Filed with the SEC from Aug 14 to Aug 20:
Shamrock Activist Value Fund urged Websense to maximize stockholders' value through a buyback program (See The Activist Spotlight, at left). Shamrock, a California investment firm run by Roy E. Disney, holds 4,689,165 shares (10.41% of the total outstanding).
We are a leading provider of Web security and data loss prevention (DLP) solutions, providing products and services that protect organizations' employees and critical business data from external Web-based and email-based attacks, and from internal employee-generated threats such as an employee error and malfeasance. Our customers use our software products to provide a secure and productive computing environment for employees, business partners and customers. We offer a portfolio of Web security, data loss prevention and email and messaging security software that allow organizations to:
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, phishing or pharming exploits and an ever-increasing variety of malicious code;
filter "spam" out of incoming email traffic;
filter viruses and other malicious attachments from email and instant messages;
manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;
prevent the unauthorized use and loss of sensitive data, such as customer or employee information; and
control misuse of an organization's valuable computing resourses, including unauthorized downloading of high-bandwidth content.
Collectively, these software products secure an organization's confidential data and increase the productivity of its employees so they can safely conduct business electronically with partners and over the Internet. Fundamental to our products are:
proactive discovery of Web and internal content, which is classified into highly granular database categories; and
policy enforcement software that automates enforcement of pre-defined business policies regarding acceptable users and uses of various content categories.
Our databases of Web sites, Internet protocols and applications are continuously updated using a proprietary process of automatic content discovery, assessment and classification, with manual verification. Our systems scan more than 600 million Web sites and 300 million emails weekly for new Web-based and email-based threats. Additionally, our experience with the characteristics, behavior and reputations of malicious Web sites and malicious applications allows us to dynamically classify uncategorized Web sites and threats as they emerge. Our Web filtering policy enforcement software works in conjunction with these databases to allow organizations to define their usage policies, consistent with their unique requirements and corporate culture. Our data loss prevention software relies on a similar process of content discovery, assessment and classification, applied to an organization's internal information and combined with policy enforcement software.
Over the past 14 years, Websense has evolved from a reseller of computer security products to a leading provider of content security software solutions, including Web security, email and messaging security and data loss prevention solutions. Our first Web filtering software product was released in 1996 and prevented access to inappropriate Web content. Since then, we focused on adapting our Web filtering capabilities to address changing Internet use patterns in the workplace and the growing incidence of Web-based criminal activity. In January 2007, we entered the emerging market for data loss prevention and acquired PortAuthority Technologies, Inc. (PortAuthority), our technology development partner for DLP solutions. In October 2007, we acquired SurfControl plc (SurfControl), a leading provider of Web and email security software solutions, which expanded our product portfolio to include email security software and hosted Web and email security solutions.
We derive the majority of our revenue from our Web security and email security offerings and expect that a majority of our revenues will continue to come from these products for several years. The market for data loss prevention solutions is still in the early phases of development, and therefore will only comprise a small percentage of our revenues in 2008.
We operate in one industry segment, as defined by U.S. generally accepted accounting principles.
We commenced operations in 1994 as NetPartners Internet Solutions, Inc., a reseller of computer security products. In 1999, we changed our name to Websense, Inc. to reflect the shift in our business focus to a developer of Web filtering solutions. Our principal offices are located at 10240 Sorrento Valley Road, San Diego, California 92121.
As part of their overall business strategies, many organizations use the Internet to enable critical business applications that are accessed over their corporate networks. Many employees also use their organization's computing resources for recreational "Web surfing," peer-to-peer file sharing, downloading of high-bandwidth content, instant messaging and other personal matters. However, unmanaged use of corporate computing resources, including Internet access, can result in increased risk and cost to the organization, including increased security risks, lost employee productivity, increased network bandwidth consumption, and potential legal liability. In recent years, the same activities that made employees efficient and productiveâ€”doing research over the Internet, sharing files and sending instant messages and emails to customers and co-workersâ€”have also made IT infrastructures and valuable corporate data vulnerable to external threats such as mobile malicious code, spyware, viruses, Trojan horses and phishing and pharming exploits.
Additionally, as organizations create collaborative networks with their customers, suppliers, technology partners and other stakeholders, they increase the amount of confidential and sensitive data that travels across these networks. Securing this data from internal threats, such as inadequate business process controls, employee error and malfeasance as well as undetected malicious code, has become a top priority for information technology executives.
Given the necessity of corporate email and Internet access and the continuing worldwide adoption of the Web as a mass communication, entertainment, information and commerce medium, we believe there is a significant opportunity for Web security, messaging security and data loss prevention solutions. Although the Web and e-mail are the primary drivers of Internet traffic today, the rapid emergence of Internet-enabled applications creates the need for software that applies management and security policies to different data types, applications, and protocols, at multiple points in the information technology infrastructure and across multiple communication technologies. To effectively address the needs of connected organizations in today's Internet-enabled business environment, software tools implement policy-based security measures that are user, content and destination aware. In order to protect against external and internal threats, organizations must be able to manage who uses what information as well as where and how the information can be sent or shared.
Our Products and Services
Our products protect data and users from threats to information security and productivity loss and can be grouped into three segments: Web security, messaging security and data security. We offer Web security and messaging security products that are available as server-based, on customer-premises software or as hosted, on-demand solutions. Our data security products are currently available as a server-based solution installed at the customer's site.
Our Web security products protect from Web-based malicious attacks by blocking access to compromised and malicious Web sites and mitigate the productivity risks associated with unmanaged Web surfing. Our messaging security products filter unsolicited and unwanted emails (spam) and malicious file attachments. Our data security products protect against the loss of confidential information due to internal threats, such as inadequate business process controls, employee error and malfeasance or undetected malicious code. Collectively, these products provide customers with Essential Information Protectionâ„˘, allowing IT administrators to manage who uses what information, where it can go and how.
We typically sell subscriptions to our products based on the number of seats or devices to be managed. Revenues from sales of subscriptions to Web security solutions and related add-on products accounted for the majority of our revenues in 2007 and all of our revenues in 2006 and 2005.
Our Web security products are based on our policy enforcement software, Websense EnterpriseÂ®, which serves as the management and reporting platform for our Web filtering and Web security products. Our Web security software works in conjunction with our databases of categorized Web sites, protocols and malicious applications to give business managers the ability to automate the enforcement of highly customized Internet and application use policies for different users and groups within the business. The software allows organizations to manage employees' use of the Internet by filtering access to Web sites and Internet protocols while providing multiple options for identifying, analyzing and reporting on Internet activity and the risks associated with employee computing.
We populate our Web filtering and Web security databases using a proprietary process of automatic content assessment and classification, with manual verification. Our systems scan more than 600 million Web sites and 300 million emails weekly for new Web-based and email-based threats. Additionally, our experience with the characteristics, behavior and reputations of malicious Web sites allows us to dynamically classify uncategorized sites as they are discovered.
Websense Enterprise. Websense Enterprise enables employers to proactively analyze, report and manage employee access to Web sites based on the content of the requested Web site. Our software application works in conjunction with a database of more than 30 million Web sites to provide patented flexibility for managers when customizing, implementing and modifying Internet access policies for various groups, user types and individuals. A graphical interface enables business managers to define the categories of Web sites to which access will be managed. The filtering software examines each Internet access request, determines the category of the requested Web site and applies the policies that have been defined by the company. Some examples of management options include:
Allow: The request is allowed to proceed, because the organization has chosen not to restrict access to the category applicable to the Web site.
Block: The requested Web site is in a category that is not allowed to be accessed according to the organization's policy in effect.
Time-based Quotas: Users are allowed a specified amount of personal Web surfing time within categories that are determined by the administrator. Once the user reaches his or her quota time, he or she is no longer able to access sites in those categories.
Continue with Exception Report: The user is reminded about the organization's Internet usage policy, but can choose to access the requested Web site.
Time of Day: Filtering options can be managed by time of day. For example, access to shopping sites could be blocked during business hours and permitted at all other times.
The breadth and specificity our of Web site categorization provide flexibility in selecting which types of material should be allowed, blocked or reported. There are currently more than 90 categories in the basic Web filtering product.
Reporting and Analysis. Websense Enterprise includes several reporting modules to meet the information needs of different management groups.
WebsenseÂ® Reporter is a batch-based reporting application that can generate tabular and graphical reports and dynamically generate thousands of exploratory reports based on an organization's historical Internet use. It analyzes information from Internet monitoring logs and builds visual charts in a variety of pre-set or customizable formats for easy distribution to and interpretation by managers.
Websense Real-Time Analyzerâ„˘ utilizes the network agent in Websense Enterprise to monitor and analyze network traffic on-the-fly. This allows IT managers to identify potential risks and bandwidth bottlenecks associated with different types of network traffic.
Websense Explorer is a browser-based forensics and analytics reporting tool for non-technical business managers that enables them to drill down on Internet use data by risk class, user group, or individual.
Deployment Options. Websense Enterprise integrates with an organization's network server, proxy server, switch, router or firewall and is designed to work in networks of virtually any size and configuration. Websense Enterprise can support everything from small businesses to very large corporations. We currently offer three deployment options:
integrated deployment on a separate server that is tightly integrated with the network gateway platform to offer pass-through filtering that maximizes stability, scalability and performance;
embedded deployment on an appliance or gateway product to reduce hardware expense and enhance ease-of-use, particularly in remote locations; and
stand-alone deployment utilizing a network agent to deliver pass-by filtering capabilities in any network environment.
Websense Web Security Suite. The Websense Web Security Suiteâ„˘ combines the functionality and database categories of the basic Websense Enterprise with the Security Filteringâ„˘ categories and several additional services, including Real Time Security Updatesâ„˘ and Websense Web Protection Servicesâ„˘, for a bundled price. The Websense Web Security Suite was created to streamline the purchase process for our customers and simplify the sales process for our value-added resellers.
Security Filtering. Security Filtering augments the database categories included as part of our basic Web filtering solution with categories for spyware and phishing Web sites, as well as sites compromised with malicious code. We continually update our security-specific filtering categories as new malicious or compromised Web sites are identified by our ThreatSeekerâ„˘ technology.
Real Time Security Updates. Real Time Security Updatesâ„˘ allow subscribing organizations to receive database updates for Web-based and application-based threats in real time as they are identified and categorized by the Websense Security Labsâ„˘. Websense Security Labs scans more than 600 million Web sites and 300 million emails every week to identify new Web-based and blended threats.
Websense Web Protection Servicesâ„˘: SiteWatcher â„˘, BrandWatcher â„˘ and ThreatWatcher â„˘ Services . The SiteWatcher and BrandWatcher services monitor our customers' Web sites and brands, respectively, for malicious code or illegal use in a phishing attack and notify the customer if either occurs. The ThreatWatcher service helps customers prevent malicious attacks on their Web servers by identifying security vulnerabilities.
Websense Express. Websense Expressâ„˘ is our Web security solution for small and medium sized businesses that require a simple and affordable solution. Websense Express is available to organizations with under 1,000 users and includes both basic Web filtering and Security Filtering, but does not include Real Time Security Updates or Web Protection Services.
Websense Hosted Web Security. Websense Hosted Web Security is a managed software service that directs a customer's Web site requests to a centralized server hosted by Websense that provides Web malware protection and granular Web filtering without the need for the customer to maintain an on-site, server-based solution. The hosted deployment model provides centralized policy management for any type of environment, including those with remote locations, home offices, and mobile laptops. Hosted Web Security can be deployed as a complete Web filtering and security solution or it can be layered with existing on-premise security to provide additional layers of Web malware protection.
Our data security products protect against the loss of confidential information due to internal threats, such as inadequate business process controls, employee error and malfeasance, and undetected malicious code. We have leveraged our deep knowledge of the Internet and Web-based threats to create integrated policy controls that are "destination-aware," thereby preventing the transmission of sensitive data to known or suspected malicious Web sites.
Websense Data Security Suite. Websense Data Security Suite, formerly known as the Websense Content Protection Suite, is based on the data loss prevention technology we acquired through the purchase of PortAuthority in January 2007. It is an integrated data loss prevention solution that protects against data loss by identifying and categorizing sensitive or confidential data based on its characteristics, monitoring the movement of sensitive data throughout the network and enforcing pre-determined usage and movement policies. The Websense Data Security Suite leverages our knowledge of high-risk Web sites to prevent the transfer of sensitive or confidential data to known or suspected phishing sites.
The Websense Data Security Suite:
discovers and accurately identifies data stored on a network-connected device (data-at-rest);
monitors and prevents sensitive data from unauthorized distribution in outgoing and internal communications, including email, instant messaging, Internet (FTP and http) and Web-based mail;
automates enforcement of policies for data-in-motion to authorized recipients;
monitors and prevents unauthorized copying of highly sensitive files to USB drives and other portable media; or being printed to hardcopy paper; and
audits and reports the distribution and use of confidential data against regulatory and internal security policy requirements.
The Websense Data Security Suite includes built-in policy templates for easy, out-of-the-box policy creation and a sophisticated policy engine to address the most common compliance requirements for United States federal and state regulations, as well as industry regulations such as the Payment Card Industry Data Security Standard (PCI DSS) and Check 21 Act, Canada's Personal Information Protection and Electronic Documents Act (PIPEDA) and international government and banking regulations for the European Union, United Kingdom, Israel, South Africa, Australia and Singapore. These templates are automatically updated as regulations change.
The Websense Data Security Suite is available in three modules: Websense Data Discover, Websense Data Monitor, and Websense Data Protect.
Websense Data Discover. Websense Data Discover provides organizations with discovery of confidential information stored on the network desktops, laptops, and file servers. It includes digital fingerprinting technology to identify virtually any type of data (e.g., customer data, intellectual property and other confidential data), and robust reporting and incident workflow to manage data at rest. Websense Data Discover provides situational awareness of where confidential data is stored, to assess whether it is at risk of leaking outside the organization, and helps manage compliance and risk.
Websense Data Monitor. Websense Data Monitor provides enterprise-wide auditing of a broad array of both external and internal communications channels, including the web, email, print, and instant messaging. It includes over 550 built-in policy templates for regulatory compliance and corporate governance, as well as digital fingerprinting technology to accurately identify confidential data in motion. Websense Data Monitor helps organizations audit business processes with an advanced policy framework that identifies who is sending what data where, and how, providing actionable intelligence and a set of remediation tools to reduce risk of data leakage and manage compliance.
Websense Data Protect. Websense Data Protect includes Websense Data Monitor, and supplements that with built-in, automated policy enforcement to secure an organization's data. Its policy framework maps data policies to business processes, and is based on real-time knowledge of the user, the data, the destination, and the channel. Websense Data Protect provides automated policy controls for data in use and data in motion, with real-time reporting for global regulatory compliance and corporate governance. With Websense Data Protect, organizations can utilize enforcement actions such as blocking, quarantining, forced encryption, and notification, in addition to incident management tools to prevent data leakage, improve business processes, and manage compliance and risk.
Our messaging security solutions include our on-premise and hosted email filtering solutions to provide protection from spam and viruses, as well as basic inbound and outbound content filtering that enforces corporate governance policies.
Websense Hosted Email Security. Websense Hosted Email Security is a managed service that directs customer email traffic to a centralized server hosted by Websense that filters email traffic without the need for the customer to install software on an on-site server in order to protect against viruses, spam, and phishing before they reach the customers' network. Our service will also encrypt sensitive email before forwarding such email to its destination.
Websense Email Security. Websense Email Security is a server-based software solution that filters outbound and inbound email traffic to perform content filtering and policy enforcement within an organization. Our email software blocks threats such as spam, phishing, and viruses, and protects confidential data within email and attachments, providing out-of-the-box compliance and basic data loss prevention.
Other SurfControl Products
Through our acquisition of SurfControl, we acquired certain legacy products for which we do not have long-term plans. The end-of-sale or end-of-life date for these products varies.
We continue to sell renewal subscriptions to SurfControl Web Filter and the SurfControl Mobile Filter and anticipate supporting these products through at least December 31, 2011. We have also enhanced the solutions by supplementing the SurfControl URL database with additional Web filtering and security coverage provided by Websense Security Labs and ThreatSeeker technology. We no longer accept new subscriptions to these products from customers as of January 8, 2008. In addition, we continue to sell new and renewal subscriptions to SurfControl RiskFilter within China.
For the products listed below, we accepted new subscriptions and renewals only through January 8, 2008. We no longer sell these legacy SurfControl products:
SurfControl Enterprise ThreatShield;
SurfControl Web Filter Appliance;
SurfControl RiskFilter (outside of China); and
SurfControl E-mail Filter for Exchange 2000/2003.
Additional Websense Services
Platinum Support. Platinum Support gives customers experienced, personalized service, plus proactive support and continuing education, to help ensure the performance, reliability, and availability of each Websense solution.
Priority One 24x7 Support. Priority One support gives customers access to a dedicated team of senior technical support specialists 24 hours a day via a toll-free support hotline.
Websense solutions integrate with a wide variety of information technology platforms. Our objective is for Websense products to be available for virtually any network environment desired by a customer.
In 2005, we implemented the Websense Web Security Ecosystemâ„˘, a comprehensive ecosystem of world class security and networking technology providers that enable easy deployment and integration of Websense solutions in enterprise environments. The Websense Web Security Ecosystem provides interoperability of joint solutions with vendors from leading security and networking markets, including: network access control, Internet gateways, certified appliance platforms, security event management and identity management.
Gene Hodges has been the Chief Executive Officer of Websense Inc. since January 2006, and was the Company's President from January 2006 to April 2007. He has been a Director of Websense, Inc. since January 2006. Prior to joining Websense, Mr. Hodges served as President of McAfee, Inc. from November 2001 to January 2006. Mr. Hodges served as President of the McAfee Product Group from January 2000 to November 2001. From August 1998 to January 2000, he served as Vice President of Security Marketing. Mr. Hodges received a B.A. in Astronomy from Haverford College and completed the Harvard Advanced Management Program for business executives.
Douglas C. Wride has been Websense, Inc.'s President since April 2007 and served as Chief Financial Officer and Secretary of Websense from June 1999 until August 2007. From March 1997 to December 1998, Mr. Wride served as Chief Financial Officer of Artios, Inc., a provider of hardware and software design solutions to companies in the packaging industry. Mr. Wride also served as Chief Operating Officer of Artios from July 1997 to December 1998. From April 1996 to March 1997, Mr. Wride served as Chief Operating Officer and Chief Financial Officer of NetCount, LLC, a provider of Internet measurement and research services. Mr. Wride is a C.P.A. and received his B.S. in Business/Accounting from the University of Southern California.
Dudley Mendenhall joined Websense as Senior Vice President, Chief Financial Officer in August 2007. Prior to joining Websense, from April 2003 to August 2007, Mr. Mendenhall was Senior Vice President and Chief Financial Officer of K2, Inc., a publicly-traded sporting equipment manufacturer. Prior to joining K2, from March 2001 until March 2003, Mr. Mendenhall was Managing Director of the west coast Corporate Finance Group of Ernst & Young, an international accounting and consulting firm. From January 1990 through March 2001, Mr. Mendenhall held a number of executive positions at Bank of America. Mr. Mendenhall received his B.A. in Economics from Colorado College.
John McCormack has served as our Senior Vice President, Product Development since July 2006. From October 2005 until May 2006, Mr. McCormack was Vice President of Engineering for Symantec Corporation, a publicly-traded security software company. Mr. McCormack joined Symantec through the acquisition of Sygate Technologies, Inc., where he was Senior Vice President of Product Development from May 2004 to October 2005. From 1997 to 2004, Mr. McCormack served in various capacities with Cisco Systems, Inc., a publicly-traded computer hardware and software company, most recently as General Manager of the Secure Managed Networks Business Unit. Mr. McCormack received his Masters degree in Engineering Management from George Washington University and a B.S. in Computer Science from the University of New Hampshire.
Michael A. Newman has served as Senior Vice President, General Counsel and Secretary since August 2007, after serving as our Vice President and General Counsel from September 2002 to August 2007. From April 1999 to September 2002, he served in various capacities in the legal department of Gateway, Inc., a publicly-traded PC manufacturer, most recently as Senior Staff Counsel, Securities, Finance and Corporate Development. Prior to that, Mr. Newman practiced as an attorney in the San Diego offices of Cooley Godward, LLP and Latham & Watkins LLP, two of California's leading law firms. Mr. Newman received his B.S. in Business Administration from Georgetown University, and a J.D. from Harvard Law School.
MANAGEMENT DISCUSSION FROM LATEST 10K
We are a leading provider of Web security and data loss prevention (DLP) solutions, providing products and services that protect organizations' employees and critical business data from external Web-based and email-based attacks, and from internal employee-generated threats such as an employee error and malfeasance. Our customers use our software products to provide a secure and productive computing environment for employees, business partners and customers. We offer a portfolio of Web security, email and messaging security, and data loss prevention software that allows organizations to:
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, phishing and pharming exploits and an ever-increasing variety of malicious code;
filter "spam" out of incoming email traffic;
filter viruses and other malicious attachments from email and instant messages;
manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;
prevent the unauthorized use and loss of sensitive data, such as customer or employee information; and
control misuse of an organization's valuable computing resources, including unauthorized downloading of high-bandwidth content.
Collectively, these software products secure an organization's confidential data and increase the productivity of its employees so they can safely conduct business electronically with partners and over the Internet. Fundamental to our products are:
proactive discovery of Web and internal content, which is classified into highly granular database categories; and
policy enforcement software that automates enforcement of pre-defined business policies regarding acceptable users and uses of various content categories.
Since we commenced operations in 1994 as a reseller of computer security products, Websense has evolved into a leading provider of content security software solutions, including Web security, email and messaging security and data loss prevention solutions. Our first Web filtering software product was released in 1996 and prevented access to inappropriate Web content. Since then, we focused on adapting our Web filtering capabilities to address changing Internet use patterns in the workplace and the growing threat of Web-based criminal activity. In January 2007, we entered the emerging market for data loss prevention and acquired PortAuthority Technologies, Inc. (PortAuthority), our technology development partner for DLP solutions. In October 2007, we acquired SurfControl plc (SurfControl), a leading provider of Web and email security software solutions, which expanded our product portfolio to include email security software and hosted Web and email security solutions.
During 2007, we derived 41% of our revenue from international sales, compared with 36% for 2006, with the United Kingdom comprising approximately 11% of our total revenue in both years. We believe international markets continue to represent a significant growth opportunity and we are continuing to expand our international operations, particularly in selected countries in the European, Asia/Pacific, Latin American and Australian markets.
We sell our products primarily through indirect channels. In 2007, we transitioned our Web security products to a two-tier distribution strategy in North America, to increase the number of value-added resellers selling our products and further extend our reach into the small and medium-sized business market segments. Our distribution strategy outside North America also relies on a two-tier system of distributors and value-added resellers. Sales through indirect channels currently account for more than 90% of our revenue.
As described elsewhere in this report, we recognize revenue from subscriptions to our products, including add-on modules, on a daily straight-line basis commencing on the day the term of the subscription begins, over the term of the subscription agreement. We recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription contract and are fully expensed in the period the product is delivered. Operating expenses have continued to increase as compared with prior periods due to expanded selling and marketing efforts, continued product research and development and investments in administrative infrastructure to support subscription sales that we will recognize as revenue in subsequent periods.
In October 2007, we closed our acquisition of SurfControl and as a result incurred an operating loss under generally accepted accounting principles (GAAP) during the fourth quarter of 2007 and for the fiscal year 2007. Similar to Websense, SurfControl sold products primarily under subscriptions whereby revenues were recorded ratably over the term of the agreement. Under purchase accounting, we wrote off $96.5 million of the deferred revenue of SurfControl, leaving a balance of $19.7 million as of the closing. This adjustment reflects the fair value of the post-contract technical support services that will be recognized daily in accordance with our revenue recognition policy. We do not expect to generate significant revenue from the installed SurfControl customer base until these subscriptions are up for renewal. In connection with the acquisition, we have incurred restructuring costs primarily in connection with reducing SurfControl headcount and eliminating redundant facilities. We also immediately started to incur the expenses of operating the SurfControl operations as well as recording the amortization of the acquired intangibles. As a result, we expect to continue to operate at a loss under GAAP until we generate sufficient revenue from the subsequent renewal of subscriptions from the installed SurfControl customer base that offsets these expenses. Given the average remaining term of the SurfControl subscriptions, we currently do not expect to operate at a profit under GAAP in 2008. Our ability to retain SurfControl customers and maintain our overall pricing levels for our products will impact our results of operations and the timing of our return to profitability.
We allocate the total costs for human resources, employee benefits, payroll taxes, information technology, facilities, fixed asset depreciation and legal costs to each of our functional areas based on salaries and headcount data. Our overall costs to be allocated have increased as a result of the growth in our headcount and increased personnel costs, the growth of our facilities costs, and increased legal costs attributable to the increased complexity and maturity of our business and overall growth, and we expect this trend to continue.
In connection with the acquisition of SurfControl, we approved plans to restructure the operations of the acquired company through involuntarily terminating certain of SurfControl's employees and exiting certain SurfControl facilities. We began formulating our restructuring plans for the operations of SurfControl in April 2007 when the acquisition was first announced. As of December 31, 2007, we have committed to a plan which includes involuntarily terminating approximately 320 employees who were terminated beginning in the fourth quarter of 2007 and will be phased out throughout 2008. These workforce reductions are across all functions and geographies and affected employees were, or will be, provided cash severance packages. Additionally, we have exited, or will be exiting, leases in certain locations as well as reducing the square footage required to operate some locations. We will finalize our facility exit plans during fiscal 2008. We have accrued the estimated costs associated with the employee severance and facility exit obligations as liabilities assumed in the purchase business combination. Accordingly, these estimated costs are included as part of the purchase price of SurfControl. Changes to the estimates of these costs will be recorded in future periods either as a reduction to goodwill or as an expense to the results of operations.
Critical Accounting Policies and Estimates
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. When a purchase decision is made for our products, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and for a fixed number of users. Other services such as upgrades/enhancements and standard post-contract technical support services are sold together with our product subscription and provided throughout the subscription term.
Prior to January 1, 2006, we recognized revenue on a monthly straight line basis, commencing with the month the subscription began. Effective as of January 1, 2006, we recognize revenue on a daily straight-line basis commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists and collectability is reasonably assured. During 2006, we re-evaluated our revenue recognition policy in accordance with the provisions of SOP 97-2, Software Revenue Recognition , and determined that our prior practice resulted in a material cumulative difference in our deferred revenue. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver access codes to users and then promptly invoice customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of the invoice. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. In connection with the change in revenue recognition policy, we adopted Staff Accounting Bulletin No. 108 (SAB 108), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements , and applied the special cumulative effect transition provision to our 2006 financial statements. The cumulative net result was an increase in deferred revenue and a reduction in retained earnings, before tax impact, as of January 1, 2006 by $8.7 million. For 2006, the impact of daily revenue recognition on subscriptions was to reduce revenue recognized by $1.7 million, reduce net income by $1.1 million, and increase deferred revenue by an additional $1.7 million to a total increase of $10.4 million when compared to what these amounts would have been under the monthly revenue recognition policy.
We record distributor marketing payments and channel rebates as an offset to revenue. We recognize distributor marketing payments as an offset to revenue as the marketing service is provided. We recognize channel rebates as an offset to revenue on a straight-line basis over the term of the subscription agreement.
Accounting for Share-Based Compensation. Through December 31, 2005, we accounted for share-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board (APB) No. 25 (APB 25), and related Interpretations, as permitted by Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 123 Accounting for Stock-Based Compensation (SFAS 123). Accordingly, we recorded no share-based employee compensation expense for options granted under our Amended and Restated 2000 Stock Incentive Plan (2000 Plan) or predecessor plans (or options granted as non-plan inducement options) during the year ended December 31, 2005 as all other options granted had exercise prices equal to the fair market value of the common stock on the date of grant. We also recorded no compensation expense in connection with the Employee Stock Purchase Plan as the purchase price of the stock was not less than 85% of the lower of the fair market value of the common stock at the beginning of each offering period or at the end of each purchase period. In accordance with SFAS 123 and SFAS No. 148, Accounting for Stock-Based Compensationâ€”Transition and Disclosure (SFAS 148), we disclosed net income or loss and net income or loss per share as if the fair value-based method was applied in measuring compensation expense for share-based incentive programs.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R), using the modified prospective transition method. Under that transition method, compensation expense that we recognized beginning on that date includes: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods will not be restated. The results for the years ended December 31, 2007 and 2006 include share-based compensation expense of $22.1 million and $20.4 million (excluding tax effects). Compensation expense related to share-based awards is generally amortized over the vesting period in the related expense categories of the consolidated statement of operations.
At December 31, 2007, there was $62.1 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 2.7 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 on our common stock, consistent with SFAS 123(R) and Securities and Exchange Commission Staff Accounting Bulletin No. 107 (SAB 107). 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. For purposes of calculating pro forma information under SFAS 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred. 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 net income or loss and net income or loss per share 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 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 in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations (SFAS 141), which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair values of net assets acquired is recorded as goodwill. The fair value of intangible assets, including acquired technology and customer relationships, is based on significant judgments made by management and accordingly we obtain the assistance from third party valuation specialists. The valuations and useful life assumptions are based on information available near the acquisition date and are based on expectations and assumptions that are considered reasonable by management. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), we review intangible assets that have finite useful lives when an event occurs indicating the potential for impairment. We review for impairment by facts or circumstances, either external or internal, indicating that we may not recover the carrying value of the asset. We measure impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. We measure fair value under SFAS 144, which is generally based on the estimated future cash flows. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets.
Income Taxes. We are subject to income taxes in the U.S. 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 fully supportable. 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.
Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109), requires that deferred tax assets be evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion 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.
Results of Operations
Years ended December 31, 2007 and 2006
Revenue increased to $211.7 million in 2007 from $178.8 million in 2006. The increase was primarily a result of the addition of new, renewed and upgraded subscriptions from our customers that resulted in a 1.3 million increase in the number of seats under subscription (excluding the addition of approximately 26.7 million SurfControl seats) from December 31, 2006 to December 31, 2007. Our 2007 revenue also increased compared to 2006 as a result of the acquistions of PortAuthority in January 2007 and SurfControl in October 2007. We expect our 2008 revenue to increase over 2007 revenue levels due to our renewal business and new business, including sales of products acquired from SurfControl and other expected growth of the SMB business, growth of our DLP business and expected growth in international revenue, partially offset by increased distributor marketing payments and channel payments, which are recorded as reductions to revenue. Until sufficient existing subscriptions for the installed SurfControl customer base are subsequently renewed, revenue contributed by the SurfControl products will be minimal. We are also impacted by the write-off of the pre-acquisition SurfControl deferred revenue explained earlier.
Cost of Revenue
Cost of revenue consists of the costs of content review, technical support, infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Cost of revenue increased to $29.1 million in 2007 from $15.3 million in 2006. The increase was primarily due to $6.6 million of amortization of acquired technology which resulted from the acquisitions of SurfControl in October 2007 and PortAuthority in January 2007, as well as increased costs for additional personnel in our technical support and database groups, including the increase in headcount attributable to the acquisition of SurfControl and the addition of DLP products, and allocated costs. Our headcount in cost of revenue departments increased from 152 at December 31, 2006 to 232 at December 31, 2007. The acquired technology is being amortized over a weighted average period of 3.7 years. We expect to incur $12.2 million in amortization expense of acquired technology in 2008 due to the full year of amortization of the SurfControl and PortAuthority intangible assets. In addition, we expect cost of revenue to increase to support the growth and maintenance of our databases and costs associated with providing our hosted security services as well as the technical support needs of our customers. As a percentage of revenue, cost of revenue increased to 14% during 2007 from 9% in 2006. We expect that cost of revenue, as a percentage of revenue, will increase for 2008.
Gross margin increased to $182.6 million in 2007 from $163.5 million in 2006. The increase was primarily due to increased revenue. As a percentage of revenue, gross margin decreased to 86% in 2007 from 91% in 2006 primarily due to the increased costs described in the preceding Cost of Revenue section. We expect that gross margin, as a percentage of revenue, will remain in excess of 80% of revenue for 2008.
Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, including costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships as well as allocated costs. Selling and marketing expenses increased to $126.3 million in 2007 from $80.1 million in 2006. Approximately $13.6 million of the increase was due to the amortization of acquired intangibles (primarily customer relationships) which resulted from the acquisitions of SurfControl in October 2007 and PortAuthority in January 2007. The acquired customer relationships intangible assets are being amortized over a weighted average period of approximately 6.8 years. In addition to the amortization of acquired intangibles, the increase in selling and marketing expenses was primarily due to additional expenses associated with our new channel strategy started in 2006, increased personnel costs and related travel, including new personnel added from the PortAuthority and SurfControl acquisitions and allocated costs. Our headcount in sales and marketing increased from 358 employees at December 31, 2006 to 546 employees at December 31, 2007. We expect selling and marketing expenses to increase in absolute dollars and as a percentage of revenue in 2008 due to having a full year of amortization of acquired intangibles, having a full year of additional sales and marketing personnel from SurfControl to support our expanding selling and marketing efforts worldwide, and increased sales resulting in higher overall sales commission expenses. We expect amortization of acquired intangibles of $37.5 million in 2008 due to the full year of amortization of acquired intagibles from the SurfControl and PortAuthority acquisitions. We also expect to achieve cost savings as compared to the historical SurfControl selling and marketing expense, primarily as a result of a reduction in headcount.
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 $39.7 million in 2007 from $22.7 million in 2006. The increase of $17.0 million in research and development expenses was primarily due to increased personnel cost, including costs of adding new full time employees due to the PortAuthority and SurfControl acquisitions, and increased hiring to support our expanding list of technology partners, the enhancements of Websense Enterprise, the development of Websense Express and enhancements to additional products, and allocated costs. Our headcount increased in research and development from 129 employees at December 31, 2006 to 346 employees at December 31, 2007. We expect research and development expenses to increase in absolute dollars in 2008 due to having a full year of additional engineering personnel from SurfControl, and the hiring of personnel to support our continued enhancements of our existing and new products. We are managing the increase in our absolute research and development expense by operating research and development facilities in multiple international locations, including Beijing, China, that have lower costs than our operations in the United States. As a result, we expect that research and development expenses, as a percentage of revenue, will decrease in 2008.
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 $32.7 million in 2007 from $21.3 million in 2006. The $11.4 million increase in general and administrative expenses was primarily due to additional personnel needed to support our growing operations, including the acquisitions of PortAuthority and SurfControl, and allocated costs. Our headcount increased in general and administrative departments from 63 at December 31, 2006 to 113 at December 31, 2007. We expect general and administrative expenses to increase in absolute dollars and as a percentage of revenue in 2008 due to having a full year of additional personnel from SurfControl and to support growth in operations and expansion of our international operations. We do not expect to incur the historical SurfControl general and administrative expense levels due to the elimination of the executive officers of SurfControl and other personnel, elimination of certain facilities, and elimination of expenses relating to SurfControl being a public UK company listed on the London Stock Exchange.
In-process research and development. In-process research and development represents the fair value of an acquired, to be completed research project obtained from the PortAuthority acquisition that had not reached technological feasibility at the acquisition date and is not expected to have an alternative future use. Accordingly, the $1.3 million of in-process research and development was charged to our consolidated statement of operations during 2007. There were no in-process research and development charges associated with the SurfControl acquisition.
Interest expense represents the interest incurred on our senior secured credit facility that we utilized to pay for a portion of the SurfControl purchase price in October 2007. Also included in the interest expense is $763,000 of amortization of deferred financing fees that were capitalized as part of the senior secured credit facility. Interest expense will increase in 2008 due to the full year of interest under the senior secured credit facility and amortization of deferred financing fees. The amount of interest expense will fluctuate due to changes in LIBOR and potential changes in our applicable spread to LIBOR based upon improvements in our leverage ratio in accordance with our senior secured credit facility.
Other Income, Net
Net other income decreased to $9.5 million in 2007 from $11.3 million in 2006. The decrease was due primarily to reduced cash, cash equivalents and marketable securities balances from which we generate interest income as a result of our use of an aggregate of $272 million to fund the acquisitions of SurfControl in October 2007 and PortAuthority in January 2007 and related transaction costs. This decline in cash, cash equivalents and marketable securities was partially offset by higher interest rates realized on our balances of cash, cash equivalents and marketable securities during 2007 as compared with 2006. The majority of our investments of cash and cash equivalents and marketable securities are tax-exempt. We expect that the majority of our cash and cash equivalents and marketable securities will continue to be held in tax-exempt investments during the foreseeable future. We expect to continue to generate significant cash flow from our operations but we do not expect to maintain the same level of cash, cash equivalent and marketable securities balances as we maintained prior to our acquisitions of PortAuthority and SurfControl, which will reduce our net other income from 2007 levels.
Provision for Income Taxes
In 2007, United States and foreign income tax expense was $2.3 million as compared to $18.7 million for 2006. The annual effective income tax rate for 2007 was (19.0)% compared to 36.8% for 2006. The decrease in the tax rate was primarily the result of the following factors. Related to the acquisition of SurfControl, we recorded certain post-acquisition net operating losses related to SurfControl's U.S. operations for which no tax benefit is currently recorded due to the uncertainty of future utilization of these losses. Related to the acquisition of PortAuthority, we expensed acquired in-process research and development in our current year net loss for which a tax deduction is not allowed. In addition, although the share-based compensation for which no tax benefit is recorded in 2007 and our state income tax provision are both comparable to prior year's amounts, the impact of these items on the effective tax rate percentage is greater due to the relative size of the pre-tax loss of $12.2 million in 2007 compared to the pre-tax income of $50.8 million in 2006.
Our effective tax rate may change in future periods due to the composition of taxable income between domestic and international operations, the magnitude of our tax-exempt income, any future acquisitions and any future changes or interpretations in tax rules and legislation, or corresponding accounting rules.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
Three months ended June 30, 2008 compared with the three months ended June 30, 2007
Revenue increased to $73.0 million in the second quarter of 2008 from $50.4 million in the second quarter of 2007. The increase was a result primarily of the addition of new, renewed and upgraded subscriptions (including $16.0 million from new or renewed SurfControl seat subscriptions and $3.0 million of revenue recognized from the deferred revenue acquired from SurfControl in October 2007). For the remainder of 2008, we expect our revenue to increase over 2007 due to the addition of our acquired SurfControl business, our deferred revenue under existing subscriptions, our renewal business, planned growth in sales, partially offset by increased channel marketing payments and channel rebates, which are recorded as reductions to revenue. Until sufficient existing subscriptions for the installed SurfControl customer base are subsequently renewed, revenue contributed by the SurfControl products will be minimal as compared to SurfControlâ€™s historic stand-alone revenue as we wrote down SurfControlâ€™s deferred revenue by $97.4 million to its estimated fair value of $19.7 million at the date of acquisition as required under GAAP.
Cost of Revenues
Cost of revenues. Cost of revenues consists of the costs of content review, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Cost of revenues increased to $8.6 million in the second quarter of 2008 from $4.8 million in the second quarter of 2007. The increase of $3.8 million was primarily due to additional personnel in our technical support and database groups, including the increased headcount attributable to the acquisition of SurfControl, the addition of hosted services and allocated costs. Our headcount in cost of revenue departments increased from 163 employees at June 30, 2007 to 217 employees at June 30, 2008. We allocate the costs for human resources, employee benefits, payroll taxes, information technology, facilities and fixed asset depreciation to each of our functional areas based on headcount data. As a percentage of revenue, cost of revenues increased to 12% from 10% during the second quarter of 2008 compared to 2007. We expect cost of revenue to remain higher in absolute dollars for the remainder of 2008 as compared to 2007 in order to support the growth and maintenance of our databases and due to costs associated with providing our hosted security services as well as the technical support needs of our customers.
Amortization of acquired technology. Amortization of acquired technology primarily relates to the developed technology acquired from the PortAuthority acquisition in January 2007 and SurfControl acquisition in October 2007. The increase of $2.5 million in amortization of acquired technology from the second quarter of 2007 to the second quarter of 2008 was primarily due to the acquisition of SurfControl in October 2007. The acquired technology is being amortized over a weighted average period of 2.9 years. We expect to incur $6.2 million in amortization expense of acquired technology during the remainder of 2008.
Gross margin increased to $61.3 million in the second quarter of 2008 from $45.0 million in the second quarter of 2007. As a percentage of revenue, gross margin decreased to 84% in the second quarter of 2008 from 89% in the second quarter of 2007 due to the increased costs described in the preceding Cost of Revenues section. We expect that gross margin as a percentage of revenue will remain in excess of 80% of revenue for the remainder of 2008.
Selling and marketing . Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, including costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships as well as allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates. Selling and marketing expenses increased to $44.3 million, or 61% of revenue, in the second quarter of 2008, from $25.1 million, or 50% of revenue, in the second quarter of 2007. Approximately $9.3 million of the increase was due to the amortization of acquired intangibles (customer relationships) which resulted from the acquisition of SurfControl in October 2007. The acquired customer relationships intangible assets are being amortized over a weighted average period of approximately 6.1 years. In addition to the amortization of acquired intangible assets, the increase in selling and marketing expenses was primarily due to increased personnel costs and related travel, including new personnel added from the SurfControl acquisition in October 2007 and allocated costs. Our headcount in sales and marketing increased from 380 employees at June 30, 2007 to 519 employees at June 30, 2008. We expect selling and marketing expenses to increase in absolute dollars for the remainder of 2008 as compared to 2007 due to having a full year of amortization of acquired intangibles, having a full year of additional sales and marketing personnel to support our expanding selling and marketing efforts worldwide, and increased sales resulting in higher overall sales commission expenses. We expect amortization of acquired intangibles of $18.7 million for the remainder of 2008 as a result of the amortization of acquired intangibles from the SurfControl and PortAuthority acquisitions.
Research and development. Research and development expenses consist primarily of salaries and benefits for software developers and allocated costs. Research and development expenses increased to $13.2 million, or 18% of revenue, in the second quarter of 2008 from $10.3 million, or 20% of revenue, in the second quarter of 2007. The increase of $2.9 million in research and development expenses was primarily due to increased personnel cost, including adding new full time employees due to the SurfControl acquisition in October 2007, and increased hiring to support our managed release of our Web content gateway, data loss prevention endpoint module and enhancements to our other products as well as to support our expanding list of technology partners and allocated costs. Our headcount increased in research and development from 193 employees at June 30, 2007 to 351 employees at June 30, 2008. We expect future research and development expenses to increase in absolute dollars for the remainder of 2008 as compared to 2007 due to having a full year of additional engineering personnel and an expanded base of product offerings. We are managing the increase in our absolute research and development expense by operating research and development facilities in multiple international locations, including Beijing, China, that have lower costs than our operations in the United States.
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 $11.8 million, or 16% of revenue, in the second quarter of 2008 from $6.6 million, or 13% of revenue, in the second quarter of 2007. The $5.2 million increase in general and administrative expense was primarily due to additional personnel needed to support our growing operations, including the acquisition of SurfControl in October 2007 and allocated costs. Our headcount increased in general and administrative departments from 66 employees at June 30, 2007 to 112 employees at June 30, 2008. We expect general and administrative expenses to increase in absolute dollars for the remainder of 2008 as compared to 2007 due to having a full year of additional personnel due to the SurfControl acquisition and to support growth in operations and expansion of our international operations.
Interest expense represents the interest incurred on our senior secured term loan that we utilized to pay for a portion of the SurfControl purchase price in October 2007. Also included in the interest expense is $325,000 of amortization of deferred financing fees that were capitalized as part of the senior secured credit facility. Interest expense will increase for the remainder of 2008 as compared to 2007 due to having the senior secured term loan outstanding for the full year of 2008. The amount of interest expense will fluctuate due to changes in the outstanding principal balance and due to changes in LIBOR and changes in our applicable spread to LIBOR based upon improvements in our leverage ratio in accordance with our senior secured credit facility agreement. Interest expense should decline in the remaining quarters of fiscal 2008 as compared to the second quarter of 2008 due to the lower outstanding principal amount and lower marginal interest rate.
Other Income, Net
Other income, net decreased to $1.1 million in the second quarter of 2008 from $1.5 million in the second quarter of 2007. The decrease was due primarily to reduced interest income of approximately $1.0 million in the second quarter of 2008 compared to the second quarter of 2007 as a result of our use of approximately $245 million in cash, cash equivalents and marketable securities to fund the acquisition of SurfControl in October 2007, offset by foreign exchange re-measurement gains of approximately $691,000 due to favorable movements in the foreign exchange rates during the second quarter of 2008 compared to the second quarter of 2007. Due to the reduced cash, cash equivalents and marketable securities as a result of the acquisition of SurfControl as well as the prepayments on our senior secured term loan and stock repurchases, we expect other income, net to decrease in absolute dollars during the remainder of 2008 as compared to 2007.
Provision for Income Taxes
We recognized an income tax benefit of $1.7 million and an income tax expense of $2.3 million for the three months ended June 30, 2008 and 2007, respectively. Our effective tax rates were a tax benefit of 17.3% and a tax provision of 52.3% for the three months ended June 30, 2008 and June 30, 2007, respectively.
Our effective tax rate decreased from the second quarter of 2007 to the second quarter of 2008 primarily due to significant book losses in foreign jurisdictions with lower statutory rates, an increase in foreign withholding taxes and the impact that non-deductible items, primarily share-based compensation had on the amount of tax benefit recorded on our losses from operations. In addition, the Companyâ€™s effective tax rate in the second quarter of 2007 was impacted by the unrealized loss on a foreign currency option contract purchased in connection with the SurfControl acquisition and tax exempt interest income that did not recur in 2008.
Our effective tax rate may change in future periods due to the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules.
In accordance with the provisions of SFAS 109, we assess, on a quarterly basis, the realizability of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items during the second quarter of 2008, it is more likely than not that we will be able to fully utilize our deferred tax assets.
Thank you all for joining us this afternoon to discuss our second quarter results. With me on the call today are Gene Hodges, Websense CEO, Dudley Mendenhall, our Chief Financial Officer and Doug Wride, our President.
Before we turn to the results, let me quickly outline our conference calendar for the third quarter. We intend to present at The Pacific Crest Technology Conference in Vaile, Colorado on August 4th; the Deutsche Bank Technology Conference in San Francisco on September 9th; the Banc of America Annual Investment Conference in San Francisco on September 15th. Please check on our website for more details and the webcast links.
We also plan to open the NASDAQ stock market on the morning of September 17th and will host a Tech Talk concerning our new products over the lunch hour on the same day. More details to follow. We hope to see you there.
Before I turn the call over to Dudley, let me remind you that during this conference call management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties, and other factors that may cause the companyâ€™s actual results to be materially different from historical results.
The potential risks and uncertainties which contribute to the uncertain nature of the statements include, among others, risks associated with integrating acquired businesses and launching new product offerings, customer acceptance of the companyâ€™s services, products, fee structures in a changing market, the success of the Websense brand development effort, the volatile and competitive nature of the Internet and security industries, changes in domestic and international market conditions, risks relating to the required use of cash for debt services, the risks of ongoing compliance through the covenants of the senior credit facility, risks related to changes in accounting interpretations, and other risks and uncertainties described in Websense's public filings with the Securities and Exchange Commission.
The information in this call related to financial results, projections, and other forward-looking statements is based on current expectations and we expressly disclaim any responsibility to update forward-looking statements should circumstances change.
Our discussion also includes financial measures that are numerical measures that canâ€™t be calculated in accordance with generally accepted accounting principles. The company believes these non-GAAP financial measures enhance investorsâ€™ ability to evaluate the companyâ€™s operating results and compare current operating results with historical operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the Investor Relations portion of our website.
I will now turn the call over our Chief Financial Officer, Dudley Mendenhall.
Thank you Kate, let me start by stating that I believe that we posted a very strong quarter. Our top line performance driven by the strength of the recurring revenue aspects of our subscription model allowed us to generate strong revenue growth that exceeded our expectations and helped us offset the macroeconomic headwinds that caused so many headlines and so much uncertainty during the quarter.
Consequently we are significantly exceeding the 20% accretion expectations for earnings that we outlined for the SurfControl acquisition with $0.37 of non-GAAP EPS for the second quarter, up 68%, and year-to-date we have generated $0.73 of non-GAAP EPS, up 70% over the first half of 2007.
Billings for the second quarter were $87.3 million, up almost $20 million or nearly 30% from Q1. Although Websense and SurfControl both historically showed a strong seasonal increase in Q2 versus Q1, our performance this quarter was above the recent norm.
For comparison purposes SurfControl was up 19% sequentially in 2007 and 26% sequentially in 2006. Websense was up 28% sequentially for both years so a combined increase based on historical averages would have been in the range of about 22% to 27% as compared to the 30% actual increase.
This was excellent performance on the part of our sales teams worldwide as they continued to establish their relationships with partners and customers in their new territories. Average contract duration increased from the Q1 average of 20.6 months to 21.8 months, but was below the year ago average duration of 23.6 months.
One year contracts accounted for 56% of total billings compared to just 48% a year ago. The strength of our billings performance despite the shortening of the average contract duration compared to a year ago suggests good ongoing demand for our products and reflects our efforts at customer retention.
As we gear up for the new product cycle the higher proportion of one year contracts is a very positive development. Having these customers up for renewal sooner accelerates the opportunity to cross-sell and up-sell our web security gateway and DLP solutions as well hosted email and hybrid solutions.
Now turning to revenue non-GAAP revenue was $88.2 million which excludes the Q2 impact of the non-cash write-down of SurfControlâ€™s deferred revenue in the amount of $15.2 million. GAAP revenue after the write-down was approximately $73 million. We will continue to report on the revenue prior to this purchase accounting adjustment to provide visibility to our normalized run rate.
The strong revenue performance compares favorably to our expectations of a modest sequential decline from Q1 revenue of $86.5 million and was driven by the strong billings performance coupled with shorter average contract duration compared to a year ago. Non-GAAP operating expenses of $60.5 million increased $1.8 million sequentially from Q1 primarily due to an increase in sales and marketing expense of $1.6 million associated with the increase in billings.
We have brought the annual expense run rate from about $300 million a year ago for Websense and SurfControl to about $240 million today. It is clear that we have achieved an even exceeded our cost synergy objectives for the acquisition and that we are generating substantial efficiencies in the combined organization.
As a result operating margin was 31.3% in the quarter well above the 25% posted in Q2 2007 and above our targeted range of 28% to 30%. Non-GAAP operating income was $27.6 million. Our non-GAAP revenue performance and improved operating margins coupled with a slightly lower share count and lower interest costs allowed us to post strong non-GAAP earnings per share of $0.37 in the second quarter.
Year-to-date we have now generated earnings per diluted share of $0.73, an increase of 70% from the $0.43 earned in the first half of 2007 well above the targeted 20% accretion anticipated from the acquisition.
Now turning to our cash flow and balance sheet, our GAAP cash flow from operations was approximately $5 million, after cash outflows of approximately $3 million associated with the acquisition. This GAAP cash flow of $5 million is nearly double the 2007 amount in Q2 and is principally a result of strong collections.
Our cash flow is driven primarily by collection of the prior quarterâ€™s billings and the second quarter is typically the low point in our operating cash flow due to the seasonal low in Q1 billings which result in lower collections during the quarter.
Year-to-date our GAAP cash flow from operations is $23.9 million including approximately $14 million in one-time expenses. If you add back the $14 million in one-time expenses cash flow is approximately $38 million as compared to our original annual guidance of $65 million to $75 million so we continue to forecast that we will exceed that range.
Our balance sheet remains strong with cash and cash equivalents of $65 million and total GAAP deferred revenue of $302.5 million, up 39% year-over-year. Non-GAAP deferred revenue which includes an add back for the deferred revenue written off as part of purchase accounting was approximately $341 million essentially flat with Q1 since billings and non-GAAP revenue were close.
Accounts receivable increased $14.5 million sequentially to $61.6 million reflecting the $20 million sequential increase in quarterly billings. Our collection performance remained excellent and DSOâ€™s remained within the historical target range, flat sequentially at 63 days and down 11 days from Q2 2007.
Our confidence in our cash flow has allowed us to make additional repayments on our long-term debt totaling $5 million bringing total principal payments to date to $55 million and reducing long-term debt to $155 million from $210 million at the close of the acquisition. During the quarter we also repurchased a total of 274,000 shares for approximately $5 million.
Now turning to our forward guidance our increasing confidence in our performance as well as our strong results in the first half of the year allows us to increase our 2008 GAAP revenue, non-GAAP revenue and non-GAAP EPS outlook. We now expect GAAP revenues to be in the range of $290 million to $295 million, non-GAAP revenues to be in the range of $340 million to $345 million and non-GAAP EPS to be in the range of $1.30 to $1.35.
The strength of our current business combined with our success at retaining customers and an increased level of renewal business in the second half of the year gives us the confidence to leave our 2008 billings guidance in the range of $345 million to $355 million even with the current uncertain economic outlook and shorter contract duration.
We still expect our non-GAAP operating margins of 29% to 30% for the year as we expect a slight uptick in sales and marketing expenses associated with the anticipated level of second half billings particularly in the seasonal strong Q4.
Turning to billings we expect to hit the inflection point in billings growth in Q3 and begin to show some upward momentum and year-over-year growth going forward. We believe that quarterly performance will reflect the seasonality of the standalone business. Websense which accounts for the majority of billings is historically flat to down slightly in Q3 compared to Q2 while SurfControlâ€™s typically witnessed a sequential downturn of as much as 30% in the September quarter.
Therefore Q3 billings could be down sequentially over Q2 in the range of 55 to 7%. For Q4 we expect strong sequential growth over Q3 and remain confident in our full year billings guidance. In terms of non-GAAP revenue I want to remind you of our typical patterns and how these play out in a subscription model, despite the fact that billings fluctuate quarterly based on normal seasonal patterns, revenue is recognized pro rata over the life of the contract which has the affect of muting the seasonal fluctuation in billings.
Therefore a change in the growth rate of our billings takes several quarters to show up in the revenue growth line. That is why cash flow should also be considered in measuring our performance. Consequently we continue to expect non-GAAP quarterly revenues to decline modestly on a sequential basis and be within the range of $84 million to $85 million for each of the remaining quarters of 2008 reflecting lower year-over-year billings in the first half, discontinued products and OEM relationships.
Let me conclude by saying I am very pleased with our financial discipline and performance. We have exceeded the anticipated accretion from the SurfControl acquisition on both the top and bottom lines and on cash flow and we have done a great job with renewals and customer retention.
We are now well positioned for growth in 2009.
With that let me turn the call over to Douglas Wride.
Thank you Dudley, first let me reiterate that we did post excellent performance this quarter as our sales people continued to adapt to new territories, customers and back office systems. As an aside, in Q2 we successfully completed the integration of our back office systems and implementation of our sales force automation globally.
Our world class IT organization accomplished this in record time and my hat goes off to them. Now let me give you a quick update on the SurfControl acquisition.
As of June 30, we officially completed the formal integration of the acquisition and have turned our focus to driving growth. Iâ€™d like to summarize the integration across key areas.
As of this week the last of the transitional employees either became full time Websense employees or left the organization. Out of 600 SurfControl positions held by employees or contractors prior to the acquisition approximately half or 300 were eliminated and the work absorbed by Websense people.
Put another way a year ago the two companies employed about 1,400 people and had an annual expense run rate of about $300 million. Today we are at about 1,200 employees and an annual expense run rate of approximately $240 million.
The integration objective has always cost synergies and not necessarily headcount but those of you doing the math will note that weâ€™ve added about 100 heads in the interim. As expected the majority of the headcount growth has been in our China operations which now accounts for over 10% of our total headcount.
Iâ€™m pleased to say that we reached our goal of reducing the annual cost structure of the combined company by at least $60 million. When you factor in assumed expense growth weâ€™ve actually exceeded those goals. By over achieving on the top line weâ€™ve been able to exceed our operating margin targets for the first half of this year as Dudley expressed.
Weâ€™ve made excellent progress on integrating the product roadmaps and rationalizing the product offering. As we mentioned last quarter we successfully completed the sale of Cyber Patrol right at the end of the quarter and we are winding down sales of other discontinued products. We experienced good renewal rates from the SurfControl installed base and are seeing a growing trend of customers deciding to migrate to the Websense platforms.
Although with the acquisition we stopped selling the SurfControl Risk Filter appliance outside of China we just released an upgraded version of Risk Filter last month in that market. We are pleased with the progress made on this front this year and we will continue to drive this offering in China.
The most challenging area of the integration has been customer support due to a combination of factors. We are working hard to remedy this situation and Iâ€™m confident that we are making very good progress.
As I mentioned last quarter Iâ€™m spending more of my time on our distribution and will our selling partners. Let me give you an update on some of our activities this quarter on that front.
We held partner road shows and meetings around the world to educate partners on our roadmap and partner programs. We have begun the certification and training process on the new Websense version 7 products worldwide which will accelerate in August and early September.
The Websense global education team has put together an extensive training plan for both internal and partner training and certification and we will be ready as the new products roll out. We continue to make small adjustments in our two tier distribution structure reflecting both the levels of new and renewal business generated as well as the competitive environment.
These small adjustments have been well received as has the creation of our new virtual partner advisory counsel. Our goal is to be the best securities partner in the space, offer the best products, create the most innovative partner programs, and become the most responsive channel organization.
This is critically important to our business model. Not only are the majority of our products sold by partner recommendation, we depend on our partners to be our first line of support and we remain 100% committed to this channel.
In Q1 and Q2 we launched our new integrated partner program and the response has been good. But I think itâ€™s fair to say we can get better. Weâ€™ve come a long way in the last two years and now that the financial side of the SurfControl integration is behind us, weâ€™re ready to focus on moving forward again with our partners, 50,000 customers, and our expanded product offering.
Our distribution channel and ongoing operational responsibilities are where my focus will be going forward. With that Iâ€™ll turn the call over to Gene.
Thanks Douglas, Q2 was the third sequential quarter of solid execution across all of Websense functions. Once again our sales team delivered the strong billing performance in spite of an uncertain macro environment. Being further through the Surf acquisition we also have a much clearer picture of what the impact of the current macro situation is. And as youâ€™ll see from the contract duration mix statistic, approximately 8% of our customers decided to take a one year subscription rather then a three contract in this Q2 as compared with Q2 of last year.
As our promotional activities were back to normal this quarter this number is a much better apples to apples comparison if you will, then the number in Q1. Since some of those 8% were former SurfControl customers who may want to wait a bit, be a bit more cautious to see that we prove ourselves, we believe we have a good sense that this 8% swing was the maximum impact the economy had on our business in Q2.
The shortening of contract duration was noticeable but it wasnâ€™t large enough to prevent us from achieving our objectives and itâ€™s important for you to note that we do not see extensive increased loss of customers. The strength of our sales team performance over three quarters is reflected by our increased revenue and EPS guidance for the rest of the year.
We not only achieved strong billings in Q2 but we did it on shorter contract duration then last year, hence every billings dollar generates more short-term revenue and our profits climb. In hindsight our strategy of focusing on retaining the SurfControl customer base through the integration turned out to be a good fit for these tough economic times.
Itâ€™s easier to hold onto an existing customer then to acquire a new one even in normal times and itâ€™s probably even easier in uncertain times. We feel confident that we can continue to maintain high retention rates with SurfControl and Websense customers over the next several quarters. Although our attention during Q2 was still mostly on holding the combined company base we did see some positive sparks in the new [inaudible] arena where weâ€™ve been investing.
Data loss prevention sales probably the most market, the DLP sales in Q2 were $2.5 million up 222% year-over-year and 80% quarter-over-quarter. Most importantly Europe is starting to produce DLP orders and did approximately $1 million of the total in Q2. Our DLP pipeline continues to build globally and we now feel comfortable that we will exceed industry growth rates for this application segment during 2008.
Donâ€™t assume weâ€™ll continue to deliver over 200% growth but weâ€™ll be pushing hard to deliver high continued growth up near triple figures. The other major execution success in Q2 was in preparation for the launch of our Q3 product sets. Q2 was the go-to quarter for both engineering and marketing and they got it done. We achieved our managed release targets for both our web security gateway and our data loss prevention endpoint clients in the middle of the quarter.
Feedback that we received from both sets of customers in the managed release was very positive. The functionality of both products looks to be right on the market and quality looks good. So we feel very comfortable about going to general release later this quarter.
Q3 is a time of excitement for Websense. After three quarters of acquisition integration tasks with the focus on retaining and expanding customer base, now we get to go out and play refocusing on new growth. Obviously this is going to be a long challenge as well but weâ€™re starting to make some excellent progress. Now the Websense sales force has a lot of new products and an expanded value proposition to bring to the customer.
Our sales and partner training that kicked off Q3 shifted from how to win in a price war against SurfControl or Blue Coat to how to call higher and broader and to show more strategic value from a killer product line. Our sales and channel team is now integrated, well organized, and has a great new CRM PRM system at their fingertips so they can spend more time selling and less time creating spreadsheets to track for customers.
Q3 marks the completion of the first full round of essential information protection products. We will ship in general availability the worldâ€™s best web security product with proprietary real time malware scanning that from all the testing weâ€™ve done is the best web security available on the planet.
Our whole web filtering and Websense security base will also be getting a big time feature update even though they donâ€™t move to the real time scanning capabilities. We basically rebuilt this product from the ground up and itâ€™s more reliable, more scalable and easier to use and extends our lead in giving customers the valuable information they need to manage web security and internet usage.
Weâ€™ll have major new improvements in our on demand product line this quarter that will improve our competitiveness in this critical market. Remember our new web security strategy utilizes both in the cloud web security as well as the new real time malware blocking weâ€™re introducing and our classic product set. Weâ€™re seeing very positive response from distributed customers who see the power of this combination which can protect workers whether they are on or off the corporate network.
Weâ€™ll also have a major new final general availability release of our DLP gateway product along with the long awaited new DLP endpoint client. These will offer integrated data loss prevention policy management that will work whether youâ€™re on the network or off it. This impressive list of new products shows the effectiveness of our engineering organization which is doing a great job in a multi product, multi product stream mode.
Our engineering team is producing innovative organic new products and is strengthening products that weâ€™ve integrated through acquisition using technology synergies to make the full product line greater then the sum of the pieces.
This ability to both build and successfully integrate acquired technologies is going to continue to be an important differentiator against our new big competitors. Having completed a profitable consolidation expansion of our company, now weâ€™re increasing on renewing growth. And as we fight for new growth we do it with our strongest new product cycle ever and with a sales team that is excited about having more to sell.
We arenâ€™t macro economists but the consensus of those of you who are seem to be clearly that things are going to get worse before they get better and we may together be in the doldrums for an extended period. We simply didnâ€™t see that in Q2 even in the last month of the quarter or for that matter, so far in the opening days of Q3. But we do feel the macro headwinds as we quantify but so far, good execution seems able to more then compensate for that.
We have many more products to sell in the second half, an energized sales force, less sales and sales management team required to attend to an endless list of issues that always arise in an acquisition.
Finally we have a nice bulge to renewal contracts up in the second half especially in the fourth quarter. Given all that the macro climate stays about where it is now, we feel weâ€™re well positioned to achieve our billings objectives for the year and to do that in a way that generates higher revenue and renewal opportunities for the first half of next year.
This will lay the foundation for higher sustained growth in 2009.