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Executives

Tania Almond – Investor Relations Officer

John Burris – Chief Executive Officer

Todd Headley – Chief Financial Officer

Tom McDonough – Chief Operating Officer

Analysts

Nick Selby - The 451 Group

Matt Hedberg - RBC Capital Markets

Gregor Schauer - Jefferies & Company

Greg Bohlen – Wasatch Advisors, Inc.

Christopher Crowe - Pacific Crest Securities

Sourcefire, Inc. (FIRE) Q2 2008 Earnings Call July 31, 2008 5:00 PM ET

Operator

Welcome to the Q2 2008 Sourcefire, Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Tania Almond, Inventor Relations Officer with Sourcefire.

Tania Almond

Joining me today on the call is John Burris, Sourcefire's Chief Executive Officer, Tom McDonough, Sourcefire's Chief Operating Officer, and Todd Headley, our Chief Financial Officer.

Before we begin, I must remind you that statements made in this conference call and our public filings, releases and website, which is not historical facts, may be forward-looking statements that involved risks and uncertainties and are subject to change at any time.

We caution investors that any forward-looking statements made by us are management's beliefs based on currently available information and should not be taken as a guarantee of future results or performance, which may differ materially as a result of a variety of factors discussed in our earnings release and our latest Form 10-Q, filed with the Securities and Exchange Commission.

We disclaim any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments. There is more complete information regarding forward-looking statements, risks and uncertainties in the Company's filings with the SEC, available on our website.

In addition, we may discuss non-GAAP financial information on the call. This information is reconciled to comparable GAAP financial information in the earnings release. The full earnings release can be found on our website at www.sourcefire.com. An online replay of this call will be available on the Investors section of our website for at least 90 days.

With that, I will turn the call over to John Burris, Sourcefire's CEO.

John Burris

First, I would like to thank Wayne Jackson, our former CEO, for his support in my transition and to thank him for all his years of service. Thanks a lot, Wayne.

I joined the Company in mid July, so this is my first earnings call as Sourcefire's CEO. I am excited to be here and I look forward to meeting many of you in person as we plan to attend a number of investor conferences throughout the remainder of the third quarter. Because I am so new, I thought I would share a little bit of my background.

As many of you know, I have been at Citrix Systems for the last nine years as Senior Vice President of Worldwide Sales and Services. In that role, I helped Citrix grow from around 800 employees and $350 million in revenue to close to 5,000 employees and over $1.5 billion in revenue while maintaining a strong focus on profitability and channel leverage. Prior to Citrix, I worked in a variety of executive level roles at Lucent and AT&T, highlighted by three international expatriate assignments in Europe, Australia, and Hong Kong.

I joined the Board of Sourcefire in March of this year and I found myself growing more and more interested in the Company as we assessed the potential. When the CEO vacancy occurred, I was very pleased that the Board asked me if I would be interested. I want to do this because I see the potential to build something very special at Sourcefire. The building blocks are already in place. We are in the Gartner Magic Quadrant, the market is large, I have inherited a great team, and, above all, great technology. So enough about me and let us get started.

Let us do a brief review of the quarterly results. We will highlight some of the accomplishments in the second quarter, we will provide an update on trends in the business, then provide our financial guidance for the third quarter of 2008, which I am sure you will all be very interested in.

As announced in our press release earlier today, total revenues for the second quarter of 2008 were $16 million. That's 42% above second quarter of 2007 revenues. Strong results, even taking in account the relatively easy year-ago comp, gross profit increased 38% to $12.3 million, or 77% of revenues, compared to $8.9 million, or 79% of revenues, in the second quarter of 2007. And as of June 30, 2008, the Company's cash, cash equivalents, and available for sale investments totaled $104.1 million.

I believe these three data points provide the clear indication of the overall strength and direction of our business. However, our operating expense for the quarter ran ahead of our expectations. The transition from Wayne to me as CEO, while quite smooth, resulted in additional one-time charges. Additionally, we successfully went live with a significant portion of our ERP system on July 1. While I am sure you can appreciate this enormous undertaking, one that will benefit us in the quarters ahead.

Lastly, we are in the first year of becoming compliant with Section 404 of Sarbanes-Oxley Act. We have made great progress, but like most companies, have incurred costs above our initial forecast to ensure this process stays on track and provides our investors the comfort that our internal controls over financial reporting are working properly. I want to ensure investors that while top line growth is important, I am equally focused on our overall results and anticipate improvement in the trends around our operating expenses.

During the quarter, our Sales force closed 33 six-figure transactions, 13 of which represent new Sourcefire 3D product customers. We do not have any transactions in the quarter in the excess of $500,000, which speaks to the broad participation across both new and existing customers and the overall execution throughout our sales force. We added 60 new 3D product customers, while 82 existing customers made repeat 3D product purchases.

Our international sales team continued to expand their reach while delivering revenues of $4.5 million this quarter, up from $2.4 million a year ago, or an increase of 88%. Our international business provided 28% of total revenue this quarter compared with 21% in the year-ago period. Since the beginning of the year, we have added quota-carrying headcount in Australia, Germany, and the UK. Our international channel just continues to make progress.

In the second quarter in our EMEA region, we announced the new tier channel program that provides incremental incentives to our partners. This program has already resulted in our signing six new premiere partners in the region, including new territory penetration in the fast-growing markets like Turkey, the Middle East, and South Africa. We have added ten new Global 2000 customers during the quarter across industry verticals, including gas and oil, manufacturing, education, and financial.

Five of these are in the Asia-Pacific region. We continue to emphasize the importance of ongoing training with our existing channel partners, both domestically and internationally, during the quarter, training 142 individuals representing 70 partner companies on the latest enhancements to our products and services.

On the OEM channel partner front, we continue to anticipate overall full-year top line growth of over 50% and our partners performed as expected. Our OEM partner, Nokia, has agreed to be our platinum sponsor for our Best of Open Source Security or BOSS Conference next February in conjunction with our customer summit. That is in Vegas, by the way.

Federal sector performance, as anticipated, showed marked improvement over 2Q 2007 with revenues of $2.1 million, or 13% of our total revenues, versus the year-ago period of revenues of $1.2 million, an increase of 78%, year over year. This year, we have seen a very different spending environment in the federal sector than what we experienced last year when the sector was operating under continuing resolution. Our third quarter is the fiscal year-end for the federal government and we are quite optimistic that we can sustain the trend of improved results in this important market segment.

The financial sector remained a solid contributor to our second quarter results and we are actively cultivating a number of compelling opportunities. We do, however, remain appropriately guarded about the timing of financial sector transactions due to potential budgetary cuts and related purchase deferrals as this particular sector continues to work through effects of the credit crunch.

On the product front, we introduced the Sourcefire 3D system 4.8, expected to become generally available in late August. Version 4.8 will provide users with a new, customizable role-based dashboard and superior automation, continuing the Company's tradition to delivering innovative solutions that enable customers to improve their network security but reducing the overall management requirement to run it. I encourage you to review our press release on this system to understand other notable features.

Regarding our financial guidance for the third quarter of 2008, we are establishing revenue guidance in the range of $17 million to $18 million and the net loss per share in the range of $0.13 to $0.16 and adjusted net loss per share in the range of $0.07 to $0.10.

With that, I will hand the call over to Todd Headley, Sourcefire's very able Chief Financial Officer, for a more detailed review of our performance for the second quarter.

Todd Headley

Starting with the statement of operations, in the second quarter of 2008, we achieved $16 million in total revenues, which compares to $11.3 million in the second quarter of 2007, or a 42.3% increase. Total product revenues for 2Q 2008 were $8.7 million, up 43.4% from $6.1 million a year ago, mostly driven by higher demand for our enterprise class of 3D sensor products.

Services revenue in 2Q 2008 totaled $7.3 million, compared with $5.2 million in the year-ago period, or an increase of 40.9%. The increase in service revenue primarily resulted from technical support provided to our growing customer install base, which includes dozens of new 3D customers, as well as existing customers who continued to renew their annual support arrangements.

In the second quarter of 2008, our revenue composition yielded 38% from existing customer product sales, 16% from new customer product sales, 40% from reoccurring technical support services, and 6% from professional services and training. This compares with 33%, 21%, 40%, and 6%, respectively, in the year-ago period. Additionally, revenue distribution by fulfillment method yielded 61% through resellers and partners and 39% that we took direct.

Turning to cost of revenue, total cost of product revenue in 2Q 2008 was $2.5 million, which compares with $1.6 million in 2Q 2007. The increase in product cost of revenues was driven primarily by higher volume demand for our sensor products for which we must procure and provide the hardware platform to our customers.

In 2Q 2008, our product gross margin was 71.4% compared to 73.8% in the year-ago period. Gross margin for products decreased primarily due to the product mix sold being weighted more toward our lower margin sensor products coupled with an increase in the systematic write down of the carrying value of our evaluation units.

Cost of service revenue in 2Q 2008 was $1.2 million, which compares to $749,000 last year. The increase in our service cost of revenue was attributable to the increase in hardware service expense and our hiring of additional personnel to service our larger install customer base and to provide expanded training and professional services. The service gross margin in 2Q 2008 was 83.7% versus 85.6% in the year-ago period, down slightly due to our investment in the growing worldwide infrastructure to support our expanded customer base.

Total blended gross margin in 2Q 2008 was 77.1% compared to 79.2% in 2Q 2007. The 2Q 2008 figure is consistent with our overall annualized historical results, while the year-over-year quarter decrease is attributable to the previously mentioned product mix and service infrastructure investment.

Looking at operating expenses, research and development increased at $3.1 million in 2Q 2008 versus $2.7 million in 2Q 2007 and decreased as a percentage of revenue to 19.6% from 23.8%. The increase in the amount of research and development is primarily due to an increase in salaries, incentive compensation, benefits, overhead expenses, and stock-based compensation. As mentioned on previous calls, we continue to invest in product innovation to support the availability of new products and the enhancement to our existing 3D products.

Sales and marketing expense totaled $7.9 million in 2Q 2008, up from $5.9 million in 2Q 2007 and, as a percentage of revenue, totaled 49.6% compared to 52.1% last year. The increase in the amount of sales and marketing expenses was primarily due to the hiring of additional international sales personnel, additional variable compensation due to achievement of higher sales volume, stock-based compensation charges, and advertising and promotional expenses in support of our network security solutions.

General and administrative expenses were $4.5 million in 2Q 2008 compared to $2.4 million in the year-ago period. As a percentage of revenues, G&A was 28.3% in 2Q 2008 compared to 21.5% in 2Q 2007. In 2Q 2008, the G&A included $386,000 of costs associated with the CEO transition.

The year-over-year increase in G&A expense outside of this item is reflective of the necessary investment in our public company infrastructure and was primarily due to an increase of $1 million in professional service fees related to legal, audit, tax, and regulatory compliance, an increase in salaries, incentive compensation, and benefits for additional finance, IT, human resource, and legal personnel, as well as stock-based compensation charges.

In looking at all our operating expenses for 2008, we expect to incur on an absolute dollar basis more expenses in all our operating categories versus 2007. However, for research and development and sales and marketing, we expect a percentage of these expenses to total revenue to decline between years.

Full year 2008 G&A expenses as a percentage of revenue will likely increase over that experience in 2007 due to the full effect of external costs for the first year implementation and testing of our internal controls under Section 404 of Sarbanes-Oxley Act, the migration to an ERP system, the expansion of our Board of Directors, and the incremental hiring of finance and legal staff to meet the growing obligations of public filings, tax planning, and international operational support.

As John mentioned, effective July 1st, we migrated our financial reporting, human resource management, and order fulfillment processes to a hosted Oracle ERP solution. So far, the implementation is proceeding as planned and we anticipate going live with additional components and features throughout the second half of the year and into the first half of 2009.

Total operating expenses for 2Q 2008 were $16.2 million, which compares to $11.4 million in 2Q 2007, an increase of 42.7%. The increase in 2Q 2008 revenues was offset by the increase in our operating expenses, resulting in 2Q 2008 operating loss of $3.9 million. This compares with an operating loss of $2.4 million in 2Q 2007.

The Company's GAAP net loss was $3.1 million in 2Q 2008 compared with the GAAP net loss of $1.1 million in 2Q 2007. In 2Q 2008, net loss attributable to common shareholders per share was $0.12 compared to $0.05 per share in 2Q 2007. The average outstanding shares in 2Q 2008 were 25.2 million compared to 24 million in 2Q 2007.

Included in GAAP net income for 2Q 2008 was a non-cash stock-based compensation charge of $881,000 compared to a charge of $667,000 in the prior-year period. Excluding non-cash stock-based compensation expense and the cost associated with our CEO transition that I mentioned earlier of $386,000, our adjusted net loss for 2Q 2008 was $1.9 million, or a loss of $0.07 per share. This compares to an adjusted net loss of $430,000, or a loss of $0.02 per share in 2Q 2007.

For the third quarter of 2008, we anticipate stock-based compensation expense to be in the range of $1.5 million to $1.6 million. This figure now includes the stock-based compensation cost for accelerated vesting of stock awards for our former Chief Executive Officer of approximately $450,000, made effective as of July 14, 2008.

As a result of this acceleration and to take account for the stock-based compensation of our new CEO, for all of 2008, we are increasing the range of anticipated stock-based compensation expense to be $4.5 million to $4.7 million. As of June 30, 2008, total cash, cash equivalents, and investments totaled $104.1 million. As such, we believe that Sourcefire is adequately capitalized to execute on our strategic initiatives.

Given the continued market attention to potential impairments of the carrying value of investments, I think it is relevant to note again on this call that we perform ongoing detailed assessments of our investments, their quality, their performance, and a level of risk inherent in those assets.

Thus, while overall interest rates and our earned interest income are down significantly from the year-ago period, our regular investment reviews have provided us with the comfort that we do not have any impaired or high-risk assets in our current investment portfolio. In the second quarter of 2008 and through today, all inventories of our investments have occurred at their full par values.

With that, I will turn the call back over to John.

John Burris

In closing, I just want to reiterate how excited I am in joining Sourcefire as CEO. My first 18 days is focused on meeting many of our nearly 300 employees and digging into the details of our business. I do not have any baked strategy to announce today. Rather, I would work further with the team to refine our plans and we will let you know about all those as soon as we pull all those together.

At a high level, I plan to focus everyone on managing our expenses, expanding our growth through further penetrating international markets, leveraging our indirect sales channels for value-added selling, and evaluating adjacent markets we can expand into. These are not new strategies to the Company but I intend to bring my experience, perspective, and discipline to improve the execution in these areas. We will also explore various ways to put the sizable cash balance we have to work, enhancing the return on those dollars.

We are in a great position as one of the leading independent network security vendors, delivering next generation real-time adaptive security solutions. Sourcefire is uniquely positioned to drive the future of network security and be an industry leader in enterprise security. I look forward to working with my new team to unlock the unrealized value I see within this Company.

We would now like to open it up for any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Nick Selby - The 451 Group.

Nick Selby - The 451 Group

I just have a question, if you could break out a little more specifically the cost of the transition. Am I looking at, was it $386,000 plus $450,000? I am looking now at transition cost and I see some other higher numbers.

Todd Headley

The $450,000 is an expense that you are going to see in our Q3 results. The $386,000 to get to our adjusted net loss is a result of costs incurred during Q2 in the transition from Wayne to John. So those are mutually exclusive.

Nick Selby - The 451 Group

And then, during the first six months, I know, I am trying to get a total to date.

Todd Headley

Total to date in the first quarter, I believe we had expenses of somewhere around $350,000 due to the transition, mostly associated with the severance package for our former CEO.

Operator

Our next question comes from Matt Hedberg - RBC Capital Markets.

Matt Hedberg - RBC Capital Markets

First of all, congratulations, John, on your first few weeks there on the job and I guess the first question for you is, given Citrix's channel strategy and program and obviously well regarded, obviously you guys announced the new EMEA channel program. Is there anything else that you are going to be targeting here over the next several quarters to sort of from the lessons learned at Citrix?

John Burris

I think there is a huge upside here to leverage our channel partners that we have and the ones that we are going to recruit. I think there is a big difference in fulfilling and value-added selling and we want to really concentrate on knowledge transfer to our partners to really get them to be able to do an end-to-end transaction by themselves without any support from Sourcefire that is truly leveraged.

Tom McDonough and I are going to concentrate on really trying to focus on leverage with our partners. And there is nothing wrong with partner fulfilling but if you can get them to be comfortable and really invest in your Company and sell the product themselves, I mean, it is amazing what can happen.

And so, we are going to really concentrate, particularly outside the U.S., where we are really just scratching the surfaces, really just getting started, building more of that kind of model here. And I have a lot of background on that. I have got a lot of experience of what not to do so we are going to be really careful about what we are going to do here and not give up any of the gains that we already have with the go-to-market that we have right now.

Matt Hedberg - RBC Capital Markets

I guess then, as a follow up to that then, I think Todd indicated that this quarter, 61% of our revenues was from resellers and 39% direct, the backdrop with some of your channel strategy. Where do you see that going in, say, and the next several quarters or into '09?

John Burris

Some of those numbers may be broken into more of fulfillment versus, like I said, the value-added selling on the front. And lots of times, it is difficult to track that but we want to see, like I said, partners that are independent, able to work a concept and opportunity from fruition, from a lead, all the way through without any involvement from us other than when they need it and we will get to that. Like I said, it is knowledge transfer, it is them understanding our services model and things like that. Tom, you got anything?

Tom McDonough

The other thing I would like to mention here is that while we roll the program out and EMEA announced it, we have also begun rolling it out in APLA, as well. And just for your information and everybody else on the line, nearly 100% of our business goes through channel partners, internationally, today. And the 61% that Todd referred to is the highest percent of channel business that we have done, I believe, since Marty started the Company seven years ago.

So we are going to take the constructs and the architecture around that program and begin to apply it to the North American marketplace. And, as you probably know, the channels are different internationally, than they are in the U.S. so, as John mentioned, we are going to have to tweak that a little bit but we're making good progress.

Matt Hedberg - RBC Capital Markets

One other high-level question, Symantec went out with good results yesterday; McAfee had good top line results today. Now how would you assess the overall budgetary environment out there as we head into the back half of the year? And your Q3 guidance is good and you indicated you expect a good further quarter but are budgets holding up better than you expected or how do you think about corporate budgets right now?

Tom McDonough

That is a really great question and the best way for me to answer it is we see softness kind of on a case-by-case basis. We are getting good traction out of financial services, we have got good traction out of Telco, energy, healthcare, retail, and federal marketplace is looking really good.

But where we do see some spotty softness is within particular accounts and, obviously, I cannot name those but those are banks that have been affected by the credit crunch or investment banks and so forth. So I continue to remain very bullish on our prospects for Q3 and Q4.

Matt Hedberg - RBC Capital Markets

Then one last question, on the 10-gig box, any update on just the general acceptance of that so far? I remember a couple quarters ago, you had about a million dollars, I believe, in quarterly revenue there. How has that been progressing so far and just the general acceptance?

Tom McDonough

We had a number of transactions in Q2 with the 10-gig box in four different industries. What is interesting though is that customers are more interested in the 10-gig line speed rather than the actual processing speed today and I think that that is just because people are not passing 10-gig worth of traffic across their networks.

So the connectivity tends to be more important right now than the actual processing. So that market is maturing but I personally felt that it was going to be a little bit more mature than it is at this stage and, in part, that could be because people are just watching their dollars.

Operator

Our next question comes from Gregor Schauer - Jefferies.

Gregor Schauer – Jefferies & Company

I would just like to actually follow up a little bit on the prior question regarding the pipeline. We would really want to get a little bit more color on what gives you confidence on being able to realize what you have in the pipeline. And, secondly, just to get some more information about what do you actually attribute your [Audio break] what is helping you get the success that you are across the verticals, especially the financial vertical? We are just seeing a lot of difficulty at this point.

So, first off, I just wanted to follow on a little bit from the prior question. Just to get some more insight into what gives you the confidence that you have in the pipeline that you currently have, because you have given pretty good guidance on the revenue side. And then, secondly, what is it also that you think is helping you get the success that you are across all the verticals, especially in the financial sector, which has seen quite a lot of weakness at this point?

Tom McDonough

Number one is, yes, we have a pretty rigorous process for managing our salespeople and expectations for pipeline growth, which we measure on a weekly, monthly, quarterly basis, through territory reviews and so forth. We will continue to do that as part of our disciplined approach to selling and granted that the market has some softness, as I said, in particular accounts but, overall, we continue to see the enterprise invest in network security products.

As I mentioned, we saw a lot of business coming out of the financial services sector, telecom, retail has really come on strong because of the requirements around PCI and we expect those rules and regulations to continue to help our business. The other thing that has really helped us out is the fact that, for the third year in a row, we have been the leader in the Gartner Magic Quadrant category for The Most Visionary Company.

And people recognize that we provide a superior solution to our competitors and that is all based upon this intelligence and adaptive network security solution that Marty originally architected five or six years ago. So it is really a combination of those things that are giving us the confidence to give you the guidance that we have.

Operator

Our next question comes from Greg Bohlen - Wasatch.

Greg Bohlen – Wasatch Advisors, Inc.

Could you tell me how your solution could play in virtualization and whether or not you guys have thought about that market and where it might best fit?

Tom McDonough

Yes. I'm kind of snickering here, Greg. You can believe, we have talked about this a lot and Marty has been very active in terms of architecting our approach to virtualization. Unfortunately, I am not really in a position to announce what we plan to announce to the marketplace. We want to keep the competitive advantage there but I assure you that we are working very aggressively towards announcing a virtualization solution which utilizes our existing technology.

John Burris

Yes. I came from that space so it is red hot. We cannot respond to it but I think there is a huge opportunity for us to message around that so that people understand our position on it so look for something short term on that.

Operator

Our next question comes from Christopher Crowe - Pacific Crest.

Christopher Crowe – Pacific Crest Securities

I just wanted to get any more granularity in terms of federal demands, in terms of what is driving it, where you see it going into 2009.

Tom McDonough

The underlying demand in our federal business is really the President's cyber security initiative. One of the things that we are seeing is the money has actually been allocated down to the agency level. We have started out very strong in July with our federal business, as you know. Q3 is always a big quarter for us in federal.

I would say that it is higher than usual though, its rate, already this quarter and most of it is that driver. Its ongoing projects around IDS and IPS but the cyber security initiative is for real. The money has been allocated to the agencies and I think that we are finally hitting our full stride in terms of the investment that we have made in terms of our federal sales teams and support team over the last four or five years.

Christopher Crowe – Pacific Crest Securities

Perfect. What is the headcount of your guys in the sales team now?

Tom McDonough

I am not sure that I can answer that, specifically, but I can tell you that we have doubled the size of the team in the last year.

Operator

Our next question comes from Nick Selby - The 451 Group.

Nick Selby – The 451 Group

In light of these results, looking at the Barracuda offer, the hot Barracuda offer, which you guys turned down, can you just talk a little bit about some of the impetus to keep investors happy.

We have heard some people saying “hey, you know, it seems like a reasonable thing!” without barring any kind of blowing the doors off quarter or sort of stuck in the quagmire and nobody gets that out of these results. So how are you addressing this stockholder pressure and how much is there?

John Burris

I have spoken to some of our largest stockholders and they are definitely supportive of our current position on this and I do not blame Barracuda for being interested in us. We have a really great Company here with some great technology but the offers that they were talking about, they are just too low.

We just do not see that that values the Company and that does not really have any upside for our shareholders. You can see, we have the capability to provide shareholder value here, as we did in Q2, and I do not think that you have seen anything yet on what the Company is capable of as we continue to build and hit critical mass in some of the international markets.

So we would ask our shareholders to hang on, support us and that we have a lot to do. We're not opposed of selling the Company. The Company would be for sale with the proper set of terms and conditions and proper price. I think most companies would be. But the current offer and the stance and the situation right now, it is not in the best interest of the shareholders.

Operator

At this time, there are no questions.

Tania Almond

Since there are no further questions, we would like to thank everyone for joining us and for your continued interest and support of Sourcefire and we look forward to speaking with you again next quarter. Thank you very much and have a good day.

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