for the interim periods presented.
These financial statements should be read in conjunction with the audited consolidated financial statements and notes for the fiscal year ended December 31, 2007, 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 and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for any other interim period or for the fiscal year ending December 31, 2008. The balance sheet at December 31, 2007 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. Certain prior period amounts have been reclassified to conform to the current period presentation.
2. Net (Loss) Income Per Share
Websense computes net (loss) income per share (EPS) as permitted by the Financial Accounting Standards Board (FASB) with Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share (SFAS 128). Under the provisions of SFAS 128, basic EPS is computed by dividing the net (loss) income for the period by the weighted average number of common shares outstanding during the period. Diluted EPS 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. Dilutive stock options and dilutive restricted stock units are calculated based on the average share price for each fiscal period using the treasury stock method. In accordance with SFAS 128, if, however, the Company reports a net loss, the diluted EPS is computed in the same manner as the basic EPS.
As the Company reported a net loss for the three and nine months ended September 30, 2008, basic and diluted EPS were the same. During the three and nine months ended September 30, 2007, the difference between the weighted average shares used in determining basic EPS versus diluted EPS is due to dilutive securities which totaled 413,000 and 489,000 shares, respectively. Potentially dilutive securities totaling 8,389,000 and 7,112,000 shares for the three months ended September 30, 2008 and 2007, respectively, were excluded from the diluted EPS calculation because of their anti-dilutive effect. Potentially dilutive securities totaling 8,492,000 and 6,232,000 shares for the nine months ended September 30, 2008 and 2007, respectively, were excluded from the diluted EPS calculation 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 (Loss) Income
The components of comprehensive (loss) income, as required to be reported by SFAS No. 130, Reporting Comprehensive Income, were as follows (in thousands):
In October 2007, the Company completed the acquisition of SurfControl plc (SurfControl), a U.K.-based provider of Web and email security solutions. The total purchase price of the acquisition was as follows (in thousands):
The purchase price allocation as of September 30, 2008 is as follows (in thousands):
In connection with the acquisition, the Companys management approved plans to restructure the operations of the acquired company by terminating 320 of SurfControls employees and exiting certain SurfControl facilities. As of September 30, 2008, all of the 320 employees originally identified for termination have been terminated and all the severance costs have been paid. These workforce reductions were across all functions and geographies and affected employees were provided cash severance packages. Additionally, the Company has consolidated facilities and has exited, or will be exiting, leases in certain locations as well as reducing the square footage required to operate some locations. As of September 30, 2008, the Company has finalized its facility exit plans. The Company has accrued the estimated costs associated with the employee severance and facility exit obligations as liabilities assumed in the acquisition of SurfControl and accordingly, these estimated costs are included as part of the purchase price of SurfControl. Changes to the estimates of the facility exit costs after September 2008 will be recorded as a reduction to goodwill or as an expense to the results of operations, as appropriate, in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. As of September 30, 2008, $5.2 million of facility exit obligations remain accrued for payments in future periods as follows (in thousands):
The accruals for facility exit costs at September 30, 2008 represent the remaining fair value of lease obligations net of estimated sublease income for exiting locations, as determined at the expected cease-use dates of those facilities, and will be paid out over the remaining lease terms, the last of which ends in fiscal year 2011.
5. Intangible Assets and Goodwill
Intangible assets subject to amortization consisted of the following as of September 30, 2008 (in thousands):
As of September 30, 2008, remaining amortization expense is expected to be as follows (in thousands):
The following table summarizes the activity related to the carrying value of the Companys goodwill during the nine months ended September 30, 2008 (in thousands):
6. Senior Secured Credit Facility
In connection with the acquisition of SurfControl in October 2007, the Company entered into an amended and restated senior credit agreement (the Senior Credit Agreement). The $225 million senior secured credit facility consists of a five year $210 million senior secured term loan and a $15 million revolving credit facility. The senior secured term loan was fully funded on October 11, 2007, and the revolving line of credit remains unused. At September 30, 2008, the outstanding balance under the senior secured term loan was $140 million as a result of the Company making optional prepayments totaling $50 million in the nine months ended September 30, 2008, including $15 million in the quarter ended September 30, 2008, as well as an optional $20 million prepayment on December 31, 2007. In October 2008, the Company made an additional optional prepayment of $5 million. The senior secured credit facility is secured by substantially all of the assets of the Company, including pledges of stock of some of its subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by the Companys domestic subsidiaries. The senior secured term loan initially amortized at a minimum rate of 2.5%, 10%, 12.5%, and 15%, respectively, during the first four years of the term and 60% during the fifth year. In conjunction with the Companys optional $20 million prepayment on December 31, 2007, the Company amended its Senior Credit Agreement to eliminate any additional mandatory payments until September 30, 2009. The senior secured term loan bears interest at a spread above LIBOR with the spread determined based upon the Companys total leverage ratio, as defined in the Senior Credit Agreement. Prior to the third quarter 2008, the annual interest rate was LIBOR plus 250 basis points (5.28% at June 30, 2008), and was subject to a potential step down in the spread over LIBOR based upon potential future improvements in the Companys total leverage ratio. The unused portion of the revolving credit facility required a 50 basis points fee per annum, also subject to a step down based upon potential future improvements in the Companys total leverage ratio. Based on the total leverage ratio as of June 30, 2008, the spread on both the senior secured term loan and revolving credit facility was reset for the third quarter of 2008 to LIBOR plus 225 basis points (6.01% as of September 30, 2008) per annum for the senior secured term loan and reduced by 25 basis points per annum for the unused portion of the revolving credit facility. The Senior Credit Agreement contains financial covenants, including a consolidated leverage ratio and a consolidated interest coverage ratio, as well as affirmative and negative covenants. Among the negative covenants are restrictions on the Companys ability to borrow money, including restrictions on (a) the incurrence of more than $15 million of new debt, including capital leases (subject to certain exceptions), (b) the incurrence of more than $7.5 million in letters of credit, (c) the incurrence of more than $50 to $75 million of new debt, depending on the Companys leverage ratio, to finance future acquisitions or (d) the assumption of more than $15 million of new debt in connection with acquisitions.
As of September 30, 2008, future remaining minimum principal payments under the senior secured term loan will be as follows (in thousands):
The Senior Credit Agreement provides that the Company must maintain hedge agreements so that at least 50% of the aggregate principal amount of the senior secured credit facility is subject to fixed interest rate protection for a period of not less than 2.5 years. On October 11, 2007 in conjunction with the funding of the senior secured term loan, the Company entered into an interest rate swap agreement to pay a fixed rate of interest (4.85% per annum) and receive a floating rate interest payment (based on three month LIBOR) on an equivalent amount. The initial notional amount of the swap agreement was $105 million on October 11, 2007 and it amortizes each quarter down to $11 million on September 30, 2010. In addition, on October 11, 2007 the Company entered into an interest rate cap agreement to limit the maximum interest rate on a portion of its senior secured term loan to 6.5% per annum. The amount of principal protected by this agreement increases from $5 million at December 31, 2007 to $74.3 million on September 30, 2010. Both the interest rate swap and cap expire on September 30, 2010.
7. Foreign Currency Hedges
The Company uses derivative financial instruments to manage foreign currency risk relating to foreign exchange rates, fluctuations arising from the sale of products internationally in foreign currencies, and from expenses in foreign currencies to support those sales. The Company does not use these instruments 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. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statements and are measured at fair value. Gains and losses resulting from changes in the fair values of those derivative instruments are recorded to earnings or other comprehensive (loss) income depending on the use of the derivative instrument and whether it qualifies for hedge accounting.
During the three and nine months ended September 30, 2008 and 2007, 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. Net realized gains (losses) related to the contracts designated as fair value hedges settled during the three and nine months ended September 30, 2008 and 2007 are included in other income, net, in the accompanying consolidated statements of operations and amounted to approximately $45,000 and $(87,000) for the three months ended September 30, 2008 and 2007, respectively and $(449,000) and $(235,000) for the nine months ended September 30, 2008 and 2007, respectively. There were no Euro contracts outstanding as of September 30, 2007.
During the three months ended September 30, 2008, the Company utilized British Pound foreign currency forward contracts to hedge anticipated British Pound 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. Net realized gains related to the contracts designated as fair value hedges settled during the three months ended September 30, 2008 are included in other income, net, in the accompanying consolidated statements of operations and amounted to approximately $2,000. There were no British Pound contracts outstanding as of September 30, 2008.
During the three months ended September 30, 2008, the Company utilized Israeli Shekel 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 133), as amended. None of the contracts were terminated prior to settlement. Net realized losses of approximately $9,000 related to the contracts designated as cash flow hedges during the three months ended September 30, 2008 are included in the respective operating categories the Company hedges its Israeli Shekel expenditures against. There were no Israeli Shekel contracts outstanding prior to the quarter ended September 30, 2008.
Notional and fair values of the Companys Euro and Israeli Shekel hedging positions at September 30, 2008 and 2007 are presented in the table below (in thousands):
8. Fair Value Measurements
SFAS No. 157
SFAS No. 157, Fair Value Measurements (SFAS 157) defines fair value, establishes a framework for measuring fair value and establishes a hierarchy that categorizes and prioritizes the sources to be used to estimate fair value. SFAS 157 also expands financial statement disclosures about fair value measurements. On February 12, 2008, the FASB issued FASB Staff Position 157-2 (FSP 157-2), which delays the effective date of SFAS 157 for one year for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company elected a partial deferral of SFAS 157 under the provisions of FSP 157-2 related to the measurement of fair value used when evaluating nonfinancial assets and liabilities. The Company is currently evaluating the impact of FSP 157-2 on its financial statements. The impact of partially adopting SFAS 157 effective January 1, 2008 was not material to the Companys financial statements.
Fair Value Measurements on a Recurring Basis
Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurements. The Companys assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy.
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2008 (in thousands):
(1) quoted prices in active markets for identical assets or liabilities
(2) observable inputs other than quoted prices in active markets for identical assets and liabilities
(3) no observable pricing inputs in the market
Included in Other assets and in Other accrued expenses are derivative contracts, comprised of interest rate swaps and an interest rate cap as well as foreign currency forward contracts and zero-cost collar contracts, that are valued using models based on readily observable market parameters for all substantial terms of the Companys derivative contracts and thus are classified within Level 2.
Fair Value Measurements on a Nonrecurring Basis
As permitted by FSP 157-2, the Company elected to defer the fair value measurement disclosure of its nonfinancial assets and liabilities.
SFAS No. 159
SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an Amendment of SFAS 115 (SFAS 159), permits but does not require companies to measure financial instruments and certain other items at
fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. As the Company did not elect to fair value any of its financial instruments under the provisions of SFAS 159, the adoption of this statement effective January 1, 2008 did not have an impact on the Companys financial statements.
9. Stockholders Equity
Employee Stock Option Plans
The following table summarizes the Companys stock option activity since December 31, 2007:
The results of operations for the three and nine months ended September 30, 2008 and 2007 include share-based compensation expense in the following expense categories of the consolidated statements of operations (in thousands):
The Company used the following assumptions to estimate the fair value of the options granted:
The Company resumed repurchasing shares of its common stock during the first nine months of 2008 as follows.
Under the terms of the Companys Senior Credit Agreement, the Company is restricted from repurchasing its common stock for an aggregate purchase price that exceeds the sum of $25 million plus 50% of the aggregate amount of its consolidated net income, as defined in the Senior Credit Agreement, during the period from the effective date of the facility through the most recent quarter end for which quarterly financial statements have been filed. The remaining shares authorized for repurchase under the Companys stock repurchase program as of September 30, 2008 was 3,039,648 shares. As of September 30, 2008, $34.6 million remained authorized for repurchase under the Companys Senior Credit Agreement.
10. Tax Matters
The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (FIN 48), at the beginning of fiscal year 2007. At September 30, 2008, the Company had approximately $8.4 million of total gross unrecognized tax benefits. Included in this balance are $5.2 million of unrecognized tax benefits that, if recognized, would reduce the Companys annual effective tax rate. 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 operations. The Company accrued potential penalties and interest of $0.3 million related to these unrecognized tax benefits during the nine months ended September 30, 2008, and in total, as of September 30, 2008, the Company has recorded a liability for potential penalties and interest of $0.8 million.
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 2003. Substantially all material foreign income tax audits have been concluded for years through 2002. The federal income tax return for 2005 and California income tax returns for 2003 and 2004 are currently under examination. At September 30, 2008, the Company had net deferred tax assets of $50.9 million.
During the quarter ended March 31, 2008, the Company received a favorable ruling regarding unrecognized state income tax benefits, resulting in the reduction of the gross uncertain tax liability of $4.2 million. This favorable ruling resulted in approximately $2.7 million of net tax benefit being recognized in the consolidated statement of operations in the nine months ended September 30, 2008 with the remaining $1.5 million being recorded as a reduction to the related deferred tax asset. In addition, due to the potential resolution of federal, state and foreign tax examinations, and the expiration of various statutes of limitations, it is reasonably possible that the Companys gross unrecognized tax benefits balance may change within the next twelve months by a range of zero to $0.7 million.
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 it has adequately reserved for any ultimate liability that may result from these actions such that any liability would not materially affect the Companys consolidated financial position, results of operations 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.
12. Recently Issued Accounting Standards
In March 2008 the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133 (SFAS 161), which requires additional disclosures about the objectives of the derivative instruments and hedging activities, the method of accounting for such instruments under SFAS 133 and its related interpretations, and a tabular disclosure of the effects of such instruments and related hedged items on the Companys financial position, financial performance and cash flows. SFAS 161 is effective for the Company beginning January 1, 2009. The Company is currently assessing the potential impact that adoption of SFAS 161 may have on its financial statements.
In December 2007 the FASB issued SFAS No. 141R, Business Combinations (SFAS 141R). SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and establishes what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations the Company engages in will be recorded and disclosed following existing GAAP until January 1, 2009. The Company expects SFAS 141R may have an impact on its consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions, if any, consummated after the effective date. The Company is currently assessing the potential impact that adoption of SFAS 141R may have on its financial statements.
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;
· plans, strategies and objectives of management for future operations;
· growth opportunities in domestic and international markets;
· new and enhanced channels of distribution;
· customer acceptance and satisfaction with our products;
· risks associated with fluctuations in foreign currency exchange rates;
· expected trends in operating and other expenses;
· anticipated cash and intentions regarding usage of cash;
· risks associated with integrating acquired businesses and launching new product offerings;
· changes in effective tax rates; and
· anticipated product enhancements or releases.
These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part II, Item 1A Risk Factors, that could cause actual results to differ materially from those anticipated as of the date of this report. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report.
Since we commenced operations in 1994 as a reseller of computer security products, Websense has evolved from a Web filtering company into a leading provider of integrated content security software solutions, including Web security, email and messaging security and data loss prevention (DLP) solutions. Our customers use our software products to provide employees, business partners and customers with a secure and productive computing environment that protects essential information and enables safe Internet access, online collaboration and electronic commerce.
In todays computing environments, customers must deploy integrated Web, email and data security products to achieve effective protection against blended Web and email attacks, as well as from inadvertent data leaks due to faulty business processes. To meet our customers requirements for comprehensive protection from these internal and external security risks, in 2006, we began expanding our product offering beyond Web filtering through both internal development and through acquisitions. In January 2007, we entered the emerging market for DLP through our acquisition of PortAuthority Technologies, Inc. (PortAuthority), a technology leader in the segment and our technology development partner for DLP solutions. In October 2007, we acquired SurfControl plc (SurfControl), a leading provider of Web and email security software solutions, which expanded our product portfolio to include email security software and hosted Web and email security solutions. Additionally, we have developed new Web security gateway software capable of dynamic Web content categorization and real-time detection and removal of malware from incoming Web traffic.
Today, we offer comprehensive suites of Web, email and data security products, available as layered software or hosted (on-demand) solutions. We have focused on integrating the intelligence and functionality from each of these product suites to provide more effective protection. Our products allow organizations to:
· prevent access to undesirable and dangerous elements on the Web, such as Web 2.0 sites that contain inappropriate content or sites that download an ever-increasing variety of malicious code;
· filter unwanted emails or spam out of incoming email traffic;
· filter viruses and other malicious attachments from email and instant messages;
· manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;
· restrict the unauthorized use and loss of sensitive data, such as customer or employee information; and
· control misuse of an organizations valuable computing resources, including unauthorized downloading of high-bandwidth content.
Collectively, our software products secure an organizations confidential data and increase the productivity of its employees so they can safely conduct business electronically with partners and over the Internet. Fundamental to our products are:
· proactive discovery of Web and internal content, which is classified into highly granular database categories;
· proactive discovery and identification of Web-based threats, including spyware, hacking tools, keyloggers, phishing and pharming exploits;
· dynamic classification of uncategorized, high-risk Web content, including user-generated Web 2.0 content, based on our knowledge of the Web, email attack vectors and malicious code characteristics; and
· policy software that automates enforcement of pre-defined business policies regarding acceptable users and uses of various Web and internal content categories.
During the nine months ended September 30, 2008, we derived approximately 44% of our revenue from international sales, compared with approximately 40% for the nine months ended September 30, 2007, with the United Kingdom comprising approximately 14% and 10% of our total revenue for the nine months ended September 30, 2008 and 2007, respectively. We believe international markets continue to represent a significant growth opportunity and we are continuing to expand our international operations, particularly in selected countries in the European, Asia/Pacific, Latin American and Australian markets.
We sell our products primarily through two tier distribution channels. On occasion, we do sell products directly to value-added resellers or to customers, but sales through indirect channels currently account for more than 90% of our revenue.
As described elsewhere in this report, we recognize revenue from subscriptions to our products on a daily straight-line basis over the term of the subscription agreement, commencing on the first day of the subscription term. We recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription contract and are fully expensed in the period the subscription term begins. Operating expenses have continued to increase as compared with prior periods due to expanded selling and marketing efforts, continued product research and development and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.
In October 2007, we completed our acquisition of SurfControl. As a result of expenses related to the combination and certain accounting adjustments, we are incurring operating losses under U.S. generally accepted accounting principles (GAAP). Similar to Websense, SurfControl sold products primarily under subscriptions whereby revenues were initially recorded as deferred revenue and recognized ratably over the term of the agreement. Under GAAP purchase accounting, we wrote off $97.4 million of SurfControls deferred revenue, leaving a balance of $19.7 million as the fair value of the obligation. This adjustment reflects the fair value of the post-contract technical support services that will be recognized daily in accordance with our revenue recognition policy. We did not expect to generate significant revenue from the installed SurfControl customer base until existing SurfControl subscriptions were renewed and we expected revenue from the SurfControl revenue base to increase over time as subscriptions were renewed. In connection with the acquisition, we have incurred restructuring costs primarily in connection with reducing SurfControl headcount and eliminating redundant facilities. We also started to incur the expenses of managing the SurfControl operations as well as recording the amortization of the acquired intangibles. As a result, we expect to continue to operate at a loss under GAAP until we generate sufficient revenue from the renewal of subscriptions of the installed SurfControl customer base. Given the average remaining term of the SurfControl subscriptions, we do not expect to operate at a profit under GAAP in fiscal year 2008. Our ability to retain SurfControl customers and maintain our overall pricing levels for our products will impact our results of operations and the timing of our return to profitability.
In connection with the acquisition of SurfControl, we approved plans to restructure the operations of the acquired company by terminating 320 of SurfControls employees and exiting certain SurfControl facilities. As of September 30, 2008, all of the 320 employees that we identified as being subject to the involuntary termination have been terminated and all the severance costs have been paid. These workforce reductions were across all functions and geographies and affected employees were provided cash severance packages. Additionally, we have consolidated facilities and have exited, or will be exiting, leases in certain locations as well as reducing the square footage required to operate some locations. Our facility exit plans were finalized in September 2008. We have accrued the estimated costs associated with the employee severance and facility exit obligations as liabilities assumed in the acquisition of SurfControl and, accordingly, included the costs as part of the purchase price of SurfControl. Changes to the estimates of the facility exit costs after September 2008 will be recorded either as a reduction to goodwill or as an expense to the results of operations, as appropriate.
Critical Accounting Policies and Estimates
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. When a purchase decision is made for our products, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and for a fixed number of users. Other services such as upgrades/enhancements and standard post-contract technical support services are sold together with our product subscription and provided throughout the subscription term. We recognize revenue on a daily straight-line basis commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver access codes to users and then promptly invoice customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of the invoice. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. For our U.S. dollar functional currency entities, when we enter into a subscription agreement that is denominated and paid in a currency other than U.S. dollars, we record the subscription billing and deferred revenue in U.S. dollars based upon the currency exchange rate in effect on the last day of the previous month before the subscription agreement is signed.
We record distributor marketing payments and channel rebates as an offset to revenue. We recognize distributor marketing payments as an offset to revenue as the marketing service is provided. We recognize channel rebates as an offset to revenue on a straight-line basis over the term of the subscription agreement.
Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair values of net assets acquired is recorded as goodwill. The fair value of intangible assets, including acquired technology and customer relationships, is based on significant judgments made by management and accordingly we obtain the assistance from third party valuation specialists. The valuations and useful life assumptions are based on information available near the acquisition date and are based on expectations and assumptions that are considered reasonable
by management. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), we review intangible assets that have finite useful lives when an event occurs indicating the potential for impairment. We review for impairment by facts or circumstances, either external or internal, indicating that we may not recover the carrying value of the asset. We measure impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. We measure fair value under SFAS 144, which is generally based on the estimated future cash flows. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets.
Share-Based Compensation. Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment (SFAS 123R) and Staff Accounting Bulletin No. 107 (SAB 107) requiring the measurement and recognition of all share-based compensation under the fair value method. Share-based compensation expense related to stock options is recorded based on the fair value of the award on its grant date which we estimate using the Black-Scholes valuation model in accordance with the provisions prescribed under SFAS 123R and SAB 107. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the date of grant.
Income Tax Provision and Uncertain Tax Positions. Significant judgment is required in determining our consolidated income tax provision and evaluating our U.S. and foreign tax positions. We adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (FIN 48) beginning in 2007. FIN 48 addresses the determination of how tax benefits claimed, or expected to be claimed, on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon resolution. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.
Results of Operations
Three months ended September 30, 2008 compared with the three months ended September 30, 2007
The following table summarizes our operating results as a percentage of total revenue for each of the periods shown.
Revenue increased to $76.7 million in the third quarter of 2008 from $50.4 million in the third quarter of 2007. The increase was a result primarily of additional customer seats in new, renewed and upgraded subscriptions (including $18.7 million from new or renewed SurfControl seat subscriptions and $1.9 million of revenue recognized from the deferred revenue acquired from SurfControl in October 2007). The number of seats under subscription increased by 62% from September 30, 2007 to September 30, 2008 primarily due to the SurfControl acquisition. Revenue from DLP products initally acquired from PortAuthority contributed $1.2 million for the third quarter of 2008 compared to $0.6 million for the third quarter of 2007. For the remainder of 2008, we expect our revenue to increase over 2007 due to the addition of our acquired SurfControl business, our deferred revenue under existing subscriptions, our renewal business and planned growth in sales, partially offset by increased channel marketing payments and channel rebates, which are recorded as reductions to revenue.
Cost of Revenues
Cost of revenues. Cost of revenues consists of the costs of content review, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Cost of revenues increased to $9.2 million in the third quarter of 2008 from $4.5 million in the third quarter of 2007. The $4.7 million increase primarily consisted of $1.3 million related to increased personnel costs in our technical support and database groups, including the increased headcount attributable to the acquisition of SurfControl, $0.8 million related to the addition of hosted services through the acquisition of SurfControl and $1.4 million related to increased allocated costs. Our headcount in cost of revenue departments increased from 164 employees at September 30, 2007 to 239 employees at September 30, 2008. We allocate the costs for human resources, employee benefits, payroll taxes, information technology, facilities and fixed asset depreciation to
each of our functional areas based on headcount data. As a percentage of revenue, cost of revenues increased to 12% from 9% during the third quarter of 2008 compared to 2007. We expect cost of revenue to remain higher in absolute dollars for the remainder of 2008 as compared to 2007 in order to support the growth and maintenance of our databases and due to costs associated with providing our hosted security services as well as the technical support needs of our customers.
Amortization of acquired technology. Amortization of acquired technology primarily relates to the developed technology acquired from the PortAuthority acquisition in January 2007 and SurfControl acquisition in October 2007. The increase of $2.5 million in amortization of acquired technology from the third quarter of 2007 to the third quarter of 2008 was primarily due to the acquisition of SurfControl in October 2007. The acquired technology is being amortized over a weighted average period of 2.7 years. We expect to incur $3.1 million in amortization expense of acquired technology during the remainder of 2008.
Gross margin increased to $64.4 million in the third quarter of 2008 from $45.3 million in the third quarter of 2007. As a percentage of revenue, gross margin decreased to 84% in the third quarter of 2008 from 90% in the third quarter of 2007 due to the increased costs described in the preceding Cost of Revenues section. We expect that gross margin as a percentage of revenue will remain in excess of 80% of revenue for the remainder of 2008.
Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, including costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships as well as allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates. Selling and marketing expenses increased to $43.0 million, or 56% of revenue, in the third quarter of 2008, from $25.2 million, or 50% of revenue, in the third quarter of 2007. Approximately $9.3 million of the increase was due to the amortization of acquired intangibles (customer relationships) which resulted from the acquisition of SurfControl in October 2007. The acquired customer relationships intangible assets are being amortized over a weighted average period of approximately 5.8 years. In addition to the amortization of acquired intangible assets, the increase in selling and marketing expenses was primarily due to increased personnel costs of $6.2 million and related travel of $0.6 million, including new personnel added from the SurfControl acquisition in October 2007 and $1.6 million of increased allocated costs. Our headcount in sales and marketing increased from 400 employees at September 30, 2007 to 531 employees at September 30, 2008. We expect overall selling and marketing expenses to decrease in absolute dollars for the remainder of 2008 as compared to 2007 primarily due to a reduction of $3.7 million in the amount of amortization of acquired intangibles from the SurfControl acquisition due to the accelerated nature of the amortization, offset by having additional sales and marketing personnel to support our expanding selling and marketing efforts worldwide and increased sales resulting in higher overall sales commission expenses. We expect amortization of acquired intangibles of $9.4 million for the remainder of 2008 as a result of the amortization of acquired intangibles from the SurfControl and PortAuthority acquisitions.
Research and development. Research and development expenses consist primarily of salaries and benefits for software developers and allocated costs. Research and development expenses increased to $13.1 million, or 17% of revenue, in the third quarter of 2008 from $8.3 million, or 17% of revenue, in the third quarter of 2007. The increase of $4.8 million in research and development expenses was primarily due to $3.2 million of increased personnel cost, including adding new full time employees due to the SurfControl acquisition in October 2007, and increased hiring to support our release of our Web content gateway, data loss prevention endpoint module and enhancements to our other products as well as to support our expanding list of technology partners and $1.4 million of increased allocated costs. Our headcount increased in research and development from 211 employees at September 30, 2007 to 353 employees at September 30, 2008. We expect future research and development expenses to increase in absolute dollars for the remainder of 2008 as compared to 2007 due to having an expanded base of product offerings and the personnel and facilities required to develop and maintain the expanded product offerings. We are managing the increase in our absolute research and development expenses by operating research and development facilities in multiple international locations, including a facility in Beijing, China that we are in the process of expanding, that have lower costs than our operations in the United States. As a result of the PortAuthority and SurfControl acquisitions, we now have research and development facilities in Raanana, Israel; Sydney, Australia; Los Gatos, California and Reading, England, that have contributed to our increased research and development expenses.
General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and administrative personnel, third party professional service fees and allocated costs. General and administrative expenses increased to $10.8 million, or 14% of revenue, in the third quarter of 2008 from $6.8
million, or 13% of revenue, in the third quarter of 2007. The $4.0 million increase in general and administrative expense was primarily due to $1.4 million of increased personnel costs needed to support our growing operations, including the acquisition of SurfControl in October 2007 and $0.8 million of increased allocated costs. Our headcount increased in general and administrative departments from 75 employees at September 30, 2007 to 115 employees at September 30, 2008. We expect general and administrative expenses to decrease in absolute dollars for the remainder of 2008 as compared to 2007 due to the reduction of the legacy SurfControl personnel in the general and administrative areas.
Interest expense increased to $3.0 million in the third quarter of 2008 from zero in the third quarter of 2007. Interest expense represents the interest incurred on our senior secured term loan that we utilized to pay for a portion of the SurfControl purchase price in October 2007. Also included in the interest expense is $513,000 of amortization of deferred financing fees that were capitalized as part of the senior secured credit facility. The amount of interest expense will fluctuate due to changes in the outstanding principal balance and due to changes in LIBOR and changes in our applicable spread to LIBOR based upon improvements in our leverage ratio in accordance with our senior secured credit facility agreement. Interest expense should decline in the fourth quarter of 2008 as compared to the fourth quarter of 2007 due to the lower outstanding principal amount and the expected lower marginal interest rate on the non-fixed rate component of our senior secured credit facility due to the reduction in our spread over LIBOR. Fluctuations in LIBOR could impact our marginal interest rate.
Other (Expense) Income, Net
Other (expense) income, net decreased to a net expense of $0.1 million in the third quarter of 2008 from net other income of $3.9 million in the third quarter of 2007. The decrease was due primarily to reduced interest income of approximately $2.3 million in the third quarter of 2008 compared to the third quarter of 2007 as a result of our use of approximately $245 million in cash, cash equivalents and marketable securities to fund the acquisition of SurfControl in October 2007, and foreign exchange re-measurement losses of approximately $1.8 million due to unfavorable movements in the foreign exchange rates during the third quarter of 2008 compared to the third quarter of 2007. Due to the reduced cash, cash equivalents and marketable securities as a result of the acquisition of SurfControl as well as the prepayments on our senior secured term loan and stock repurchases, we expect other income, net to decrease in absolute dollars during the remainder of 2008 as compared to 2007.
Provision for Income Taxes
We recognized an income tax benefit of $2.1 million and an income tax expense of $2.5 million for the three months ended September 30, 2008 and 2007, respectively. Our effective tax rates were a tax benefit of 37.0% and a tax provision of 27.7% for the three months ended September 30, 2008 and September 30, 2007, respectively. Our effective tax rate increased from the third quarter of 2007 to the third quarter of 2008 primarily due to our results of operations in foreign jurisdictions, including the allocation of profit among jurisdictions with varying tax rates and an increase in foreign withholding taxes, as well as the impact that non-deductible items, primarily share-based compensation, had on the amount of tax benefit recorded on our losses from operations. In addition, our effective tax rate in the third quarter of 2007 was impacted by the unrealized loss on a foreign currency option contract purchased in connection with the SurfControl acquisition and certain tax exempt interest income that did not recur in 2008.
Our effective tax rate may change in future periods due to the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules.
In accordance with the provisions of SFAS 109, we assess, on a quarterly basis, the realizability of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items during the third quarter of 2008, it is more likely than not that we will be able to fully utilize our deferred tax assets.
Nine months ended September 30, 2008 compared with the nine months ended September 30, 2007
The following table summarizes our operating results as a percentage of total revenue for each of the periods shown.