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

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

Commission File Number
1-33350

 

SOURCEFIRE, INC.

Delaware		52-2289365
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
9770 Patuxent Woods Drive Columbia, Maryland (Address of Principal Executive Offices)		21046 (Zip Code)

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.

Large Accelerated Filer o		Accelerated Filer þ		Non-Accelerated Filer o		Smaller reporting Company o
				(Do not check if a smaller reporting company)

     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 October 31, 2010, there were 28,009,789 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, 2010 and December 31, 2009			3
Consolidated Statements of Operations for the three months and nine months ended September 30, 2010 and 2009			4
Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2010			5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009			6
Notes to Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3. Quantitative and Qualitative Disclosures About Market Risk			33
Item 4. Controls and Procedures			33
Part II.
Item 1. Legal Proceedings			34
Item 1A. Risk Factors			34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			46
Item 3. Defaults Upon Senior Securities			46
Item 4. Reserved			46
Item 5. Other Information			46
Item 6. Exhibits			46
Signatures			47
EX-10.1
EX-10.2
EX-31.1
EX-31.2
EX-32.1

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

SOURCEFIRE, INC.

CONSOLIDATED BALANCE SHEETS

		September 30,				December 31,
		2010				2009
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	75,034			$	53,071
Short-term investments			58,677				49,074
Accounts receivable, net of allowances of $978 as of September 30, 2010 and $1,157 as of December 31, 2009			38,927				32,771
Inventory			5,323				4,414
Deferred tax assets			2,741				63
Prepaid expenses and other current assets			3,818				4,365
Total current assets			184,520				143,758
Property and equipment, net			9,135				7,447
Investments			8,869				21,075
Deferred tax assets, noncurrent			4,625				—
Other assets			2,180				1,887
Total assets		$	209,329			$	174,167
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	4,079			$	2,846
Accrued compensation and related expenses			5,545				5,074
Other accrued expenses			3,455				3,025
Current portion of deferred revenue			32,230				29,294
Other current liabilities			681				464
Total current liabilities			45,990				40,703
Deferred revenue, less current portion			7,418				4,883
Other long-term liabilities			129				92
Total liabilities			53,537				45,678
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value; 19,700,000 shares authorized; no shares issued or outstanding			—				—
Series A junior participating preferred stock, $0.001 par value; 300,000 shares authorized; no shares issued or outstanding			—				—
Common stock, $0.001 par value; 240,000,000 shares authorized; 27,978,648 and 27,117,051 shares issued and outstanding as of September 30, 2010 and December 31, 2009, respectively			27				26
Additional paid-in capital			181,878				170,157
Accumulated deficit			(26,143	)			(41,716	)
Accumulated other comprehensive income			30				22
Total stockholders’ equity			155,792				128,489
Total liabilities and stockholders’ equity		$	209,329			$	174,167

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Revenue:
Products		$	22,904			$	16,650			$	54,794			$	38,798
Technical support and professional services			13,260				10,773				37,809				29,396
Total revenue			36,164				27,423				92,603				68,194
Cost of revenue:
Products			5,748				4,281				14,191				10,730
Technical support and professional services			1,715				1,786				4,777				4,561
Total cost of revenue			7,463				6,067				18,968				15,291
Gross profit			28,701				21,356				73,635				52,903
Operating expenses:
Research and development			5,146				4,227				13,283				10,943
Sales and marketing			12,397				9,164				34,426				25,462
General and administrative			5,345				4,604				14,400				12,439
Depreciation and amortization			811				815				2,458				2,466
Total operating expenses			23,699				18,810				64,567				51,310
Income from operations			5,002				2,546				9,068				1,593
Other income, net:
Interest and investment income			117				190				316				868
Interest expense			(3	)			—				(15	)			(16	)
Other expense			(54	)			(45	)			(222	)			(94	)
Total other income, net			60				145				79				758
Income before income taxes			5,062				2,691				9,147				2,351
Provision (benefit) for income taxes			847				(6	)			(6,426	)			138
Net income		$	4,215			$	2,697			$	15,573			$	2,213
Net income per share:
Basic		$	0.15			$	0.10			$	0.57			$	0.08
Diluted		$	0.15			$	0.09			$	0.54			$	0.08
Weighted average shares outstanding used in computing per share amounts:
Basic			27,818,610				26,662,046				27,537,080				26,284,576
Diluted			28,835,105				28,487,916				28,834,327				27,686,847

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)

																		Accumulated
										Additional								Other
		Common Stock								Paid In				Accumulated				Comprehensive
		Shares				Amount				Capital				Deficit				Income				Total
Balance as of January 1, 2010			27,117,051			$	26			$	170,157			$	(41,716	)		$	22			$	128,489
Exercise of common stock options			656,402				1				3,524				—				—				3,525
Issuance of common stock under employee stock purchase plan			35,531				—				585				—				—				585
Issuance of restricted common stock			176,223				—				—				—				—				—
Cancellation of restricted common stock			(6,559	)			—				—				—				—				—
Stock-based compensation expense			—				—				6,881				—				—				6,881
Excess tax benefits relating to share-based payments			—				—				731				—				—				731
Comprehensive income:
Net income for the nine months ended September 30, 2010			—				—				—				15,573				—				15,573
Change in unrealized gain on investments, net of tax			—				—				—				—				8				8
Total comprehensive income																							15,581
Balance as of September 30, 2010			27,978,648			$	27			$	181,878			$	(26,143	)		$	30			$	155,792

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)

		Nine Months Ended
		September 30,
		2010				2009
Operating activities
Net income		$	15,573			$	2,213
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			2,614				2,547
Stock-based compensation			6,881				4,426
Excess tax benefits related to share-based payments			(731	)			(89	)
Amortization of premium on investments			753				112
Loss on disposal of assets			36				—
Deferred taxes			(7,322	)			—
Changes in operating assets and liabilities:
Accounts receivable, net			(6,156	)			1,992
Inventory			(818	)			140
Prepaid expenses and other assets			263				(1,790	)
Accounts payable			1,233				(2,540	)
Accrued expenses			1,632				(456	)
Deferred revenue			5,471				3,238
Other liabilities			212				(250	)
Net cash provided by operating activities			19,641				9,543
Investing activities
Purchase of property and equipment			(4,384	)			(1,641	)
Purchase of investments			(80,068	)			(66,743	)
Proceeds from maturities of investments			81,945				60,225
Net cash used in investing activities			(2,507	)			(8,159	)
Financing activities
Repayments of capital lease obligations			(12	)			(32	)
Proceeds from employee stock-based plans			4,110				3,224
Excess tax benefits related to share-based payments			731				89
Net cash provided by financing activities			4,829				3,281
Net increase in cash and cash equivalents			21,963				4,665
Cash and cash equivalents at beginning of period			53,071				39,768
Cash and cash equivalents at end of period		$	75,034			$	44,433

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Description of Business

     We are a leading provider of intelligent cybersecurity solutions for information technology, or IT, environments of commercial enterprises, including healthcare, financial services, manufacturing, energy, education, retail and telecommunications companies, and federal, state and local government organizations worldwide. Our solutions are comprised of multiple hardware and software product and service offerings, enabling a comprehensive, intelligent approach to network security. Our security solutions provide our customers with an efficient and effective network security defense of assets and applications before, during and after an attack.

     We are also the creator of Snort® and the owner of ClamAV®. Snort is an open source intrusion prevention technology that is incorporated into the IPS software component of our comprehensive Intrusion Detection and Prevention System. ClamAV is an open source anti-virus and anti-malware project.

     In addition to our commercial and open source network security products, we offer a variety of services to help our customers install and support our solutions. Available services include Customer Support, Education, Professional Services and Snort rule subscriptions.

2. Summary of Significant Accounting Policies

  Basis of Presentation

     The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial reporting and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments which are, in the opinion of management, considered necessary for a fair presentation. These financial statements should be read in conjunction with the audited consolidated financial statements and the notes included in our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the Securities and Exchange Commission on March 12, 2010. The results of operations for the interim periods are not necessarily indicative of results to be expected in future periods.

  Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

     On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable allowance, sales return allowance, warranty reserve, reserve for excess and obsolete inventory, useful lives of long-lived assets, income taxes, and our assumptions used for the purpose of determining stock-based compensation, among other things. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented.

     Investments

     We determine the appropriate classification of our investments at the time of purchase and reevaluate such classification as of each balance sheet date. Our investments are comprised of money market funds, corporate debt investments, commercial paper, government-sponsored enterprise securities, government securities and certificates of deposit. These investments have been classified as available-for-sale. Available-for-sale investments are stated at fair value, with the unrealized gains and losses, net of tax, reported in accumulated other comprehensive income. The amortization of premiums and accretion of discounts to

maturity are computed using the effective interest method. 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 charged against earnings for the period. 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 charged against earnings for the applicable period and the non-credit component of the other-than-temporary impairment is recognized in other comprehensive income on our consolidated statement of changes in stockholders’ equity. 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 consist primarily of cash and cash equivalents, investments, accounts receivable, cash surrender value on our split-dollar life insurance policy, accounts payable and deferred revenue. 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 Return Allowance

     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 if the allowance does not reflect our actual 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, 2010 and December 31, 2009, the allowance for doubtful accounts was $428,000 and $777,000, respectively.

     We also use our judgment to make estimates regarding potential future product returns related to reported product revenue in each period. 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. If any of the factors used to calculate the sales return allowance were to change, we may experience a material difference in the amount and timing of our product revenue for any given period. As of September 30, 2010 and December 31, 2009, the sales return allowance was $550,000 and $380,000, respectively.

     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. We make estimates of forecasted demand for our products, and inventory that is obsolete or in excess of our estimated 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-downs, which would negatively impact our gross margin.

     Inventory consisted of the following (in thousands):

		As of
		September 30,				December 31,
		2010				2009
Finished goods		$	2,955			$	2,850
Evaluation units			1,183				733
Advance replacement units			1,185				831
Total inventory		$	5,323			$	4,414

     Inventory write-downs, mostly related to evaluation units and excess and obsolete inventory, are reflected as cost of revenues and amounted to approximately $488,000 and $977,000 for the three months ended September 30, 2010 and 2009, respectively, and $815,000 and $2.1 million for the nine months ended September 30, 2010 and 2009, respectively.

  Revenue Recognition

     We derive revenue from arrangements that include hardware 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 Vulnerability Research Team, or 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 recognize revenue when: (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, or VSOE. If VSOE 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 VSOE of fair value can be determined for any undelivered elements or all elements of the arrangement have been delivered. If the only undelivered elements are elements for which we currently have VSOE of fair value, we recognize revenue for the delivered elements based on the residual method. When VSOE of fair value does not exist for undelivered elements such as maintenance and support, the entire arrangement fee is recognized ratably over the performance period.

     We have established VSOE of fair value for substantially all of 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 VSOE of fair value of our other services is based on the price for these same services when they are sold separately. Revenue for professional 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 and 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. 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 ended September 30, 2010, one customer, a distributor of our products to the U.S. government, accounted for 29% of total revenue. For the nine months ended September 30, 2010, two customers, one a reseller and the other a distributor of our products to the U.S. government, accounted for 10% and 18%, respectively, of total revenue. 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 22% and 14%, respectively, of total revenue.

     As of September 30, 2010, one customer, a distributor of our products to the U.S. government, accounted for 35% of our accounts receivable. As of December 31, 2009, one customer, a distributor of our products to the U.S. government, accounted for 31% of our accounts receivable.

  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 units sold, 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

     We account for income taxes using the liability method, which requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax bases of our assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse.

     We continue to assess the realizability of our deferred tax assets, which primarily consists of net operating loss, or NOL, carryforwards, and temporary differences associated with stock-based compensation expense and deferred revenue. In assessing the realizability of these deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized. In assessing the need for a valuation allowance, we consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies.

     With respect to foreign earnings, it is our policy to invest the earnings of foreign subsidiaries indefinitely outside the U.S. Any excess tax benefit, above amounts previously recorded on stock-based compensation expense, from the exercise of stock options is recorded in additional paid-in-capital in the consolidated balance sheets to the extent that cash taxes payable are reduced.

     We have determined there are no material uncertain tax positions that would require a reserve as of September 30, 2010.

     Because tax laws are complex and subject to different interpretations, significant judgment is required. As a result, we make certain estimates and assumptions, in (i) calculating our provision for income taxes, deferred tax assets and deferred tax liabilities, (ii) determining any valuation allowance recorded against deferred tax assets and (iii) evaluating the amount of unrecognized tax benefits, as well as the interest and penalties related to such uncertain tax positions. Our estimates and assumptions may differ significantly from tax benefits ultimately realized. See Note 4 for additional discussion of income taxes.

  Stock-Based Compensation

     Stock-based awards granted include stock options, restricted stock awards, restricted stock units and stock purchased under our Amended and Restated 2007 Employee Stock Purchase Plan, or ESPP. Stock-based compensation expense is measured at the grant date, based on the fair value of the awards, and is recognized as expense over the requisite service period, net of estimated forfeitures.

     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 a prior option award that contained a market condition relating to our stock price achieving specified levels, we used 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. 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. See Note 5 for additional discussion of stock-based compensation.

  Net Income Per Share

     Basic net income per share is computed on the basis of the weighted-average number of shares of common stock outstanding during the period. Diluted net income 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. See Note 6 for additional discussion of our net income per share.

  Recent Accounting Pronouncements

     In October 2009, the FASB clarified the accounting guidance for sales of tangible products containing both software and hardware elements and issued new guidance that amends the criteria for evaluating the individual items in a multiple deliverable revenue arrangement and how to allocate the consideration received to the individual items. The 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 believe this literature is applicable to our revenue arrangements. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

     In January 2010, the FASB issued revised guidance intended to improve disclosures related to fair value measurements. This guidance requires new disclosures as well as clarifies certain existing disclosure requirements. New disclosures under this guidance require separate information about significant transfers in and out of Level 1 and Level 2 and the reason for such transfers, and also require purchases, sales, issuances, and settlements information for Level 3 measurement to be included in the rollforward of activity on a gross basis. The guidance also clarifies the requirement to determine the level of disaggregation for fair value measurement disclosures and the requirement to disclose valuation techniques and inputs used for both recurring and nonrecurring fair value measurements in either Level 2 or Level 3. This accounting guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the rollforward of activity in Level 3 fair value measurements, which is effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of this guidance did not have an effect on our consolidated financial statements.

  Reclassifications

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

3. Investments

     The following is a summary of available-for-sale investments as of September 30, 2010 (in thousands):

						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
		Cost				Gains				Losses				Fair Value
Money market funds		$	20,373			$	—			$	—			$	20,373
Corporate debt investments			27,625				39				(8	)			27,656
Commercial paper			6,542				2				—				6,544
Government-sponsored enterprises			31,620				11				(3	)			31,628
Government securities			3,209				9				—				3,218
Total investments			89,369			$	61			$	(11	)			89,419
Amounts classified as cash equivalents*			(21,873	)											(21,873	)
Total available-for-sale investments		$	67,496											$	67,546
Due in one year or less		$	58,627			$	58			$	(8	)		$	58,677
Due after one year through five years			8,869				3				(3	)			8,869
		$	67,496			$	61			$	(11	)		$	67,546

     The following is a summary of available-for-sale investments as of December 31, 2009 (in thousands):

						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
		Cost				Gains				Losses				Fair Value
Money market funds		$	17,617			$	—			$	—			$	17,617
Corporate debt investments			17,715				15				(17	)			17,713
Commercial paper			7,543				2				—				7,545
Government-sponsored enterprises			39,218				41				(27	)			39,232
Government securities			1,995				8				—				2,003
Certificate of deposit			4,905				—				—				4,905
Total investments			88,993			$	66			$	(44	)			89,015
Amounts classified as cash equivalents*			(18,866	)											(18,866	)
Total available-for-sale investments		$	70,127											$	70,149
Due in one year or less		$	49,030			$	48			$	(4	)		$	49,074
Due after one year through five years			21,097				18				(40	)			21,075
		$	70,127			$	66			$	(44	)		$	70,149

     The following tables show the gross unrealized losses and fair value of our investments as of September 30, 2010 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):

		Less Than 12 Months								12 Months or More								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
Corporate debt investments		$	11,790			$	8			$	—			$	—			$	11,790			$	8
Government-sponsored enterprises			13,515				3				—				—				13,515				3
Total		$	25,305			$	11			$	—			$	—			$	25,305			$	11

     As of September 30, 2010, the unrealized holding gain, net of tax on available-for-sale securities included in accumulated other comprehensive income totaled $30,000. We have evaluated our investments and have determined there were no other-than-temporary impairments as of September 30, 2010. There are ten corporate debt investments and six 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.

4. Income Taxes

     Our provision for income taxes for the three months ended September 30, 2010 consisted primarily of a tax provision for federal and state income taxes and withholding taxes that we incurred in connection with certain foreign operations. Our benefit for income taxes for the nine months ended September 30, 2010 reflects a tax benefit from the release of the valuation allowance recorded against our deferred tax assets in the U.S., partially offset by a tax provision for federal and state income taxes and withholding taxes that we incurred in connection with certain foreign operations. Our provision for income taxes for the three months and nine months ended September 30, 2009 consisted primarily of a tax provision for state income taxes and the income generated by our foreign subsidiaries, as well as withholding taxes that we incurred in connection with certain foreign operations.

     As of December 31, 2009, we had a full valuation allowance against our deferred tax assets in the U.S., consisting primarily of net operating loss carryforwards and temporary differences associated with deferred revenue and stock-based compensation. In preparing our interim tax provision, we compute a forecast of our annual effective tax rate. Our forecasted annual effective tax rate includes a $4.1 million tax benefit from the release of the valuation allowance attributable to deferred tax assets associated with our NOL carryforwards which are expected to be utilized during the year. Based upon our operating results over recent years and through June 30, 2010, as well as an assessment of our expected future results of operations, during the second quarter of 2010 we determined that it had become more likely than not that we will ultimately realize the tax benefits of our deferred tax assets in the U.S. As a result, during the second quarter, we released the remaining $7.6 million of our valuation allowance, which was recorded as a one-time tax benefit.

5. Stock-Based Compensation

     In March 2007, our Board of Directors and stockholders approved the Sourcefire, Inc. 2007 Stock Incentive Plan, or 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, 2009, we had reserved an aggregate of 5,164,850 shares of common stock for issuance under the 2007 Plan. On January 1, 2010, 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, 2009, or 1,084,682 shares. Therefore, as of September 30, 2010, we have reserved an aggregate of 6,249,532 shares of common stock for issuance under the 2007 Plan. Prior to adoption of the 2007 Plan, we granted stock options and restricted stock awards under the Sourcefire, Inc. 2002 Stock Incentive Plan, or 2002 Plan.

     The 2002 Plan and the 2007 Plan are administered by the Compensation Committee of our Board of Directors. The vesting period for awards under the plans is generally between three and five years. Options granted prior to March 2010 have a maximum term of ten years, and options granted beginning March 2010 have a maximum term of seven 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 a prior option award that contained a market condition relating to our stock price achieving specified levels, we used 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. 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 stock-based awards is recognized as expense over the requisite service period, net of estimated forfeitures. We rely on historical experience of employee turnover to estimate our expected 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 ESPP grants.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Stock options:
Average risk-free interest rate			1.5	%			2.9	%			2.3	%			2.6	%
Expected dividend yield			—	%			—	%			—	%			—	%
Expected life (years)			4.75				6.25				5.38				6.25
Expected volatility			61.6	%			64.3	%			61.4	%			64.5	%
Weighted-average fair value at grant date		$	11.31			$	8.91			$	12.72			$	6.90
Employee stock purchase plan:
Average risk-free interest rate			—	%			—	%			0.2	%			0.3	%
Expected dividend yield			—				—				—				—
Expected life (years)			—				—				0.50				0.50
Expected volatility			—	%			—	%			48.3	%			77.5	%
Weighted-average fair value at grant date		$	—			$	—			$	5.15			$	3.52

     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, as of the grant date.

     Expected dividend yield — We use an expected dividend yield of zero, as we have never declared or paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

     Expected life — This is the period of time that the stock options granted under our equity incentive plans and ESPP grants are expected to remain outstanding.

     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 ESPP grants, the expected 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, since our historical stock data from our IPO in March 2007 is less than the expected life of the stock options, we have used a blended volatility to estimate expected volatility. The blended volatility includes a weighting of our historical volatility from the date of 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 ESPP grants, we use our historical volatility since we have historical data available since our IPO, which is consistent with the expected life.

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

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

		Three Months Ended								Nine Months Ended,
		September 30,								September 30,
		2010				2009				2010				2009
Product cost of revenue		$	56			$	29			$	134			$	54
Services cost of revenue			105				60				261				114
Stock-based compensation expense included in cost of revenue			161				89				395				168
Research and development			387				286				1,048				702
Sales and marketing			1,111				535				2,613				1,315
General and administrative			1,291				959				2,825				2,241
Stock-based compensation expense included in operating expenses			2,789				1,780				6,486				4,258
Total stock-based compensation expense		$	2,950			$	1,869			$	6,881			$	4,426

Stock Options

     The following table summarizes stock option activity under the plans for the nine months ended September 30, 2010 (in thousands, except share and per share data):

														Weighted
														Average
										Weighted-				Remaining				Aggregate
		Number of				Range of				Average				Contractual				Intrinsic
		Shares				Exercise Prices				Exercise Price				Term				Value
Outstanding at December 31, 2009			2,542,038			$	0.24 to 15.49			$	7.75							$	5,878
Granted			459,525				18.48 to 28.03				22.99
Exercised			(656,402	)			0.24 to 22.00				5.37
Forfeited			(67,792	)			5.26 to 27.09				16.12
Outstanding at September 30, 2010			2,277,369			$	0.24 to 28.03			$	11.26				7.18			$	40,028
Vested and exercisable at September 30, 2010			1,053,397			$	0.24 to 22.00			$	6.24				6.28			$	23,805
Vested and expected to vest at September 30, 2010			2,099,801							$	10.77				7.11			$	37,950

     The following table summarizes information about stock options outstanding as of September 30, 2010:

		Options Outstanding												Options Exercisable
										Weighted-
						Weighted-				Average								Weighted-
Range of			Number of			Average				Contractual				Number of				Average
Exercise Prices		Shares				Exercise Prices				Life (Years)				Shares				Exercise Prices
$  0.24 to   6.56			569,434			$	3.56				5.56				422,220			$	2.64
$  6.61 to   6.77			597,880				6.76				7.80				351,246				6.77
$  7.10 to 19.92			604,030				12.64				7.06				266,556				10.48
$21.32 to 28.03			506,025				23.60				8.41				13,375				21.73
			2,277,369			$	11.26				7.18				1,053,397			$	6.24

     The aggregate intrinsic value of all options exercised during the nine months ended September 30, 2010 and 2009 was $12.4 million and $9.4 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 $1.0 million and $910,000 for the three months ended September 30, 2010 and 2009, respectively, and $2.9 million and $2.3 million for the nine months ended September 30, 2010 and 2009, 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, 2010 was $8.1 million, which is expected to be recognized over a weighted average period of 2.66 years.

Restricted Stock Awards

     The following table summarizes the unvested restricted stock award activity during the nine months ended September 30, 2010:

						Weighted-Average
		Number of				Grant Date
		Shares				Fair Value
Unvested at December 31, 2009			435,222			$	7.85
Granted			28,876				17.98
Vested			(195,663	)			8.42
Forfeited			(6,559	)			8.04
Unvested at September 30, 2010			261,876			$	8.54

     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. Holders of restricted stock awards have the right to vote such shares and receive dividends. The restricted stock awards are considered issued and outstanding at the date the award is granted. 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. We recognized compensation expense related to restricted stock awards of $567,000 and $462,000 for the three months ended September 30, 2010 and 2009, respectively, and $1.4 million for each of the nine months ended September 30, 2010 and 2009. For the three months and nine months ended September 30, 2010, stock-based compensation expense was adjusted by $59,000 as the achievement of certain performance measures was deemed probable. For the three months and nine months ended September 30, 2009, stock-based compensation expense was adjusted by $247,000 as the achievement of certain performance measures was deemed probable.

     As of September 30, 2010, there was $1.4 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 1.28 years.

Restricted Stock Units

     The following table summarizes the unvested restricted stock unit activity during the nine months ended September 30, 2010:

						Weighted-Average
		Number of				Grant Date
		Shares				Fair Value
Unvested at December 31, 2009			604,400			$	10.91
Granted			303,650				22.14
Vested			(147,347	)			10.64
Forfeited			(8,450	)			19.32
Unvested at September 30, 2010			752,253			$	15.43

     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 48 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. We recognized compensation expense related to restricted stock units of $1.2 million and $432,000 for the three months ended September 30, 2010 and 2009, respectively, and $2.3 million and $574,000 for the nine months ended September 30, 2010 and 2009, respectively. For the three months and nine months ended September 30, 2010, stock-based compensation expense was adjusted by $512,000 as the achievement of certain performance measures was deemed probable.

     As of September 30, 2010, there was $7.1 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 2.95 years.

     Employee Stock Purchase Plan

     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. During the nine months ended September 30, 2010, an aggregate of 35,531 shares were purchased under the ESPP for a total of $586,000. As of September 30, 2010, 801,313 shares remain available for future issuance under the ESPP. The total compensation expense related to the ESPP for the three months ended September 30, 2010 and 2009 was $114,000 and $65,000, respectively, and $335,000 and $147,000 for the nine months ended September 30, 2010 and 2009, respectively.

6. Net Income Per Share

     The calculation of basic and diluted net income per share for the three months and nine months ended September 30, 2010 and 2009 is summarized as follows (in thousands, except share and per share data):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Numerator:
Net income		$	4,215			$	2,697			$	15,573			$	2,213
Denominator:
Weighted-average shares outstanding — basic			27,818,610				26,662,046				27,537,080				26,284,576
Dilutive effect of employee stock plans			1,016,495				1,825,870				1,297,247				1,402,271
Weighted-average shares — diluted			28,835,105				28,487,916				28,834,327				27,686,847
Net income per share:
Basic		$	0.15			$	0.10			$	0.57			$	0.08
Diluted		$	0.15			$	0.09			$	0.54			$	0.08

     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:

		Three Months Ended								Nine Months Ended,
		September 30,								September 30,
		2010				2009				2010				2009
Options to purchase common stock			641,851				182,162				521,676				913,802
Restricted stock units			—				1,500				57,833				38,146
			641,851				183,662				579,509				951,948

7. Comprehensive Income

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

		Three Months Ended								Nine Months Ended,
		September 30,								September 30,
		2010				2009				2010				2009
Net income		$	4,215			$	2,697			$	15,573			$	2,213
Comprehensive income:
Change in unrealized gains (losses) on investments, net of tax			7				(51	)			8				(191	)
Total comprehensive income		$	4,222			$	2,646			$	15,581			$	2,022

8. 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 fair value of investments classified as Level 2 utilized the market approach. There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2010.

     The following table presents our financial assets and liabilities that were accounted for at fair value as of September 30, 2010 by level within the fair value hierarchy (in thousands):

						Fair Value Measurement Using
		Fair Value				Level 1				Level 2				Level 3
Cash and cash equivalents:
Money market funds		$	20,373			$	20,373			$	—			$	—
Government-sponsored enterprises			1,500				—				1,500				—
Investments:
Corporate debt investments			27,656				—				27,656				—
Commercial paper			6,544				—				6,544				—
Government-sponsored enterprises			30,128				—				30,128				—
Government securities			3,218				—				3,218				—
Total		$	89,419			$	20,373			$	69,046			$	—

9. 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, 2010 and 2009 were as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
United States		$	28,752			$	21,367			$	70,481			$	51,526
All foreign countries			7,412				6,056				22,122				16,668
Total		$	36,164			$	27,423			$	92,603			$	68,194

10. 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. A portion of our reported purchase commitments arising from these agreements are firm, non-cancelable, and unconditional commitments. As of September 30, 2010, we had total purchase commitments for inventory of approximately $8.8 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, 2009.

     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 key financial metrics that we use in assessing our performance, 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, 2010 and 2009.

•

Non-GAAP Financial Measures. This section discusses non-GAAP financial results that we use in evaluating the operating performance of our business. These measures should be considered in addition to results prepared in accordance with United States generally accepted accounting principles, or GAAP, but should not be considered a substitute for, or superior to, GAAP results. The non-GAAP measures discussed have been reconciled to the nearest GAAP measure in a table included in this section.

•

Liquidity and Capital Resources. This section provides an analysis of our cash flows for the nine months ended September 30, 2010 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, including healthcare, financial services, manufacturing, energy, education, retail and telecommunications companies, and federal, state and local government organizations worldwide. Our solutions are comprised of multiple hardware and software product and service offerings, enabling a comprehensive, intelligent approach to network security. Our security solutions provide customers with an efficient and effective network security defense of assets and applications before, during and after an attack.

     We sell our network security solutions to a diverse customer base that includes Global 2000 companies, global enterprises, U.S. and international 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 general economic conditions in the United States and globally, the amount and type of technology spending of our customers, and the financial condition of our customers and other entities in the industries and geographic areas that we serve. Beginning in the second half of 2008, the industries and geographic areas that we serve experienced weakness as macroeconomic conditions, credit market conditions and levels of business confidence and activity deteriorated. Although financial markets appear to have stabilized and improved recently, the economic outlook and availability of credit remain uncertain. We are continuing to monitor economic conditions and their potential effect on our customers and on us. An additional economic downturn could adversely 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.

     A significant portion of our revenue growth resulted from sales of our products and services to U.S. federal and state government agencies. Contracts with the U.S. federal and state government agencies collectively accounted for 38% and 29% of our total revenue for the three months ended September 30, 2010 and 2009, respectively, and 30% and 26% of our total revenue for the nine months ended September 30, 2010 and 2009, respectively. We expect sales to U.S. federal and state government agencies to continue to account for a significant portion of our total revenue for the year ended December 31, 2010. However, we expect a material decrease in revenue from these sales in the three months ended December 31, 2010, as compared to the same period of 2009, primarily as a result of a large sale to the U.S. federal government that we recognized as revenue during the three months ended December 31, 2009 and the potential negative impact on federal sales due to the failure, thus far, of the U.S. government to adopt a budget for its fiscal year commencing October 1, 2010. 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 key financial metrics, including 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. We also evaluate performance on the basis of adjusted income from operations, adjusted income from operations as a percentage of revenue, adjusted net income and adjusted net income per share, which are non-GAAP financial measures. Information regarding our non-GAAP financial measures and a reconciliation to the nearest GAAP measure is provided under “Non-GAAP Financial Measures” below.

     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 and new rule releases on a when and if available basis 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 services typically occur on-site after delivery has occurred.

     Product sales are typically recognized as revenue upon 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, 80% and 78% of our revenue for the three months ended September 30, 2010 and 2009, respectively, and 76% and 76% of our revenue for the nine months ended September 30, 2010 and 2009 was generated by sales to U.S.-based customers. We expect that our revenue from customers based outside of the United States will increase in absolute dollars and as a percentage of revenue 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 59% and 75% of total product revenue for the three months ended September 30, 2010 and 2009, respectively, and 62% and 75% of total product revenue for the nine months ended September 30, 2010 and 2009, respectively. We expect product sales to existing customers to continue to account for a significant portion of our product revenue in 2010.

     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. 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. While we expect these historical trends to continue, they could be affected by a number of factors, including another decline in general economic conditions, changes in the timing or amounts of U.S. government spending and our planned international expansion. 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. In addition, because we typically recognize revenue upon shipment, the timing of our quarter-end and year-end shipments could materially affect our reported product revenue for a given quarter or year. Because many of our expenses are incurred before we recognize 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, royalties for third-party software, materials and labor, logistics, warranty, shipping and handling costs, expense for inventory excess and obsolescence and depreciation in the instances where we lease our network security solutions to our customers. We allocate overhead costs, including facilities, supplies, communication and information systems and employee benefits, to the cost of product revenue. Overhead costs are reflected in each cost of revenue and operating expense category. As our product volume increases, we anticipate incurring an increased 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 could 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 and the expense for advance replacement unit inventory excess and obsolescence. 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 provide support and service to 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, new product introductions, the cost of hardware platforms, expense for inventory excess and obsolescence, warranty expense, the cost of labor and materials 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 high-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 design, test and certify 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 year ending December 31, 2010; however, we expect these expenses to remain flat or decline slightly as a percentage of revenue.

     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 continue to focus on increasing our market penetration, expanding internationally, increasing our indirect sales channel and building brand awareness, we anticipate that selling and marketing expenses will continue to increase in absolute dollars for the year ending December 31, 2010 but remain relatively flat as a percentage of our revenue.

     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. We anticipate that general and administrative expenses will increase in absolute dollars for the year ending December 31, 2010.

     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 a prior option award that contained a market condition relating to our stock price achieving specified levels, we used 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 $3.0 million and $1.9 million for the three months ended September 30, 2010 and 2009, respectively, and $6.9 million and $4.4 million for the nine months ended September 30, 2010 and 2009, respectively.

Results of Operations

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

		Three Months Ended																Nine Months Ended
		September 30,								Variance								September 30,								Variance
		2010				2009				$				%				2010				2009				$				%
Products		$	22,904			$	16,650			$	6,254				38	%		$	54,794			$	38,798			$	15,996				41	%
Percentage of total revenue			63	%			61	%											59	%			57	%
Technical support and professional services			13,260				10,773				2,487				23	%			37,809				29,396				8,413				29	%
Percentage of total revenue			37	%			39	%											41	%			43	%
Total revenue		$	36,164			$	27,423			$	8,741				32	%		$	92,603			$	68,194			$	24,409				36	%

     The increase in our product revenue for the three months ended September 30, 2010, as compared to the prior-year period, was primarily due to higher volume demand for our sensor products. For the three months ended September 30, 2010, sensor product revenue increased $5.5 million over the prior-year period. The increase in our product revenue for the nine months ended September 30, 2010, as compared to the prior-year period, was primarily due to higher volume demand for our sensor

products and increased sales of our software licenses. For the nine months ended September 30, 2010, sensor product revenue increased $11.6 million and software license revenue increased $4.0 million over the prior-year period.

     The increase in our services revenue for the three months and nine months ended September 30, 2010, 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):

		Three Months Ended																Nine Months Ended
		September 30,								Variance								September 30,								Variance
		2010				2009				$				%				2010				2009				$				%
Products		$	5,748			$	4,281			$	1,467				34	%		$	14,191			$	10,730			$	3,461				32	%
Percentage of total revenue			16	%			16	%											15	%			16	%
Technical support and professional services			1,715				1,786				(71	)			(4	)%			4,777				4,561				216				5	%
Percentage of total revenue			5	%			7	%											5	%			7	%
Total cost of revenue		$	7,463			$	6,067			$	1,396				23	%		$	18,968			$	15,291			$	3,677				24	%
Percentage of total revenue			21	%			22	%											20	%			22	%

     The increase in our product cost of revenue for the three months and nine months ended September 30, 2010, 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, partially offset by a decrease in inventory write-downs related to excess and obsolete inventory.

     The decrease in our services cost of revenue for the three months ended September 30, 2010, as compared to the prior-year period, was primarily attributable to a decrease in hardware service expense we pay to our third-party integrators to help maintain our install base, partially offset by our hiring of additional personnel to service our larger installed customer base, provide training to our resellers and customers, and provide professional services to our customers. The increase in our services cost of revenue for the nine months ended September 30, 2010, as compared to the prior-year period, was primarily attributable to our hiring of additional personnel to service our larger installed customer base, provide training to our resellers and customers, and provide professional services to our customers, partially offset by decreased hardware service expense we pay to our third-party integrators to help maintain our install base.

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

		Three Months Ended																Nine Months Ended
		September 30,								Variance								September 30,								Variance
		2010				2009				$				%				2010				2009				$				%
Products		$	17,156			$	12,369			$	4,787				39	%		$	40,603			$	28,068			$	12,535				45	%
Product gross margin			75	%			74	%											74	%			72	%
Technical support and professional services			11,545				8,987				2,558				28	%			33,032				24,835				8,197				33	%
Technical support and professional services gross margin			87	%			83	%											87	%			84	%
Total gross profit		$	28,701			$	21,356			$	7,345				34	%		$	73,635			$	52,903			$	20,732				39	%
Total gross margin			79	%			78	%											80	%			78	%