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WEBSENSE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(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; • management's plans, strategies and objectives for future operations; • growth opportunities in domestic and international markets; • reliance on indirect channels of distribution; • anticipated product enhancements or releases; • customer acceptance and satisfaction with our products, services and fee structures; • expectations regarding competitive products and pricing; • risks associated with launching new product offerings; • changes in domestic and international market conditions; • risks associated with fluctuations in exchange rates of the foreign currencies in which we conduct business; • the impact of macroeconomic conditions on our customers; • expected trends in expenses; • anticipated cash levels and intentions regarding usage of cash; • risks related to compliance with the covenants in our credit agreement; • changes in effective tax rates, laws and interpretations and statements related to tax audits; • risks related to changes in accounting interpretations or accounting guidance; • the volatile and competitive nature of the Internet and information technology ("IT") security industries; and • the success of our marketing programs and brand development efforts. These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part II, Item 1A "Risk Factors," that could cause actual results to differ materially from those anticipated as of the date of this report. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report. 15-------------------------------------------------------------------------------- Table of Contents Overview We are a global provider of unified Web, email, mobile and data security solutions designed to protect an organization's data and users from external and internal threats, including modern cyber-threats, advanced malware attacks, information leaks, legal liability and productivity loss. Our customers deploy our subscription software solutions on standard servers or other IT hardware, including our optimized appliances, as a software-as-a-service (otherwise referred to as cloud-based or "Cloud" service) offering, or in a hybrid hardware/Cloud configuration. Our products and services are sold worldwide to provide content security to enterprise customers, small and medium sized businesses, public sector entities and Internet service providers through a network of distributors, value-added resellers and original equipment manufacturers ("OEMs"). Our products use our deep content inspection, advanced content classification and policy management technologies to: • prevent access to undesirable and dangerous elements on the Web, including Web pages that download viruses, spyware, keyloggers, hacking tools and an ever-increasing variety of malicious code, and Web sites that contain inappropriate content; • identify and remove malware from incoming Web content; • manage the use of social Web sites; • manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging; • prevent misuse of computing resources, including unauthorized downloading of high-bandwidth content; • inspect the content of encrypted Web traffic to prevent data loss, malware and access to Web sites with inappropriate content; • filter spam, viruses and malicious attachments from incoming email and instant messages; • protect against data theft and loss by identifying and categorizing sensitive or confidential data and enforcing pre-determined policies regarding its use and transmission within and outside an organization; and • enable the secure use of mobile smartphones and tablets within an organization's network by providing protection from Web-based malware, malicious applications, data loss and theft of intellectual property, and by providing mobile device management features that keep mobile devices secure, minimize risk and maintain compliance. Since we commenced operations in 1994, Websense has evolved from a reseller of network security products to a leading developer and provider of IT security software solutions. Our first commercial software product was released in 1996 and controlled employee access to inappropriate Web sites. Since then, we have focused on developing our Web filtering and content classification capabilities to address changes in the Internet and the external threat environment, including the rise of Web-based social and business applications and the growing incidence of sophisticated, timed and targeted cyber-attacks designed to steal valuable information. During the three months ended March 31, 2013 and 2012, we derived 52% and 51%, respectively, of our revenues from international sales. Revenues from the United Kingdom comprised 11% and 12% of our total revenues in the three months ended March 31, 2013 and 2012, respectively. We utilize a multi-tiered distribution strategy globally to sell our products through indirect distributors and value-added reseller channels. During the first quarter of 2013, sales through indirect channels accounted for approximately 95% of our revenues, which is consistent with previous periods. In North America, we use Ingram Micro, Arrow Enterprise Computing Solutions and ComputerLinks to distribute our products and provide credit facilities, marketing support and other services to regional and local value-added resellers who sell to end-user customers. Outside of North America we utilize a similar distribution structure, although we tend to operate with international distributors and value-added resellers on a country-by-country basis. We also have several arrangements with OEMs that grant them the right to incorporate our products into their products for resale to end users. Our sales force supports our channel sales by generating leads and helping close sales. As part of our strategy to expand the subscriptions of our existing customers and to grow sales to new customers, we increased headcount in our sales force beginning in the fourth quarter of 2012 and substantially completed the sales force expansion in the first quarter of 2013. 16-------------------------------------------------------------------------------- Table of Contents We sell subscriptions for our software and Cloud products, generally in 12, 24 or 36 month contract durations, based on the number of seats or devices managed. Higher annualized prices are typically associated with shorter contract durations. Conversely, lower annualized prices are typically associated with longer contract durations. As described elsewhere in this report, we recognize revenues from subscriptions for our software and Cloud products on a daily straight-line basis, commencing on the day the term of the subscription begins, over the term of the subscription agreement. We recognize revenues associated with OEM contracts ratably over the contractual period for which we are obligated to provide our services. We generally recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription agreement and are fully expensed in the period the product and/or software activation key is delivered. Billings represent the amount of subscription contracts, OEM royalties and appliance sales billed to customers during the applicable period. Any excess of billings booked in a period compared with revenue recognized in that same period results in an increase in deferred revenue at the end of the period compared with the beginning of the period. Subscription billings are recorded initially to our balance sheet as deferred revenue and then recognized to our statement of operations as revenue ratably over the subscription term or, in the case of OEM arrangements, over the contractual obligation period. Our billings are not a numerical measure that can be calculated in accordance with generally accepted accounting principles ("GAAP") in the United States of America. We provide this measurement (net of channel marketing payments and rebates, and adjustments to the allowance for doubtful accounts) in reporting financial performance because this measurement provides a consistent basis for understanding our sales activities each period. We believe the billings measurement is useful because the GAAP measurements of revenue and deferred revenue in the current period include subscription contracts commenced in prior periods. Total billings increased 1.5% to $81.8 million during the first quarter of 2013 from $80.6 million during the first quarter of 2012, primarily due to the growing strength of our TRITON products across all global markets. Our appliance billings increased 15%, from $6.0 million in the first quarter of 2012 to $6.9 million in the first quarter of 2013, primarily due to increased TRITON software sales which are the general driver of our appliance sales. Billings from our TRITON content security solutions accounted for 67% of total billings in the first quarter of 2013 and grew approximately 11.6% year-over-year to $54.7 million, from $49.0 million in the first quarter of 2012. Billings from our non-TRITON solution products declined 14% year-over-year to $27.1 million in the first quarter of 2013, from $31.6 million in the first quarter of 2012. The continuing increase in TRITON billings reflects sales to new customers, the ongoing migration to TRITON solutions by customers of our non-TRITON products and the expansion of subscriptions of existing customers. The ongoing decrease in non-TRITON billings reflects the ongoing migration of existing customers to our more advanced TRITON security solutions, and to a lesser extent, customer losses to lower priced competitive solutions. Our TRITON solutions include our TRITON family of security gateways for Web, email, mobile and data security (including related appliances and technical support subscriptions), our standalone data security suite and our Cloud security solutions. Our non-TRITON solutions include our Web filtering products, such as our Websense Web Filter, Web Security Suite, legacy server-based email security and related hardware. We expect the proportion of billings from our TRITON solutions to continue to increase as a percentage of total billings during the remainder of 2013. International billings represented $42.8 million, or 52% of our total billings, for the first quarter of 2013, compared with $43.1 million, or 53% of total billings, for the first quarter of 2012. Average contract duration decreased to 23.3 months for the first quarter of 2013, from 25.5 months for the first quarter of 2012, with 52% of our billings in 12 month contracts, 7% in 24 month contracts and 41% in contracts with durations of 36 months or more. The number of transactions valued at over $100,000 in the first quarter of 2013 increased by 19% from 121 transactions to 144 transactions compared with the first quarter of 2012. Our billings depend in part on the number of subscriptions up for renewal each quarter and are affected by cyclical variations, with the highest billings occurring in the fourth quarter and the lowest billings occurring in the first quarter. 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. 17-------------------------------------------------------------------------------- Table of Contents Revenue Recognition. The majority of our revenues is derived from software and Cloud products sold on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats. We recognize revenues for the software and Cloud subscriptions, including any related technical support, on a daily straight-line basis, commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver software access codes to customers and then promptly invoice customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of the invoice date. In October 2009, the Financial Accounting Standards Board ("FASB") amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product's essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to: • provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; and • require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence ("VSOE"), if available; third-party evidence ("TPE"), if available and VSOE is not available; or the best estimate of selling price ("BESP"), if neither VSOE nor TPE is available. We adopted the amended standards as of January 1, 2011 on a prospective basis for transactions entered into or materially modified after December 31, 2010. A portion of our revenues is generated from the sale of appliances, which are standard server platforms optimized for our software products. These appliances contain software components, such as operating systems, that operate together with the hardware platform to provide the essential functionality of the appliance. Based on accounting standards, when sold in a multiple element arrangement that includes software deliverables, our hardware appliances are considered non-software deliverables. When appliance orders are taken, we ship the product, invoice the customer and recognize revenues when title/risk of loss passes to the buyer (typically upon delivery to a common carrier) and the other criteria of revenue recognition are met. The revenues recognized are based upon BESP, as outlined further below. For transactions entered into prior to the adoption of amended revenue standards on January 1, 2011, all elements in a multiple element arrangement containing software were treated as a single unit of accounting as we did not have adequate support for VSOE of undelivered elements. As a result, we deferred revenue on our multiple element arrangements until only the post-contract customer support (database updates and technical support) or other services not essential to the functionality of the software remained undelivered. At that point, the revenue was amortized over the remaining life of the software subscription or estimated delivery term of the services, whichever was longer. For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, we allocate the arrangement fee to the software-related elements and the non-software-related elements based upon the relative selling price of such element. When applying the relative selling price method, we determine the selling price for each element using BESP, because VSOE and TPE are not available. The revenues allocated to the software-related elements are recognized based on the industry-specific software revenue recognition guidance that remains unchanged. The revenues allocated to the non-software-related elements are recognized based on the nature of the element provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged. We determine BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. We estimate the selling price by considering internal factors such as historical pricing practices and gross margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands and geography. As there is a significant amount of judgment when determining BESP, we review all of our assumptions and inputs around BESP on a quarterly basis and maintain internal controls over the establishment and updates of these estimates. 18-------------------------------------------------------------------------------- Table of Contents During the three months ended March 31, 2013, we recognized $7.3 million in revenues from appliance sales, of which $6.5 million represented the immediate recognition of revenue upon shipment and the remaining $0.8 million represented primarily the ratable recognition of deferred revenue from appliance sales recorded prior to the adoption of the amended revenue recognition rules. We expect to recognize revenues of $1.4 million throughout the remainder of 2013 from appliance sales made prior to 2011 that are recorded in deferred revenue as of March 31, 2013. The amended revenue recognition standards are expected to continue to affect total revenues in future periods, although the impact on the timing and pattern of revenues will vary depending on the nature and volume of new or materially modified contracts in any given period. We grant our OEM customers the right to incorporate our products into the OEMs' products or services for resale to end users. The OEM customers generally pay us a royalty fee for each resale of our product to an end user over a specified period of time. We recognize revenues associated with the OEM contracts ratably over the contractual period for which we are obligated to provide our services to the OEMs, which will vary for each OEM depending on the information available, such as underlying end user subscription periods. To the extent we provide any custom software and engineering services in connection with an OEM arrangement, we defer recognition of all revenue until acceptance of the custom software. We record channel marketing payments and channel rebates as an offset to revenues, unless we receive an identifiable benefit in exchange for the consideration and we can estimate the fair value of the benefit received. We recognize channel marketing payments as an offset to revenues in the period the marketing service is provided, and we recognize channel rebates as an offset to revenues generally on a straight-line basis over the term of the underlying subscription sale. Income Taxes. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes may be due. These reserves for tax contingencies are established when we believe that certain positions might be challenged despite our belief that our tax return positions are consistent with prevailing law and practice. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. The provision for income taxes includes the impact of these reserves and changes to the reserves that are considered appropriate. We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which require periodic adjustments and which may not accurately anticipate actual outcomes. Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent we believe it is more likely than not that all or a portion of the deferred tax assets will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience and expectations of future taxable income by taxing jurisdiction, the carry-forward periods available for tax reporting purposes and other relevant factors. Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the acquisition method of accounting, in accordance with GAAP accounting rules for business combinations, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair value of net assets acquired is recorded as goodwill. We review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. We review for impairment by analyzing facts and circumstances, either external or internal, indicating that we may not recover the carrying value of the asset. We measure impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. We measure fair value generally based on the estimated future cash flows generated by the asset. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets. Share-Based Compensation. We account for share-based compensation under the fair value method. Share-based compensation expense related to stock options and employee stock purchase plan share grants is recorded based on the fair value of the award on its grant date. We estimate the fair value using the Black-Scholes option valuation model. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the date of grant. 19-------------------------------------------------------------------------------- Table of Contents The determination of fair value using the Black-Scholes option valuation model requires the use of certain estimates and highly judgmental assumptions that affect the amount of share-based compensation expense recognized in our consolidated statements of operations. These include estimates of the expected volatility of our stock price, expected life of an award, expected dividends and the risk-free interest rate. 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 on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon bond 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. We amortize the fair value ratably over the vesting period of the awards. 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. 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, 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. 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. 20-------------------------------------------------------------------------------- Table of Contents Results of Operations Three months ended March 31, 2013 compared with the three months ended March 31, 2012 The following table summarizes our operating results as a percentage of total revenues for each of the periods shown. Three Months Ended March 31, 2013 2012 Revenues: Software and service 92% 92% Appliance 8 8 Total revenues 100 100 Cost of revenues: Software and service 13 12 Appliance 3 4 Total cost of revenues 16 16 Gross profit 84 84 Operating expenses: Selling and marketing 50 44 Research and development 19 17 General and administrative 11 12 Total operating expenses 80 73 Income from operations 4 11 Interest expense (1 ) (1 ) Other income (expense), net - - Income before income taxes 3 10 Provision for income taxes - 13 Net income (loss) 3% (3)% Revenues Software and service revenues. Software and service revenues decreased to $80.1 million in the first quarter of 2013 from $82.0 million in the first quarter of 2012. The decrease was primarily the result of decreased OEM contract revenue in the first quarter of 2013 compared with the first quarter of 2012. Because we recognize software and service revenues ratably over the term of the subscription, any increase or decrease in software and service revenues reflects changes in current deferred revenue at the beginning of the period compared with the prior period, as well as the change in current period billings. Software and service revenues generated in the United States accounted for $38.7 million, or 44% of first quarter 2013 revenues, compared with $40.4 million, or 45% of revenues, in the first quarter of 2012. International software and service revenues accounted for $41.4 million, or 48% of first quarter 2013 revenues, compared with $41.6 million, or 46% of revenues, in the first quarter of 2012. Current deferred software and service revenue was $239.8 million as of March 31, 2013, compared with $237.3 million as of March 31, 2012. Total deferred software and service revenue was $390.8 million as of March 31, 2013, compared with $375.9 million as of March 31, 2012. Of the $239.8 million in current deferred software and service revenue as of March 31, 2013, $78.1 million is expected to be recognized as revenue in the second quarter of 2013. We expect our software and service revenues to remain relatively flat in absolute dollars and as a percentage of revenue for the remainder of 2013 as compared with 2012. Our software and service revenues are impacted by the duration of contracts billed, the timing of sales of renewal and new subscriptions, the average annual contract value and per seat price, the volume of OEM sales activity and the effect of currency exchange rates on new and renewal subscriptions in international markets. 21-------------------------------------------------------------------------------- Table of Contents Appliance revenues. Appliance revenues decreased to $7.3 million in the first quarter of 2013 from $7.5 million in the first quarter of 2012. First quarter appliance revenues of $7.3 million consisted of $6.5 million in revenue from sales of appliances sold in the first quarter of 2013 and $0.8 million recognized primarily from deferred revenue for sales of appliances recorded prior to the adoption of the amended revenue recognition rules, as described above. This compares with $7.5 million in appliance revenues in the first quarter of 2012, which included $5.8 million in revenue from appliances sold in the first quarter of 2012 and $1.7 million recognized from deferred revenue. The decrease in total appliance revenues was primarily the result of the decline in appliance revenues recognized from deferred revenue in the first quarter of 2013 compared with the first quarter of 2012, due to the amended revenue recognition rules. As of March 31, 2013, deferred appliance revenue was $4.5 million and included $1.9 million related to appliance sales recorded prior to the adoption of the amended revenue recognition rules. Appliance revenues generated in the United States accounted for $3.6 million, or 4% of first quarter 2013 revenues, compared with $3.3 million, also 4% of revenues, in the first quarter of 2012. Appliance revenues generated internationally accounted for $3.7 million, or 4% of first quarter 2013 revenues, compared with $4.2 million, 5% of revenues, in the first quarter of 2012. We expect our appliance revenues to decrease for the remainder of 2013 compared with 2012 appliance revenues, primarily as a result of the decline in deferred appliance revenue to be recognized in the remainder of 2013. For the remainder of 2013, we expect to recognize $1.4 million of deferred revenue for appliance sales recorded prior to January 1, 2011. Cost of Revenues Software and service cost of revenues. Software and service cost of revenues consists of the costs of Web content analysis, amortization of acquired technology, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our Cloud offerings. Software and service cost of revenues increased to $11.4 million in the first quarter of 2013 from $11.0 million in the first quarter of 2012. The $0.4 million increase was primarily due to increased costs of operating our infrastructure for our Cloud offerings. As a percentage of software and service revenues, software and service cost of revenues were 14% during the first quarter of 2013 and 13% during the first quarter of 2012. We expect software and service cost of revenues will increase in absolute dollars and as a percentage of software and service revenues for the remainder of 2013 as compared with 2012 due to increased costs of operating our infrastructure for our Cloud offerings. Appliance cost of revenues. Appliance cost of revenues consists of the costs associated with the sale of our appliance products, primarily the cost of the hardware platform and software installation costs. Appliance cost of revenues decreased to $2.9 million in the first quarter of 2013 from $3.2 million in the first quarter of 2012. The $0.3 million decrease was due to the decreased cost of revenues from sales prior to 2011, due to the adoption of amended revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues for the first quarter of 2013, we recognized $0.4 million of the ratable cost of appliances sold prior to 2011 compared with $0.8 million in the first quarter of 2012. The remaining $2.5 million represents costs of appliances sold in the first quarter of 2013. As a percentage of appliance revenues, appliance cost of revenues were 40% and 42% during the first quarter of 2013 and first quarter of 2012, respectively. We expect appliance cost of revenues will decrease in absolute dollars and as a percentage of appliance revenues for the remainder of 2013 compared with 2012. For the remainder of 2013, we expect to recognize $0.6 million in deferred cost of revenues recorded prior to January 1, 2011. Gross Profit Gross profit decreased to $73.1 million in the first quarter of 2013 from $75.4 million in the first quarter of 2012, primarily as a result of decreased revenues. As a percentage of total revenues, our gross profit was 84% in both the first quarter of 2013 and the first quarter of 2012. We expect that gross profit as a percentage of total revenues will be approximately 83% for the remainder of 2013. 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 revenues. 22-------------------------------------------------------------------------------- Table of Contents Selling and marketing expenses increased to $43.7 million, or 50% of revenues, in the first quarter of 2013, compared with $39.0 million, or 44% of revenues, in the first quarter of 2012. The $4.7 million increase in total selling and marketing expenses was primarily due to increased personnel costs of $3.6 million and increased allocated costs of $0.9 million resulting from higher average headcount due to the expansion of our sales force that we substantially completed in the first quarter of 2013. Our headcount in sales and marketing increased from an average of 595 employees during the first quarter of 2012 to an average of 702 employees during the first quarter of 2013. We allocate the costs for human resources, employee benefits, payroll taxes, IT, facilities and fixed asset depreciation to each of our functional areas based on headcount data. We expect overall selling and marketing expenses to increase in absolute dollars and as a percentage of revenues for the remainder of 2013 compared with 2012, due to increased headcount. Fluctuations in foreign currencies may also impact our selling and marketing expenses in 2013. If our billings for the remainder of 2013 exceed expectations, our sales commission expenses can be expected to exceed our forecasts and result in higher than expected selling and marketing expenses. Conversely, if our billings are lower than expected, our sales commission expenses can be expected to be lower than our forecasts. 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 $16.7 million, or 19% of revenues, in the first quarter of 2013 from $15.3 million, or 17% of revenues, in the first quarter of 2012. The increase of $1.4 million in research and development expenses was primarily due to increased personnel and increased allocated costs. Our headcount increased in research and development from an average of 516 employees for the first quarter of 2012 to an average of 548 employees for the first quarter of 2013. The impact of the higher headcount was partially mitigated by an increase in the number of employees in relatively low cost foreign locations. We expect research and development expenses to increase in absolute dollars and as a percentage of revenue for the remainder of 2013 compared with 2012 due to an expanded base of product offerings, increased average headcount to support our continued enhancements and new product developments. Fluctuations in foreign currencies may also impact our research and development expenses in 2013. We are managing the increase in our 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 operation in the United States. We also have research and development facilities in Los Gatos and San Diego, California and Reading, England. 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 decreased to $9.3 million, or 11% of revenues, in the first quarter of 2013 compared with $10.3 million, or 12% of revenues, in the first quarter of 2012. The $1.0 million decrease in general and administrative expenses was primarily due to the decrease in third party professional service fees. We expect general and administrative expenses to decrease in absolute dollars and as a percentage of revenue for the remainder of 2013 compared with 2012 primarily due to decreased third-party professional service fees. Interest Expense Interest expense decreased to $0.6 million in the first quarter of 2013 from $0.7 million in the first quarter of 2012, primarily due to a lower average outstanding loan balance on our secured loan of $68.0 million during the first quarter of 2013 compared with an average outstanding loan balance of $70.5 million during the first quarter of 2012. Our weighted average interest rate was 3.1% in the first quarter of 2013 and is expected to remain consistent in the second quarter of 2013. We expect total interest expense for the remainder of 2013 to remain flat compared with 2012. See "Liquidity and Capital Resources" for a description of our secured loan issued pursuant to the senior credit facility which we entered into in October 2010 (the "2010 Credit Agreement" or the "2010 Credit Facility"). Other Income (Expense), Net Other expense was $0.4 million in the first quarter of 2013, compared with $0.3 million other expense in the first quarter of 2012. 23-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes For the three months ended March 31, 2013, we recognized an income tax benefit of $0.3 million compared with an income tax expense of $11.7 million for the three months ended March 31, 2012. The effective tax rates were (12.0)% for the three months ended March 31, 2013 and 118.7% for the three months ended March 31, 2012. For the first quarter of 2013, the effective tax rate variance from the U.S. federal statutory rate was primarily related to the favorable impact from earnings in lower tax rate jurisdictions, the reversal of various reserves for uncertain tax positions for tax years 2005 through 2007 due to the expiration of the federal statute of limitations for those years, and the recognition of the federal research and development tax credit due to the retroactive extension of these provisions by the American Taxpayer Relief Act of 2012 in the first quarter of 2013. These benefits were offset in part by the unfavorable impact of foreign withholding taxes and non-deductible share-based payments. For the first quarter of 2012, the effective tax rate variance from the U.S. federal statutory rate was primarily related to a discrete tax provision of $8.8 million resulting from an agreement with the IRS Appeals Office to settle certain outstanding tax matters for tax years 2005 through 2007, as well as the unfavorable impact of foreign withholding taxes and non-deductible share-based payments, partially offset by the unfavorable impact of earnings in lower tax rate 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. 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 first quarter of 2013, specifically the expected reversal of existing taxable temporary differences and a history of generating taxable income in applicable tax jurisdictions, 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 sheets. Liquidity and Capital Resources Capital Resources. Our cash and cash equivalents totaled $83.7 million and $64.6 million as of March 31, 2013 and December 31, 2012, respectively, and our retained earnings totaled $93.4 million and $90.6 million as of March 31, 2013 and December 31, 2012, respectively. Of our total cash and cash equivalents, the cash held by our foreign subsidiaries was $41.9 million and $27.8 million, as of March 31, 2013 and December 31, 2012, respectively, and we plan to indefinitely reinvest the undistributed foreign earnings into our foreign operations. During the first three months of 2013, we primarily used cash in excess of cash required for operations to repurchase $5.1 million of our common stock, of which $0.1 million was purchased during the fourth quarter of 2012 in a transaction that settled in the first quarter of 2013. Cash Flows. Net cash provided by operating activities was $29.2 million in the first three months of 2013, compared with $22.4 million in the first three months of 2012. The increase in cash flow from operations for the first three months of 2013 compared with the first three months of 2012 was primarily due to increased collections resulting from increased accounts receivable balances to begin the quarter and a decrease in days sales outstanding resulting from increased collections of sales recorded within the quarter. Our operating cash flow is typically significantly influenced by the timing of new and renewal subscriptions, including historical seasonal business trends, 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 $2.9 million in the first three months of 2013, compared with $2.8 million in the first three months of 2012. Net cash used in financing activities was $6.7 million in the first three months of 2013, compared with $26.0 million in the first three months of 2012. The $19.3 million decrease in cash used in financing activities was driven primarily by a reduction in repurchases of our common stock and reduced payments on our secured loan during the first three months of 2013 compared with the first three months of 2012. During the first three months of 2012, we made repayments of $5.0 million under the 2010 Credit Agreement and made no principal payments under the 2010 Credit Agreement during the first three months of 2013. 24-------------------------------------------------------------------------------- Table of Contents In October 2010, we entered into the 2010 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 a $5 million sublimit for swing line loans. We may increase the maximum aggregate commitment under the 2010 Credit Agreement to up to $200 million if certain conditions are satisfied, including that we are not in default under the 2010 Credit Agreement at the time of the increase. Loans under the 2010 Credit Agreement are designated, at our election, as either base rate or Eurodollar rate loans. Base rate loans bear interest at a rate equal to (i) the highest of (a) the federal funds rate plus 0.5%, (b) the Eurodollar rate plus 1.00%, and (c) Bank of America's prime rate, plus (ii) 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 March 31, 2013, the total amount outstanding under the 2010 Credit Facility was $68.0 million and the weighted average interest rate was 3.1%. 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 our assets, including pledges of stock of certain of our subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by our 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 our 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 us to use excess cash to pay down debt. The 2010 Credit Agreement provides for acceleration of our 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 our representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against us or our 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 our outstanding common stock, or our 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 March 31, 2013 (in thousands): Payment Obligations by Year 2013 2014 2015 2016 2017 Thereafter Total 2010 Credit Agreement: Contractual principal payments $ - $ - $ 68,000 $ - $ - $ - $ 68,000 Estimated interest and fees 1,755 2,312 1,913 - - - 5,980 Operating leases 5,100 4,870 3,302 2,556 2,629 1,576 20,033 Software licenses 705 705 710 - - - 2,120 Other commitments 218 2,306 16 1 - - 2,541 Total $ 7,778 $ 10,193 $ 73,941 $ 2,557 $ 2,629 $ 1,576 $ 98,674 Obligations under our 2010 Credit Agreement represent the future minimum principal debt payments due under this facility. Estimated interest and fees expected to be incurred on the 2010 Credit Facility are based on known rates and scheduled principal payments, as well as the interest rate swap agreement, as of March 31, 2013 (see Notes 6 and 8 to the consolidated financial statements). We lease our facilities under operating lease agreements that expire at various dates through 2018. Approximately 65% of our operating lease commitments are related to our corporate headquarters lease in San Diego, which has escalating rent payments through 2018. The San Diego lease expires in July 2018; however, we have an option to extend the lease for an additional five years. The rent expense related to our worldwide office space leases is recorded monthly on a straight-line basis in accordance with GAAP. Included in other commitments above are contractual commitment obligations as of March 31, 2013 for equipment maintenance and automobile leases. 25-------------------------------------------------------------------------------- Table of Contents Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at March 31, 2013, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $8.6 million of gross unrecognized tax benefits have been excluded from the contractual payment obligations table above. Our board of directors has authorized us to repurchase up to 24 million shares of our common stock under a stock repurchase program. The stock repurchase program does not have an expiration date, does not require us to purchase a specific number of shares and provides the board of directors with authority to modify, suspend or terminate the program at any time. In October 2012, the board of directors authorized management to repurchase up to $5.0 million of our common stock per calendar quarter. Since October 2009, all share purchases under the stock repurchase program have been made in open market transactions at prevailing market prices in accordance with certain timing conditions set forth in Rule 10b5-1 stock repurchase plans. Depending on market conditions and other factors, including compliance with covenants in the 2010 Credit Agreement, purchases by our agent under the current Rule 10b5-1 stock repurchase plan may be suspended at any time, or from time to time. We repurchased an aggregate of 331,908 shares in the first quarter of 2013 for an aggregate of approximately $5.0 million at an average price of $15.06 per share. As of March 31, 2013, we had repurchased a total of 23,367,985 shares of our common stock under this stock repurchase program, for an aggregate of $462.7 million at an average price of $19.80 per share. The 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 $20.0 million; provided, however, if, after giving effect to any repurchase, our consolidated leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10.0 million in the aggregate in any fiscal year. 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. Our cash requirements may increase if, as part of our growth strategy, we make acquisitions that increase our cash requirements, or for reasons we do not currently foresee. We may elect to borrow under the 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 March 31, 2013, we did not have any off-balance sheet arrangements. Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk Our market risk exposures are related to our cash and cash equivalents and the 2010 Credit Facility. We invest our excess cash in highly liquid short-term investments such as money market funds. These investments are not held for trading or other speculative purposes. Changes in interest rates affect the investment income we earn on our investments and the interest expense incurred on our secured loan and therefore impact our cash flows and results of operations. We are exposed to changes in interest rates primarily from our money market funds and from our borrowings at variable rates under the 2010 Credit Facility. In connection with the 2010 Credit Agreement, we entered into an interest rate swap agreement to pay a fixed rate of interest (1.778% per annum) and receive a floating rate interest payment (based on the three-month LIBOR) on a principal amount of $50 million. The $50 million swap agreement became effective on December 30, 2011 and expires on October 29, 2015. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would materially affect our interest expense. However, the impact of this type of adverse movement would be partially mitigated by our interest rate swap agreement that became effective on December 30, 2011. Based on our revolving credit balance at March 31, 2013 and taking into consideration our interest rate swap agreement, our interest expense would increase on a pre tax basis by approximately $200,000 during the next 12 months if a 100 basis point adverse move in the interest rate yield curve occurred. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive investments at March 31, 2013. Changes in interest rates over time will, however, affect our interest income. 26-------------------------------------------------------------------------------- Table of Contents Foreign Currency Exchange Rate Risk We sell our products through an international distribution network in approximately 130 countries, and we bill certain international customers in Euros, British Pounds, Australian Dollars, Japanese Yen and Chinese Renminbi. Additionally, a significant portion of our foreign subsidiaries' operating expenses are incurred in foreign currencies. As a result, our financial results could be significantly affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we sell our products. To mitigate the effect of changes in currency exchange rates, we utilize foreign currency forward contracts and zero cost collar contracts to hedge foreign currency market exposures of underlying assets, liabilities and expenses. We also keep working funds necessary to facilitate the short-term operations of our subsidiaries in the local currencies in which they do business. As exchange rate fluctuations can significantly vary our sales and expense results when converted to U.S. dollars, our objective is to reduce the risk to earnings and cash flows associated with changes in currency exchange rates. We do not use foreign currency contracts for speculative or trading purposes. The notional and fair values of our foreign currency contracts are summarized as follows (in thousands): March 31, 2013 December 31, 2012 Notional Notional Value Notional Fair Value Notional Fair Local Value Value Local Value Value Currency USD USD Currency USD USD Contracts not designated as hedging instruments Euro 7,168 $ 9,410 $ 9,196 9,400 $ 12,197 $ 12,401 British pound 4,000 $ 6,155 $ 6,077 6,000 $ 9,653 $ 9,759 Australian dollar 1,500 $ 1,522 $ 1,558 2,500 $ 2,585 $ 2,595 Contracts designated as hedging instruments Israeli Shekel 16,228 $ 4,216 $ 4,436 17,971 $ 4,649 $ 4,799 All of the Euro, British Pound and Australian Dollar foreign currency contracts in place as of March 31, 2013 are scheduled to be settled before February 2014. All Israeli Shekel hedging contracts in place as of March 31, 2013 are scheduled to be settled before February 2014. A significant portion of our foreign subsidiaries' operating expenses are incurred in foreign currencies and if the U.S. dollar weakens, our consolidated operating expenses would increase. Should the U.S. dollar strengthen, our products may become more expensive for our international customers with subscription contracts denominated in U.S. dollars. Changes in currency rates also impact our future revenues under subscription contracts that are not denominated in U.S. dollars. Our revenues and deferred revenue for these foreign currencies are recorded in U.S. dollars when the subscription is entered into based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss. Item 4. Controls and Procedures Disclosure Controls and Procedures We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) that are designed to ensure that the information required to be disclosed in the reports we file or submit under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and (b) accumulated and communicated to management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), as appropriate, to allow timely decisions regarding required disclosure. As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness and design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of March 31, 2013. 27-------------------------------------------------------------------------------- Table of Contents Changes In Internal Control over Financial Reporting An evaluation was also performed under the supervision and with the participation of our management, including our CEO and CFO, of any change in our internal control over financial reporting that occurred during our last fiscal quarter. That evaluation did not identify any changes in our internal control over financial reporting during the three months ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 28-------------------------------------------------------------------------------- Table of Contents |