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Sourcefire Inc. (NASDAQ:FIRE)

Q3 2012 Earnings Conference Call

November 1, 2012, 08:30 AM ET

Executives

Staci Strauss Mortenson – Senior Vice President, ICR

Martin F. Roesch – Chief Technology Officer & Interim CEO

Todd P. Headley – Chief Financial Officer

Tom M. McDonough – President & Chief Operating Officer

Analysts

Jonathan Ho - William Blair

Joel Fishbein - Lazard Capital Markets

Jonathan Ruykhaver of Stephens, Inc

Brent Thill – Analyst, UBS Securities

Rob D. Owens – Pacific Crest Securities

Scott Zeller – Needham & Co.

Walter H. Pritchard – Citigroup Global Markets

Shebly Seyrafi – FBN Securities

Fatima Boolani – Jefferies

Operator

Good day ladies and gentleman. Welcome to the Sourcefire Inc., third quarter 2012 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host Staci Mortenson. Ma’am you may begin.

Staci Strauss Mortenson

Thank you. This is Staci Mortenson, Sourcefire’s investor relations representative. I want to thank you for joining our third quarter 2012 earnings conference call. Joining me today on the call is Marty Roesch, Interim Chief Executive Officer; Todd Headley, Chief Financial Officer; and Tom McDonough, Chief Operating Officer. Before we begin, I must remind you that statements made in this conference call and in our public filings, releases and websites, which are not historical facts may be considered to be forward-looking statements that involve 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 that was issued today and our Form 10-K and most recent Form 10-Q filed with the Securities and Exchange Commission. We disclaim any obligation to update any of these forward-looking statements or to announce publicly the results of any revision 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 at www.sourcefire.com.

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. 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 Marty Roesch, Sourcefire’s Interim CEO.

Marty Roesch

Thanks, Staci, and good morning everyone. Welcome to our 2012 Q3 earnings call. Before we begin, I wanted to take a moment to honor John Burris, a great leader and mentor and a true friend who passed away on October 19. His management style was pretty straight forward, say what you mean, do what you say, challenge the status quo, hold yourself accountable for your actions. He left us with a lasting legacy that has positioned the company to continue to succeed into the future through the collective efforts of all fireman led by a deep and experienced management team. We’ll miss John and we feel that the best way to celebrate the success that he brought us is to continue to build on it as he would have done.

In the spirit of that success, Q3 was a quarter of record revenue for Sourcefire. Our results were driven by our market leading FirePOWER platform and our increased distribution capability. We felt the same growth across all sectors of our business due to our ability to detect, understand and stop threats and do it better than anyone else.

Before hand in the call after our CFO Todd Headley, who will provide more detailed financial information including our guidance to the fourth quarter and updated thoughts on the full yea. I want to talk to you about three specific items. First, a brief overview of our financial results for the third quarter. Second, the increasing commitments by our customers and partners to our FirePOWER platform and third, a more in depth look at our threat centric approach and why we believe it will drive long term growth. Okay, first the financial results.

Revenues came in at $58.8 million in the third quarter of 2012, an increase of 30% over the year ago period and we generated adjusted net income of $7.6 million or $0.25 per diluted share. These results exceeded the top end of the guidance we provided on our second quarter earnings call. During the quarter, we saw strengths across all sectors of our business as a result of a strong adoption of our Firepower platform, our continued investment in our go-to market initiative and existing customers making a larger commitment to our solutions.

Our federal revenue grew 4% year-over-year in-line with our expectations and year-to-date our performance is very strong with revenue up 24%. We remained very well positioned with the federal government and recognized as a trusted security advisor. We have an increased level of confidence that this business can be an important element of our growth moving forward. Earlier this month, our next generation IPS was named to the Department of Defense unified capabilities improves product list enabling DoD customers to deploy our solution with even greater confidence.

Our international business improved 69% as we saw growth across all three of our non-domestic territories driven by our increased distribution footprint and greater time in territory which is our historical recipe for seeing and winning more opportunities. We will continue to monitor the macro-economic uncertainty in the European region investing there and in other territories around the globe where we see an opportunity to drive meaningful growth.

Our U.S. commercial revenue increased 31%. We have experienced remarkably consistent revenue growth in our U.S. commercial business over the first 9 months of the year that we believe reflects the continued strong demand for our solutions with both new and existing customers combined with our solid positioning and execution in the channel. Overall, we are extremely pleased to see that our product and go-to market strategies are bearing fruit.

Now, let’s move on to our results with partners and customers. We continued building additional global sales capacity by adding 32 net new partners during the quarter. Additionally, during the quarter significant partner training occurred which resulted in more partners being certified on our solutions than the previous quarter. Channel influenced deals were a seasonal 35% reflecting the strength of our federal business which, given our direct involvement with the agencies cannot be scored as channel influence, though 100% of these opportunities are typically worked and fulfilled through partners.

I would like to spend a moment on large transactions. We closed 26 deals over $0.5 million which is up from 18 in a year ago period and this figure contained several 7-figure deals including a 7-figure transaction with one of the world’s largest telecommunication companies where our next generation firewalls were selected to secure the cloud infrastructure. Q3 also saw us close 117 6-figure deals up from 87 in the same quarter of 2011. These results are significant as they validate that are enterprise customers are making larger commitments to us because of our FirePOWER platform. Enterprise class performance in scalability matter in which FirePOWER customers have the leading edge platform to enable their network security.

FirePOWER can be deployed as next generation IPS or next generation firewall and has the flexibility for expansion by turning on incremental capabilities for your license keys. This quarter, we are introducing a new license option to expand the capabilities of our FirePOWER platform and a network based advanced malware protection that provides visibility control of malware throughout the network both in real time and retrospectively. To give you some perspective on the potential of FirePOWER to drive long-term growth, we have seen very strong product adoption over the past four quarters, yet as of end of Q3, the FirePOWER platform represents less than a quarter of the units in our installed base. So, we still have a lot of opportunity in front of us.

Let’s move on to our threat centric approach. As Sourcefire, we believe that security today is about understanding, detecting and stopping threats. This threat centric philosophy has been the driving principle behind the development of our solutions and has resulted in consistent recognition by NSS labs that Sourcefire products are the most effective network security solutions on the market, more on that in a bit. The need for a threat centric approach to security is more necessary than ever today. Attackers will use any method available to them to break into an organization in today’s rapidly evolving network environments regularly present them with new opportunities. The security industry has traditionally produced technologies focused primarily on policy enforcements and access control, the notion being that you can effectively secure all routes and devices in an environment to make them hack proof. This reassures that this notion is patently false. Policies and controls are important, but they are only a piece of the overall security puzzle. Why? Because vulnerabilities will remain and threats will get through.

Today’s sophisticated threats require a broader approach to security. One that does more than attempting to secure an environment before an attacker arrives, on that also provides significant capabilities against modern threats during an attach or even after an attack has been successful. The approach needed is one that addresses the full attack continuing – before an attacker shows up during an active attack and after there has been a compromise.

Our threat centric approach is a key differentiator for Sourcefire and a primary driver of Our Agile Security Vision. Visibility into and awareness of all aspects of a protected environment, it is a foundation of our approach. We cause the ability to see, our FireSIGHT technology enables our customers to see more of their IT environment, network, threats, devices, applications and users than others in the market. And once you see it, you can protect it and control it.

Today’s rapidly evolving network, endpoints, mobile and virtual environments place a premium on the ability to see everything so that information superiority can be established over attackers and threats can be effectively addressed for or during and after an attack.

One final comment before I turn the call over to Todd. I am pleased to announce that the FirePOWER platform running our next generation firewall solution excelled in the most recent NSS labs independent next generation firewall product analysis. This analysis represents the industries’ most rigorous NGFW testing available today and the results speak for themselves which set new standards for security effectiveness protecting against 99% of all attacks and we demonstrated superior performance and best in class total cost to ownership. We also scored 100% on firewall enforcement, application control, identity and user awareness.

Additionally, with all features turned on and with real-world traffic throughput we achieved performance of 10 gigabits per second meeting our stated performance on the tested appliance. This thorough analysis validates our approach to next generation firewall and demonstrates performance consistency across our NGIPS and NGFW solutions running on our FirePOWER platform.

With that I will turn the call over to our CFO, Todd Headley.

Todd Headley

Thank you Marty. By now I assume that you’ve seen our earnings press release with the attached financial statements and other significant metrics by which we measure the progress and success of our business. I will highlight some of these results for you, talk about some trends and end with our guidance for Q4 and the full year of 2012.

On the revenue front as Marty indicated we had a record third quarter. Total revenue of $58.8 million represents the 30% increase over the third quarter of 2011. We believe this indicates continued strong global demand for our solutions, the successful execution of our go-to market strategy and excellent customer retention and expansion. Our federal government business reported revenue of $16.4 million in the quarter up 4% over the year ago quarter. Year-to-date, our fed business has achieved $34.6 million in revenue which puts it 24% ahead of the first 9 months of last year. We are encouraged by these results and believe they indicate that we remain well positioned as a trusted cyber security advisor to the federal government. Both our U.S. commercial and international businesses saw continued momentum and significant growth during the third quarter of 2012. Over the year ago period, U.S. commercial revenue increased 31% to $24.7 million while international revenue increased 69% to $17.7 million. These strong results were driven by our best in class solutions running on FirePOWER, the enabling platform that Marty talked about earlier and the effective execution of our growing sales channels.

Looking at our two revenue lines, products and services. In Q3 of 2012, we saw significant growth for both over the year ago period at 33% and 25% respectively. During the third quarter of 2012, our sales force and partner channel combined to close 108 new product customers. Both new and existing customers are making larger commitments to us. As Marty previously noted we had a 117 6-figure transaction and 26 transactions in excess of a $0.5 million. Both figures represent significant year-over-year increases. We are having great success expanding across our client base and owning more of their security budgets. Also, this quarter new customer product revenue was second only to Q4 of last year which shows that new customers are making greater initial commitments to our platform. Overall, we believe we are well positioned to capture future revenue growth. Okay, turning to gross margins.

Product gross margins for the third quarter of 2012 was 71% or identical to the year ago quarter. For the first three quarters of this year we have seen product gross margins of 67%, 71% and 71% respectively. On a trending basis, these margin figures are a point or two below our historical attainment due to the cost of the FirePOWER platform and the FireAMP infrastructure which we introduced earlier this year and it is highly influenced by product mix. We anticipate that our product margins will vary somewhat for the next few quarter as we complete the FirePOWER platform rollout at the low end this coming quarter and ramp up our advanced malware protection business for which revenue recognition occurs on a subscription basis. Services gross margin in the third quarter of 2012 was 87% compared to 88% in the year ago quarter. For the past 11 quarters the services margin has consistently run between 86% and 88%. The predominant portion of our services business continues to be maintenance and support provided to an expanding customer base. This is complemented by a modest amount of professional services and training that is targeted at the certification of a knowledge transfer to our growing distribution channel.

Total blended gross margin was 77% for the quarter which compares to 78% in the third quarter of 2011 and on a trending basis we have achieved 76% to 77% for the past four quarters. As we have indicated on recent calls we believe that our blended gross margins would face some pressure this year versus the levels attained in comparative year ago period. As I just indicated, this is due to the inclusion of the FireAMP infrastructure, the average underlying cost of the FirePOWER platform versus the former hardware platform and additional channel enablement investments. We believe that this is playing out according to our expectation and that is a 76% to 77% level for blended gross margin should be considered are new normal.

Now, let’s move on to operating costs. Please note these are GAAP figures and thus include non-cash stock based compensation charges. Total operating expenses for the third quarter were $41.1 million an increase of 30% over the $31.6 million in the third quarter of last year. We continue to invest significantly and product innovation and our go-to market activities and also in every other area of our business to support our significant growth and international expansion. As of the end of the quarter, we had 560 employees. In the past month, we have hired about two dozen more and as of today we have over 60 open positions worldwide. Overall, given the focus on adding appropriate head count we expect aggregate spending to continue to increase when you look at us on a sequential quarter basis.

Now let’s take a closer look at operating margins, net income and EPS. In the press release we issued this morning figures are included in both GAAP and adjusted or non-GAAP form and we show the nature and amount of the items that are excluded when arriving at our adjusted results. I want to highlight some of these adjusted figures which we believe are meaningful indicators of trends in our business. Adjusted operating margin for the third quarter of 2012 was 20% versus 19% in the year ago period. As we have stated in the past and is still true today, we are most focused on driving significant and sustainable revenue growth while from an operating margin expansion perspective we plan to deliver modest improvements. Our internal operating posture is such that we look to invest revenue upside back in to the growth of the business. This past quarter we did exactly that. Adjusted net income for the third quarter of 2012 was $7.6 million or $0.25 per diluted share compared to $5.7 million or $0.19 per diluted share for the third quarter of 2011.

Let’s take a brief look at taxes. Based on our current projections and given the amount of our net operating loss carry-forward for tax purposes we do not anticipate being a cash payer for federal tax purposes in 2012. This past quarter we continued with the rollout of our international tax structure and as we anticipated we felt some favorability in our GAAP tax rate as we were not able to fully benefit from the revenue stream of service contracts originated by our international entity. We expect our GAAP tax rate to vary for the next few quarter, however, as we’ve done in the past we will continue to normalize our adjusted quarterly results to reflect an overall assumed tax rate of 35%. For the third quarter of 2012, we generated $3.7 million in cash from operating activities and spent $2.1 million on capital expenditures resulting in free cash flow of $1.6 million. Due to seasonality trends around our account receivable balance we typically generate our most significant free cash flows in our first and fourth quarter so this modest cash flow figure was anticipated. As of September 30, 2012 cash, cash equivalents and investments totaled to $188.5 million.

Turning to guidance, for the fourth quarter of 2012 we expect revenue in the range of 62 to $64 million, net income per diluted share in the range of $0.03 to $0.05 and on an adjusted basis net income per diluted share in the range of $0.27 to $0.29. Our expectation of adjusted net income per diluted share exclude stock based compensation expense for the fourth quarter in an expected range of $10 million to $10.2 million and the amortization of acquired and tangibles of approximately $0.3 million and it assumes a normalized tax rate of 35%. Included in our fourth quarter stock based compensation expense is $3.7 million related to the accelerated vesting of John Burris’ restricted shares as outlined in his retirement agreement filed in our 8K on October 2.

Based on our fourth quarter guidance, we now believe we can grow our topline by approximately 32% for the full year over 2011 and regarding our adjusted operating margin we now believe that we can deliver approximately 150 to 200 basis points of improvement for the full year over 2011.

With that operator we would like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jonathan Ho of William Blair. You may begin.

Jonathan Ho - William Blair

Congratulations on the strong quarter. So, my first question is on the international growth. Can you guys give us a little bit more color on the individual sub regions and how they performed and maybe an update around the number of distribution points that you typically gave in the call.

Marty Roesch

Sure, I think Tom McDonough would be the right guy to address that one.

Tom McDonough

Yeah. Hey Jonathan. Really, we had very consistent growth across all of our international regions. There was no region that really stood out in terms of dollars or transactions. We had good growth rates, we had good pipeline expansion, so it was really very solid performance across the board.

Jonathan Ho - William Blair

Got it and just in terms of the federal government, with the potential of the sequestration coming down in the next quarter or so, are you guys seeing any potential impact there or any concerns around spending pace at the DoD relative to your business?

Marty Roesch

Yeah, we haven’t had this time again, we haven’t had any indication of that thus far. In many ways we are a trusted advisor to the federal government. We’re built into many many large programs that include cyber security that is not to say that we are totally insulated from any changes in government funding, but we are pretty confident moving forward that we’re in a good position with fed as Marty said.

Jonathan Ho - William Blair

Thank you.

Operator

Our next question is from Joel Fishbein of Lazard Capital Markets, you may begin.

Joel Fishbein - Lazard Capital Markets

Good morning and my condolences to you and John’s family, first of all. Question around the, any color you can give around the telco win with the next-generation firewall will be really helpful in terms of how large it could be potentially and also in terms of the bake offer competitive situation there.

Marty Roesch

Sure, that is once again in the sales arena, so over to Mr. McDonough.

Tom McDonough

Yeah Joel it was a very very competitive deal, large telco service provider, we did a bake off with several of our competitors and based on the performance of the FirePOWER platform we came out on top once again. So, it was a huge win for us and it really I believe is just the beginning of an opportunity within this account. So, we are going to see some really great growth out of the account over the next couple of years.

Joel Fishbein - Lazard Capital Markets

Right, thank you.

Operator

Thank you. Our next question is from Keith Weiss from Morgan Stanley. You may begin.

Gorham[ph] - Morgan Stanley

Gorham[ph] calling in for Keith Weiss. Thanks for taking my question. I have a question on distribution, you mentioned that you added 35 more partners. Can you just talk about where you are adding distribution, is it still internationally focused and are there any limits on your ability to add partners at this point.

Marty Roesch

Yeah, great questions. We actually we added 32 new partners during the quarter and again that is net new partners. One of the things that we’ve done over the course of the last couple of quarter has increased the requirements in the biding process for new partners. We want to make sure that the partners we bring on board are capable of selling our solution because we are making any investment in them and if they don’t have the capability then we are really burning up cycles. As far as the distribution of it goes, it’s pretty evenly across the board on a percentage increase to tie her internationally than it is in the U.S. because we have smaller numbers to work with. So, we are pleased with the progress that we are making, the number of large deals that our partners closed in the quarter was the highest ever and they are driving their ASP up. So, we are really pleased performance that we’re getting out of the partner base.

Gorham[ph] - Morgan Stanley

Okay, that is helpful thanks and then on the FireAMP product, can you may be provide some more color and he compete with mostly, with that solution and is the mostly anti-year existing base right now that you are selling the project in to or you seeing new customer adoption with FireAMP. Thanks.

Marty Roesch

This is Marty, we are seeking both new and existing customers adopting the product. Competitively speaking it is actually, the technology has pretty broadened scope, so it potentially competes with a variety of technologies from kind of classic anti-malware systems through newer types of technologies that are primarily dealing with embedded malware and environment and things like that. We have evals and progress all over the place and what we see frequently is we see it used in places where people are thinking about new strategies around dealing with malware that is being introduced in our environment. The enterprise that we frequently see it deployed is places that have figured out they’ve already got malware, their existing tools aren’t capable of kind of scoping where it’s gotten to and getting it out which is another great application that technology is capable of understanding things about your environment even after a compromise in giving you the tools to get an infection out. So, we are kind of it is spanning a lot of areas of utility and customers are signing pretty interesting things to do that, but it is really gotten to the point where we’ve seen it really kind of going in two directions. One, for people who want to better chance of securing their environment ahead of attacks and the other place where people already have active infections, they don’t have any existing tools that can clean it up. And, interesting thing about it is that now with the amp for the FirePOWER platform that we have coming up this quarter is we are going start tying it into our ability to control the network as well. So, we’ve got some really powerful capabilities that are coming online here with this technology.

Gorham[ph] - Morgan Stanley

Got it. That is very helpful. Thank you guys.

Marty Roesch

Welcome.

Operator

Thank you. Our next question is from Jonathan Ruykhaver of Stephens, Inc, you may begin.

Jonathan Ruykhaver of Stephens, Inc

Hi guys. Good morning. When you enter into sales discussions around next gen firewall it seems like there could be a number of different drivers to those conversations including a use case, for example around access control or in application control and then a specific use case around the need for full network visibility and security at high performance. Do you see situations with those conversations are – I won’t say mutually exclusive, but one feature more important than the other driving the opportunity or our organizations taking those features all into account when evaluating next gen firewall.

Marty Roesch

Hi Jonathan, it is Marty. The – what we largely see with next gen firewall adoption is that it’s project date, so they have a project who’s specific list of requirements that’s in play. I think that the thing that is kind of driving the buzz around next generation firewall is the application control capabilities so, that is what we see emphasize in a lot of these deals, is the ability to start getting a grip on these applications, but the thing that they like about our approach too it is that it is also comes with a full strength IPS and in fact the best IPS out there and it comes on an appliance that posts our performance numbers and nobody can touch. So, I think that kind of the combination is what we’re seeing driving the interest in ours, but from a buying perspective, the fact that you can get application control with the most capable IPS is something that I think is driving people to look at our system.

Jonathan Ruykhaver of Stephens, Inc

Okay, just one following question. When you look at the pipeline activity around the FirePOWER platform relative to NGIPS and next-gen firewall, should we expect a growing portion of sales activities we enter next year to be driven by next-gen firewall or will be majority of the pipeline activity remain centered around your IPS in the next-gen IPS?

Marty Roesch

Well, I’d say that it is going to be largely, for us, centered around IPS for starters. I think the way people are approaching is that we typically interact with, you see them starting up with IPS deployments and then turning on license keys to bring the additional functionality to bear where necessary and we are of course very comfortable with this approach to getting access to the market because it plays to our strength.

Jonathan Ruykhaver of Stephens, Inc

Right. Okay. Good luck, thanks.

Operator

Thank you, our next question is from Brent Thill of UBS Securities, you may begin.

Brent Thill – Analyst, UBS Securities

The overall demand environment we’ve seen a lot of other tech companies say things that it is soft and obviously your results don’t suggest that in the forecast for Q4. Can you give us a sense of your confidence and what you are seeing in terms of numbers you gave on the pipeline, why you think he may be seeing something a little different than the others are seeing right now, thank you.

Tom McDonough

Dear Brent, this time I’ll take that one. It really comes back down to the fundamentals. It’s this increased footprint we have from a distribution standpoint. Secondly, it is time and territory that we have. We have a lot of sales people and channel folks that have been with the company for a long time and those relationships are really beginning to pay off for us and frankly the third one once again is just FirePOWER, I mean we are getting so many inbound requests to try the technology out or our partners identify these opportunities or we do. And I think as Marty said during his script we have only replaced about one quarter of our installed base with FirePOWER platform so just that in and of itself creates a huge opportunity for us.

Operator

Thank you. Our next question is from Rob D. Owens of Pacific Crest Securities. You may begin.

Rob D. Owens – Pacific Crest Securities

Great. Thank you and good morning. Todd, I want to ask a little bit about the differed revenue in the quarter and I think the sequential build in deferred wasn’t quite what you had seen over the last couple of years. Is this the function of a more linear federal year, is it timing or is there something else in that number?

Todd Headley

No, I think you hit the nail on the head. Rob is – a year ago the way he said business came in, it was really significant in Q3 given the continuing resolutions in the quarters that preceded it. We had a more normalized spending environment in fact this year and business came in more ratably earlier in the year. We still had our largest quarter as we expected here with the budget flush in Q3, but I think that is a predominant driver since a lot other renewals in fed do occur in Q3.

Rob D. Owens – Pacific Crest Securities

Great and then the second question as you think about 2013 though I am sure you won’t give any guidance. Can you talk a little bit about new products and potential contribution either from the next-gen firewall/IPS the new mid market low end products or FireAMP?

Todd Headley

Sure and I think you’re right. We are not going to really talk about 2013 yet, we will in the next call to get the above perspective where we are kind of towards the tail end of our planning process. So, we’ll have that refined probably in the next 60 days here. If you think about next year from a higher level perspective we have multiple products that are now on the market again as Marty indicated in his remarks where we are going to have advanced malware protection running on FirePOWER as a license key on a subscription basis that comes out shortly. So, we think we have a number of drivers to continue to sustain really meaningful revenue growth and when you take a look at our distribution footprint and how we’re investing into that we believe we’ll get more at bats in opportunities that we had previously seen before especially as the lower end of the FirePOWER platform gets introduced later this quarter and we believe the channel can take that into accounts that we just didn’t have the bandwidth to call on. So, for us this presents a pretty significant opportunities not only for 2013, but into 2014 as we grow all of these businesses and sell all of our solutions to those customers and gain their trust. I think as Tom indicated, we are a trusted advisor in the federal government we want to maintain that all around the globe in terms of the type of the solution that we are bringing and again I think Marty’s threat centric approach is what is really resonating with customer. We have a significant problem today, they need real solutions not a feel good solution and we are delivering that.

Rob D. Owens – Pacific Crest Securities

Great. Thank you.

Operator

Thank you. Our next question is from Scott Zeller of Needham & Co. You may begin.

Scott Zeller – Needham & Co.

Hi, good morning. Thanks. So, I know Rob didn’t want to ask about ’13, but I’ll try anyway maybe you could tell us a little bit about your seasonal expectations just at a high levels for maybe to start off the year?

Todd Headley

Sure. This is Todd again. So, let’s kind of take up the product revenue and the services revenue separately from a services perspective we grow that business on a sequential quarterly basis and that is because we have a larger install base and we have significant renewal rates amongst that install base. And so very predictably that grows quarter-over-quarter. On a product front, what we have seen historically is a level of seasonality and that from the hike in Q4, it gets a little bit in Q1 and it starts to build throughout the year. We do get the federal year end in our Q3 that tends to be a driver that is of a good part of the increase there over Q2. And then we get to Q4 if you take a look at global multinational corporations U.S. entities, they tend to have a calendar year budget, and there tends to be maybe not call it a flush, but there is a lot of spending on technologies that occurs in Q4 and I think that is similar to other technology companies. So, we think from a product revenue perspective you are still going to see what I would describe as our normal seasonality tends to be about 40% of our product revenue occurs in the first half of the year and 60% in the second half of the year. It is going to take a little while as our subscription based businesses ramp up for that maybe to change by a couple of points, but that is certainly what we are looking for over time.

Scott Zeller – Needham & Co.

That is really helpful. Thank you and one question about federal, I know there is one earlier, but just to get a little more color. Did you find that there was obviously the performance is good, but did you find that there was urgency to flush and spend for some of the larger projects or did you find that a lot of the revenues coming from larger projects and it is concentrated now with some of the agencies just some color about the behavior please in federal.

Tom McDonough

This is Tom, I’ll take that one. As Todd talked about, there was definitely a seasonal budget flush with the feds and we closed some very large opportunities several of which were new, but all the other business was pretty evenly spread out. So, there wasn’t really a change in behavior over what we’ve seen in prior Q3s.

Scott Zeller – Needham & Co.

Thank you very much.

Operator

Thank you. Our next question is from Walter H. Pritchard of Citigroup Global Markets, you may begin.

Walter H. Pritchard – Citigroup Global Markets

NGFW side, but could you give us a sense maybe more quantitative or metrics around your success so far with the NGFW product?

Todd Headley

Sorry Walter, your question got cut off at the beginning, we missed it.

Walter H. Pritchard – Citigroup Global Markets

Oh got it. So your NGFW product – you talked about the telco win, it was a large win and I guess I am wondering if there is any other evidence you can give us overall of deal volume, customers that help us understand at this point your success with the NGFW product.

Todd Headley

Sure. We’ll let Tom speak to that one.

Tom McDonough

Yeah. Good morning Walter. What I can tell you is this that we had a significant increase in the number of NGF firewall transactions in Q3 versus Q2, great indicators are pipeline growth, the number of evals that we are doing more than the half of the NGFW transactions that we did in Q3 were with new customers. So, I think we are doing really well and I was actually a little surprised at how many NGFW transactions we did in Q3. I didn’t think that it would grow as fast as it did, but that is a good indicator of how competitive the product is and I think the NSS results kind of validate that as well.

Walter H. Pritchard – Citigroup Global Markets

Got it. And then, Marty, just on the CEO search status, understanding these things may be hard to predict and so forth, but any update there and any sorts of things to watch in terms of the process you are going forward.

Marty Roesch

We don’t really have any updates at this time, but the process is underway and we’ll update you when we have something to discuss, but it is just in progress right now.

Walter H. Pritchard – Citigroup Global Markets

Okay, great. Thank you very much.

Operator

Thank you. (Operator Instruction) Our next question is from Shebly Seyrafi of FBN Securities. You may begin.

Shebly Seyrafi – FBN Securities

Thank you. Related to that prior question, can you provide a quantification perhaps of the percentage of next generation IPS transactions, FirePOWER transactions with the next-generation firewall license turned on, what was that in Q3 and how did that change perhaps from prior quarters in relation to that it is the next generation firewall business that you see it enough to swing the needle right now, or is it just still very early stages? Thanks.

Todd Headley

Shelby, this is Todd. We don’t get that granular when we get in front of our customer and when our partners get in front of customers what we are doing is having the whole discussion about the kind of issues, the customer, the end user, is having with regard to securing their network. And that conversation can run from just standard IPS discussion all the way up to the requirement for needing what is in next generation firewall. What we are seeing at a 25,000-foot level is that those conversations have gotten more significant and meaningful and we are seeing greater traction in terms of uptake of what we call our control license so that if a customer bought the FirePOWER platform a year ago and we continued to talk to them about their issues they may have purchased a controlled license running on that FirePOWER platform to turn on the incremental functionality that Marty talked about. So, this is how we go to market we have a discussion about their issues and what they have budget for today what their immediate needs are and what they understand is that the FirePOWER platform adds a tremendous amount of flexibility through the implementation of license keys down the road to continue to augment that solution. So, it is becoming an increasing contributor I would say to our overall revenue dollars, but again when you take a look at that control license is the mere 10% uplift to our standard IPS pricing. So, if you buy that say a quarter two later the dollars don’t feel as big to guys like you, but to us it’s very meaningful to the customer. It’s obviously very meaningful because now that FirePOWER platform is running as a full NGFW.

And again, I think that is perhaps unique as to how we’re approaching this market opportunity versus some of the competition but we think it served us well and it served the customer well given the flexibility.

Shebly Seyrafi – FBN Securities

Separately, I was impressed by your large deal activities, 26 deals over half a million. Can you quantify the number of deals over $1 million this last quarter and how that trended?

Todd Headley

Well this is Todd again, we’re not going to get too granular into how many of those were 7-figure deals, what we would like to offer is that every quarter we have a handful of 7-figure transactions and when you look at our pipelines. We have a number of 7-figure transactions again when you look at the fidelity of the performance of the FirePOWER platform certainly at the high end of our solution set you are talking about going in to global enterprises that have pretty significant networks and it is pretty easy to get into the 7-figure transaction echelon. It’s where we’ve tended to do best given the performance of our solution and I suspect we’ll continue to focus on that as well as go a little bit further downstream once the channel gets the FirePOWER at the lower end of the solution set later this quarter.

Shebly Seyrafi – FBN Securities

Thank you.

Operator

Thank you. Our next question is from Aaron Schwartz of Jefferies. You may begin.

Fatima Boolani – Jefferies

Good morning. This is Fatima Boolani on behalf of Aaron. Just two quick questions from me. Your services gross margin in the quarter came out very solid in spite of the expected additional re-investments and so was your other subscription products and subscription revenue streams building. Could you help us with your longer term outlook here for this services gross margin specifically?

Todd Headley

Sure, this is Todd. Just to be clear, the subscription based business will show up in our product revenue and not our services revenues. The services revenue is again predominantly maintenance and support services provided to a growing install base which is why it makes it very predictable and then that is complimented by a modest amount of professional services and training which customers participate in, but is also very very focused on our partners in order to get that knowledge transfer to them regarding our solutions as well as the certifications necessary to maintain the partnership here with Sourcefire. So, that becomes very predictable because we continue to sell products to new customers and the customers that we’ve already landed we’ve tended to expand our footprint inside those customers and so with high renewal rates again that services revenue becomes very predictable. We continue to invest in more personnel to do the certifications, the training and to support our customer base, but we are doing so at a rate that allows us to stay within that 86 to 88% margin threshold on that business.

On the product front, as we talked about, that is a little different, that is subject to product mix and again as we said some things that are in play for this year is the fact that we have the advanced malware protection infrastructure that we introduced at the beginning of the year that is up and running. And we’re absorbing the full cost of that as the revenues ramp up on a subscription basis and then the FirePOWER platform itself is a little bit more costly than the predecessor platforms, but given the performance capability we’re very comfortable in terms of where that is coming up.

Fatima Boolani – Jefferies

Okay and now perhaps shifting gears into FireAMP and the product traction there, you spoke a little bit to that, but we’re just curious if there is any particular verticals that you’re seeing more broader at options and this is regarding the FireAMP product.

Marty Roesch

Hi, this is Martyi, We’re actually seeing it across all verticals, it is interesting as much like other technologies that it does kind of have value across all verticals, but I’ve seen fair amount of utilities actually embracing the technology early. They see the value for keeping a lid on malware and their environments for example, but really we're seeing broad-based adoption not just in terms of the industries, but also in terms of geographies it is being picked up pretty much around the globe as we go to market we’re seeing great growth in our pipelines as we have been moving forward with the product as well. So, we’re very pleased with how it is progressing so far.

Fatima Boolani – Jefferies

And a very last one for me, if I could. Just relating to the advanced malware capabilities that you will be introducing on to the FirePOWER platform you spoke to it being sort of a licensed key upgrade. Does that preclude customers from purchasing the FireAMP end point product separately if their integration that will be had in the coming quarters if you could just provide some color on that it would be really helpful and that is it from me, thank you.

Marty Roesch

So the FireAMP technology on the FirePOWER platform is actually very complementary of the end point technology. In fact, we like to say they're better together, because what they do is they allow us to extend the visibility that we get from the FireAMP technology to network activity as well and we also have some features that are coming up there going to allow us to marry the view that we get from the connector technology that we used with mobile virtual and end point FireAMPs to the network picture that we get. So, he’ll be able to have visibility not just into malware activity that we see going on around the network, but if you decide you need to trace something back if you are in incident response mode or trying to figure out a malware infection that you’ve got you’ll be able to see where the granularity right down to the process of what processes on computers are generating flows on the network and being able to map back and forth between our network and end point based capability.

We believe this feature set and this set of is extremely powerful, and this is really the first time that you’ve been able to bring this data together under one roof where from the network level view. If I am sitting at the IPS counsel and I want to know, gee, what is generating this traffic on the network. I can map this right down to not just the computer that it’s coming from, but I can map it back to the executable that’s generating the flows on the network. Nobody’s ever been able to do that before with this kind of seamless integration between endpoint technologies, network technologies. So, we are very excited about getting his technologies in the field together. And we believe that once people see what they are capable of doing that they are going to launch them to operate better together. So, we think we’re lined up for a lot of success from these areas.

Operator

Thank you. I am sure no further questions at this time. I would now like to turn the conference back to Staci Strauss Mortenson for closing remarks.

Staci Strauss Mortenson

Okay great, since there are no further questions we would like to thank everyone for your continued interest and support for Sourcefire and we look forward to speaking again next quarter. Have a great day.

Operator.

Ladies and gentlemen, this concludes today conference. Thank you for your participation. Have a wonderful day/

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