• 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.

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
                       2009           2008           $           %           2009           2008           $            %
Products            $   16,650      $ 12,661      $ 3,989          32 %    $  38,798      $ 28,189      $ 10,609          38 %
Percentage of
total revenue               61 %          62 %                                    57 %          56 %
Technical
support and
professional
services                10,773         7,628        3,145          41 %       29,396        21,769         7,627          35 %
Percentage of
total revenue               39 %          38 %                                    43 %          44 %

Total revenue       $   27,423      $ 20,289      $ 7,134          35 %    $  68,194      $ 49,958      $ 18,236          37 %

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):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                Variance
                       2009           2008           $           %           2009           2008           $           %
Products            $    4,281       $ 3,585      $   696          19 %    $  10,730      $  8,061      $ 2,669          33 %
Percentage of
total revenue               16 %          18 %                                    16 %          16 %
Technical
support and
professional
services                 1,786         1,345          441          33 %        4,561         3,583          978          27 %
Percentage of
total revenue.               7 %           7 %                                     7 %           7 %

Total cost of
revenue             $    6,067       $ 4,930      $ 1,137          23 %    $  15,291      $ 11,644      $ 3,647          31 %

Percentage of
total revenue               22 %          24 %                                    22 %          23 %

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):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                 Variance
                       2009           2008           $           %           2009           2008           $            %
Products            $   12,369      $  9,076      $ 3,293          36 %    $  28,068      $ 20,128      $  7,940          39 %
Product gross
margin                      74 %          72 %                                    72 %          71 %
Technical
support and
professional
services                 8,987         6,283        2,704          43 %       24,835        18,186         6,649          37 %
Technical
support and
professional
services gross
margin                      83 %          82 %                                    84 %          84 %

Total gross
profit              $   21,356      $ 15,359      $ 5,997          39 %    $  52,903      $ 38,314      $ 14,589          38 %

Total gross
margin                      78 %          76 %                                    78 %          77 %

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):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                 Variance
                       2009           2008           $           %           2009           2008           $            %
Research and
development         $    4,227      $  3,267      $   960          29 %    $  10,943      $  9,525      $  1,418          15 %
Percentage of
total revenue               15 %          16 %                                    16 %          19 %
Sales and
marketing                9,164         8,655          509           6 %       25,462        23,834         1,628           7 %
Percentage of
total revenue               33 %          43 %                                    37 %          48 %
General and
administrative           4,604         4,984         (380 )       (8) %       12,439        13,929        (1,490 )      (11) %
Percentage of
total revenue               17 %          24 %                                    18 %          28 %
Depreciation and
amortization               815           775           40           5 %        2,466         1,852           614          33 %
Percentage of
total revenue                3 %           4 %                                     4 %           4 %

Total operating
expenses            $   18,810      $ 17,681      $ 1,129           6 %    $  51,310      $ 49,140      $  2,170           4 %

Percentage of
total revenue               69 %          87 %                                    75 %          99 %

Research and development expenses for the three months ended September 30, 2009 increased over the prior-year quarter, primarily due to an increase of $416,000 in salaries, incentive compensation and allocated overhead costs as a result of additional personnel and increased overhead costs and an increase of $451,000 in consulting and professional fees. For the nine months ended September 30, 2009, research and development expenses increased over the prior year period, primarily due to an increase of $898,000 in salaries, incentive compensation and allocated overhead costs as a result of additional personnel and increased overhead costs, an increase of $384,000 in consulting and professional fees and an increase of $159,000 in stock-based compensation expense.
Sales and marketing expenses for the three months ended September 30, 2009 increased over the prior-year quarter, primarily due to an increase of $448,000 in salary, commissions and incentive compensation and allocated overhead costs as a result of additional sales and marketing personnel, increased revenue and increased overhead costs, an increase of $216,000 in consulting fees and an . . .