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Proofpoint Inc. (NASDAQ:PFPT)

2013 Wedbush Transformational Technologies Management Access Conference Call

March 6, 2013 10:55 am ET

Executives

Gary Steele – Chief Executive Officer

Paul Auvil – Chief Financial Officer

Analysts

Sanjit Singh – Wedbush Securities, Inc.

Sanjit Singh – Wedbush Securities, Inc.

All right. Good morning, everyone. We have Proofpoint at our conference here. I’m Sanjit Singh, Communications Analyst with Wedbush. Gary Steele, the CEO of Proofpoint is joined with Paul Auvil, the Chief Financial Officer. I think as we go over the presentation, I have a few questions and we’ll turn it over to the audience for Q&A as well.

Gary, go ahead.

Gary Steele

Great. Thank you very much. It’s great to here today. What I’ll do is just give you a very quick short overview. So Proofpoint is a company that is focused on the $5 billion data security market and we’re using SaaS to truly transform that industry with a whole set of new disruptive technologies and we’re seeing great residence across our customer base.

If you look at our business today, we have roughly 2,700 customers. We focus on midsize and large customers with many of the world’s largest and most brands as customers today. We have some key partners. Microsoft, IBM, VMware being good examples of that. Microsoft, for example, resells part of our solutions to their largest cloud customers. IBM has a resell rate of relationship with us where they have the ability to resell all of our products across the globe.

If you look at our revenue and growth, our annual growth rate has run roughly 33% and we continue to be recognized in industry as a leader. So Gartner has its place, for example, and the two major quadrants where we play. We are considered a leader in those quadrants. We also get great feedback from the industry price as well as customers be a way for example it’s been a longstanding customer. They actually rank all their vendors on a scale of one to 100. Last quarter we got 100 and it’s difficult to get 100.

So to give you little bit of perspective on the capabilities that we deliver, we deliver a broad platform of capabilities broken into four key product areas. The first key product area is protection. This is where we got started in the business. In this particular context, we’re looking at spam viruses and other forms of malware coming into an organization. We’re protecting our customers from that. We’re blocking it before it ever gets to their inbox.

So the way this works today in our datacenters is, as an example, we have a retailer that employs 2 million people. All the email from that global organization goes into our datacenters. We run our analytics and email that’s coming through. We determine what is potentially malicious, what is just truly unwanted and then we route back to that retailer a clean email stream.

In this category we’ve also introduced a new capability. We introduced it in August called Targeted Attack Protection. This is focused on the most malicious advance for system threats coming into an organization. We’re leveraging our strength and the email strength to look for spear phishing and it’s interesting. We had one of our large financial services customers do an analysis on their threat environment and they found that in a quarter, 91% of the malicious attacks had come through the email stream.

So with this particular capability effectively what we do is we look for URLs and email. When we see the URL, we use a set of big data techniques that determine whether something is potentially malicious. We actually rewrite the URL in the email and with that rewrite we’re able to redirect that user to our cloud-based service. And so, at the time the user decides to click on it, we can determine whether something is malicious or not.

And so what’s interesting and cool about this is, because we analyzed the URL for malicious code at the time, that someone clicks, we can protect people out enough of their corporate network, because a lot of times people do not want to be on their VPN. They want to be sitting on their hotel bed with their iPad, reviewing their email and then they click at that time. Well, we’ll protect you then and we’ll also protect you when you’re in corporate network.

So this is a new capability for us. We announced in August, we had a first full quarter selling in Q4. In our Q4 conference call, we announced that we’ve closed several of those customers. So it is one that is clearly creating a lot of value for customers and getting people excited.

Second key product area is privacy. So with privacy, we’re helping organizations deal with our compliance initiatives as it relates to private data; private data meaning, banking information, health information, a range of data that they want to be kept proprietary and private. We provide a policy engine that controls or lease the organization. But if they want to send that private information over the Internet, we give them two ways to do that. One is with encryption. So they can send all the way to an end-user in an encrypted format.

We also announced in January a new product capability called Secure Share. Secure Share is a capability to allow for fast, secure file sharing over the Internet as well. And so, what is interesting and exciting about this new capability is we’re doing within the structure of the security policies. What’s driving CIO’s net today is people are taking essentially corporate data, data that needs to be managed and secured and they’re sticking into drop-offs and that are called file sharing techniques, but not within the compliance of their security policies. So that’s a new capability that we just introduced as part of our privacy suite.

The third key area is archiving. So we capture all forms of enterprise information, whether it’s email, whether it’s SharePoint, whether it’s files, whether it’s social post we capture that information for the purposes of eDiscovery and compliance. And what is interesting here is this is 100% cloud-based service where we’re delivering disruptive economics to a market that is traditionally been on plan.

What has traditionally happened is people had to meet these requirements. They went about software from a large vendor. They then went in part of that storage and they managed this all themselves. We built an entire storage stack in the cloud leveraging commodity components that ultimately has driven prices way down in terms of the value we can deliver and this is a market that clearly is at the early stages of moving from on-premise to the cloud.

And finally, the final product area is our governance solution. So governance helps organizations manage unstructured information as it lives across the enterprise. People want to do this, because they want to know where sensitive information lives and they want to be able to control it and retention policies around it. So good example here is McKenzie uses a solution as it relates to particular engagements. So you think about a large engagement, you’re going to have many consultants involved. You’re going to generate a lot of working papers. At the end of that engagement, they want to know what is the data that they ultimately want to keep and they want to move to central depository and where is the information they actually want to lead, because not having a true cleaner process actually creates liability and risk for the organization.

So these are the four product areas that we sell today. All this is based on our big data capabilities of lending out cloud. When we talk about big data that’s just a buzz where we’ve been big users of the open source stack and dupe. We’ve been using it for about four years. It is what enables us to determine and identify threats and we see all kinds of information from all kinds of sources that then helps us with the analysis that we can do. In real-time we’re able to better, help protect our customers. That tells all of that capability runs in our cloud. When we talk about our cloud, we run six data centers. These are third-party data centers that we established in the U.S. We use [Tall City] in Europe, we use Verizon in Canada. We run everything in pairs and we build an architecture that enables us to run wide across those various data centers. So, rather than having a classic sale of environment, we actually run wide across data centers. So we can deliver at a very high level of redundancy and deliver that with the value of financially backed SOAs.

So that’s a quick snapshot of product and I’ll just give you a sense on financials of the skip forward here so that we can get to other topics. So we announced our fourth quarter at the end of January. Subscription revenue grew 29% to $27.5 million. Subscription, as a recurring business, 96% of our revenue is subscription and 4% are one-time items. We had billings growth of 37%. We generated free cash flow for the full year of $2.7 million and we have a very strong balance sheet. We went public in April of last year. The balance sheet today is roughly $87 million.

And so with that, we can open it up for questions.

Question-and-Answer Session

Sanjit Singh – Wedbush Securities, Inc.

Thanks, Paul.

Gary Steele

Gary.

Sanjit Singh – Wedbush Securities, Inc.

Sorry. To kind of level up the conversation, once you talk about the size of the market, about the messaging market as well as the archive market, what the expected growth rates are and where you see your market share currently?

Gary Steele

Sure. Great question. So, if you look at the markets that we serve today, the market TAM is roughly $5 billion. And the way you get there is protection is roughly $1.5 billion, privacy is $0.75 billion, archiving is between $1.5 billion and $2 billion but wildcard and all of this is this new area Advanced Persistent Threats, I’m not sure anybody can give you a good market number because mini organizations believe they have to buy something there is a lot of aggressive buying going on.

So I think that really represents a wildcard, if you look across the various segments and the rate at which these markets are growing, protection is a single-digit grower, in fact cloud is growing double-digits and we’re growing much, much faster than what the market is growing, archiving on-premise is a single-digit grower, cloud is a double-digit grower and we’re continuing to beat the market there as well.

And so we feel like the broad range of products that we serve, we’re excited about the opportunity and we’ve demonstrated very good growth across these various segments.

Sanjit Singh – Wedbush Securities, Inc.

On the competitive line, one of the things I found interesting is a market share gain story that appears to be happening, I think Google is looking at existing partners in this market, Cisco are – say they seem to be deemphasizing their high import capabilities looking more on firewall. Talk to me about the competitive environment, how much runway do you think is left on your market share gain story that you’ve been executing on?

Gary Steele

Yeah it’s interesting, so we compete against a number of large vendors. So, as you indicated, Google got into this business through the acquisition of the company called Postini, they announced in August of this year that they were obsoleting the standalone version. As a result of that we’ve seen aggressive pipeline build, we’ve seen a lot of good customers move over to us.

We anticipate that that is a six to eight quarter phenomenon. Customers who have an existing subscription with Postini likely will change at the time when their subscription is up. So we’re excited about this, we’re building good pipeline but we see it not as a one quarter phenomenon, we see as a multi-quarter phenomenon, we compete against Symantec. Clearly there is a transformation happening in Symantec. And while Symantec figures out how to reduce its belly fat, we’re going to be focused on customers and winning deals

And obviously with the change of transition there, it’s created a lot of opportunity for us as a company. As you indicate, Cisco got in this business through an acquisition of a company called IronPort. We’re seeing channel partners move, we’re seeing consumers frustrated with the lack of innovation. The price is capable of the product, but it’s definitely falling behind. So as we look at the opportunity, we see this as a multi-year process to drive consolidation of market share. Today we’re a single market share player, single-digit market share player that’s growing faster in all segments than our competitors.

Sanjit Singh – Wedbush Securities, Inc.

I appreciate that. Let me hand it over to the audience. Looks like we have a packed room. Do you have any questions? Please raise your hand.

Unidentified Analyst

Hi, moving up to archiving business, since we are a faster growing business for you guys, can you talk about the margins of that business, how they look like when compared to company average?

Gary Steele

Yeah. Paul, do you want to…

Paul Auvil

(inaudible) so the markets of archiving business, it’s a newer product line. We’ve been selling that since 2008. So there is some significant costs associated with initially building that out. We’re starting to get good leverage on that. So the margins are little bit below the numbers we see currently for our averages. The security products are little bit above that average. We do expect that we’re able to get the archiving business up to kind of our 75% target, which we talked about in a road show back a year ago from the IPO over the next, call it, 18 months to 24 months.

Unidentified Analyst

Quick question on your renewal rates, where are they currently? It sounds like it’s around 90%. How high can they be realistically? And then, a follow-up question on that seems like the contract duration is trending down. Where are the drivers of that and how was the impact of the billings growth?

Paul Auvil

Yeah (inaudible). So in terms of the renewal rates, our renewal rates consistent within, over 90% really for the entire history of the company and when we talked about 90%, we’re talking about absolute customer churn. So we look at the number of customers that do fall in, in any given quarter or any given year, what percent of them actually renew with us. So that’s a remarkably high rate of renewal rate over 90%.

If you look across all the SaaS companies, no one runs that rate and it’s because of the quality of the products that we have, but quite frankly, it’s also the culture that Gary has built into the company from the day the business was founded where we have a very focused approach on creating and maintaining relationships with accounts. Even when we do business with the channel partners we reach out, clear relationship with the account, help them get up to speed with the products, and then we’re regularly checking with them, even if they don’t call up to file or support ticket to find out how things were going, what they like, what they don’t like, what we can do better for them?

And so, we really can’t make the churn rate lower than where we are currently in our realistic sense of, as we view it. Most of the customers we lose honestly are our smaller customers who ultimately get acquired and then become part of a bigger company and that bigger company is using a different security fabric. And so, the customers disappear accordingly.

Now, to your other question about duration and what’s going on there? We historically have done deals that are one, two or three years in duration and when the customer buys the product due to a three-year deal, you pay me for all three years upfront. So I take that amount, put it for revenue, recognize it over three years.

We typically have provided about a 20% discount from three-year deal versus a one-year deal. What we found is we consistently ran a churn rate that was well under 10%. We have a higher lifetime value of customer by signing people up for one-year deals versus three-year. So in 2011 we actually changed the comp plan for our sales team to get them focused on doing one year versus three year deals. And we’ve seen some good progress there. So, whereas in the S1 that we filed, we talked about historical average duration that was 20 months to 25 months. We find that in the four quarters of 2012 when we talked about this on each one of our calls, we actually had a duration which was in the high-teens.

Now realistically, we’d love to get all the deals down to one year deals, I don’t think we’re actually ever going to quite get there, a part of it is that we have a number of prospects out there who historically have bought two or three year deals from competitors, when they’re looking to switch, they prefer to stay there. And so because we’re going to absolutely insist on pushing the pricing up, if you go to a one-year contract, inherently we end up customers that still want to get two or three year deals and our existing customers that have historically done two or three year deals, they tend to stay with that as well.

But we do expect to be able to get the duration probably towards the mid-teens over time particularly because the archiving business which doesn’t have a history in the industry of doing multi-year deals. We’re going to stick with one-year transaction there. So as we have more revenue in our mix coming from archiving that will help push duration down as well.

Sanjit Singh – Wedbush Securities, Inc.

I just wanted to ask you an industry question. We keep hearing about Java zero-day intrusions. They go through e-mail, and just how these things get in?

Gary Steele

Yes.

Sanjit Singh – Wedbush Securities, Inc.

The nature of them with my understanding is that no one would really knows about zero-day intrusions because they’re not yet reflected. Can you spot a zero-day Java intrusion?

Gary Steele

We can’t because the way in which we’re doing that with our Targeted Attack Protection is we actually sandbox that particular content. And so we will look at the behavior of the links that are coming in, look for malware that’s been sort of odd behaviors and downloads that are being done. And so we are able to detect the zero-day kinds of attacks because we heard sandbox every time.

Sanjit Singh – Wedbush Securities, Inc.

Do you have like case studies because RSA was full of the zero day charter if you will?

Gary Steele

We do have some case studies. I can (inaudible) get you that information directly.

Sanjit Singh – Wedbush Securities, Inc.

Can you talk about some of the private companies you are trying to push a little bit into your space or maybe some of the public companies who are also kind of interested in getting into your space? And secondarily, what are your thoughts on M&A, are there some areas where you need to be beef up your capabilities?

Gary Steele

Yes. So I’ll start and Paul, if I miss anything jump in. So today we predominantly compete with larger public companies. So if you think about what has happened in the segments that we served, there’s been a lot of industry consolidation. So Symantec, for example, we compete with Brightmail (inaudible) got to Symantec, MessageLabs, which is our cloud-based solution, which we bought several years ago. We compete against PGP and the encryption capabilities that they bought two years ago. We compete against LiveOffice, which is their cloud-based archive solution. So they basically bought the line up that Proofpoint is delivering today.

You look at other companies like McAfee. McAfee has many properties. So they bought a company that’s probably seven years ago now called CipherTrust, which got by secure competing, which got by McAfee, which got by Intel. It’s comical in that as all those acquisitions happen the lack of – this has been a true lack of innovation.

Now, as we go to all of these, but essentially we’re competing probably 90% with big guys. There is no one coming from behind in the – with a broad set of capabilities targeting our market today. In particular segment, you might find smaller players. So there are some smaller archived players, for example, but they’re actually relatively small, relatively insignificant.

In this new space where we focused our Targeted Attack Protection as some of that the gentleman indicated, RSA was the rage about APTs. There’s many different approaches been taken there. So there are smaller competitors that live in that market and I expect to see even more of them because the venture community is very focused on it. But today if you would ask any of our sales reps they are thinking about the big guys, the Symantecs, the McAfees and frankly taking them out versus competing against them.

Paul Auvil

So the second part of the question was around acquisitions. So I’ve been with the company six years now and we’ve done five acquisitions since I joined, small acquisitions, little technology companies with a handful of super, smart engineers and have customers to prove that they actually had a product and not just a science project that they could run in the lab. But really we don’t want to pay a revenue multiple because we’re looking for early technologies that are unique, groundbreaking that we can then weed into our platform in the earlier stage of this each of this (inaudible) corporate into our cloud infrastructure. And so, as we look going forward, we continue to be interested in doing small deals like that.

So of the $87 million in cash, don’t expect us to spend $45 million on one deal, but we’ll probably do deals where we’re spending $2 million, $3 million, $5 million, maybe a $10 million deal that we’re really compelling, but again, it’s not companies that have revenue. It’s companies that have interesting technology. We seek to do these in a way that would be non-dilutive.

So we require our company and either the headcount and the burn rate is small enough that it just fits into our otherwise hiring plan. So other than the cash that goes out of the door it, it doesn’t dilute the existing plants earning stream or we believe that we can create enough early traction in terms of selling additional product on an add-on base store, existing installed base (inaudible) customers that we would be able to cover that with cash flow that comes in from the sale of our platform.

Sanjit Singh – Wedbush Securities, Inc.

We’ll go back to the audience for questions, okay before I do, one of the thing that from RSA was, there is a lot to talk about the executive order signed by the President. Has that had any growth, any discussions or activity with your customer base, any thoughts on the executive order?

Gary Steele

Yeah. I think just in general, we got a lot of conversations today with investors about the spread. This is the high-end awareness about security in general, I don’t think anyone cannot pay attention to it, so as the posture of organizations change, including the U.S. Government, I think there is a much more aggressive posture being taken as relates to security and being thoughtful about the investments are going to be made. And in fact, I think it approved benefits from that.

Sanjit Singh – Wedbush Securities, Inc.

Paul, on the last earnings call, you talked about driving the upside in billings and revenue back into the business. What areas are you investing in? What are you seeing out there in the market that’s making you feel opportunistic and better investing now?

Paul Auvil

Sure, so couple of things there. We’re working with supportive important about footprint model, it’s different than some from other SaaS companies as we think it’s important to drive growth, cash flow then ultimately profitability all in term of so, we’re in some businesses might be growing little faster, but they are burning a huge amount of cash to accomplish that. We want a balanced approach so as Gary said, here we generated about $1 million of free cash flow in 2012 archive for 2013 is generated about $5 million of free cash flow and then expand from there obviously in 2014 and beyond and drive EBITDA profitability along with that.

So, as we look at all that, we do think that there are some opportunities to potentially invest to continue to differentiate our product offering as well as to improve our reach into the market. So, right now, we have a very solid footprint of sales team members in North America, but even then we think there is opportunity to broaden that distribution footprint, but equally importantly in Europe, we have just a small set of teams on the ground in the UK, Germany and France to serve that broader European market.

The European market represents almost 70% of the same opportunity that you see in North America and we’re really just getting started there. And so, we think there is a tremendous opportunity in sort of the extent that we do see some over performance in the business and we see to invest that cash flow both in terms of driving a little bit more footprint in North America to better broader our distribution capabilities there, but as well as we see Europe improving both in terms of the execution of the teams we have combined with just improved economic conditions of that comes sooner rather than later. We think there is a big opportunity there and will invest accordingly.

Sanjit Singh – Wedbush Securities, Inc.

Do you have any questions?

Unidentified Analyst

Good morning guys. I just wanted to follow-up on this more of a conceptual question and (inaudible) this might be for you, how much is your customers determine and ROI and what I am getting at is, there’s been a lot of investment in the perimeter firewalls, IPS, IDS.

Gary Steele

Yes.

Unidentified Analyst

And the more money that goes in, we still hear about attacks almost every week in the headlines, so however, your CIAs at your customer base, how do they go about thinking about ROI?

Gary Steele

Yeah, I think in general, Chief Information Security Officers don’t think about ROI or the security solutions that they buy. I think they look at they think of it more as how do they ensure that fee organization is well-protected and then they have taken appropriate security posture and so, we get to have the caliber much more on what we’re actually preventing from getting into the organization.

And we regularly review with our customers, the kinds of the tax we’ve blocked and stopped, and that’s what ultimately resonates with those individuals, now the other area that is – people think about it differently, and there is ROI although the list is very detailed TCO analysis that gets done in the archiving world where people are spending way too much money on their on-premises solutions, spending way too much money on storage. And what’s driving them to the cloud is brand new architecture, truly disruptive economics. We are basically half what people traditionally pay it and so it gets peoples attention.

Unidentified Analyst

(inaudible).

Gary Steele

Well, actually with Microsoft, so as email goes off the cloud it’s actually beneficial to us because of our relationship with Microsoft. So as Microsoft takes its largest customers to Office 365, we are their recommended solution for that. So we’re actually benefiting from that.

Unidentified Analyst

(inaudible).

Gary Steele

Yeah, on the protection side they have a solution today. We find that a lot of organizations aren’t happy with that, and they will ultimately go and purchase something else. And the cloud is the Office 365 and moving to the cloud is changing the decision making process, but it’s not radically different. I was with CIO yesterday afternoon. He is like, we’re trying to figure our the Office 365, but we definitely need what you guys can give us with your protection capabilities and TAP because we know we’re not going to get what we need from Microsoft. So it’s a little bit different with Google. We don’t see as much opportunity although Google is very much focused on the inside business for the most part. Microsoft is having more like at the high-end of the market.

Unidentified Analyst

You mentioned partners. How much of your colored, your top three, your major strategic partners; VMware, Microsoft you mentioned, make up your revenue? And then, maybe a question on how much visibility you have going to the quarter, meaning how much revenue or business you have to close to meet your targets.

Gary Steele

Meet our targets, Paul will take that.

Paul Auvil

Gary knows the answer he just wants me to give little bit of a break. So, first your question on partners, so we talked about as Microsoft represents about mid-teens as a percentage of our revenue, we disclosed that because it’s over 10% and we knew it was going to have to be included in the filings and so we share that. With IBM and VMware, I could tell you that definition wise they are below 10% since we have to talk about them individually.

We do think IBM in particular represents tremendous opportunity that Gary can expand on, it’s we have that relationship officially on paper for on the order of the year now and I can tell you from my past experience as CFO at VMware, it took a couple of years before IBM finally really kicked in and grow meaningful revenue for us back in 2005, I anticipate that it can do some really compelling things for Proofpoint as well as we invest to drive that relationship. Back to your question about visibility going to the quarter, if you count the monthly business that we do with Microsoft which is essentially at no risk as we enter our quarter combined with the fact that is, if you presume that we are going to maintain our low churn rate meaning kind of below 10%.

We enter a quarter with more than 90% visibility based on what’s in deferred revenue and the monthly billing activity and even for the full-year we ended the full-year with 70%, 75% visibility into revenue stream.

Sanjit Singh – Wedbush Securities, Inc.

I think that’s all time we have. Thank you.

Paul Auvil

Thank you.

Gary Steele

Thanks.

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