Quarterly Report

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number
1-33350

Registrant’s telephone number, including area code: (410) 290-1616

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ       No o

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o       No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o    No þ

     As of November 2, 2009, there were 26,894,675 outstanding shares of the registrant’s Common Stock.

 

 

SOURCEFIRE, INC.
Form 10-Q
TABLE OF CONTENTS

Part I
Item 1. Financial Statements			3
Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008			3
Consolidated Statements of Operations for the three and nine months ended September 30, 2009 and 2008			4
Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2009			5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2009 and 2008			6
Notes To Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 3. Quantitative and Qualitative Disclosures About Market Risk			30
Item 4. Controls and Procedures			30
Part II.
Item 1. Legal Proceedings			32
Item 1A. Risk Factors			32
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			45
Item 3. Defaults Upon Senior Securities			46
Item 4. Submission of Matters to a Vote of Security Holders			46
Item 5. Other Information			46
Item 6. Exhibits			46
Signatures			47

Part I. FINANCIAL INFORMATION

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

gains and losses, net of tax, reported in accumulated other comprehensive income. The amortization of premiums and accretion of discounts to maturity are computed under the effective interest method. Such amortization is included in interest and investment income. Interest on securities classified as available-for-sale is also included in interest and investment income. (See Note 3 for further discussion of the classification of our investments.)

     We evaluate our investments on a regular basis to determine whether an other-than-temporary decline in fair value has occurred. If an investment is in an unrealized loss position and we have the intent to sell the investment, or it is more likely than not that we will have to sell the investment before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded in earnings. For investments that we do not intend to sell or it is more likely than not that we will not have to sell the investment, but we expect that we will not fully recover the amortized cost basis, the credit component of the other-than-temporary impairment is recorded in earnings and the non-credit component of the other-than-temporary impairment is recognized in other comprehensive income. Unrealized losses entirely caused by non-credit related factors related to investments for which we expect to fully recover the amortized cost basis are recorded in accumulated other comprehensive income.

   Fair Value of Financial Instruments

     Our financial instruments include cash and cash equivalents, accounts receivable, cash surrender value on our split-dollar life insurance policy, accounts payable and deferred revenue. Due to their short-term nature, the fair value of these financial instruments approximates their carrying amounts reported in the consolidated balance sheets. The fair value of available-for-sale investments is determined using quoted market prices for those investments.

   Allowance for Doubtful Accounts and Sales Returns

     We make estimates regarding the collectability of our accounts receivable. When we evaluate the adequacy of our allowance for doubtful accounts, we consider multiple factors, including historical write-off experience, the need for specific customer reserves, the aging of our receivables, customer creditworthiness and changes in customer payment cycles. Historically, our allowance for doubtful accounts has been adequate based on actual results. If any of the factors used to calculate the allowance for doubtful accounts change or does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed, and our future results of operations could be materially affected. As of September 30, 2009 and December 31, 2008, the allowance for doubtful accounts was $690,000 and $538,000, respectively.

     We make estimates regarding potential future product returns related to reported product revenue. We analyze factors such as our historical return experience, current product sales volumes, and changes in product warranty claims when evaluating the adequacy of the sales returns allowance. Our judgment is used in connection with estimating the sales returns allowance in any accounting period. If any of the factors used to calculate the sales return allowance change, we may experience a material difference in the amount and timing of our product revenue for any period. As of September 30, 2009, the sales return allowance was $330,000. There was no sales return allowance as of December 31, 2008.

   Inventories

     Inventories consist of hardware and related component parts and are stated at the lower of cost on a first-in, first-out basis or market, except for evaluation and advance replacement units which are stated at the lower of cost, on a specific identification basis, or market. Evaluation units are used for customer testing and evaluation and are predominantly located at the customers’ premises. Advance replacement units, which include replacement units and spare parts, are used to provide replacement units under technical support arrangements if a customer’s unit is not functioning. In prior periods, advance replacement units were included in other assets and depreciated using the straight-line method. In the third quarter of 2009, we reclassified them to inventory to better reflect the nature of the assets. Inventory that is obsolete or in excess of our forecasted demand is written down to its estimated net realizable value based on historical usage, expected demand, the timing of new product introductions and age. It is reasonably possible that our estimate of future demand for our products could change in the near term and result in additional inventory write-offs, which would negatively impact our gross margin.

     Inventory consisted of the following (in thousands):

     Inventory write-downs, primarily related to evaluation units and excess and obsolete inventory, are reflected as cost of revenues and amounted to $977,000 and $380,000 for the three months ended September 30, 2009 and 2008, respectively, and $2.1 million and $655,000 for the nine months ended September 30, 2009 and 2008, respectively.

   Revenue Recognition

     We derive revenue from arrangements that include products with embedded software, software licenses and royalties, technical support, and professional services. Revenue from products in the accompanying consolidated statements of operations consists primarily of sales of software-based appliances, but also includes fees and royalties for the license of our technology in a software-only format and subscriptions to receive rules released by the VRT that are used to update the appliances for current exploits and vulnerabilities. Technical support, which generally has a contractual term of 12 months, includes telephone and web-based support, software updates, and rights to software upgrades on a when-and-if-available basis. Professional services include training and consulting.

     For each arrangement, we defer revenue recognition until: (a) persuasive evidence of an arrangement exists (e.g., a signed contract); (b) delivery of the product has occurred and there are no remaining obligations or substantive customer acceptance provisions; (c) the fee is fixed or determinable; and (d) collection of the fee is deemed probable.

     We allocate the total arrangement fee among each deliverable based on the fair value of each of the deliverables, determined based on vendor-specific objective evidence. If vendor-specific objective evidence of fair value does not exist for each of the deliverables, all revenue from the arrangement is deferred until the earlier of the point at which sufficient vendor-specific objective evidence of fair value can be determined for any undelivered elements or all elements of the arrangement have been delivered. However, if the only undelivered elements are elements for which we currently have vendor-specific objective evidence of fair value, we recognize revenue for the delivered elements based on the residual method.

     We have established vendor-specific objective evidence of fair value for our technical support based upon actual renewals of each type of technical support that is offered and for each customer class. Technical support and technical support renewals are currently priced based on a percentage of the list price of the respective product or software and historically have not varied from a narrow range of values in the substantial majority of our arrangements. Revenue related to technical support is deferred and recognized ratably over the contractual period of the technical support arrangement, which is generally 12 months. The vendor-specific objective evidence of fair value of our other services is based on the price for these same services when they are sold separately. Revenue for services that are sold either on a stand-alone basis or included in multiple element arrangements is deferred and recognized as the services are performed.

     All amounts billed or received in excess of the revenue recognized are included in deferred revenue. In addition, we defer all direct costs associated with revenue that has been deferred. These amounts are included in either prepaid expenses or other current assets or inventory in the accompanying balance sheets, depending on the nature of the costs and the reason for the deferral.

     For sales through resellers and distributors, we recognize revenue upon the shipment of the product only if those resellers and distributors provide us, at the time of placing their order, with the identity of the end-user customer to whom the product has been sold. We do not currently offer any rights to return products sold to resellers and distributors. To the extent that a reseller or distributor requests an inventory or stock of products, we defer revenue on that product until we receive notification that it has been sold through to an identified end-user.

     We record taxes collected on revenue-producing activities on a net basis.

     For the three months and nine months ended September 30, 2009, one customer, a distributor of our products to the U.S. government, accounted for greater than 10% of total revenue. For the three months ended September 30, 2008, we had two significant customers, both distributors of our products to the U.S. government, that each accounted for greater than 10% of revenue. For the nine months ended September 30, 2008, we had one significant customer, a distributor of our products to the U.S. government, that accounted for greater than 10% of revenue.

   Warranty

     Under our standard warranty arrangement, we warrant that our software will perform in accordance with its documentation for a period of 90 days from the date of shipment. Similarly, we warrant that the hardware will perform in accordance with its documentation for a period of one year from date of shipment. We further agree to repair or replace software or products that do not conform to those warranties. The one year warranty on hardware coincides with the hardware warranty that we obtain from the manufacturer. We estimate the additional costs, if any, that may be incurred under our warranties outside of the warranties supplied by the manufacturer and record a liability at the time product revenue is recognized. Factors that affect our warranty liability include the number of sold units, historical and anticipated rates of warranty claims and the estimated cost per claim. We periodically assess the adequacy of our recorded warranty liability and adjust the amounts as necessary. While actual warranty costs have historically been within our cost estimations, it is possible that warranty rates could increase in the future due to new hardware introductions, general hardware component cost and availability, among other factors.

   Income Taxes

     The provision for income taxes is determined using the asset and liability approach. Under this approach, deferred income taxes are recorded for the expected tax consequences of temporary differences between the basis of assets and liabilities recorded for financial reporting purposes and the amounts recognized for income tax purposes. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. As of September 30, 2009 and December 31, 2008, our deferred tax assets were fully reserved except for foreign deferred tax assets of $69,000 and $71,000, respectively, expected to be available to offset foreign tax liabilities in the future. For the three months and nine months ended September 30, 2009, our tax provision consists principally of foreign income tax expense and U.S. alternative minimum tax. For the three months and nine months ended September 30, 2008, our tax provision consists principally of foreign income tax expense.

   Stock-Based Compensation

     We use the Black-Scholes option pricing model for estimating the fair value of stock options granted and for employee stock purchases under the 2007 Employee Stock Purchase Plan (the “ESPP”). For certain option awards that contain market conditions relating to our stock price achieving certain levels, we use a Lattice option pricing model. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected price volatility. Additionally, the recognition of expense requires the estimation of the number of options that will ultimately vest and the number of options that will ultimately be forfeited. The fair value of share-based awards is recognized as expense over the requisite service period, net of estimated forfeitures. See Note 4 for additional discussion of stock-based compensation.

Recent Accounting Pronouncements

     In February 2008, the Financial Accounting Standards Board, or FASB, issued new accounting guidance for the fair value measurement of all non-financial assets and non-financial liabilities. The guidance delayed the effective date for certain nonfinancial assets and liabilities that are recognized at fair value on a nonrecurring basis (at least annually) until fiscal years beginning after November 15, 2008. The adoption of this guidance did not have a material impact on our consolidated financial statements. See Note 7 for additional discussion of fair value measurements.

     In December 2007, the FASB issued new accounting guidance for business combinations and related disclosures. The new guidance changed the accounting for business combinations in a number of areas, including the treatment of contingent consideration, contingencies, acquisition costs, in-process research and development and restructuring costs. In addition, changes in deferred tax asset valuation allowances and acquired income tax uncertainties in a business combination after the measurement period will impact income tax expense. The guidance is effective for fiscal years beginning after December 15, 2008. The adoption of this guidance did not have a material impact on our consolidated financial statements.

     In April 2009, the FASB issued new accounting guidance about the fair values of financial instruments. This guidance requires disclosures about the fair value of financial instruments during interim reporting periods. The effective date for this guidance is interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on our consolidated financial statements.

     In April 2009, the FASB issued guidance related to the recognition and presentation of other-than-temporary impairments. This guidance amends the other-than-temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on our consolidated financial statements.

     In April 2009, the FASB issued guidance related to determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material impact on our consolidated financial statements.

     In May 2009, the FASB issued guidance related to subsequent events. This guidance is intended to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued. This guidance is effective for fiscal years and interim periods ended after June 15, 2009. The adoption of this guidance did not have a material impact on our consolidated financial statements.

     In June 2009, the FASB established the FASB Accounting Standards Codification as the single source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. This guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of this guidance, while it impacts the way we refer to accounting pronouncements in our disclosures, did not have an affect on our consolidated financial statements.

     In October 2009, the FASB issued new guidance that amends the criteria for when to evaluate individual delivered items in a multiple deliverable arrangement and how to allocate consideration received. This guidance is effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

     In October 2009, the FASB clarified the accounting guidance for sales of tangible products containing both software and hardware elements. This guidance is effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We are currently evaluating the impact this new guidance will have on our consolidated financial statements.

   Reclassifications

     Certain reclassifications have been made to the prior year consolidated financial statements to conform with the current year presentation.

3. Investments

     The following is a summary of available-for-sale investments as of September 30, 2009 (in thousands):

     The following tables show the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands):

     As of September 30, 2009, the net unrealized holding gain on available-for-sale securities included in accumulated other comprehensive income totaled $113,000. We have evaluated our investments and have determined there were no other-than-temporary impairments as of September 30, 2009. There are seven corporate debt investments and two government-sponsored enterprise investments with unrealized losses that have existed for less than one year. The unrealized losses related to these investments are entirely caused by non-credit related factors. We do not have the intent to sell these securities and we expect to fully recover the amortized cost basis of these investments. For the nine months ended September 30, 2009, the deferred tax benefit recorded in other comprehensive loss was fully offset by the increase of the valuation allowance we recorded for related deferred tax assets.

     The net carrying value and estimated fair value of available-for-sale investments by contractual maturity as of September 30, 2009 are as follows (in thousands):

4. Stock-Based Compensation

     During 2002, we adopted the Sourcefire, Inc. 2002 Stock Incentive Plan (the “2002 Plan”). The 2002 Plan provides for the granting of equity-based awards, including stock options, restricted or unrestricted stock awards, and stock appreciation rights to employees, officers, directors, and other individuals as determined by our Board of Directors. As of September 30, 2009, we have reserved an aggregate of 5,100,841 shares of common stock for issuance under the 2002 Plan. Following the adoption of the 2007 Stock Incentive Plan (the “2007 Plan”) described below, there are no additional shares available for grant under the 2002 Plan.

     In March 2007, our Board of Directors approved the 2007 Plan, which provides for the granting of equity-based awards, including stock options, restricted or unrestricted stock awards, and stock appreciation rights to employees, officers, directors,

and other individuals as determined by the Board of Directors. As of December 31, 2008, we had reserved an aggregate of 4,128,149 shares of common stock for issuance under the 2007 Plan. On January 1, 2009, under the terms of the 2007 Plan, the aggregate number of shares reserved for issuance under the 2007 Plan was increased by an amount equal to 4% of our outstanding common stock as of December 31, 2008, or 1,036,701 shares. Therefore, as of September 30, 2009, we have reserved an aggregate of 5,164,850 shares of common stock for issuance under the 2007 Plan.

     The 2002 Plan and the 2007 Plan are administered by the Compensation Committee of our Board of Directors, which determines the vesting period for awards under the plans, generally from three to five years. Options granted have a maximum term of 10 years. The exercise price of stock option awards is equal to at least the fair value of the common stock on the date of grant. The fair value of our common stock is determined by reference to the closing trading price of the common stock on the NASDAQ Global Market on the date of grant.

   Valuation of Stock-Based Compensation

     We use the Black-Scholes option pricing model for estimating the fair value of stock options granted and for employee stock purchases under the ESPP. For certain option awards that contain market conditions relating to our stock price achieving certain levels, we use a Lattice option pricing model. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected price volatility. Additionally, the recognition of expense requires the estimation of the number of options that will ultimately vest and the number of options that will ultimately be forfeited. The fair value of share-based awards is recognized as expense over the requisite service period, net of estimated forfeitures.

     The following are the weighted-average assumptions and fair values used in the Black Scholes option valuation of stock options granted under the 2002 Plan and the 2007 Plan and employee stock purchases under the ESPP.

      Average risk-free interest rate — This is the average U.S. Treasury rate (with a term that most closely resembles the expected life of the option) for the period in which the option was granted.

      Expected dividend yield — We have never declared or paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

      Expected useful life — This is the period of time that the stock options granted under the 2002 Plan and the 2007 Plan and employee purchases under the ESPP are expected to remain outstanding.

     For stock options granted under the 2002 Plan and the 2007 Plan, we have elected to use the simplified method of determining the expected term of stock options. This estimate is derived from the average midpoint between the weighted-average vesting period and the contractual term. In future periods, we expect to begin to incorporate our own data in estimating the expected life as we develop appropriate historical experience of employee exercise and post-vesting termination behavior considered in relation to the contractual life of the option.

     For purchases under the ESPP, the expected useful life is the plan period.

      Expected volatility — Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period.

     For stock options granted under the 2002 Plan and the 2007 Plan, given our limited historical stock data from our IPO in March 2007, we have used a blended volatility to estimate expected volatility. The blended volatility includes the average of our historical volatility from our IPO to the respective grant date and an average of our peer group historical volatility consistent with the expected life of the option. Our peer group historical volatility includes the historical volatility of companies that are similar in revenue size, in the same industry or are competitors. We expect to continue to use a larger proportion of our historical volatility in future periods as we develop additional historical experience of our own stock price fluctuations considered in relation to the expected life of the option.

     For purchases under the ESPP, we use our historical volatility since we have historical data available since our IPO consistent with the expected useful life.

     If we had made different assumptions about the stock price volatility rates, expected useful life, expected forfeitures and other assumptions, the related stock-based compensation expense and net loss could have been significantly different.

     The following table summarizes stock-based compensation expense included in the accompanying consolidated statements of operations (in thousands):

     The following table summarizes information about stock options outstanding as of September 30, 2009:

     The aggregate intrinsic value of all options exercised during the nine months ended September 30, 2009 and 2008 was $9.4 million and $4.2 million, respectively.

     Outstanding stock option awards are generally subject to service-based vesting; however, in some instances, awards contain provisions for acceleration of vesting upon performance measures, change in control and in certain other circumstances. On a quarterly basis, we evaluate the probability of achieving performance measures and adjust compensation expense accordingly. Based on the estimated grant date fair value of employee stock options granted, we recognized compensation expense of $910,000 and $736,000 for the three months ended September 30, 2009 and 2008, respectively, and $2.3 million and $1.7 million for the nine months ended September 30, 2009 and 2008, respectively. For the three months and nine months ended September 30, 2009, stock-based compensation expense included $145,000 and $193,000, respectively, related to the accelerated vesting of market condition based stock options for our CEO. The grant date aggregate fair value of options, net of estimated forfeitures, not yet recognized as expense as of September 30, 2009 was $4.5 million, which is expected to be recognized over a weighted average period of 2.70 years.

Restricted Stock Awards

     The following table summarizes the unvested restricted stock award activity during the nine months ended September 30, 2009:

     Restricted stock awards are generally subject to service-based vesting; however, in some instances, awards contain provisions for acceleration of vesting upon performance measures, change in control and in certain other circumstances. On a quarterly basis, we evaluate the probability of achieving performance measures and adjust compensation expense accordingly. The compensation expense is recognized ratably over the estimated vesting period. The vesting restrictions for outstanding restricted stock awards generally lapse over a period of 36 to 60 months.

     The fair value of the unvested restricted stock awards is measured using the closing price of our stock on the date of grant, or the estimated fair value of the common stock if granted prior to our IPO. The total compensation expense related to restricted stock awards for the three months ended September 30, 2009 and 2008 was $462,000 and $794,000, respectively, and $1.4 million and $1.6 million for the nine months ended September 30, 2009 and 2008, respectively. For the three months and nine months ended September 30, 2009, stock-based compensation expense included $247,000 related to the accelerated vesting of performance-based restricted stock awards.

     As of September 30, 2009, there was $1.9 million of unrecognized compensation expense, net of estimated forfeitures, related to unvested restricted stock awards. This amount is expected to be recognized over a weighted-average period of 2.08 years.

     Restricted stock units are generally subject to service-based vesting; however, in some instances, restricted stock units contain provisions for acceleration of vesting upon performance measures, change in control and in certain other circumstances. On a quarterly basis, we evaluate the probability of achieving performance measures and adjust compensation expense accordingly. The compensation expense is recognized ratably over the estimated vesting period. The vesting restrictions for outstanding restricted stock units generally lapse over a period of 36 to 60 months.

     The fair value of the unvested restricted stock units is measured using the closing price of our stock on the date of grant. The total compensation expense related to restricted stock units for the three months and nine months ended September 30, 2009 was $432,000, and $574,000, respectively. No restricted stock units were granted in 2008.

     As of September 30, 2009, there was $3.2 million of unrecognized compensation expense, net of estimated forfeitures, related to unvested restricted stock units. This amount is expected to be recognized over a weighted-average period of 3.56 years.

Employee Stock Purchase Plan

     On October 3, 2007, our stockholders approved the ESPP that had previously been approved by our Board of Directors. We adopted the ESPP to provide a means by which our employees, and the employees of any parent or subsidiary as may be designated by the Board of Directors, will be given an opportunity to purchase shares of our common stock. The ESPP allows eligible employees to purchase our common stock at 85% of the lower of the stock price at the beginning or end of the offering period, which generally is a six-month period. The Compensation Committee of our Board of Directors administers the ESPP. An aggregate of 1,000,000 shares of our common stock have been reserved for issuance under the ESPP. During the nine months ended September 30, 2009, an aggregate of 40,826 shares were purchased under the ESPP for a total of $176,633. The total compensation expense related to the ESPP for the three months ended September 30, 2009 and 2008 was $65,000 and $37,000, respectively, and $147,000 and $107,000 for the nine months ended September 30, 2009 and 2008, respectively.

5. Earnings per Share

     Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and restricted stock units.

     The calculation of basic and diluted net income (loss) per share for the three months and nine months ended September 30, 2009 and 2008 is summarized as follows (in thousands, except share and per share data):

     The following potential weighted-average common shares were excluded from the computation of diluted earnings per share, as their effect would have been anti-dilutive

6. Comprehensive Income (Loss)

     The components of comprehensive income (loss), net of tax, are as follows (in thousands):

7. Fair Value Measurement

     We measure the fair value of assets and liabilities using a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires us to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

•

Level 1 — Unadjusted quoted prices in active markets that are accessible at the measurement date for identical unrestricted assets or liabilities.

•

Level 2 — Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly.

•

Level 3 — Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

     The fair value measurement of an asset or liability is based on the lowest level of any input that is significant to the fair value assessment. Our investments that are measured at fair value on a recurring basis are generally classified within Level 1 or Level 2 of the fair value hierarchy.

     The following table presents our financial assets and liabilities that were accounted for at fair value as of September 30, 2009 by level within the fair value hierarchy (in thousands):

     Assets and liabilities that are measured at fair value on a non-recurring basis include intangible assets, which are recognized at fair value when they are considered to be impaired. For the nine months ended September 30, 2009, there were no fair value measurements for assets or liabilities on a non-recurring basis.

8. Business and Geographic Segment Information

     We manage our operations on a consolidated basis for purposes of assessing performance and making operating decisions. Accordingly, we do not have reportable segments. Revenues by geographic area for the three months and nine months ended September 30, 2009 and 2008 were as follows (in thousands):

9. Commitments and Contingencies

     We purchase components for our products from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that allow them to procure inventory based upon information we provide. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Consequently, a portion of our reported purchase commitments arising from these agreements are firm, non-cancelable, and unconditional commitments. As of September 30, 2009, we had total purchase commitments for inventory of approximately $5.6 million due within the next 12 months.

     We maintain office space in the United Kingdom for which the lease agreement requires that we return the office space to its original condition upon vacating the premises. The present value of the costs associated with this retirement obligation is approximately $140,000, payable upon termination of the lease. This cost is being accreted based on estimated discounted cash flows over the lease term.

      Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

      Certain statements contained in this Quarterly Report on Form 10-Q may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words or phrases “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or similar expressions, or the negative of such words or phrases, are intended to identify “forward-looking statements.” We have based these forward-looking statements on our current expectations and projections about future events. Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include those below and elsewhere in this Quarterly Report on Form 10-Q , particularly in “Risk Factors,” and our other filings with the Securities and Exchange Commission. Statements made herein are as of the date of the filing of this Form 10-Q with the Securities and Exchange Commission and should not be relied upon as of any subsequent date. Unless otherwise required by applicable law, we do not undertake, and we specifically disclaim, any obligation to update any forward-looking statements to reflect occurrences, developments, unanticipated events or circumstances after the date of such statement.

      The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Introduction

     Management’s discussion and analysis of financial condition, changes in financial condition and results of operations is provided as a supplement to the accompanying consolidated financial statements and notes to help provide an understanding of Sourcefire, Inc.’s financial condition and results of operations. This item of our Quarterly Report on Form 10-Q is organized as follows:

	•		Overview . This section provides a general description of our business, the performance indicators that we use in assessing our financial condition and results of operations, and anticipated trends that we expect to affect our financial condition and results of operations.
	•		Results of Operations . This section provides an analysis of our results of operations for the three months and nine months ended September 30, 2009 as compared to the three months and nine months ended September 30, 2008.
	•		Liquidity and Capital Resources . This section provides an analysis of our cash flows for the nine months ended September 30, 2009 and 2008 and a discussion of our capital requirements and the resources available to us to meet those requirements.
	•		Critical Accounting Policies and Estimates . This section discusses accounting policies that are considered important to our financial condition and results of operations, require significant judgment or require estimates on our part in applying them. Our significant accounting policies, including those considered to be critical accounting policies, are summarized in Note 2 to the accompanying consolidated financial statements.

Overview

     We are a leading provider of intelligent Cybersecurity solutions for information technology, or IT, environments of commercial enterprises (such as healthcare, financial services, manufacturing, energy, education, retail, and telecommunications) and federal, state and international government organizations. The Sourcefire 3D ^® System — comprised of multiple Sourcefire hardware and software product offerings — provides a comprehensive, intelligent approach to network protection that equips our customers with an efficient and effective layered security defense — protecting computer network assets before, during and after an attack.

     We sell our network security solutions to a diverse customer base that includes Fortune 1000 companies, Global 500 companies, U.S. government agencies and small and mid-size businesses. We also manage two of the security industry’s leading open source initiatives, Snort ^® and ClamAV ^® .

Key Financial Metrics and Trends

     Our financial results are affected by a number of factors, including broad economic conditions, the amount and type of technology spending of our customers, and the financial condition of our customers and the industries and geographic areas that we serve. During the second half of 2008 and continuing in 2009, the industries and geographic areas that we serve experienced weakness as macroeconomic conditions, credit market conditions, and levels of business confidence and activity deteriorated. We are continuing to monitor economic conditions and their potential effect on our customers and on us. A severe or prolonged economic downturn could affect our customers’ financial condition and the levels of business activity. This could reduce demand and depress pricing for our products and services, which could have a material adverse effect on our results of operations or financial condition.

     During the three months and nine months ended September 30, 2009, a significant portion of our revenue growth resulted from sales of our products to U.S. government agencies. Contracts with the U.S. federal and state government agencies accounted for 29% and 37% of our total revenue for the three months ended September 30, 2009 and 2008, respectively, and 26% and 21% for the nine months ended September 30, 2009 and 2008, respectively. We expect sales to U.S. government agencies to continue to account for a significant portion of our total revenue in 2009. A reduction in the amount of U.S. government purchases of our products could have a material adverse effect on our results of operations or financial condition.

     We evaluate our performance on the basis of several performance indicators, including pricing and discounts, credit and collections, revenue, cost of revenue, gross profit, and operating expenses. We compare these key performance indicators, on a quarterly basis, to both target amounts established by management and to our performance for prior periods.

Pricing and Discounts

     We maintain a standard price list for all of our products. Additionally, we have a corporate policy that governs the level of discounts our sales organization may offer on our products, based on factors such as transaction size, volume of products, federal or state programs, reseller or distributor involvement and the level of technical support commitment. Our total product revenue and the resulting gross profit percentage are directly affected by our ability to manage our product pricing policy. During the fourth quarter of 2008 and continuing in 2009, in some cases we increased discounts on the prices of our products and services as a result of the operating and financial difficulties facing our customers, and in response to discounts offered by our competitors. We expect the pressure to provide increased discounts to continue and, in the future, we may be forced to further discount or reduce our prices to remain competitive, which could have a material impact on our revenues and gross profit percentage.

Credit and Collections

     We evaluate the creditworthiness of our customers prior to accepting an order for our products and extending the customer terms of payment which typically range from 30 to 90 days from the date of our invoice. In the fourth quarter of 2008 and continuing in 2009, we experienced an increase in the aging of our outstanding receivables which we attributed to the decline in macroeconomic conditions and credit market conditions. As a result of the increase in our aging, we increased our reserve for uncollectible accounts. Any further decline in macroeconomic conditions may lead to a further increase in the aging of our receivables and we may have to increase our reserve as a result.

Revenue

     We currently derive revenue from product sales and services. Product revenue is principally derived from the sale of our network security solutions. Our network security solutions include a perpetual software license bundled with a third-party hardware platform. Services revenue is principally derived from technical support and professional services. We typically sell technical support to complement our network security product solutions. Technical support entitles a customer to product updates, new rule releases and both telephone and web-based assistance for using our products. Our professional services revenue includes optional installation, configuration and tuning, which we refer to collectively as network security deployment services. These network security deployment services typically occur on-site after delivery has occurred.

     Product sales are typically recognized as revenue at shipment of the product to the customer. For sales through resellers and distributors, we recognize revenue upon the shipment of the product only if those resellers and distributors provide us, at the time of placing their order, with the identity of the end-user customer to whom the product has been sold. We recognize revenue from services when the services are performed. For technical support services, we recognize revenue ratably over the term of the support arrangement, which is generally 12 months. Our support agreements generally provide for payment in advance.

     We sell our network security solutions globally. However, 78% and 81% of our revenue for the three months ended September 30, 2009 and 2008, respectively, and 76% and 75% for the nine months ended September 30, 2009 and 2008, respectively, was generated by sales to U.S.-based customers. We expect that our revenue from customers based outside of the United States will increase as we strengthen our international presence. We also expect that our revenue from sales through our indirect sales channel, comprised of resellers, distributors, managed security service providers, or MSSPs, government integrators and other partners, will increase in amount and as a percentage of total revenue as we expand our current relationships and establish new relationships with these third parties.

     We continue to generate a majority of our product revenue through sales to existing customers, both for new locations and for additional technology to protect existing networks and locations. Product sales to existing customers accounted for 75% and 59% of total product revenue for the three months ended September 30, 2009 and 2008, respectively, and 75% and 64% of total product revenue for the nine months ended September 30, 2009 and 2008, respectively. We expect product sales to existing customers to continue to account for a significant portion of our product revenue in 2009.

     Historically, our product revenue has been seasonal, with a significant portion of our total product revenue in recent fiscal years generated in the third and fourth quarters. While we expect this historical trend to continue, any further decline in general economic conditions in the fourth quarter and the effects of increased U.S. government spending in the first and second quarters may result in this trend being less pronounced in 2009. The timing of our year-end shipments could materially affect our fourth quarter product revenue in any fiscal year and quarterly comparisons. Revenue from our government customers has been influenced by the September 30th fiscal year-end of the U.S. federal government, which has historically resulted in our revenue from government customers being highest in the second half of the year. Notwithstanding these general seasonal patterns, our revenue within a particular quarter is often affected significantly by the unpredictable procurement patterns of our customers. Our prospective customers usually spend a long time evaluating and making purchase decisions for network security solutions. Historically, many of our customers have not finalized their purchasing decisions until the final weeks or days of a quarter. We expect these purchasing patterns to continue in the future. Therefore, a delay in even one large order beyond the end of the quarter could materially reduce our anticipated revenue for a quarter. Because many of our expenses must be incurred before we expect to generate revenue, delayed orders could negatively impact our results of operations and cash flows for a particular period and could therefore cause us to fail to meet the financial performance expectations of financial and industry research analysts or investors.

Cost of Revenue

     Cost of product revenue includes the cost of the hardware platform bundled into our network security solution, royalties for third-party software included in our network security solution, materials and labor that are incorporated in the quality assurance of our products, logistics, warranty, shipping and handling costs, expense for inventory excess and obsolescence and depreciation in the limited instances where we lease our network security solutions to our customers. We incur labor and allocated overhead costs as part of managing our outsourced manufacturing process. Allocated overhead costs include facilities, supplies, communication and information systems and employee benefits. Overhead costs are reflected in each cost of revenue and operating expense category. As our product volume increases, we anticipate incurring an increasing amount of both direct and overhead expenses to supply and manage the increased volume. Hardware unit costs, our most significant cost item, have generally remained constant on a per unit basis; however, hardware unit costs or other costs of manufacturing may increase in the future.

     Cost of services revenue includes the direct labor costs of our employees and outside consultants engaged to furnish those services, as well as their travel and associated direct material costs. Additionally, we include in cost of services revenue an allocation of overhead costs, as well as the cost of time and materials to service or repair the hardware component of our products covered under a renewed support arrangement beyond the manufacturer’s warranty. As our customer base continues to grow, we anticipate incurring an increasing amount of these service and repair costs, as well as costs for additional personnel to support and service our customers.

Gross Profit

     Our gross profit is affected by a variety of factors, including competition, the mix and average selling prices of our products, our pricing policy, technical support and professional services, new product introductions, the cost of hardware platforms, expense for inventory excess and obsolescence, warranty expense, the cost of labor to generate revenue and the mix of distribution channels through which our products are sold. Our gross profit would be adversely affected by price declines or pricing discounts if we are unable to reduce costs on existing products and fail to introduce new products with higher margins. Currently, product sales typically have a lower gross profit as a percentage of revenue than our services due to the cost of the hardware platform. Our gross profit for any particular quarter could be adversely affected if we do not complete a sufficient level of sales of higher-margin products by the end of the quarter. As discussed above, many of our customers do not finalize purchasing decisions until the final weeks or days of a quarter, so a delay in even one large order of a higher-margin product could reduce our total gross profit percentage for that quarter.

Operating Expenses

      Research and Development. Research and development expenses consist primarily of salaries, incentive compensation and allocated overhead costs for our engineers, costs for professional services to test our products, and costs associated with data used by us in our product development.

     We have expanded our research and development capabilities and expect to continue to expand these capabilities in the future. We are committed to increasing the level of innovative design and development of new products as we strive to enhance our ability to serve our existing commercial and federal government markets as well as new markets for security solutions. To meet the changing requirements of our customers, we will need to fund investments in several development projects in parallel. Accordingly, we anticipate that our research and development expenses will continue to increase in absolute dollars for the foreseeable future; however, as a percentage of revenue we expect these expenses to remain relatively flat.

      Sales and Marketing. Sales and marketing expenses consist primarily of salaries, incentive compensation and allocated overhead costs for sales and marketing personnel; trade show, advertising, marketing and other brand-building costs; marketing consultants and other professional services; training, seminars and conferences; and travel and related costs.

     As we focus on increasing our market penetration, expanding internationally, increasing our indirect sales channel and continuing to build brand awareness, we anticipate that selling and marketing expenses will continue to increase in absolute dollars, but decrease as a percentage of our revenue, in the future.

      General and Administrative. General and administrative expenses consist primarily of salaries, incentive compensation and allocated overhead costs for executive, legal, finance, information technology, human resources and administrative personnel; corporate development expenses and professional fees related to legal, audit, tax and regulatory compliance; travel and related costs; and corporate insurance.

      Stock-Based Compensation. Stock-based compensation expense is based on the grant date fair value of stock awards granted or modified after January 1, 2006 using the prospective transition method.

     We use the Black-Scholes option pricing model to estimate the fair value of stock options granted and employee stock purchases. For certain option awards that contain market conditions relating to our stock price achieving specified levels, we use a Lattice option pricing model. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected stock price volatility. Based on the estimated grant date fair value of stock-based awards, we recognized aggregate stock-based compensation expense of $1.9 million and $1.6 million for the three months ended September 30, 2009 and 2008, respectively, and $4.4 million and $3.4 million for the nine months ended September 30, 2009 and 2008, respectively.

     The increase in our product revenue for the three months and nine months ended September 30, 2009, as compared to the prior-year periods, was primarily due to higher volume demand for our sensor products, mainly our higher performance 3D products. For the three months and nine months ended September 30, 2009, sensor product revenue increased $3.4 million and $10.7 million, respectively, over the prior-year periods, which included a $3.4 million and $8.1 million increase, respectively, in revenue from our higher performance 3D products.

     The increase in our services revenue for the three months and nine months ended September 30, 2009, as compared to the prior-year periods, resulted from an increase in our installed customer base due to new product sales in which associated support was purchased, as well as technical support renewals by our existing customers.

      Cost of revenue . The following table shows products and technical support and professional services cost of revenue (in thousands):

     For the three months and nine months ended September 30, 2009, the increase in product cost of revenue, as compared to the prior-year periods, was primarily due to higher volume demand for our sensor products, for which we must procure and provide the hardware platform to our customers, and write-downs for excess and obsolete inventory as a result of the introduction of newer products. Write-downs as a result of the introduction of newer products for the three months and nine months ended September 30, 2009 were $559,000 and $1.4 million, respectively.

     The increase in our services cost of revenue for the three months and nine months ended September 30, 2009 was attributable to increased hardware service expense related to support renewal contracts and our hiring of additional personnel to both service our larger installed customer base and to provide training and professional services to our customers.

      Gross profit . The following table shows products and technical support and professional services gross profit (in thousands):

     Product gross margin for the three months and nine months ended September 30, 2009 increased compared to the prior-year periods, as higher margins on product revenue, primarily due to the product mix sold favoring products with higher gross margins, were partially offset by write-downs for excess and obsolete inventory as a result of the introduction of newer products. Write-downs as a result of the introduction of newer products for the three months and nine months ended September 30, 2009 were $559,000 and $1.4 million, respectively.

     Services gross margin for the three months and nine months ended September 30, 2009, as compared to the prior-year periods, increased slightly, primarily due to service revenue increasing at a higher rate than service expense.

      Operating expenses . The following table highlights our operating expenses (in thousands):