[August 05, 2011] WEBSENSE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the financial statements and related notes contained elsewhere in this report. See "Risk Factors" under Part II, Item 1A below regarding certain factors known to us that could cause reported financial information not to be necessarily indicative of future results. Forward-Looking Statements This report on Form 10-Q may contain "forward-looking statements" within the meaning of the federal securities laws made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements, which represent our expectations or beliefs concerning various future events, may contain words such as "may," "will," "expects," "anticipates," "intends," "plans," "believes," "estimates" or other words indicating future results. Such statements may include but are not limited to statements concerning the following: • anticipated trends in revenues and billings; • plans, strategies and objectives of management for future operations; • growth opportunities in domestic and international markets; • new and enhanced reliance on channels of distribution; • anticipated product enhancements or releases; • customer acceptance and satisfaction with our products, services and fee structures; • expectations regarding competitive products and pricing; • changes in domestic and international market conditions; • risks associated with fluctuations in foreign currency exchange rates; • the impact of macro-economic conditions on our customers; • expected trends in operating and other expenses; • anticipated cash and intentions regarding usage of cash; • risks related to compliance with the covenants in our credit agreement; • risks associated with launching new product offerings; • changes in effective tax rates, laws and interpretations and statements related to tax audits and proposed adjustments; • risks related to changes in accounting interpretations or accounting guidance; • the volatile and competitive nature of the Internet and security industries; and • the success of our brand development efforts. These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part II, Item 1A "Risk Factors," that could cause actual results to differ materially from those anticipated as of the date of this report. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report. Overview We are a global provider of unified Web, data and email content security solutions designed to protect data and users from modern cyber-threats, information leaks, legal liability and productivity loss. We provide our solutions to our customers as software installed on standard server hardware, as software pre-installed on optimized appliances, as a cloud-based service (security as-a-service or SaaS) offering, or in a hybrid appliance/SaaS configuration. Our products and services are sold worldwide to public sector entities, enterprise customers, small and medium sized businesses ("SMBs"), and Internet service providers through a network of value-added resellers and OEM arrangements. Our portfolio of Web security, data security and email content security solutions allows organizations to: 17-------------------------------------------------------------------------------- Table of Contents • prevent access to undesirable and dangerous elements on the Web, such as Web sites that contain inappropriate content or sites that download viruses, spyware, keyloggers, hacking tools and an ever-increasing variety of malicious code, including Web 2.0 sites with user-generated content; • protect from spam, inappropriate content and malware embedded in user-generated content on Web 2.0 sites; • prevent unauthorized use and leaks of sensitive data, such as customer or employee information; • identify and remove malware from incoming Web content; • filter spam from incoming email; • 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; • control misuse of an organization's valuable computing resources, including unauthorized downloading of high-bandwidth content; and • protect against data loss by identifying and categorizing sensitive or confidential data, monitoring the movement of data throughout the network and enforcing pre-determined usage and movement policies. Since we commenced operations in 1994, Websense has evolved from a reseller of computer security products to a leading developer and provider of information technology ("IT") security software solutions. Our first Web filtering software product was released in 1996 and prevented access to inappropriate Web content. Since then, we have focused on adapting our Web filtering and content classification capabilities to address changing Internet use patterns including the rise of Web-based social and business applications and the growing incidence of Web-based criminal activity. During the three and six months ended June 30, 2011, we derived 50% of our revenues from international sales, as compared to 51% during the three and six months ended June 30, 2010. The United Kingdom comprised approximately 11% of our total revenues in the three and six months ended June 30, 2011 compared to 13% in the three and six months ended June 30, 2010. 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. We utilize a two-tier distribution strategy in North America to sell our products, with an objective of increasing the number of value-added resellers selling our products and further extending our reach into the SMB market segment. Our distribution strategy outside North America also relies on a multi-tiered system of distributors and value-added resellers. Sales through indirect channels currently account for more than 90% of our revenue. We also have several arrangements with OEMs that grant the OEM customers the right to incorporate our products into the OEM's products for resale to end-users. We sell subscriptions to our software products, generally in 12, 24 or 36 month contract durations, based on the number of seats or devices managed. As described elsewhere in this report, we recognize revenue from subscriptions to our software products on a daily straight-line basis commencing on the day the term of the subscription begins, over the term of the subscription agreement. We recognize revenue associated with OEM contracts ratably over the contractual period for which we are obligated to provide our services. We generally recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription contract and are fully expensed in the period the product and/or key is delivered. Our operating expenses, including cost of revenues, in the first half of 2011 increased compared to the first half of 2010, primarily due to increased cost of revenues from the immediate recognition of appliance cost of sales as a result of the adoption of the new revenue recognition accounting standards and our increased headcount, partially offset by a reduction in the amortization of acquired intangible assets of $5.4 million. Billings represent the amount of subscription contracts, OEM royalties and appliance sales billed to customers during the applicable period. Our primarily subscription-based business model operates such that subscription billings are recorded initially to our balance sheet as deferred revenue and then recognized to our income statement as revenue ratably over the subscription term or, in the case of OEM arrangements, over the contractual obligation period. Our billings are not a numerical measure that can be calculated in accordance with generally accepted accounting principles ("GAAP"). We provide this measurement (net of distributor marketing payments, channel rebates and adjustments to the allowance for doubtful accounts) in reporting financial performance because this measurement provides a consistent basis for understanding our sales activities each period. We believe the billings measurement is useful because the GAAP measurements of revenue and deferred revenue in the current period include subscription contracts commenced in prior periods. Billings to end user customers increased 3.8% year-over-year from $82.0 million in the second quarter of 2010 to $85.1 million in the second quarter of 2011. Billings from OEM arrangements declined from $1.7 million in the second quarter of 2010 to $0.8 million in the second quarter of 2011. Our total billings, including our OEM business, grew 2.6% from $83.7 million during the second quarter of 2010 to $85.9 million during the second quarter of 2011. Billings from our TRITON solution products increased from $30.3 million in the second quarter of 2010 to $44.4 million in the second quarter of 2011, whereas billings from our non- 18 -------------------------------------------------------------------------------- Table of Contents TRITON solution products declined from $51.7 million in the second quarter of 2010 to $40.7 million in the second quarter of 2011. Our TRITON solutions include our Web Security Gateway family of products (including appliances), data security and cloud-based security solutions. Our non-TRITON solutions include our web filtering products, such as our web security suite, on-premises e-mail security and related hardware. Our appliance billings increased from $4.6 million in the second quarter of 2010 to $7.2 million in the second quarter of 2011. Billings from incremental sales, which includes subscriptions to new customers, upgraded subscriptions and cross-sales to existing customers, increased from $22.5 million in the second quarter of 2010 to $25.3 million in the second quarter of 2011, which increase was driven by increased sales of our TRITON products. Our international billings to end-user customers represented $45.6 million or 54% of our total billings for the second quarter of 2011 compared to $42.0 million or 51% of total billings for the second quarter of 2010. The average annual value of each subscription sold during the second quarter of 2011 was $10,100 compared to $8,400 during the second quarter of 2010, reflecting our increased sale of Web Security Gateway and Data Security products to larger enterprise customers, reflecting the increased sale of TRITON products in the product mix. Our average contract duration decreased from 24.0 months for the second quarter of 2010 to 23.7 months for the second quarter of 2011 with approximately 51% of our billings in 12 month contracts, 6% in 24 month contracts and 43% in contracts with durations of 36 months or more. We expect our billings to grow for the remainder of 2011 relative to 2010 billings. Our billings depend in part on the number of subscriptions up for renewal each quarter and are influenced by seasonal variations with our fourth quarter generally being the strongest quarter in billings, and our first quarter generally being the lowest quarter for billings each fiscal year. As a trend, the percentage of billings from subscriptions to our Web Security Gateway and data security products, including those pre-installed on appliances, is increasing, and the percentage of billings from our pure Web filtering products is declining. During 2010, we completed a global restructuring of our international distribution operations, which we anticipate will reduce the complexity and compliance risks associated with our global distribution activities. We expect that the restructuring also will reduce our GAAP effective tax rate relative to the GAAP effective tax rate that would have applied absent the restructuring because we expect to reduce our taxable income in certain foreign jurisdictions and expect to increase our taxable income in a lower tax rate foreign jurisdiction where we streamlined and consolidated the ownership of our intellectual property and distribution rights. The restructuring did not materially impact our U.S. business operations or the relative amount of taxable income in the U.S. versus outside the U.S. While we anticipate that our GAAP effective tax rate will be lower than it would have been without the global distribution restructuring, we cannot predict whether the GAAP effective tax rate in any particular period will be less than the GAAP effective tax rate in the immediately preceding prior period or in the comparable period of the prior fiscal year. The actual impact of the restructuring on our GAAP effective tax rate is highly dependent on our future results of operations. Critical Accounting Policies and Estimates Critical accounting policies are those that may have a material impact on our financial statements and also require management to exercise significant judgment due to a high degree of uncertainty at the time the estimate is made. Our senior management has discussed the development and selection of our accounting policies, related accounting estimates and disclosures with the Audit Committee of our Board of Directors. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition. The majority of our revenue is derived from software and SaaS sold on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats. We recognize revenue for the software and SaaS subscriptions, including any related technical support and professional services, on a daily straight-line basis, commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver access codes to customers and then promptly invoice customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of invoicing. In October 2009, the FASB amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product's essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to: • provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; and • require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on VSOE, if available; TPE, if available and VSOE is not available; or the BESP, if neither VSOE nor TPE is available. We adopted the amended standards as of January 1, 2011 on a prospective basis for transactions entered into or materially modified after December 31, 2010. 19 -------------------------------------------------------------------------------- Table of Contents A portion of our sales is for appliances, which are standard server hardware platforms optimized for our software products. These appliances contain software components such as operating systems that operate together to provide the essential functionality of the appliance. Based on the amended accounting standards, when sold in a multiple element arrangement that includes software deliverables, our hardware appliances are considered non-software deliverables and are no longer accounted for under the industry-specific software revenue recognition guidance. When appliance orders are taken, we ship the product, invoice the customer and recognize revenue when title/risk of loss passes to the buyer (typically upon delivery to a common carrier) and the other criteria of revenue recognition are met. The revenue recognized is based upon BESP, as outlined further below. We also enter into multiple element revenue arrangements in which a customer may purchase a combination of software or SaaS subscriptions, appliances, appliance and software upgrades, technical support and professional services. For transactions entered into prior to the adoption of the amended revenue standards on January 1, 2011, all elements in a multiple element arrangement containing software were treated as a single unit of accounting as we did not have adequate support for VSOE of delivered elements. As a result, we deferred revenue on our multiple element arrangements until only the post-contract customer support (database updates and technical support) or other services not essential to the functionality of the software remained undelivered. At that point, the revenue was amortized over the remaining life of the software subscription or estimated delivery term of the services, whichever was longer. For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, we allocate the arrangement fee to the software related elements and the non-software related elements based upon the relative selling price of such element. When applying the relative selling price method, we determine the selling price for each element using BESP, because VSOE and TPE are not available. The revenue allocated to the software related elements is recognized based on the industry-specific software revenue recognition guidance that remains unchanged. The revenue allocated to the non-software related elements is recognized based on the nature of the element provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged. We determine BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. We estimate the selling price by considering internal factors such as historical pricing practices and gross margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands and geography. As there is a significant amount of judgment when determining BESP, we regularly review all of our assumptions and inputs around BESP and maintain internal controls over the establishment and updates of these estimates. During the three and six months ended June 30, 2011 we recognized $9.8 million and $18.1 million, respectively, in revenue from appliance sales, of which $6.6 million and $11.4 million, respectively, represented the immediate recognition of revenue upon shipment and the remaining $3.2 million and $6.7 million, respectively, represented ratable recognition of deferred revenue from appliance sales recorded prior to the adoption of the amended revenue recognition rules. We expect throughout the remainder of 2011 to recognize revenue of $4.7 million from appliance sales recorded prior to 2011 that are in deferred revenue as of June 30, 2011. Had we not adopted the amended revenue recognition rules, the amount of revenue recognized from appliance sales would have been $5.0 million and $9.3 million for the three and six months ended June 30, 2011, respectively. The new accounting guidance for revenue recognition is expected to continue to have a significant effect on total revenues in future periods, although the impact on the timing and pattern of revenue will vary depending on the nature and volume of new or materially modified contracts in any given period. For our OEM contracts, we grant our OEM customers the right to incorporate our products into the OEMs' products for resale to end users. The OEM customer pays us a royalty fee for each resale of our product to an end user over a specified period of time. We recognize revenue associated with the OEM contracts ratably over the contractual period for which we are obligated to provide our services to the OEM. The timing of the OEM revenue recognition will vary for each OEM depending on the information available, such as underlying end user subscription periods, to determine the contractual obligation period. To the extent we provide any custom software and engineering services in connection with an OEM arrangement we defer recognition of all revenue until acceptance of the custom software. We record distributor marketing payments and channel rebates as an offset to revenue, unless we receive an identifiable benefit in exchange for the consideration and we can estimate the fair value of the benefit received. We recognize distributor marketing payments as an offset to revenue in the period the marketing service is provided and we recognize channel rebates as an offset to revenue generally on a straight-line basis over the term of the underlying subscription sale. Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the acquisition method of accounting in accordance with GAAP accounting rules for business combinations which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair 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. The valuations and useful life assumptions are 20 -------------------------------------------------------------------------------- Table of Contents based on information available near the acquisition date and are based on expectations and assumptions that are considered reasonable by management. In our assessment of the fair value of identifiable intangible assets acquired in the PortAuthority and SurfControl acquisitions, management used valuation techniques and made various assumptions. Our analysis and financial projections were based on management's prospective operating plans and the historical performance of the acquired businesses. We engaged third party valuation firms to assist management in the following: • developing an understanding of the economic and competitive environment for the industry in which we and the acquired companies participate; • identifying the intangible assets acquired; • reviewing the acquisition agreements and other relevant documents made available; • interviewing our employees, including the employees of the acquired companies, regarding the history and nature of the acquisition, historical and expected financial performance, product lifecycles and roadmap, and other factors deemed relevant to the valuation; • performing additional market research and analysis deemed relevant to the valuation analysis; • estimating the fair values and recommending useful lives of the acquired intangible assets; and • preparing a narrative report detailing methods and assumptions used in the valuation of the intangible assets. All work performed by the outside valuation firms was discussed and reviewed in detail by management to determine the estimated fair values of the intangible assets. 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. We review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. We review 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 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. We account for share-based compensation under the fair value method. Share-based compensation expense related to stock options and employee stock purchase plan share grants is recorded based on the fair value of the award on its grant date. We estimate the fair value using the Black-Scholes valuation model. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the date of grant. At June 30, 2011, there was $43.9 million of total unrecognized compensation cost related to share-based compensation arrangements granted under all equity compensation plans (excluding tax effects). That total unrecognized compensation cost will be adjusted for estimated forfeitures as well as for future changes in estimated forfeitures. We expect to recognize that cost over a weighted average period of approximately 1.7 years. We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions described below. We estimate the expected term of options granted based on the history of grants and exercises in our option database. We estimate the volatility of our common stock at the date of grant based on both the historical volatility as well as the implied volatility of publicly traded options for our common stock. We base the risk-free interest rate that is used in the Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms. We have never paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. We amortize the fair value ratably over the vesting period of the awards, which is typically four years. We use historical data to estimate pre-vesting option forfeitures and record share-based expense only for those awards that are expected to vest. We may elect to use different assumptions under the Black-Scholes option valuation model in the future or select a different option valuation model altogether, which could materially affect our results of operations in the future. We determine the fair value of share-based payment awards on the date of grant using an option-pricing model that is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise 21 -------------------------------------------------------------------------------- Table of Contents behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because our employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management's opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although the fair value of employee stock options is determined using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction. Income Taxes. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves for tax contingencies are established when we believe that certain positions might be challenged despite our belief that our tax return positions are consistent with prevailing law and practice. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate. Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent we believe it is more-likely-than-not that all or a portion of the deferred tax assets will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience and expectations of future taxable income by taxing jurisdiction, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which require periodic adjustments and which may not accurately anticipate actual outcomes. During the first quarter of 2010, we were informed by the IRS that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued us a 30-day letter which outlined all of their proposed audit adjustments and required us to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and our Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in our cost sharing arrangement could have on our effective tax rate. We disagree with all of the proposed adjustments and have submitted a formal protest to the IRS for each matter. The IRS assigned our case to an IRS Appeals Officer and the Appeals process commenced during the second quarter of 2011. We intend to continue to defend our position on all of these matters, including through litigation if required. The timing of the ultimate resolution of these matters cannot be reasonably estimated at this time. Allowance for Doubtful Accounts and Other Loss Contingencies. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to pay their invoices. We establish this allowance using estimates that we make based on factors such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, changes to customer creditworthiness, current economic trends and other facts and circumstances of our existing customers. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires significant judgment by management based on the facts and circumstances of each matter. 22 -------------------------------------------------------------------------------- Table of Contents Results of Operations Three months ended June 30, 2011 compared with the three months ended June 30, 2010 The following table summarizes our operating results as a percentage of total revenues for each of the periods shown. Three Months Ended June 30, 2011 2010 Revenues: Software and service 89 % 97 % Appliance 11 3 Total revenues 100 100 Cost of revenues: Software and service 12 14 Appliance 5 2 Total cost of revenues 17 16 Gross profit 83 84 Operating expenses: Selling and marketing 46 48 Research and development 16 17 General and administrative 11 11 Total operating expenses 73 76 Income from operations 10 8 Interest expense 0 (1 ) Other income (expense), net 0 0 Income before income taxes 10 7 Provision for income taxes 5 3 Net income 5 % 4 % Revenues Software and service revenues. Software and service revenues increased to $81.0 million in the second quarter of 2011 from $79.3 million in the second quarter of 2010. The increase was primarily a result of increased incremental sales to new customers and upgrades to existing customers, as well as higher OEM revenues from the second quarter of 2010 to the second quarter of 2011. Software and service revenues generated in the United States accounted for $40.7 million or 44.9% of second quarter 2011 revenues compared to $39.0 million or 47.7% of revenues in the second quarter of 2010. Software and service revenues generated internationally accounted for $40.3 million or 44.5% of second quarter 2011 revenues compared to $40.3 million or 49.2% in the second quarter of 2010. We had current deferred revenue relating to software and service revenues of $234.9 million as of June 30, 2011, compared to $229.4 million as of June 30, 2010. Of the $234.9 million in current deferred revenue as of June 30, 2011, $79.0 million is expected to be recognized as revenue in the third quarter of 2011. For the remainder of 2011, we expect our software and service revenues to increase over 2010 revenue levels due to the amount of current deferred revenue that will be recognized as revenue during 2011, subscriptions that are scheduled for renewal that are expected to be renewed and upgraded, and expected new business for which some revenues will be recognized during 2011. We expect our software and service revenues to decrease as a percentage of total revenues as appliance revenues increase at a faster rate than software and service revenues increase. Our software and service revenues in 2011 are impacted by the duration of contracts for renewal and new subscriptions, the timing of sales of renewal and new subscriptions, the average annual contract value and per seat price, the volume of OEM revenue activity and the effect of currency exchange rates on new and renewal subscriptions in international markets. Appliance revenues. Appliance revenues increased to $9.8 million in the second quarter of 2011 from $2.6 million in the second quarter of 2010. The increase was primarily a result of our adoption of new revenue recognition rules (as more fully described in Note 1 to the Consolidated Financial Statements) starting January 1, 2011 under which revenues from sales of appliances are now generally recognized when sold. Accordingly, $3.2 million of the revenue recognized in the second quarter of 2011 represented the ratable recognition of deferred revenue for sales recorded prior to the adoption of the amended revenue recognition rules and the remaining $6.6 million represented revenues from sales of appliances sold in the second quarter of 2011. As of June 30, 2011, we had $13.9 million of remaining deferred revenue primarily for sales recorded prior to the adoption of the amended revenue recognition rules. Appliance revenues generated in the United States accounted for $4.9 million or 5.3% of second quarter 2011 revenues compared to $1.3 million or 1.6% of revenues in the second quarter of 2010. Appliance revenues generated internationally accounted for $4.9 million or 5.3% of second quarter 2011 revenues compared to $1.3 million or 1.5% in the second quarter of 2010. For the remainder of 2011, we expect our appliance revenues to increase in both absolute dollars and as a percentage of total revenues over 2010 revenue levels primarily as a result of the adoption of the new revenue recognition rules as of January 1, 2011 and expected increase in sales of our appliances. Cost of Revenues Software and service cost of revenues. Software and service cost of revenues consists of the costs of Web content review, amortization of acquired technology, technical support and infrastructure costs associated with maintaining our databases and costs 23-------------------------------------------------------------------------------- Table of Contents associated with providing our hosted security services. Software and service cost of revenues decreased to $10.3 million in the second quarter of 2011 from $11.4 million in the second quarter of 2010. The $1.1 million decrease was primarily due to decreased amortization of acquired technology of $1.5 million and partially offset by increased personnel costs. The decrease in amortization of acquired technology from the second quarter of 2010 to the second quarter of 2011 was primarily due to certain acquired technology being fully amortized in 2010. As of June 30, 2011, the remaining acquired technology is being amortized over a remaining weighted average period of 3.2 years. We expect to incur $1.5 million in amortization expense of acquired technology during the remainder of 2011 and that full year 2011 levels will be lower than 2010 levels by approximately $5.9 million. Our full-time employee headcount in cost of revenues departments decreased slightly from an average of 267 employees during the second quarter of 2010 to an average of 260 employees during the second quarter of 2011. 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 total revenues, software and service cost of revenues decreased to 12% from 14% during the second quarter of 2011 compared to 2010. We expect software and service cost of total revenues will decrease in absolute dollars and as a percentage of revenues in 2011 as compared to 2010 primarily due to the expected increase in revenues and decreased amortization of acquired technology. Appliance cost of revenues. Appliance cost of revenues consists of the costs associated with the sale of our appliance products. Appliance cost of revenues increased to $4.8 million in the second quarter of 2011 from $1.6 million in the second quarter of 2010. As described in the Appliance revenues section above, the $3.2 million increase was primarily due to our adoption of new revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues, we also recognized $1.4 million of the ratable cost of appliances sold prior to 2011 that were recognized in revenues in the second quarter of 2011. As a percentage of total revenues, appliance cost of revenues increased to 5% from 2% during the second quarter of 2011 compared to 2010. We expect appliance cost of revenues will increase in absolute dollars and as a percentage of total revenues in 2011 as compared to 2010 primarily due to the adoption of the new revenue recognition rules in 2011 under which the related costs are generally recognized when the appliances are sold as well as due to increased sales of our appliance products. Gross Profit Gross profit increased to $75.6 million in the second quarter of 2011 from $68.9 million in the second quarter of 2010 primarily as a result of increased revenues. As a percentage of total revenues, our gross profit decreased to 83% in the second quarter of 2011 from 84% in the second quarter of 2010 primarily due to the lower margin earned from increased appliance sales, as compared to software and service sales, as described in the Revenues and Cost of Revenues sections above. We expect that gross profit as a percentage of total revenues will remain in excess of 80% for the remainder of 2011. Operating Expenses Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships, and other allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates as those are recorded as an offset to revenue. Selling and marketing expenses were $42.0 million, or 46% of revenues, in the second quarter of 2011, compared to $39.0 million, or 48% of revenues, in the second quarter of 2010. The $3.0 million increase in total selling and marketing expenses was primarily due to our increased personnel costs of $3.7 million and increased allocated costs of $0.4 million, partially offset by a reduction in the amortization of acquired intangibles (customer relationships) of approximately $1.2 million. Our headcount in sales and marketing increased from an average of 586 employees during the second quarter of 2010 to an average of 612 employees for the second quarter of 2011. As of June 30, 2011, the acquired customer relationships intangible assets are being amortized over a remaining weighted average period of approximately 4.8 years. We expect overall selling and marketing expenses to increase in absolute dollars for the remainder of 2011 as compared to 2010, with the reduction of amortization of acquired intangibles from the SurfControl acquisition due to the accelerated nature of the amortization being offset by additional sales and marketing personnel supporting our expanding selling and marketing efforts worldwide and increased sales resulting in higher overall sales commission expenses. If our sales exceed expectations, our sales commission expenses would also exceed our expectations and result in higher than expected selling and marketing expenses in 2011, while revenues from the higher sales of software and services would be recognized in future periods. We also expect that selling and marketing expenses as a percentage of revenues will decrease in 2011 compared to 2010 due to the expected increase in revenues. Based on the existing sales and marketing related intangible assets as of June 30, 2011, we expect amortization of sales and marketing related acquired intangibles of $6.3 million for the remainder of 2011, which would be a reduction of approximately $2.4 million from 2010. 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 $14.3 million, or 16% of revenues, in the second quarter of 2011 from $13.6 million, or 17% of revenues, in the second quarter of 2010. The increase of $0.7 million in research and development expenses was primarily due to increased personnel costs. Our headcount increased in research and development from an average of 444 employees for the second quarter of 2010 to an average of 485 employees for the second quarter of 2011. We expect research and development expenses to increase in absolute dollars for the remainder of 2011 as compared to 2010 due to an expanded base of product offerings and increased headcount compared to 2010 to support our continued enhancements and new products. We 24-------------------------------------------------------------------------------- Table of Contents are managing the increase in our absolute research and development expenses by operating research and development facilities in multiple international locations, including facilities in Beijing, China and Ra'anana, Israel, that have lower costs than our operations in the United States. We also have research and development facilities in Los Gatos and San Diego, California and Reading, England. While we expect research and development expenses to increase in absolute dollars for the remainder of 2011 relative to 2010, we expect that research and development expenses as a percentage of revenues will remain relatively flat in 2011 compared to 2010 due to the expected increase in revenues. 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 $9.8 million, or 11% of revenues, in the second quarter of 2011 from $9.2 million, or 11% of revenues, in the second quarter of 2010. The $0.6 million increase in general and administrative expenses was primarily due to an increase in third party professional service fees which was primarily related to the global restructuring of our international distribution operations. Our headcount in general and administrative departments increased from an average of 118 employees during the second quarter of 2010 to an average of 122 employees for the second quarter of 2011. We expect general and administrative expenses to increase in absolute dollars primarily due to expected higher third party professional service fees but remain relatively flat as a percentage of revenues for the remainder of 2011 as compared to 2010 due to the expected increase in revenues. Interest Expense Interest expense decreased to $0.4 million in the second quarter of 2011 from $0.9 million in the second quarter of 2010. The decrease was primarily due to a lower average outstanding loan balance on our secured loan of $63.0 million during the second quarter of 2011 compared to an average loan balance of $72.5 million during the second quarter of 2010. In addition, the effective interest rate was lower in the second quarter of 2011 compared to 2010 primarily due to the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 credit facility entered into in October 2010. Included in the interest expense for the second quarter of 2011 and 2010 is $0.1 million and $0.2 million, respectively, of amortization of deferred financing fees that were capitalized as part of the secured credit facilities. We made net principal payments (net of borrowings) on the secured loan totaling zero and $5 million during the second quarter of 2011 and 2010, respectively. Primarily as a result of the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 credit facility entered into in October 2010, our weighted average interest rate decreased from 3.5% at June 30, 2010 to 1.9% at June 30, 2011. Interest expense should decline in the remaining quarters of 2011 as compared to 2010 primarily due to the expected lower effective interest rate from our new credit facility and the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010. Other (Expense) Income, Net Other (expense) income, net was $0.1 million in both the second quarter of 2010 and the second quarter of 2011. Due to a continued low interest rate environment, we expect our net other (expense) income for the remainder of 2011 to be similar to 2010 levels. Provision for Income Taxes For the three months ended June 30, 2011 we recognized an income tax expense of $4.6 million compared to an income tax expense of $2.9 million for the three months ended June 30, 2010. The effective tax rates were 51.5% for the three months ended June 30, 2011 and 48.2% for the three months ended June 30, 2010. For the second quarter of 2011, the effective tax rate variance from the U.S. federal statutory rate was primarily related to the unfavorable impact of foreign withholding taxes, non-deductible share-based payments and increased earnings in higher tax rate jurisdictions. For the second quarter of 2010, the effective tax rate variance from the U.S. federal statutory rate was primarily related to an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, a favorable state tax ruling, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions. Our effective tax rate may change in future periods due to differences in the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules. During 2010, we completed a global restructuring of our international distribution operations, which we anticipate will reduce the complexity and compliance risks associated with our global distribution activities. We expect that the restructuring also will reduce our GAAP effective tax rate relative to the GAAP effective tax rate that would have applied absent the restructuring because we expect to reduce our taxable income in certain foreign jurisdictions and expect to increase our taxable income in a lower tax rate foreign jurisdiction where we streamlined and consolidated the ownership of our intellectual property and distribution rights. The restructuring did not materially impact our U.S. business operations or the relative amount of taxable income in the U.S. versus outside the U.S. While we anticipate that our GAAP effective tax rate will be lower than it would have been without the global distribution restructuring, we cannot predict whether the GAAP effective tax rate in any particular period will be less than the GAAP effective tax rate in the immediately preceding prior period or in the comparable period of the prior fiscal year. The actual impact of the restructuring on our GAAP effective tax rate is highly dependent on our future results of operations. 25 -------------------------------------------------------------------------------- Table of Contents We assess, on a quarterly basis, the ultimate realization of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items during the second quarter of 2011, we believe that it is more likely than not that we will fully realize the balance of the deferred tax assets currently reflected on our consolidated balance sheet. Six months ended June 30, 2011 compared with the six months ended June 30, 2010 The following table summarizes our operating results as a percentage of total revenues for each of the periods shown. Six Months Ended June 30, 2011 2010 Revenues: Software and service 90 % 97 % Appliance 10 3 Total revenues 100 100 Cost of revenues: Software and service 12 14 Appliance 5 2 Total cost of revenues 17 16 Gross profit 83 84 Operating expenses: Selling and marketing 46 49 Research and development 16 17 General and administrative 12 12 Total operating expenses 74 78 Income from operations 9 6 Interest expense 0 (1 ) Other income (expense), net 1 (1 ) Income before income taxes 10 4 Provision for income taxes 3 2 Net income 7 % 2 % Revenues Software and service revenues. Software and service revenues increased to $161.3 million in the first six months of 2011 from $157.2 million in the first six months of 2010. The increase was primarily a result of increased incremental sales to new customers and upgrades to existing customers, as well as higher OEM revenues from the first six months of 2010 to the first six months of 2011. Software and service revenues generated in the United States accounted for $81.2 million or 45.3% of the first six months of 2011 revenues compared to $77.3 million or 47.9% of revenues in the first six months of 2010. Software and service revenues generated internationally accounted for $80.1 million or 44.7% of the first six months of 2011 revenues compared to $79.9 million or 49.4% in the first six months of 2010. Appliance revenues. Appliance revenues increased to $18.1 million in the first six months of 2011 from $4.4 million in the first six months of 2010. The increase was primarily a result of our adoption of new revenue recognition rules (as more fully described in Note 1 to the Consolidated Financial Statements) starting January 1, 2011 under which revenues from sales of appliances are now generally recognized when sold. Accordingly, $6.7 million of the revenues recognized in the first half of 2011 represented the ratable recognition of deferred revenue for sales recorded prior to the adoption of the amended revenue recognition rules and the remaining $11.4 million represented revenues from sales of appliances sold in the first half of 2011. Appliance revenues generated in the United States accounted for $9.0 million or 5.0% of the first six months of 2011 revenues compared to $2.3 million or 1.4% of revenues in the first six months of 2010. Appliance revenues generated internationally accounted for $9.1 million or 5.0% of the first six months of 2011 revenues compared to $2.1 million or 1.3% in the first six months of 2010. Cost of Revenues Software and service cost of revenues. Software and service cost of revenues decreased to $20.8 million in the first six months of 2011 from $22.5 million in the first six months of 2010. The $1.7 million decrease was primarily due to decreased amortization of acquired technology of $3.0 million and decreased allocated costs partially offset by increased personnel costs. The decrease in 26 -------------------------------------------------------------------------------- Table of Contents amortization of acquired technology from the first six months of 2010 to the first six months of 2011 was primarily due to certain acquired technology being fully amortized in 2010. Our full-time employee headcount in cost of revenues departments decreased from an average of 272 employees during the first six months of 2010 to an average of 259 employees during the first six months of 2011. Appliance cost of revenues. Appliance cost of revenues increased to $9.0 million in the first six months of 2011 from $2.6 million in the first six months of 2010. As described in the Appliance revenues section above, the $6.4 million increase was primarily due to our adoption of new revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues, we also recognized $3.0 million of the ratable cost of appliances sold prior to 2011 that were recognized in revenues in the first six months of 2011. Gross Profit Gross profit increased to $149.6 million in the first six months of 2011 from $136.5 million in the first six months of 2010 primarily as a result of increased revenues. As a percentage of total revenues, our gross profit decreased to 83% in the first six months of 2011 from 84% in the first six months of 2010 primarily due to the lower margin earned from increased appliance sales, as compared to software and service sales, as described in the Revenues and Cost of Revenues sections above. Operating Expenses Selling and marketing. Selling and marketing expenses were $82.8 million, or 46% of revenues, in the first six months of 2011, compared to $79.7 million, or 49% of revenues, in the first six months of 2010. The $3.1 million increase in total selling and marketing expenses was primarily due to our increased personnel costs of $5.6 million offset by a reduction in the amortization of acquired intangibles (customer relationships) of approximately $2.4 million. Our headcount in sales and marketing increased from an average of 590 employees during the first six months of 2010 to an average of 603 employees for the first six months of 2011. Research and development. Research and development expenses increased to $28.5 million, or 16% of revenues, in the first six months of 2011 from $27.8 million, or 17% of revenues, in the first six months of 2010. The increase of $0.7 million in research and development expenses was primarily due to increased personnel and allocated costs. Our headcount increased in research and development from an average of 442 employees for the first six months of 2010 to an average of 483 employees for the first six months of 2011. General and administrative. General and administrative expenses increased to $21.0 million, or 12% of revenues, in the first six months of 2011 from $18.3 million, or 12% of revenues, in the first six months of 2010. The $2.7 million increase in general and administrative expenses was primarily due to an increase in third party professional service fees of $2.9 million and partially offset by a reduction in personnel costs of $0.3 million. The increase in third party professional service fees was primarily related to the global restructuring of our international distribution operations. Our headcount in general and administrative departments increased slightly from an average of 117 employees during the first six months of 2010 to an average of 121 employees for the first six months of 2011. Interest Expense Interest expense decreased to $0.8 million in the first six months of 2011 from $2.0 million in the first six months of 2010. The decrease was primarily due to a lower average outstanding loan balance on our secured loan of $64 million during the first six months of 2011 compared to an average loan balance of $77 million during the first six months of 2010. In addition, the effective interest rate was lower in the first six months of 2011 compared to 2010 primarily due to the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 credit facility entered into in October 2010. Included in the interest expense for the first six months of 2011 and 2010 is $0.1 million and $0.5 million, respectively, of amortization of deferred financing fees that were capitalized as part of the secured credit facilities. We made net principal payments (net of borrowings) on the secured loan totaling $4 million and $17 million during the first six months of 2011 and 2010, respectively. Other (Expense) Income, Net Other (expense) income, net went from a net other expense of $0.9 million in the first six months of 2010 to a net other income of $1.3 million in the first six months of 2011. The change was due primarily to foreign exchange related gains of $1.5 million in the first six months of 2011 compared to losses of $1.0 million in the first six months of 2010 resulting from favorable movements in the foreign exchange rates during the first six months of 2011. Provision for Income Taxes For the six months ended June 30, 2011 we recognized an income tax expense of $5.4 million compared to an income tax expense of $3.8 million for the six months ended June 30, 2010. The effective tax rates were 30.0% for the six months ended June 30, 2011 and 49.3% for the six months ended June 30, 2010. For the first six months of 2011, the effective tax rate variance from the 27-------------------------------------------------------------------------------- Table of Contents U.S. federal statutory rate was primarily related to the unfavorable impact of foreign withholding taxes, non-deductible share-based payments and increased earnings in higher tax jurisdictions, offset by a non-recurring net discrete tax benefit of $2.8 million related primarily to our global distribution restructuring, which was completed during 2010 and became effective at the beginning of 2011. The entire net tax benefit of $2.8 million was reflected in the first quarter of 2011 upon completion of our global distribution restructuring and is not expected to recur. For the first six months of 2010, the effective tax rate variance from the U.S. federal statutory rate was primarily related to an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, a favorable state tax ruling, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions. Liquidity and Capital Resources As of June 30, 2011, we had cash and cash equivalents of $76.2 million and retained earnings of $53.8 million. Of the $76.2 million of cash equivalents, $25.9 million was held by our foreign subsidiaries, and we plan to indefinitely reinvest the undistributed foreign earnings into our foreign operations. During the first six months of 2011, we used our cash and cash equivalents primarily to pay down $4.0 million on our secured loan as net principal payments (net of borrowings) and for stock repurchases of approximately $48.9 million. Net cash provided by operating activities was $40.6 million in the first six months of 2011 compared with $48.9 million in the first six months of 2010. The decrease in cash flow from operations for the first half of 2011 compared to the first half of 2010 was primarily a result of higher cash operating expenses resulting from higher headcount and third party professional fees. Our operating cash flow is significantly influenced by new and renewal subscriptions, accounts receivable collections and cash expenses. A decrease in sales of new and/or renewal subscriptions or accounts receivable collections, or an increase in our cash expenses, would negatively impact our operating cash flow. Net cash used in investing activities was $5.0 million in the first six months of 2011 compared with $4.1 million in the first six months of 2010. The $0.9 million increase in net cash used in investing activities was primarily due to increased purchases of property and equipment during the first half of 2011 compared to the first half of 2010. Net cash used in financing activities was $37.5 million in the first six months of 2011 compared with $44.1 million in the first six months of 2010. The Company used approximately $48.9 million to repurchase its common stock and made $4 million in net principal payments under the 2010 Credit Agreement, which were offset in part by $12.5 million in proceeds from the exercise of options, which represented an $8.9 million increase in stock repurchases, a $13.0 million reduction in net principal payments, and a $1.5 million increase in proceeds from the exercise of stock options compared to the first half of 2010. During the first quarter of 2010, we were informed by the IRS that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued us a 30-day letter which outlined all of their proposed audit adjustments and required us to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and its Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in our cost sharing arrangement could have on our effective tax rate. We disagree with all of the proposed adjustments and have submitted a formal protest to the IRS for each matter. The IRS assigned our case to an IRS Appeals Officer and the Appeals process commenced during the second quarter of 2011. We intend to continue to defend our position on all of these matters, including through litigation if required. The timing of the ultimate resolution of these matters cannot be reasonably estimated at this time. In October 2007, the Company entered into the 2007 Credit Agreement, a $225 million senior credit facility which consisted of a five year $210 million senior secured term loan and a $15 million revolving credit facility. In October 2010, the Company entered into the "2010 Credit Agreement" and used the proceeds to repay the term loan under the 2007 Credit Agreement and retired the 2007 Credit Agreement. The 2010 Credit Agreement provides for a secured revolving credit facility that matures on October 29, 2015 with an initial maximum aggregate commitment of $120 million, including a $15 million sublimit for issuances of letters of credit and $5 million sublimit for swing line loans. The Company may increase the maximum aggregate commitment under the 2010 Credit Agreement up to $200 million if certain conditions are satisfied, including that it is not in default under the 2010 Credit Agreement at the time of the increase and that it obtains the commitment of the lenders participating in the increase. Loans under the 2010 Credit Agreement are designated at the Company's election as either base rate or Eurodollar rate loans. Base rate loans bear interest at a rate equal to the highest of (i) the federal funds rate plus 0.5%, (ii) the Eurodollar rate plus 1.00%, and (iii) Bank of America's prime rate, in each case plus a margin set forth below. Eurodollar rate loans bear interest at a rate equal to (i) the Eurodollar rate, plus (ii) a margin set forth below. As of June 30, 2011, the Company's weighted average interest rate was 1.9%. 28-------------------------------------------------------------------------------- Table of Contents The applicable margins are determined by reference to our leverage ratio, as set forth in the table below: Eurodollar Rate Base Rate Consolidated Leverage Ratio Loans Loans <1.25:1.0 1.75 % 0.75 % >1.25:1.0 2.00 % 1.00 % Indebtedness under the 2010 Credit Agreement is secured by substantially all of the Company's assets, including pledges of stock of certain of its subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by its domestic subsidiaries. The 2010 Credit Agreement contains affirmative and negative covenants, including an obligation to maintain a certain consolidated leverage ratio and consolidated interest coverage ratio and restrictions on the Company's ability to borrow money, to incur liens, to enter into mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. The 2010 Credit Agreement does not require the Company to use excess cash to pay down debt. The 2010 Credit Agreement provides for acceleration of the Company's obligations thereunder upon certain events of default. The events of default include, without limitation, failure to pay loan amounts when due, any material inaccuracy in the Company's representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against the Company or its subsidiaries involving an aggregate liability of $10 million or more, the security interest or guarantee ceasing to be in full force and effect, any person becoming the beneficial owner of more than 35% of the Company's outstanding common stock, or the Company's board of directors ceasing to consist of a majority of Continuing Directors (as defined in the 2010 Credit Agreement). Obligations and commitments. The following table summarizes our contractual payment obligations and commitments as of June 30, 2011 (in thousands): Payment Obligations by Year 2011 2012 2013 2014 2015 Thereafter Total2010 Credit Agreement: Scheduled principal payments $ - $ - $ - $ - $ 63,000 $ - $ 63,000 Estimated interest and fees 1,068 2,236 2,234 2,224 1,840 - 9,602 Operating leases 4,478 7,192 6,436 1,789 1,145 - 21,040 Other commitments 145 945 94 15 - - 1,199 Total $ 5,691 $ 10,373 $ 8,764 $ 4,028 $ 65,985 $ - $ 94,841 Obligations under our 2010 Credit Agreement represent the future minimum principal debt payments due under the secured revolving credit facility. Estimated interest and fees expected to be incurred on the secured revolving credit facility are based on known rates and scheduled principal payments, as well as the interest rate swap agreement, as of June 30, 2011 (see Note 5 to the consolidated financial statements). We lease our facilities under operating lease agreements that expire at various dates through 2015. Approximately 40% of our operating lease commitments are related to our corporate headquarters lease in San Diego, which extends through December 2013 and has escalating rent payments from 2011 to 2013. The rent expense related to our worldwide office space leases are generally recorded monthly on a straight-line basis in accordance with GAAP. Other commitments represent minimum contractual commitments for inbound software licenses, equipment maintenance and automobile leases. In addition, due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at June 30, 2011, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $14.5 million of gross unrecognized tax benefits have been excluded from the contractual payment obligations table above. In 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 4 million shares of our common stock. In 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. In 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. In January 2010, our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program 29 -------------------------------------------------------------------------------- Table of Contents size of up to 16 million shares. In October 2010, our Board of Directors increased the number of shares authorized for repurchase under the program by 8 million shares, for a total program size of up to 24 million shares. Repurchases may be made from time to time on the open market at prevailing market prices. In January 2008, we adopted a 10b5-1 plan that provides for quarterly purchases of our common stock in open market transactions. In November 2010, our Board of Directors increased the value of shares to be repurchased under our existing 10b5-1 plan to $25 million per quarter, or $100 million in aggregate for 2011. Depending on market conditions and other factors, purchases by our agent under this program may be commenced or suspended at any time, or from time to time, without prior notice to us. During the six months ended June 30, 2011, we repurchased 2,223,167 shares of our common stock for an aggregate of approximately $50.0 million at an average price of $22.48 per share. As of June 30, 2011, we have repurchased a total of 17,847,686 shares of our common stock under this program, for an aggregate of $359.8 million at an average price of $20.16 per share. Our 2010 Credit Agreement permits us to repurchase our securities so long as we are not in default under the 2010 Credit Agreement, have complied with all of our financial covenants, and have liquidity of at least $20 million; provided, however, if, after giving effect to any repurchase, our leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10 million in the aggregate in any fiscal year. We intend to continue repurchasing shares during 2011. We believe that our cash and cash equivalents balances, accounts receivable, revolving credit balances and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures, debt repayment obligations and stock repurchases, if any, for at least the next 12 months. During the first six months of 2011, we made net principal payments on our secured loan of $4.0 million and repurchased approximately $50.0 million of our common stock, of which $1.5 million was settled in July 2011. 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 borrow under our 2010 Credit Agreement, raise funds for these purposes or reduce our cost of capital through capital markets transactions or debt or private equity transactions as appropriate. We intend to continue to invest our cash in excess of current operating and capital requirements in interest-bearing, investment-grade money market funds. Off-Balance Sheet Arrangements As of June 30, 2011, we did not have any off-balance sheet arrangements. [ Back To TMCnet.com's Homepage ]