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Proofpoint Inc (NASDAQ:PFPT)

Q2 2013 Earnings Conference Call

July 25, 2013 04:30 p.m. ET

Executives

Paul Auvil – CFO

Gary Steele – CEO

Analysts

Phil Winslow – Credit Suisse

Rob Owens – Pacific Crest Securities

Robert Breza – RBC Capital Markets

Jonathan Ruykhaver – Stephens, Inc.

Tim Klasell – Northland Securities

Craig Nankervis – First Analysis Securities Corp

Sanjit Singh – Wedbush Securities

Operator

Good day and welcome to the Proofpoint Second Quarter 2013 Financial Results Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Paul Auvil, Chief Financial Officer. Please go ahead, sir.

Paul Auvil

Thanks. Good afternoon and welcome to Proofpoint’s second quarter 2013 earnings call. Today, we will be discussing the results announced in our press release that was issued after the after close today. I’m Paul Auvil, Chief Financial Officer of Proofpoint, and with me on the call today is Gary Steele, Proofpoint’s Chief Executive Officer.

During the course of this call, we will make forward-looking statements regarding future events and the future financial performance of the company. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements, contained in the press release and this conference call. These risk factors are described in our press release and more fully detailed under the caption Risk Factors in Proofpoint’s most recent Form 10-K filed with the SEC and the company’s other SEC filings.

During this call, we will present both GAAP and non-GAAP financial measures. These non-GAAP measures may exclude both stock-based compensation expenses as well as the amortization of intangibles related to acquisitions or other components of GAAP metrics. These non-GAAP measures are not intended to be considered in isolation form, a substitute for or superior to our GAAP results and we encourage you to consider all measures when analyzing Proofpoint’s performance.

A reconciliation of GAAP to non-GAAP measures is included in today’s press release regarding our second quarter 2013 results, which can be found in the Investors Relations section of our website. In addition, please note that the date of this conference call is July 25, 2013, and any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events.

So, with that I’ll turn the call over to Gary.

Gary Steele

Thanks, Paul. I’d like to thank everyone for joining us on the call today. We are very pleased with the company’s ongoing momentum and strong execution during the second quarter. Our ability to once again exceed the high end of our guidance across all key operating metrics was driven by the combination of strong competitive win rates, and new products along with robust add on and renewal activity during the quarter.

From a macro perspective we continue to benefit from the increase and types of security threats worldwide including advanced persistent threats. Enterprises are replacing their legacy security infrastructure with our integrated cloud based solution to more fully defend, protect, archive and govern them as sensitive data.

We’re very proud to again be positioned in the Leaders quadrant in Gartner’s 2013 Magic Quadrant for Secure Email Gateways, and in particular, Proofpoint being positioned as having the most completeness of vision from among all the vendors included in the analysis. We view this as further confirmation of the company’s proven ability to execute in the email security market and our ongoing innovation in using the cloud and big data technology to protect enterprises from today’s most advanced targeted attacks.

Taking a look at our financial results for the second quarter, total revenue increased 23% year-over-year to $31.8 million and was driven by the 25% increase in subscription revenue. This represented our 40th consecutive quarter of sequential revenue growth. We also recorded billings of $35.1 million, up 33% on a year-over-year basis.

Both revenues and billings exceeded our second quarter guidance ranges. Our continued strong growth was driven by several key factors including renewal rates that once again exceeded 90%, sustained strong competitive win rates, new and add on business momentum and further traction with our strategic and channel partners.

Now, turning to some of our key accomplishments during the second quarter. Similar to the last few quarters, we benefited from Google’s end-of-life decision for their standalone Postini infrastructure and we expect to continue to drive replacements during the second half of 2013 and throughout 2014. In addition, we saw many of Postini’s largest distributors and resellers signed up for Proofpoint Essentials, our recently launched security and governance offering targeted at smaller enterprises worldwide.

Some examples of significant competitive wins during the second quarter were the Proofpoint enterprise protection and privacy solution replace Postini include a large global professional services company with more than a 160,000 users worldwide, one of the world’s largest federal research centers with 12,500 users and a Fortune 500 industrial supply company with over 12,000 users.

In addition to Postini, we continue to see weakness with our other competitors which resulted in a number of new customer wins during the second quarter including one of the largest U.S. energy and utilities companies with 25,000 users, a global provider of technology solutions for the energy industry with over 18,000 users and notably the first Cisco IronPort customer to adopt their cloud solution, and of the world’s leading automobile manufacturers.

We’re also very excited about the ongoing success of Proofpoint’s Targeted Attack Protection and the sustained momentum we saw during the second quarter for this offering. Specifically, the number of TAP customers roughly doubled quarter-over-quarter and represented a significantly larger percentage of Proofpoint’s total new and add on business as compared to the first quarter of 2013.

As well, I am pleased to note that approximately half the customers purchasing TAP this quarter were new and the other half were existing customers highlighting our continued success in not only selling TAP to our installed base, but also utilizing TAP as a lead product to drive our initial penetration into new accounts.

According to a recent survey of IT enterprise decision makers 58% of the enterprises surveyed reported that their organization had been the target of email phishing attacks in the 12 months and out of the same group 56% believe they had experienced some other form of targeted attack or advanced persistence threat during the past year. We believe that Proofpoint remains in a position to benefit from these trends as the pipeline of opportunities accelerate worldwide.

Some of the note worthy TAP wins during the quarter included a regional healthcare services provider with over 30,000 users. A premier regional energy company which has more than 30,000 users, an energy and construction management company with 12,000 users and a worldwide leader in technology storage solutions with nearly 25,000 users.

Looking forth, we’re very excited about the acquisition of Abaca as that enhances our innovation in malware detection for both Protection and TAP founded in 2006 by Steve Karsh (ph) a respected silicon valley entrepreneur privately held Abaca provides innovative real time in memory threat scoring technologies.

Similar to the acquisition in MailDistiller that we announced in the first quarter, Abaca is the type of acquisition that Proofpoint has successful completed in the past a technology related purchase accompanied by its small focused team of developers who are excited to have their work incorporated into Proofpoint SaaS platform.

We also continue to experience growth in cloud base archive and governance business. Specifically during the second quarter we closed deals with a large healthcare services company with approximately 9,000 that also purchased protection privacy and TAP, a leading electronic design company with over 5,000 users and a leading national financial holding company.

We expect the recent introduction of our cloud based social media platform for archiving to further extend our overall archiving and governance capabilities by delivering social media compliance for enterprises in regulated industries. These capabilities enable customers to capture an archive social post from both private and public social media sites such as Microsoft EMR, Salesforce Chatter, LinkedIn, Facebook and Twitter for the purposes of both compliance any discovery.

This is a rapidly emerging requirement and we’re excited to provide this capability to both customers using the Proofpoint enterprise archive as well as those using legacy archive in systems. Today with over 30 customers already deployed our social media platform archiving strengthens our competitive advantage and provides a must have feature for regulated organizations that embrace social media and their business practices.

In regard to selling additional products to our standing customer base we continue to gain traction there as well resulting our ability to further increase the number and size of add on deals booked during the second quarter. Examples of key add on wins this quarter include one of the world’s largest mutual companies which enhanced their privacy capabilities by adding protection for over 15,000 users and a global industry leading hospitality company that enhanced their privacy solution and added our protection solution for 30,000 users.

As a remainder only of our customers had more than one Proofpoint product in 2012 and we view the adoption of multiple modules on a platform by customers to represent an ongoing growth opportunity for the company.

Turning to our strategic partnerships, we continue to see growth and we’re pleased with our ability to meet expectations during the second quarter. Specifically we closed a handful of deals with IBM during the quarter and continue to cautiously optimistic about the opportunity as we cultivate the relationship and the pipeline continues to build.

In regards to Microsoft, we again saw growth as they continued to support customer demand for Proofpoint’s client based archiving solution running in conjunction with the Microsoft Office 365 platform. Looking forward we expect Microsoft to remain an important partner with revenues derived from customers running on Office 365 to continue to expand. However, we anticipate our billings and revenue activity to gradually shift overtime. Under our existing relationship Microsoft has resold the Proofpoint archive solution directly to its customers and we billed Microsoft on a monthly basis for this usage.

Going forward, we anticipate that that growth in our business associate with the Office 365 platform will be driven through the partner channel consistent with Microsoft overall shift and go to market strategy around this product offering.

With this shift we expect our future growth in terms of customers running on Office 365 to come through with the partner channel rather through than to Microsoft themselves. As a result, the revenues that we derive for Microsoft resale of our archive of these solutions will represent a smaller portion of our business as we continue to grow overtime.

Finally, we continue to see good early progress in our international operations as the year-to-year growth rate was above the overall average of the company during the second quarter.

We also had a number of key wins within our international operations highlighting the momentum we are starting to experience. This success is evidenced by our deal this quarter with a large global professional services company with more than 160,000 users worldwide that I mentioned earlier on the call.

We believe that the market outside of the United States in both EMEA and Asia will represent the ongoing growth opportunities for Proofpoint and we plan to expand our sales and marketing teams and add new channel partners to grow our market share in these regions.

Before turning the call over to Paul, I am pleased to announce that we have completed the search for our new EDPA sales and expected individual they are officially starting in August at which point we will release a formal press release with additional details.

This is an addition to the recent 8-K filing where we announced the re-organization of the engineering team around three product lines along with the fact that chambers of former EDPA of engineering have left the company, hence eliminating the need for this role going forward.

I am excited about this new organizational structure and believe that we have the right team of experience, growth oriented and result-driven leaders to ensure we achieve our full potential as a company.

So in summary, I am very pleased with the strong execution in the second quarter which was highlighted by our ability to, once again, exceed expectations across all of our key operating metrics. The rapid it up option of our platform by-large and this size enterprise confirms the value that these organizations placing the point best in cloud based solutions as we were able to add a number of blue chip customers during the quarter.

We are well positioned to maintain our momentum during the second half of the year as we continue to broaden our customer base, increase sales to existing customers, and expand our international presence and channel partnership.

With that, let me turn it back over to Paul.

Paul Auvil

Thanks, Gary. I am very pleased with our continued strong execution during the second quarter and our ability to once again, exceed expectations for revenue, billings, profitability, and cash flow.

These outstanding results were once again driven by a combination of strong renewal activity and a robust mix of both new customer acquisition and expansion of business with our existing customers.

I am going to start by providing additional details on our performance to the second quarter of 2013 and then conclude with our outlook for the third quarter and the full year 2013.

Turning to our second quarter results, total revenue was $31.8 million up 23% year-over-year and above our previously announced guidance range of $30.8 million to $31.4 million. These strong results were driven by the 25% growth in our subscription revenue which accounted for 97% of total revenue during the quarter.

From a geographic perspective, our growth continues to be largely driven by our strength in the U.S. market where our revenue grew by 24% year-over-year and accounted for 83% of total revenue compared to 82% in the same period last year.

However, as Garry mentioned earlier, we continue to build momentum in our international operation as the year-over-year growth rate was above the overall average of the company during the second quarter.

Billings for the second quarter totaled $35.1 million, reflecting growth of 33% on a year-over-year basis and exceeding our previously announced guidance range of $33.7 million to $34.3 million. Our continued execution in terms of billings performance was a result of the sustained strength of our competitive win rates on new accounts, our increase success in selling additional solutions to our installed base of existing customers and retention rate that once again continued to exceed 90%.

Regarding the net new subscription business that we closed during the second quarter, approximately one half of this activity was driven by sales of new products to our existing customers consistent with our performance during the past several quarters and in line with our long-term target.

We remain pleased with this statistic as it demonstrates our ability to leverage our considerable and growing list of customers by selling them additional solutions and expanding their user base, hence providing a meaningful and important contribution to our long-term revenue growth.

In addition, our strategic partners and resellers continued to account for approximately one half of our billings activity during the quarter reflecting our ongoing ability to leverage external sales resources to further drive growth and market share gains in a cost effective manner.

Turning to expenses and profitability for the second quarter; on a non-GAAP basis, which excludes stock-based compensation and the amortization of intangibles associated with acquisitions, our total gross margin was 72% during the second quarter which is consistent with the same period last year and in line with our second quarter guidance.

In terms of our operating expenses, we continue to invest in both sales and marketing as well as research and development to support our future growth.

During the second quarter, non-GAAP sales and marketing expenses increased 21% over the prior year period to $15.2 million representing 48% of total revenue. This growth in expense was primarily driven by additional sales personnel as well as the investment in key marketing and lead generation programs.

Research and development expenses increased 23% year-over-year to $7 million accounting for 22% of total revenue and reflecting our continued focus on enhancing and expanding our solutions and platform.

General and administrative expense was $3.1 million compared to $2.5 million last year driven primarily by our larger scale.

Non-GAAP operating loss was $2.3 million for the quarter compared to the non-GAAP operating loss of $2 million during the second quarter of 2012. Non-GAAP net loss, which excludes stock-based compensation expense and amortization of intangibles associated with acquisitions was $2.5 million or $0.07 per share based on 34.0 average shares outstanding and exceeded our previously announced guidance range of a loss of $0.08 to $0.09 per share. This compares to a non-GAAP net loss of $2 million or $0.08 per share based on 30.3 million weighted average shares outstanding in the year-ago period.

Second quarter 2013 adjusted EBITDA was negative $0.9 million consistent with the same period last year and was better than our previously announced guidance range. On a GAAP basis, GAAP net loss for the second quarter totaled $2.1million or $0.06 per share based on $34.6 million weighted average diluted shares outstanding. This compares to a GAAP net loss of $5.5 million or $0.21 per share based on $26.2 million weighted average diluted shares outstanding in the prior year period.

The GAAP net loss during the second quarter of 2013 included $3.4 million or $0.10 per share non-recurring tax benefit related to the release of deferred tax asset evaluation allowance for the company's Canadian subsidiary.

Specifically, the company's operations in Canada historically had cumulative losses hence requiring us to book evaluation allowance against the Canadian deferred tax assets.

However, these cumulative losses changed to three years cumulative income position during the second quarter of 2013. This change to three years cumulative income combined with management analysis of our ongoing operations resulting the conclusion that the net deferred tax assets in Canada are now more likely not to be utilized and as such the evaluation allowance previously recorded against the net deferred tax assets was reversed in the second quarter resulting in the fore mentioned $3.4 million tax benefit.

A reconciliation of GAAP to non-GAAP financial measures has been provided in the financial statement table included in our press release. In terms of cash flow, we used $0.7 million in operating cash flow for the quarter and invested $1 billion in capital expenditures as part of our ongoing build up of infrastructure for our global SaaS platform. This resulted in free cash flow a negative $1.7 million to the quarter compared to our guidance a negative $2.5 million to $3 million.

As we know noted on the first quarter earning calls, our cash flow to the second quarter 2013 includes a onetime disbursement of approximately $2 million as we move to a zero accrual vacation methodology for all of our U.S. employees.

The methodology is similar to the same systems that have been adopted at many other leading technology companies.

Turning to the balance sheet, we ended the quarter with $89.7 million in short-term investment and $3.2 million of debt compared to $90.2 million cash in short-term investments and $3.6 million of debt as of March 31, 2013.

This sequential decrease in cash during the quarter was primarily driven by aforementioned disbursement for the vacation methodology change as well as the cash disbursement associated with the purchase of MailDistiller and was partially up set by proceeds from ongoing stock option exercises as well as contributions to capital from our employee stock purchase plan.

We ended the first quarter with an accounts receivable balance of $21.1 million resulting in DSOs of 55 days during the first quarter, a bit above our historical long-term average due primarily to our strong billings activity late in the quarter. Total deferred revenue increased $18.6 million year-over-year to $94.5 million during the first quarter, up from $75.9 million in the year ago period. Compared to the first quarter of 2013, deferred revenues increased $3.3 million.

During the second quarter, the overall duration of our contract terms finished slightly below our historical range of 20 to 25 months, and down sequentially from our fourth quarter results marking ongoing progress in our goal to shorten contractor ratio across our customer base.

Now turning to our financial outlook, starting with the third quarter, we currently expect billings to be $37.5 million to $38.5 million resulting in a year-over-year growth of 25% to 28%.

Regarding revenue for the third quarter, we are targeting total revenue of $32.5 million to $33 million or 21% year-over-year at the mid-point of the range.

We expect third quarter non-GAAP gross margin to be approximately 72% consistent with the second quarter. We are currently targeting adjusted EBITDA of negative $1.2 million to negative $0.9 million for the third quarter. We expect third quarter non-GAAP net loss, which excludes stock based compensation and amortization related acquisitions to be $2.9 million to $2.6 million or a loss of $0.08 to $0.07 per share based on approximately $35.5 million weighted average diluted shares outstanding. This assumes an income tax provision exclusive of discreet items of $0.1 million for the quarter.

From a full-year perspective, we believe that the company is well positioned to maintain the momentum during the second half of the year as the worldwide demand for our Cloud base solution remains strong. As a result, during the full-year 2013, we expect billings to be in the range of $151million to $153 million, an increase from our prior guidance of $149.5 million to $151 million. This presents growth of 29% to 31% compared to last year. Note that this full-year guidance suggest that our fourth quarter billings will grow at a rate of approximately 20% year-over-year and it's important to know that this figure is not indicative of deceleration in our business in the fourth quarter, but rather a reflection of a relatively tough comparison with respect to the fourth quarter of 2012 due to the unexpectedly strong growth in billings for the new business contracts in that prior period combined with the record cycle of renewal activity driven my multi-year deals that were renewed in that quarter which by definition are not pre-renewal again here in the fourth quarter of 2013.

With this billings performance, we would expect total revenue of $129.5 million to $130. 5 million, again an increase from our prior guidance of $128.5 million to $129.5 million and hence an annual growth rate of 22% to 23%.

Subscription revenue should continue to account for approximately 95% or more of our total revenue for the year. We expect full-year 2013 non-GAAP gross margins to be approximately 72% and adjusted EBITDA for full-year of 2013 to be in the range of negative $4.4 million to negative $3.9 million with breakeven performance in the fourth quarter reflecting our continued plan to invest in sales, marketing and product development to drive further our top line growth.

I’m pleased to note that our updated full-year outlook remains consistent with our guidance provided last quarter, despite our acquisition of Abaca.

We expect full-year 2013 non-GAAP net loss which excludes stock-based compensation and amortization related acquisitions to be $11.4 million to $10.9 million or loss of $0.35 to $0.30 per share based on approximately 35.1 million weighted average diluted shares outstanding.

This assumes an income tax provision, exclusive of potential discrete items of approximately $0.4 million to $0.5 million for 2013. Note that the revenue contribution from Abaca existing customer base are not material to our financial and the associate operate expense that we will take on as a result of this transaction will be accommodated by our ongoing hiring and spending plans already considered in our prior period guidance and as such the acquisition will have no dishonorable impact in our income statement going forward.

I would like to highlight again that we are currently generating a net loss and as such our fully diluted share count of $34.6 million for Q2 did not include the impact of vested stock options. If we were profitable today, our fully diluted share count would have been approximately 37 million shares when applying the treasury stock method to these vested options.

Finally, consistent with the guidance provided during our last earnings call, we are continuing to target positive free cash flow of approximately $5 million for the full-year 2013. This range assumes capital expenditures of $6 million to $7 million for the full-year. Note that we expect that the cash disbursement associate with the purchase of Abaca will be essentially offset by the expected proceeds from ongoing stock option exercises as well as contributions to capital from our employee stock purchase plan.

So in summary, we had a strong second quarter and are pleased with our continued strong execution in terms of both adding new customers and cross selling our complete suite of cloud based solutions to our existing customers worldwide.

With that, I want to thank you for taking the time to join us on our call today and we would be happy to take your questions at this time. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And we will go first to Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi! Thanks and congrats guys on a great quarter. I just have a question on the competitive side, and obviously in your comments you mentioned Google and clearly that's a focus of a lot of investors. Why don't you give us more color just how you think about the win rates of the opportunities that you have been in for that Google business that's up for grabs. And then when you also think just sort of over the course of the year and sort of as these contract are up for renewal, would you expect to see more in the first half versus second half and how do you think sort of the competition goes for those going forward and then there is one follow up to that?

Gary Steele

Yeah. So clearly the announcement by Google to obsolete the standalone Postini infrastructure has been a benefit to the company. And we have seen a significant amount of sales activity related to that. Our win rate in this particular deal is relatively high. We don't have good measures on that.

But it is – it's hard to put a specific number on, but we continue to win more than our fair share and I think that's demonstrated by the kinds of customers that we talked about on the call today.

When we look at broadly who we see showing up in the deals, you could almost always anticipate that people go to things like the Gartner’s Magic Quadrant that just got published where we are a leader. So, you will see Symantec showing up, you will see Cisco showing up; those would be the two vendors that we would most frequently see in the deals.

Our strength has been our focus on the cloud, our broad integrated offering and just the investment that we are making around being the most effective from a threat point of view that's what’s distinguishing us.

In evals, we went at very high percentage of the evals that happened and we don't have a good simple number on that but it's very high.

And one thing I might add just for the broader benefit of everyone listening on the call is just to remind everyone that our focus is on large and mid-size enterprise. So as we look at all the opportunities that have historically been the part of the Postini installed base, we are focusing on really just the largest accounts and that's where we drive to go get an eval and then ultimately convert them to the Proofpoint platform.

Postini historically had a very large number of SMB and smaller customers which is nary - that we historically haven’t focused on; now with the MailDistiller acquisition we completed last quarter we do have now a new mechanism for potentially soaking up some of that smaller enterprise opportunity and we’re just starting to ramp that now. Again we're focused more on getting the think of it this kind of revenue share of the Postini installed base as opposed to focusing on converting the largest number of customers by customer count.

Phil Winslow – Credit Suisse

Got it. And then also guys you’ve commented on a cross sell of the portfolio wondering if you could give us a sense sort of the [inaudible] price beyond security whether email compliance, archiving or the TAP products where you’re seeing the best growth this quarter then, and I will just turn it over others for questions.

Gary Steele

I would say that number one place that we saw the most cross sells this last quarter was with TAP. So, people that had - were existing protection customers looking to protect themselves from advanced persistent threat, the message is resonating well and as we indicated we doubled the number -- doubled the amount of business that we’ve done from quarter-to-quarter so that we felt very good about in terms of the resonance within our existing installed base.

Operator

Okay, and we’ll go next to Rob Owens with Pacific Crest Securities.

Rob Owens – Pacific Crest Securities

Great. Thanks for taking my questions, so with regard to selling TAP into the installed base are there any metrics you can provide in terms of how it’s helping you increasingly monetize customers is it at 30% rate, 50% rate just trying to get a sense of what that opportunity might look like within the installed base?

Gary Steele

Yeah, that’s great question Rob. I would characterize it as follows, so in the early days when we first started selling it as it came out of beta, we were pricing it fairly aggressively in order to get some initial momentum, get some customers that were using it so we’d have reference accounts; as we’ve now hit more of what I’d describe as kind of the sweet spot or our stride in the marketplace we’re finding that the pricing on the TAP product is essentially equal to and then sometimes greater than what we charge for protection itself and so when you think about the size, the overall protection market broadly as deployed across the global industry, it’s a $1.5 billion market, we think that there’s an equally sized opportunity over time; now you could argue that some specific verticals may not be as interested in a TAP solution as others, but certainly as we look at the markets that we’ve historically focused on with a greater degree of intensity like financial services, healthcare, retail, these industries all very much have this need. And so we see it as a very meaningful uplift in terms of value that we can pull in terms of revenue per user out of all these accounts by providing the TAP product in addition to protection which many of our existing customers are already users of.

Rob Owens – Pacific Crest Securities

Great and then number two just Gary, looking at your - Paul, excuse me, looking at your subscription line, showed I think 8% sequential growth really strong and I realized deferred revenue has been strong for the last year plus on shrinking duration, but as I look at the Q3 guidance I think you are guiding roughly if I assume kind of hardware and service as flat to be about 23% a little bit of a deceleration and just curious is that something in deferred revenue that had more of a onetime impact to the June quarter specially given your comments around Microsoft or I think we appreciate conservatism but it seems like that Q3 could be a little stronger from a subscription perspective given where deferred sits right now?

Paul Auvil

Yeah, I think, trying to think how best to characterize the answer there beyond the fact that as you already mentioned Gary and I are always very thoughtful about how we put guidance together to make sure we feel comfortable with our ability to meet or exceed the numbers wherever possible, that said I think the other thing to keep in mind is you’re thinking about our guide is that we, we would expect an ongoing modest deceleration in the hardware and services line as we think kind of our baseline guide and so little bit more that overall guide is probably in the subscription line as opposed to hardware and services as you think about the mix.

Rob Owens – Pacific Crest Securities

Great, thanks.

Operator

We’ll go now next to Robert Breza with RBC Capital Markets.

Robert Breza – RBC Capital Markets

Hi, thanks for taking my questions and nice quarter. Gary, I was wondering if you can help me understand just a little bit, I’m familiar with Abaca, I see from the press release and just looking at the website here the in-memory piece really kind of thinking about how do you think this acquisition really helps you once it’s integrated kind of distinguish itself from the competition and may be if you could just provide a little bit of how you see this integrating with your pretty large backend, thanks.

Gary Steele

Yeah. So, there is two things we really liked about Abaca, one is they’ve built some really interesting technology so that’s in-memory scoring technology, we view it as an opportunity integrated into our overall solution providing yet another perspective on detecting malicious content. And so, we will basically integrate it as yet another view into whether something could be bad or good and then the other piece that really motivated us on Abaca, is they just got an incredible group of people and as I indicated in the script we really liked the team and felt that they would be a great addition and finding stellar security people is not a simple thing in the valley and so we got both great technology and great people.

Robert Breza – RBC Capital Markets

How many people have you acquired just as a follow up?

Gary Steele

This is a small handful of people, it’s a small handful.

Robert Breza – RBC Capital Markets

Okay, thank you.

Operator

And we’ll go next to Jonathan Ruykhaver with Stephens, Incorporated.

Jonathan Ruykhaver – Stephens, Inc.

Yeah, hi guys. Nice execution once again, the question regarding TAP can you just comment on the comparatively landscape around events threat starting the email gateway and who do you see in comparative situations in and how do you differentiate?

Gary Steele

Yeah, great question. Today when we go and sell the things that had been differentiating us are the fact that we’re really focused on the sphere fishing problem and we hear time and time again from prospects and customers that it’s one of the greatest concern does it relate to advance persistence. we typically only see today will see Fireeye because Fireeye has obviously web solution and email solution, our approach is different in that Fireeye focuses at the, at the gateway level we’re actually rewriting URLs redirecting people to our sandbox in the cloud and using those capabilities to determine a quick time whether something is malicious so that things that had differentiated that from Fireeye one were cloud based solution so we’re not asking people to put lots of systems in their networking build out complete capacity, two we work on and off in networks so if I’m sitting at Starbucks with my iPad, I can be protected through the Proofpoint TAP solution and three we get people incredible visibility from a standpoint of remediation of these kinds of threats which has very much resonated in the market, consistent this quarter with what we said previously we see people buying Fireeye for the web and Proofpoint for email and persistence attacks and it’s worked out quite well.

Jonathan Ruykhaver – Stephens, Inc.

Yeah, that was going to be my question so it doesn’t seem like the fact that you don’t have the web gateway solution doesn’t have the ability to do well against them in the market place?

Gary Steele

That’s our assessment as well.

Jonathan Ruykhaver – Stephens, Inc.

Okay. And then, I thought that it was interesting recently, you put out a press release regarding a social platform for archiving and in previous comments I always felt that the adoption of social enterprise is it really it’s somewhat flow, you have seen any change in that opportunity?

Paul Auvil

So, where we see the biggest demand today is in regulated specifically financial services, it’s where those organizations are opening up social allowing their employees to interact externally with different constituencies and social sites so that’ s been a big priority and a big demand and we do see within the financial services sector where organizations are traditionally blocked all interactivity with social that’s beginning to change but they need these capabilities like what we’re offering and like what we announced to be able unable and truly embrace social within the enterprise. We have not seen as much demand frankly on internal social, but it’s a combination.

Jonathan Ruykhaver – Stephens, Inc.

Okay.

Paul Auvil

Intellectual private and public.

Jonathan Ruykhaver – Stephens, Inc.

Right. Okay, good. And a last question from me can you just remind us your federal exposure and what would you expect to see in the current quarter?

Paul Auvil

Sorry, can you repeat that again?

Jonathan Ruykhaver – Stephens, Inc.

Yes Steele, your federal business what that looks like and what you see in terms of end market demand out of the federal vertical in the current quarter?

Paul Auvil

As you’re probably aware federals very nascent product of our overall business, it’s an area that we expected to eventually build out more meaningful presence, but historically we focus on other parts of the market and so we’ve seen your good modest your business attraction there over the years but as I looked at the reminder of the year we have a very modest expectation in terms of what would think to bring in from Federal Government combined with its combination of size that we have there along with the ongoing sequestration in kind of modeled federal spending so at this point we have limited exposure so we don’t have a lot built in the plan on that.

Jonathan Ruykhaver – Stephens, Inc.

Okay. Okay, good enough. Thanks guys.

Gary Steele

Thanks.

Operator

Next is from Tim Klasell with Northland Securities.

Tim Klasell – Northland Securities

Yeah, my congratulations as well just a quick question on TAP, I’m sorry if I miss this but did you mention of how many of your TAP customers were non Proofpoint security customers, how often that you seen TAP installed over somebody else’s security solution.

Gary Steele

So we’ve reference in the script about half of TAP in Q2 was sold to existing and half was sold to new.

Tim Klasell – Northland Securities

Okay and with sort safe to say that half that was new were none, didn’t take security at the same time?

Gary Steele

Most of the customers that were new customers, but our protection solution along with TAP.

Tim Klasell – Northland Securities

Okay, okay, good. That’s very helpful. And then…

Gary Steele

And slightly and slightly just one clarification there one of the sales strategies we’ve employ is we’ll get in the door on TAP with that customer probably not thinking about replacing their existing protection solution and we will elbow out whoever is in there.

Tim Klasell – Northland Securities

That’s, that’s very helpful. And then, as we begin start to seeing more Microsoft partners into your reseller channel how should we think about that financially are there terms to those resellers similar to what you have with Microsoft direct or will there be some changes there?

Gary Steele

I would say as I look at it I would expect the margins and profitability the business to be essentially the same between the two channels, the business might be little more profitable going through the resellers as opposed to the margins that we shared with Microsoft and their resale agreement but we’ll see how the market pricing and the demand overtime.

Tim Klasell – Northland Securities

Okay, good and then one final line. For Postini for the smaller customers that may not be in your current sweet spot right now if they are going off of Postini who they’re often going to?

Gary Steele

So, the smaller set of customers today try to captures those with Proofpoint Essentials and their reference in our script were having very good success signing up the all Postini distributors and reseller partners that address that market that other vendors from a competitive standpoint that we see there are the McAfee with the old MX logic product that would be the number one vendor that we see and then kind of a cast of random characters beyond that.

Tim Klasell – Northland Securities

Okay, good. That’s very helpful. Thank you very much guys and congratulations again.

Gary Steele

Thanks.

Paul Auvil

Thanks Tim.

Operator

Next we’ll go to Nandan Amladi with Deutsche Bank.

Unidentified Speaker

Hey guys, it’s actually Kas [ph] on behalf of Nandan thanks for taking my question. Another follow up on the Microsoft partnership, what is changing, what is driving that change from Microsoft agreeing to the channel, is there a change in your contract with Microsoft?

Paul Auvil

No, in fact we signed the three years extension to that contract late last year, that governs all the existing customers that we have as well as other deals that would be done by Microsoft on a direct basis but what we’ve found is that Microsoft is trying to accelerate Office 365 broadly it’s a platform is now really aggressively energizing their entire global partnership framework of resellers to go up drive it and so increasing their pushing larger and larger accounts they come in to work with those reseller partners to develop an ultimately close Office 365 deployment and so we obviously been encouraged to work with those partners with as well and in offering our platform. So there are still some deals particularly in the deferral space that from what we can tell will still be done by Microsoft on a direct basis and for those we’ll continue to participate and look to close the business.

But, as we look at the other pipeline in the queue of opportunity that’s developing for us in and around the Office 365 Ecosystem it’s really now, very much shifting and accelerating towards this partner framework based on Microsoft’s evolving go to market channel strategy and so hence we thought it was important to let the investment community understand what we see in terms of that shift as our business develops overtime.

Unidentified Speaker

Got it. Now the partnership with Microsoft was just on the archiving piece so even that if you go to the partner, to the channel directly, you’ll be resell nudge of that having but also protection and privacy, is that A fair statement?

Paul Auvil

Yeah, that's an excellent point and just to be clear, for the customers that we have historically closed through the Microsoft reseller partnership, we have been with Microsoft sponsorship and support gone out and done some ad-on sell directly to those customers for additional modules but your point, Microsoft itself has officially been a reseller of anything other than the archiving platform.

With this broader set of partners, we have the opportunity, we have, in fact, engaged in contracts where they are selling the entire spectrum of Proofpoint solutions from archiving and governance and one end spectrum to TAP and protection on the other.

And so we are excited about that prospect to your point it increases the value in terms of revenue per year so that we can potentially get from these accounts when sold through that channels as opposed to Microsoft channel.

Unidentified Speaker

Just one, just one last one. Will the billing to the partners be also monthly like you have in Microsoft or will that be a different billing dynamics compared to directly working with Microsoft?

Paul Auvil

Yeah I am glad you asked that question. I should have put that into the script. Now the reseller partner is that we are similar to the other resellers where we currently do business worldwide. So there will be annual contracts, potentially in some cases, multi-year if the customer very much wants that. I have always, --we have talked about before we were largely driving to win your contracts across the board we can.

Unidentified Speaker

Great. Thanks.

Gary Steele

Thanks.

Operator

The next we will hear from Craig Nankervis with First Analysis

Craig Nankervis – First Analysis Securities Corp

Thanks very much. Good afternoon. Nice job. Gary, maybe a couple of questions. Gary just going back to the distributors and bars that have signed up for essentials, I wonder if you could offer a little more flavor and color on that, did you expect to see that activity, were you surprised by the level that you saw, do you think that's going to continue and how do you think about that it's additive to your Google opportunity?

Gary Steele

Yeah. Good question. So the thing that has pleased that there is we are getting that top distributors and resellers from Postini and it's happening relatively quickly. So clearly what that says is those organizations we are looking for a good alternative. And I feel like, relatively start period of time, we have been able to get them signed up.

They do use some multiple solutions typically. So the next step really is how does that they convert the revenue and we will obviously report on in the coming quarters. But I am pleased with the results that we have seen that's for with essential. We will now need to see how much of that lower in Postini business we can capture overtime.

Craig Nankervis – First Analysis Securities Corp

And essential is – so did you have essential business in the quarter year. I guess I need to be clear by how –

Gary Steele

We did. So, we close the number of these partners and signed them up to become providers of the solution but ultimately since it was very early in that cycle they did sell some product, but not a lot so we had a modest I would say a contribution to revenue from the essentials platform, but we were optimistic about now that we got all these partners signed up their ability to not go out and drive business opportunity for us as we walk away through the second half of the year.

Craig Nankervis – First Analysis Securities Corp

Thanks. Okay, and then just one more eon the Microsoft side for Gary and then I have two for Paul, but can you just sort refresh us or summarize us where you are Gary with the Microsoft partners and how you work at on your portfolio and Microsoft partners and where you’re trying to go with that portfolio and I know you did announce something a few quarters back on that front, how do you look given there’s the shift going how do you look at your position for that shift?

Gary Steele

Yeah, so we started investing in the Microsoft channel guys, it almost been a year ago now, we announced special program there and alliance program we had very good success in getting those partners interested in working with Proofpoint there, they look a little bit different, partners look a little bit different in the traditional security virus that you guys all are familiar with and so they have longstanding relationships with Microsoft itself the broader set up a portfolio of Microsoft products they showed a great love of interest and we had some good success with them thus far so we’re encouraged as the shift happens where more the Office 365 business goes to Microsoft channel we actually feel like we’re well positioned there and if you look at the comparative landscape today as it relates to archiving our competitors include people like Symantec. So, you would see Symantec in that channel and then you have autonomy I’m not sure that we’ll see a whole lot of autonomy in that channel, I would say I would guess that we would continue to see Symantec and you might see some of the other smaller vendors but we haven’t seen much of them today.

Craig Nankervis – First Analysis Securities Corp

Could you think that the shift to the channel is going to notch you a better opportunity for you than versus the where the previous arrangement or is the just too hard to make such assessment?

Gary Steele

I think it’s very early to be able to make that assessment I think that at a very simple level will have broader reach with a diversified set up organization motivated to sell, so I think that it could be, it could be very good for us, but time will tell.

Craig Nankervis – First Analysis Securities Corp

Okay, and then Paul real quicker just a couple of lines if I could this is a first quarter in several I’ve not heard you to referred to billings anomalies in the quarter that that helped results if that’s the case should I infer that there were no particular anomalies for the first time in awhile just a simple question there.

Paul Auvil

Yeah, I think you can infer to provide you a simple answer to your simple question.

Craig Nankervis – First Analysis Securities Corp

And sales and marketing expense was roughly flatter, slightly down sequentially it was somewhat notable up sequentially in the year ago period, any reason any comment what should I think about that?

Paul Auvil

Yeah, one thing that’s notable is we didn’t have VP worldwide sales and that individual tends to be relatively expensive both in terms of their compensation as well as travel cost etcetera so that’s one factor. We also, the cycle of dollars that we spend on marketing related activities for LeadGen it does have some amount of variation kind of quarter-to-quarter and that’s another factor that play there.

Craig Nankervis – First Analysis Securities Corp

Thank you.

Gary Steele

Thanks.

Operator

(Operator Instructions) And we will go next to Sanjit Singh with Wedbush Securities.

Sanjit Singh – Wedbush Securities

Thank you for taking my questions and then nice quarter guys.

Gary Steele

Thanks.

Company Representative

Thanks.

Sanjit Singh's – Wedbush Securities

To start off with the sale of the Zimbra I was wondering if there’s any impact from your point of view and I know there’s a relationship there I don’t know it was a very significant and driver revenue, but any thoughts on the Zimbra deal and what it means for the business.

Paul Auvil

Yeah, good question, if you look back on our your prior conversations with the street we had talked a lot about Zimbra over the last several quarters and it’s because I think under BMR transition leadership it hadn’t got a lot of attention and so well the BMR itself is a great customer Proofpoint and in fact we provide archiving of their mix deployment of both Zimbra and exchange so they’d historically run internally there hadn’t been a lot of attraction because there hadn’t been driving a lot to go to market activity so we actually here excited about the fact that it’s now moved over to the new ownership and think there could be some interesting opportunities there too early to really comment on whether or not that would be the case but we continue to provide support for the ongoing evolution of the Zimbra platform both for our protection and privacy products as well as archiving and are excited to be really the only provider of world class solution for that platform as hopefully new customers continue to adopt that as a solution worldwide.

Sanjit Singh – Wedbush Securities

I appreciate that clarification. Now I could just follow up on the announcement yesterday by the Cisco and the Fire ramp eye acquisitions may be a little two part of here first did you ever run into in terms if TAP, did you ever run into the kind of fire ramp protection any kind of competitive deals on and then the second part of that question is if you look at their portfolio network then core network security wasn’t an issue for Cisco in terms of rocket share if there are going to address that let’s say over the next year or so, let’s they integrate Swiss fire what is the potential threat in terms of them leveraging IronPort important that may be discounting IronPort terms drive some more network security-- how do you think about that from a comparative standpoint?

Paul Auvil

Yeah, three questions, we have not changed source fire/fire ramp in the market as a competitive offering, we’re engaged in a lot deals at this point and we don’t hear source fire’s name coming up as any form of alternative I think the reality to that is because we’re focused on the advanced receipts and threat problem from a sphere fishing point of view and it’s not something that’s naturally addressed by the pirate solution as we look at the move of Cisco to acquire source fire we actually don’t see any short-term competitive risk or completive threat coming from that side of things, the one thing that we’re doing uniquely today that is a big advantage in the marketplace as we really embraced the cloud and what we were doing with advanced versus address marrying the source fire and fire ramp capabilities to IronPort is a very challenging thing that I don’t think deals by comparative solution. I think that the source fire Cisco relationship will really all be about next generation firewall and showing up what is better in the routine firewall business for Cisco versus empowering non-important anyway.

Sanjit Singh – Wedbush Securities

That’s very helpful. And my final question is actually on the APT market, I think you’ve mentioned in your script about the potential opportunity there it’s emails gateway security markets that’s 1.25 billion, is your point of view that it has the APT market is at least that size.

Paul Auvil

It is, our prospective is that market still early and evolving, we see universal concern from a variety of vertical markets. Organizations today are struggling with what they should do about these advanced persistence threats I think the only exception to that is at the lowering to the market, it’ll be interesting to see do you buy, how big a company do you need to be before it becomes an issue that you really going to spend money on and that’ll be something we will have to see as the market evolves.

Sanjit Singh – Wedbush Securities

I appreciate it, thank you.

Gary Steele

Thanks.

Paul Auvil

Thanks.

Operator

And we have no additional questions in our queue, I’d like to turn the call back over to Mr. Steele for any additional or closing remarks.

Gary Steele

Thanks, I just wanted to take a moment and thank everyone for joining us today. We appreciate your time and we look forward to speaking with you.

Operator

This concludes today’s call, and thank you all for your participation.

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