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Proofpoint, Inc. (NASDAQ:PFPT)

Q3 2013 Earnings Conference Call

October 30, 2013 16:30 ET

Executives

Paul Auvil - Chief Financial Officer

Gary Steele - Chief Executive Officer

Analysts

Phil Winslow - Credit Suisse

Rob Owens - Pacific Crest Securities

Robert Breza - RBC Capital Markets

Nandan Amladi - Deutsche Bank

Jonathan Ruykhaver - Stephens

Tim Klasell - Northland Securities

Sanjit Singh - Wedbush Securities

Michael Kim - Imperial Capital

Operator

Good day and welcome to the Proofpoint Third 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. You may begin.

Paul Auvil - Chief Financial Officer

Thank you and good afternoon and welcome to Proofpoint’s third quarter 2013 earnings call. Today, we will be discussing the results announced in our press release that was issued after the market close this afternoon. I am 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 be making 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 press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in Proofpoint’s most recent Form 10-K and Form 10-Q filed with the SEC and the company’s other filings with the SEC.

During this call, we will present both GAAP and non-GAAP financial measures. These non-GAAP measures may exclude both stock-based compensation expense, acquisition-related costs 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 third 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 October 30, 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.

With that said, I will turn the call over to Gary.

Gary Steele - Chief Executive Officer

Thanks Paul. I’d like to thank everyone for joining us on the call today. We are once again very pleased with our strong execution during the third quarter, which enabled us to meet or exceed our guidance across each of our key operating metrics. Proofpoint’s market share is expanding as we continue to benefit from high demand for our next-generation threat protection solutions. We are also very excited about our ability to enhance the company’s cloud-based platform through our recent acquisitions and believe they place us in a stronger position to defend, protect, archive and govern the most sensitive data for the world’s largest enterprises.

Taking a look at our financial results, for the third quarter, total revenue increased 27% year-over-year to $34.5 million and was driven by the 29% increase in subscription revenue. This represented our 41st consecutive quarter of sequential revenue growth. We also recorded billings of $41.4 million, up 38% on a year-over-year basis. Both the revenue and billings exceeded our third quarter guidance ranges and were driven by renewal rates that were once again exceeded 90%, sustained strong competitive win rates, ongoing new and add-on business momentum and traction with our strategic and reseller partners.

Now, turning to some of our key accomplishments during the third quarter. Similar to the last several quarters, Proofpoint is benefiting from the replacement of legacy security solutions in favor of our next generation cloud-based platform that is capable of addressing the growing number and types of advanced security attacks. Specifically, Google’s end-of-life decision for their standalone Postini infrastructure, continue to drive replacements during the third quarter, which we expect to persist through 2014 and into 2015. In addition, similar to last quarter, we saw many of Postini’s largest distributors and resellers sign up for Proofpoint Essentials, our security and governance offering that targets smaller enterprises worldwide. As a reminder, our acquisition of Maildistiller during the first quarter of 2013 provided the foundation for essentials offering.

We are pleased to report that we have seen early traction and moving customers over to that platform. Some examples of significant competitive wins during the third quarter were Proofpoint solutions replaced Postini include a global financial services firm and one of the world’s largest asset managers with 25,000 employees, a large mutual fund company with 7,000 users, a worldwide agricultural supplier and producer with 16,000 users, a global technology and materials company with 8,000 users. In addition to Postini, we saw ongoing weakness with our other competitors particularly Cisco IronPort, which resulted in additional new customer wins during the third quarter. Specifically, a leading global investment banking and management firm replaced Cisco IronPort with our protection privacy and TAP solution for 35,000 users. A European based global leader in apparel and accessories purchased our protection and TAP solution to replace Cisco IronPort for more than 20,000 users worldwide. And one of the world’s leading research and advisory company also purchased our protection and TAP solution to replace Cisco IronPort for 6000 users.

We also continued to experience strong momentum with Proofpoint’s Targeted Attack Protection in Q3. In particular the new TAP business represented approximately 15% of the total new and add-on activities during the quarter driven by particularly strong cycle of interest from our installed base, which resulted in over half of these new deployments being driven by add-on bookings. Given the increasing number and frequency of advanced persistent threats and the growing number of solutions in the marketplace, I wanted to take a few minutes to highlight TAP’s differentiation and competitive advantages. TAP is an end-to-end cloud based protection solution that identifies and blocks targeted attacks delivered through email. TAP’s advantages include predictive defense, utilizing Proofpoint’s big data systems, attacks are identified before end users even click on the threat, dynamic malware analysis that is designed to defeat the most sophisticated targeted attacks that bypass traditional gateways and endpoint securities.

And Follow Me Protection, which provides cloud-based protection for any device on or off the corporate network. This is particularly critical as enterprises search for ways to meet the accelerating challenge of the security requirements for mobile platforms, particularly in a world increasingly dominated by the BYOD trend. It is important to note that over 90% of targeted attacks come through email highlighting the importance of Proofpoint’s cloud-based TAP solution a marked contrasted offering from other major vendors in the space. As a result, we believe we are well-positioned to benefit from this large predominately Greenfield opportunity. Some of the noteworthy TAP wins during the quarter included one of the world’s largest mutual fund companies which added TAP for over 15,000 users, one of the 10 largest software companies in the world, which added TAP for 14,000 users, a Fortune 100 consumer food company which added TAP for 16,000 users, and a leading financial services and communication company for 13,000 users.

We also continued to experience growth in our cloud-based archiving business during the third quarter, as evidenced by our ability to win deals with a regional healthcare company that added our archive solution for 25,000 users, a large municipality which added on both our archiving and governance solution for 15,000 users. And a leading global hotel company that purchased our archive solution for approximately 5000 users for their Office 365 environment. This is an excellent example of our ability to develop, drive and close opportunities in concert with the Office 365 platform without the assistance of the Microsoft partnership. In July, we introduced our social media compliance capability as part of our archiving solution and I am pleased to say that we signed a handful of customers during the quarter. We believe that our social media platform for archiving continues to strengthen our competitive advantage and provide a must have feature for regulated organizations that embrace social media in their business practices.

Finally, we continued to see solid progress in developing operations internationally as the year-over-year growth rate was once again above the overall average of the company. During the quarter we had key customer wins with one of the world’s largest advertising agencies, a European based global leader in apparel and accessories and a global law firm with over 2500 employees. We believe that the market outside of the United States in both EMEA and Asia represents an ongoing growth opportunity for Proofpoint and we plan to expand our sales and marketing teams and add new channel partners to grow market share in these regions.

In addition, we are excited to announce that we hired Richard Turner as our new VP of the EMEA. Richard brings with him a wealth of sales experience in the security industry in particular and international operations in general. Looking forward, we are very excited about our recent acquisitions, which we expect to further enhance our technology leadership. In July, we acquired Abaca Technology Corporation, which help to further extend our technological lead in malware detection. We are currently completing pilot deployments of Abaca’s unique capabilities with the select set of customers and we are excited about how the functionality is likely to enhance our overall set of security solutions once fully deployed.

In September, we completed our acquisition of Armorize Technologies, which brought dynamic malware detection technology to Proofpoint’s already robust capabilities further enhancing and accelerating our TAP solution. We are pleased to report that we have already incorporated the key facets of this technology into our platform, which is reasonably straightforward given that we had already been using certain elements of the Armorize product line in our initial launch of our TAP solution over a year ago. As a reminder, Armorize pioneered next-generation threat protection technologies, including dynamic threat protection, anomaly detection and malware sandboxing. We have applied this core technology to detect advanced and zero-day malware across multiple threat factors, which is now included as part of our TAP solution. We believe the acquisition further solidifies Proofpoint’s leading position in cloud-based next-generation threat detection technology along with providing its full access to their world-class malware research expertise.

Finally, earlier this month, we announced the acquisition of Sendmail which gives Proofpoint ownership of this industry leading messaging transfer, MTA, further strengthening the foundation of our enterprise security and messaging platform. Over many years, Sendmail established itself as the messaging, processing backbone for both public and private cloud implemented by both service providers and the enterprises throughout the world. In fact, as case in point, Proofpoint’s entire platform is built around the core Sendmail solution. We believe that as the industry evolves. Owning this capability will be critical as businesses need to continue to broaden and enhance their deployments.

In addition, given the many large enterprises that are current Sendmail customers, Proofpoint has a potentially compelling opportunity to leverage this relationship to sell our world-class security archiving and governance solution to this installed base of Sendmail customers and users. Paul will provide additional details on the financial implications of these acquisitions, but as I discussed earlier, I am pleased to highlight that the integration has already been effectively completed for two of these three acquisitions and our most recent acquisition of Sendmail is already well on its way to being integrated.

I would like to also note that each one of these transactions is consistent with the type of acquisition that Proofpoint has successfully completed in the past. Opportunistic, technology-related purchases accompanying by small focused teams and developers who are excited to have their work incorporated into Proofpoint’s SaaS platform. Before I turn it over to Paul, I did want to highlight that in mid-August, we announced that Tracy Newell joined Proofpoint as our new EVP of Sales. Tracy brings more than 20 years of experience in global sales leadership and has an extensive background in SaaS, security and international operations. Since joining, Tracy has already made a positive impact on the company as demonstrated by her recent hiring of Richard Turner to lead our efforts in EMEA. I am confident that she will be a very strategic addition to the team as we continue to scale our operations throughout the world.

So in summary, I am very pleased with our strong execution in the third quarter and our ability to once again exceed expectations. I believe that Proofpoint is well-positioned to maintain its momentum, not only through the remainder of the year, but throughout 2014 as we continue to benefit from our compelling technology leadership and favorable competitive environment and momentum in our business across our installed base of customers throughout the world.

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

Paul Auvil - Chief Financial Officer

Thanks Gary. I am very pleased with our strong execution during the third quarter. Our ability to once again meet or exceed our guidance across all key operating metrics was driven by a combination of new customer acquisition, expansion of business with our existing customers and renewal rate that continues to be well over 90%. I am going to start by providing details on our performance in third quarter of 2013 and then conclude with our outlook for the fourth quarter and full year 2013 as well as provide some preliminary thoughts regarding our 2014 expectations.

Turning to our third quarter results. Total revenue was $34.5 million, up 27% year-over-year and above our previously announced guidance range of $32.5 million to $33 million. These strong results were driven by the 29% year-over-year growth in our subscription revenue, which accounted for 97% of total revenue during the quarter. I would like to highlight that this performance is consistent with the preliminary guidance that we provided over a year ago in October of 2012, where we indicated that revenue growth rates would accelerate as we entered the second half of this year. From a geographic perspective, our growth continues to be largely driven by strength in the U.S. market, where our revenue grew by 29% year-over-year and accounted for 82% of total revenue this compared to 81% last year.

Sellings for the third quarter totaled $41.4 million, reflecting growth of 38% on a year-over-year basis and exceeding our previously noted guidance range of $37.5 million to $38.5 million. Our strong billings performance was driven by a combination of our sustained strength of competitive win rates on new accounts, our ongoing success in selling additional solutions to our installed base of customers and a renewal rate that again exceeded 90%. It is important to note that our renewal activity was particularly strong this quarter with the number of customers opting to renew ahead of their contractual due dates, effectively pulling a few million dollars of billings activity into the third quarter from future periods. In the absence of this groundswell of early renewal activity, our billings growth rate would have been in the low 30s.

Consistent with the past several quarters, approximately one-half of the net new subscription business that we closed during the third quarter was driven by sales of new solutions to our existing customers. We remain very pleased with this statistic as it demonstrates our ability to leverage our extensive and growing customer base by selling them additional solutions and expanding their number of users, 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 third quarter, on a non-GAAP basis, which excludes stock-based compensation, acquisition-related cost and the amortization of intangibles associated with acquisitions, our total gross margin was 72% during the third quarter, which is in line with our prior guidance. In terms of our operating expenses, we continued our investment in sales and marketing as well as research and development to support our future growth plans. During the third quarter, non-GAAP sales and marketing expense increased 20% over the prior year period to $15.9 million, representing 46% of total revenue. This growth in expense was primarily driven by the addition of key sales personnel as well as the investment in marketing and lead generation programs.

Research and development expense increased 36% year-over-year to $7.8 million accounting for 23% of total revenue and reflecting our continued focus on enhancing and expanding our solutions and platforms, particularly driven by the incorporation of the development teams that have joined Proofpoint through our recent acquisitions. General and administrative expense was $3.7 million compared to $2.8 million last year driven primarily by our larger scale as well as the resources needed to accommodate the integration of our recent acquisitions.

Non-GAAP operating loss was $2.4 million for the quarter compared to a non-GAAP operating loss of $2.2 million during the third quarter of 2012. Non-GAAP net loss, which excludes stock-based compensation expense, acquisition-related cost and amortization of intangibles associated with acquisitions, was $2.3 million, or $0.07 per share based on 35.4 million weighted average shares outstanding. And it was at the favorable end of a guidance range of a loss of $0.07 to $0.08 per share provided during the second quarter call.

We are very pleased with this result, particularly since it included the Abaca and Armorize Technology acquisitions, which we had expected to increase the loss by approximately $0.01 per share during the third quarter of 2013, excluding one-time cost associated with the execution of the merger. This compares to a non-GAAP net loss of $2.2 million, or $0.07 per share based on 31.8 million weighted average shares outstanding during the year ago period.

Third quarter 2013 adjusted EBITDA was negative $0.9 million compared to negative $1.1 million during the same period last year and was at the favorable end of our original guidance range. This despite the increased operating cost associated with our acquisitions of Abaca and Armorize. On a GAAP basis, GAAP net loss for the third quarter totaled $7.2 million, or $0.20 per share based on 35.4 million weighted average diluted shares outstanding. This compares to a GAAP net loss of $4.6 million, or $0.14 per share based on 31.8 million weighted average diluted shares outstanding in the prior year period. A reconciliation of GAAP to non-GAAP financial measures has been provided in the financial statement tables included with our press release.

In terms of cash flow, I am pleased to report that we generated $7 million in operating cash flow for the quarter and invested $2.5 million in capital expenditures in support of our ongoing build outs of infrastructure for our global SaaS platform. This resulted in positive free cash flow of $4.4 million for the quarter. Cash flow was – for the quarter was bolstered by stronger than expected collection cycle of orders that were invoiced and collected within the quarter as evidenced by our sequential improvement in DSO performance.

We are pleased with this performance for the quarter, and at least just with the year-to-date GAAP free cash flow of roughly $3 million. Note that a portion of the purchase price paid for the acquisitions closed during the quarter were associated with the payments by Proofpoint of certain current liabilities carried in the balance sheets of these acquired companies at the time the acquisition is closed. And as such a portion of the purchase price was recorded as a negative adjustment to operating cash flow rather than investing activities. In the absence of this affect our overall cash flow year-to-date is closer to $4 million well in our way to the $5 million guidance that we provided in October of last year for cash flow for our business this year.

Turning to the balance sheet, we ended the quarter with $71.6 million in cash and short-term investments and $2.8 million in debt compared to $89.7 million in cash and short-term investments and $3.2 million in debt as of June 30, 2013. This sequential decrease in cash during the quarter was driven by the combination of cash flow generated from operations, the proceeds from ongoing stock, stock option exercises and the contributions to capital from our employee stock purchase plan offset by the cash disbursements associated with the purchases of Abaca and Armorize.

On a pro forma basis, including the cash used to purchase Sendmail, we currently stand with approximately $50 million in cash and cash equivalents on the balance sheet as of today. We ended the quarter with an accounts receivable balance of $21.9 million resulting in DSOs of 49 days during the third quarter and notable sequential improvement from the 55 days recorded last quarter due to the strong collections cycle during the third quarter. Total deferred revenue increased $22.5 million year-over-year to $101.3 million during the third quarter, up from 7$8.8 million in the year ago period. Compared to the second quarter of 2013, deferred revenues increased by $6.9 million. During the third quarter the overall duration of our contract terms finished below our historical average of 20 to 25 months and down sequentially from our second quarter results, marking ongoing progress and our goal to shorten contract duration across our customer base.

Now turning to our financial outlook starting with the fourth quarter, we currently expect billings to be $44 million to $46 million resulting in year-over-year growth rate of approximately 23% at the midpoint of the range. As we noted on the second quarter call, this lower billings growth rate in this coming quarter as compared to first three quarters of 2013 is not indicative of a deceleration in our business, but rather as a reflection of a relative tough comparison with respect to the fourth quarter of 2012 due to our unexpectedly strong growth in billings in new business contracts for that prior period, combined with a record cycle of renewal activities driven by multi-year renewals that were renewed in that quarter, which by definition are not of renewal again here in the fourth quarter of 2013. Note that this current billings guidance reflects contributions from our recent acquisitions of less than $1 million. I should also note that Proofpoint’s business with the U.S. federal government is well under 5% of total revenue on an annual basis. And as such, we believe that we are particularly well insulated from the ongoing challenges that grip the current fiscal policies in our nation’s capital. Regarding revenue for the fourth quarter, we are targeting total revenue of $35 million to $36 million or 24% growth year-over-year as the midpoint of the range.

As a reminder, per the prior press release that we issued regarding each of our recent acquisitions, we do not expect any of them to have a meaningful impact on revenues during the fourth quarter. We expect fourth quarter non-GAAP gross margins to be approximately 72% essentially in line with the second and third quarters. In regards to adjusted EBITDA we are currently targeting negative $3 million to negative $2 million for the fourth quarter. And I would like to highlight that in the absence of the approximately $2.5 million unfavorable impact to non-GAAP net income attributable to the Armorize and Sendmail acquisitions for the fourth quarter of this year, the midpoint of this updated EBITDA guidance range meets our preliminary guidance for 2013 that we provided in October 2012 specifically that Proofpoint will deliver a breakeven adjusted EBITDA in the fourth quarter of 2013.

We expect fourth quarter non-GAAP net loss which excludes stock-based compensation, acquisition-related costs and amortization related to acquisitions to be $5 million to $4 million or a loss of $0.14 to $0.11 per share based on approximately 36.2 million weighted average diluted shares outstanding. This assumes an income tax provision exclusive of discrete items of $0.1 million to $0.2 million during the quarter. And it also incorporates the $0.02 per share loss impact from the Armorize acquisition, as well as $0.07 per share loss impact associated with the recent acquisition of Sendmail as Proofpoint takes on the costs associated with these newly acquired teams and begins to build a recurring revenue stream.

From a full year perspective, we expect billings to be in the range of $155.5 million to $157.5 million, an increase from our prior guidance of $151 million to $153 million due to our strong performance this quarter and a modest increase in our outlook for the fourth quarter. This represents growth of 33% to 35% as compared to last year. With this billings performance we would expect total revenue of $132 million to $133 million, again an increase from our prior guidance of $129.5 million to $130.5 million reflecting an annual growth rate of 24% to 25%.

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 the full year 2013 to be in the range of negative $7 million to negative $6 million. We expect full year 2013 non-GAAP net loss which excludes stock-based compensation, acquisition related costs and amortization related to acquisitions to be $13.5 million to $12.5 million or a loss of $0.38 to $0.36 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 $0.5 million to $0.6 million for all of 2013. This includes loss adjustments related to the acquisitions of Armorize and Sendmail of $0.04 and $0.08 per share respectively.

I would like to highlight again that we are currently generating a net loss and as such, our fully diluted share count of 35.4 million for Q3 did not include the impact of vested stock options. If we were profitable today, our fully diluted share count would have been approximately 40 million shares when applying the treasury stock method to these vested options. Finally, we are reiterating our free cash flow guidance of approximately $5 million for the full year 2013. And this range assumes capital expenditures of $6 million to $7 million for the full year. Note that this does not include the cash disbursements associated with the purchases and acquisition of Armorize and Sendmail.

While we are in the early stages of our planning process, I would also like to share some preliminary thoughts in terms of a few key characteristics of our model for 2014. We are comfortable with providing an estimated initial baseline revenue growth rate of approximately 24% to 25% for our full year 2014 with our recent acquisitions contributing approximately two percentage points of this outlook. Note that our revenue growth rates in the first quarter of 2014 and it’s a particularly challenging year-over-year compare due to the $1 million customer data import that was completed and recorded as revenue in the first quarter of 2013, which will not occur in the first quarter of 2014. We would expect to record billings growth rate, but as a few percentage points higher than the stated range of the revenue growth. Note that the billings growth rate in the first quarter of 2014 is likely to be lower than the other three quarters of the year pressured by the seven figure four year add-on deal that we closed during the first quarter of 2013, which by definition will not occur in 2014.

We believe that this preliminary 2014 guidance for revenue and billings represents a strong growth outlook particularly considering that it is on top of our just increased 2013 outlook, the global economic environment and the fact that we are still a few months away from the start of the year. We expect Sendmail in particular to contribute approximately $5 million total revenue in 2014, half from the legacy renewals associated with our maintenance contracts and the other half after new sales of Proofpoint solutions to these existing customers. And this class of revenue we consider to be organic revenue growth.

I think it is important to also highlight that Sendmail was built on a perpetual license model and as such, we will be for all intents and purposes rebuilding the revenue base from scratch as we transition to our subscription based business model. With respect to adjusted EBITDA for 2014 we currently expect to report an adjusted EBITDA loss with our initial range in the single digit millions, mid-single digit millions achieving breakeven or positive results during the fourth quarter as the company assimilates the Armorize and Sendmail acquisitions, which together created drag on 2014 EBITDA of approximately $5 million for the full year. We also plan to modestly accelerate our investment in sales and marketing to capitalize on the weakening competitive environment as well as the rapidly expanding opportunity in the new landscape of advanced persistent threats and continue to expand our investment in research and development to support our ongoing slate of key product development initiatives. We would expect our EBITDA loss to increase in the first quarter of 2014 as compared to the – the first quarter of 2014 as compared to the fourth quarter of 2013 with a gradual improvement over the course of the year.

Finally, in terms of cash flow, I am pleased to indicate that despite these acquisitions and our stepped up levels of investment to pursue the key opportunities in the market, we currently expect that our free cash flow will roughly double or perhaps a bit more for the full year 2014 as compared to our current expectations for the full year 2013, which we believe is particularly compelling given our current baseline growth rate. We plan to further refine our 2014 forecast as we continue our planning process, integrate our acquisitions and gain additional insights from our extended network of partners and sales channels and as such we will provide a more detailed update during the fourth quarter earnings call. Note that is in the past periods to the extent that we can deliver upside to the revenues as outlined in our guidance, we do expect to reinvest most or all of that upside back into the company in the form of initiatives that we believe will deliver differentiated solutions for our customers and improve long-term growth for the business overall.

So in summary, we have a strong third quarter and believe that Proofpoint remains well-positioned to maintain the momentum through the end of this year and 2014 as the worldwide demand for our integrated cloud-based solution remains strong.

And so with that, I want to thank all of you for taking the time to join us on the call today. And we’d be happy to take your questions now. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Phil Winslow with Credit Suisse.

Phil Winslow - Credit Suisse

Hi, thanks guys and congrats on another great quarter. Gary, I wonder if you’d provide some color on what you are seeing in the, just the competitive dynamics out there and also in terms of just pricing environment? Before the core security solutions, obviously there have been a lot of changes from your competitors over the past year, it’s kind of where you are seeing right now and then particularly with Google sort of where do you think we are in that process? And also on the archiving front, you obviously highlighted some good wins there. I wonder if you could provide just a little more detail on archiving and just sort of what your expectations are there for sort of the rest of this year and then into next year?

Gary Steele

Great. So from a competitive standpoint as we indicated in the prepared remarks, it is continuing to be favorable for us. So as we indicated there has been a good number of large customers that have moved from Postini to Proofpoint. We expect that to continue all the way through ‘14 and into ‘15. And we have – we are already in contact with customers today that have renewals for Postini in the ‘14 timeframe. So we feel good about the continued opportunity there. If you look more broadly beyond the Google Postini opportunity, we are seeing erosion in the Cisco IronPort base, there is a level of question and dissatisfaction that we have frankly taken the advantage of. We think that will present for quite some time. The customers that we indicated in our prepared remarks I view as key marquee accounts. They were all very – they had great stature, great customers, great reputations, but I view that as really the tipping point. I think we will see more customers to follow based on that.

So overall, we feel very good in the traditional security world from a TAP perspective or finding that we are winning our share of business out there or providing that something is uniquely differentiated. And frankly we are winning share, our share of wallet and which makes me feel quite good about our ability to deliver something that is working well for our customers. And I think frankly what’s happening in that particular market segment is there is a broad interest and a growing concern about the different types of threats people are seeing and therefore are willing to evaluate solutions.

Turning to archiving, we did have some very nice wins in the quarter. And in that particular market segment, the two places where we find opportunities will replace existing solutions one would be with customers that have invested in an on-premise solution like a Symantec enterprise vault. And secondarily, we are seeing erosion of the HP autonomy base and that is creating opportunity for us. We also believe that with these new social capabilities, people are rethinking their overall compliance strategy and that’s providing an entry point into customers. So from a pricing point of view, which I think was the last part of your question, Phil and hopefully I captured all this. From a pricing point of view, I think pricing was very stable in the quarter. We are not seeing sort of desperate moves from the competitors driving price down. We found it to be quite stable throughout the quarter. Did I miss anything in your question, Phil?

Phil Winslow - Credit Suisse

No, that’s perfect. Thanks guys.

Gary Steele

You bet. Thank you.

Operator

Our next question comes from Rob Owens with Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Great, thank you very much. Maybe could you just talk about your acquisition strategy, you have seen a couple over the last quarter just in terms of how you are thinking about these the type of them the pace we should expect in the relative side. And I know you noted that these are not revenue-based acquisitions, they are most strategic in nature, but just want to kind of get my arms around kind of what’s your thinking is, where some of the holes are that you can fill in and just what the pace of these should be on a go-forward basis?

Gary Steele

Yes, great question. So as we talked about it in the call, I think that the way to characterize the acquisitions that we are focused on are ones that are technology centric, but I look at Armorize, for example, we ended up with some incredible technology. You add to that then a phenomenal team people with unique expertise. The same is true of what we got from Sendmail, their unique messaging knowledge is super beneficial to the company. And then if there are – I think that combination of technology plus people was kind of the primary things that we look for. With Sendmail, we actually got a reasonably interesting customer base. And as think we can create some leverage there by taking our solutions and selling those to that Sendmail customer base.

In terms of the pace, I think that we will be very thoughtful about the kinds of deals we do. We will moderate the pace as required to ensure that we are successful with the integration efforts that we have. And so we will basically pace ourselves where we think that we can drive the appropriate level of integration to get maximum value for the money that we are spending, but look to us to do smaller technology-centric, talent-centric kinds of acquisition. We don’t see ourselves in the short-term to do anything that would be larger that would be trying to buy a bunch of revenue. Paul, would you add anything to that?

Paul Auvil

I think just the fact that because we did do three in a relatively short period of time after a reasonably long period, where we hadn’t done much don’t look to us to do anything here in the near-term. We need to digest the technologies that we have acquired. That’s actually as Gary talked about it in the prepared remarks, it will come along quite nicely and we are pleased with where we are, but Gary and I have been around the block a few times and so we understand the importance of making sure you get full value out of the things you acquired before you go out and buy something else. So of course, we are always trolling the universe looking for interesting opportunities. And as they come along, we will certainly drive something over the line, but don’t look for anything here in the current quarter. I think it’s extremely unlikely we do a deal between now and the end of the year, just new sample.

Rob Owens - Pacific Crest Securities

Great, thanks for that. And then if we look at some of the strategic partner influenced revenue that you get in period, how is that trending and maybe some update on the Microsoft relationship?

Paul Auvil

Yes, so that the revenue that we get in period to your point where we do monthly billings comes from the strategic partnerships. Principally, the primary progenitor of that is Microsoft. As we have talked about two calls ago, it’s not this call, but the call prior, the Microsoft relationship is evolved so that they have specifically started to push net new business around the Office 365 platform out to their partners. And as a result, we are now engaged with Microsoft partners to drive net new businesses. And so as a result, when we close business through those partnerships, we are not dealing with this Microsoft directly and hence it’s not under that kind of classic monthly paid contract. It’s with those partners, where it’s more of our classic paid annually in advance and then recognized over a 12-month period. So with all that as sort of the backdrop, Microsoft is a percentage of revenue and monthly billings as a percentage of revenue will modestly trend downward quarter-to-quarter on a go-forward basis, which is what we suggested at 90 days ago and I think you will see that as evidenced in what we formally file in our Q this quarter and that’s what we would expect go forward. So it’s been a wonderful source of revenue, we actually does continue to grow on an absolute basis but the growth rate of business coming from the Office 365 partnerships combined with business that we largely closed through these other channels is growing at a pace that is greater than the rate at which the Microsoft business through the historical monthly payment agreement grows and sort of becomes small percentage of revenue over time.

Rob Owens - Pacific Crest Securities

Great, thanks guys.

Paul Auvil

Yes.

Operator

Our next question comes from Robert Breza with RBC Capital Markets.

Robert Breza - RBC Capital Markets

I was wondering if you can just talk a little bit about TAP I know you mentioned in your prepared remarks it’s 15% of the new business. I am curious that just for you to understand a little bit how much of that new business is being pulled through or maybe existing business is being pulled through with TAP and where do you think TAP can be 12 to 24 months from now? Thanks.

Gary Steele

Yes I will start and Paul will probably have some additional comments so great question so we – what we are seeing today is that TAP is opening the doors for many opportunities that we are pursuing. Because of the new threats that organizations are seeing they want to have a dialogue about TAP that gives us the opportunity to get in there and then drive not only a TAP sale but typically a replacement cycle of whatever they might have on the email security side. And so strategically for us it’s played a critical role in helping drive interesting new opportunities for the business. And as indicated in the script, we talked about the fact that we had a very successful quarter going back to our install base and then over half of the TAP business this last quarter was sold to the install base which we were really encouraged by. So we are getting the benefit not only of opening doors in new customers, but also creating more value with the existing customers. And I will let Paul for some additional comments there.

Paul Auvil

Yes so that’s spot on, so as we look at the pipeline we have a very strong pipeline of both existing accounts that we would like to add to TAP to their current platform solution from us, as well as a number of net new accounts. And as Gary described what’s interesting about the net new accounts is often that TAP sales cycle also that generates opportunities to sell other things with it was the most natural thing going along with it being protection. So that’s been a very nice marker for us in helping to drive broader growth, and we are excited about how that will play out here particularly over the next several quarters. So in terms of TAP can be over time, it’s interesting, it’s actually the smallest of all the markets that we currently play in when you look at protection, when you look at privacy, when you look at archiving. The advanced persistent threat market is the smallest but the most rapidly growing by far and a Greenfield market as opposed to the other businesses that we are in. So we are cautiously optimistic that it could become quite a meaningful part of our revenue stream as you look at over the next call 12 months to 18 months. But it remains to be seen as we basically drive execution of our sales team to go out and develop and ultimately close on that pipeline.

Gary Steele

And Rob one other quick comment, the one thing that I would say that is really encouraging to me as we are looking at the sales process is when we are selling today we are going in, we are setting someone up because it’s the cloud based service we can do that very quickly and we can show people the effectiveness of the TAP in a very short amount of time. And frankly there is nothing more powerful in the security world to be able to show and demonstrate the kinds of threats that you can block. We are clearly not selling insurance, we are really showing people the kinds of attacks that we can identify and block and protect the users from, so that gained a lot of interest and frankly just makes it a how lot easier to sell.

Robert Breza - RBC Capital Markets

Great maybe just and more of a modeling question for Paul here. As we think about our model and thank you for the guidance on preliminary FY ’14 numbers. You mentioned that we should expect cash flow to double I am assuming most of that would come from deferred revenue possible upside or possibly working capital just given the operating profile that you laid out or could you correct me there or guide?

Paul Auvil

Yes, as I talked about the billings growth rate will be a few points higher than the revenue growth rate as we look at our current expectation and so that higher billings growth rate produces deferred revenue growth which then ultimately produces additional surplus cash flow. So I would look for most of it to come through deferred revenue production.

Robert Breza - RBC Capital Markets

Perfect. Thank you. Nice quarter.

Paul Auvil

Thanks.

Operator

Our next question comes from Nandan Amladi with Deutsche Bank.

Nandan Amladi - Deutsche Bank

Hi good afternoon. Thanks for taking my questions, it’s actually related to some of the comments you made on the acquisition front. If you just sort of contrast the two recent acquisitions you made, it seemed like Armorize was more skewed towards a unique technology and perhaps Sendmail, it appears may have had an element of a customer base associated with it. So can you elaborate a little bit about the strategic rationale particularly for the Sendmail acquisition, given it was a well-established, older company?

Gary Steele

Sure. So with Armorize as we indicated in our prepared remarks, the thing that we were excited about is we have the opportunity for over a year to be able to utilize that technology as part of our TAP solution. So we had, had the ability to one fully test that understand all that technology. And we were seeing the benefits of that being delivered through TAP. So we were very confident, not only about the product, but we also had the opportunity to work with the team. So we knew the team well. We knew that they would fit culturally into the company and we felt like integration will be easy. So that we have just bettered it front to back, we felt very good about the opportunity and obviously critical to delivering in this exciting new APT market. And then with Sendmail, similar – so they – as we indicated in our prepared remarks, underlying MTA solution that we use when we ship our protection solution and we turn customers on, underlying that is the Sendmail product. So we had been leveraging the open source version of that. And we have been doing that since the inception of the company. And so we would have lots of experience with that particular technology. And as you indicated, the company is older in age, but what was exciting for us is the ability to actually own that technology, have control over it, was extremely beneficial. Yes, we did get some customers with it, but really it was about technology and people that’s what drove us to go and complete that acquisition. So we are extremely excited about it. We think there is just a lot of synergy and having control over that critical piece of technology as we have already seen the benefits of that.

Nandan Amladi - Deutsche Bank

Okay, thank you.

Gary Steele

Thanks.

Operator

Our next question comes from Jonathan Ruykhaver with Stephens.

Jonathan Ruykhaver - Stephens

Yes, hi guys. Congrats on the strong execution. My question is around the Sendmail open source community, will you continue to support that effort? And if so how does it benefit you? Is there an opportunity to accelerate the commercialization opportunity somehow?

Gary Steele

Yes. So we will continue to support the open source community. We will do updates and make contribution that we make modifications to the commercial version. The interesting and cool thing think about the open source community is it drives broad usage of across many, many, many enterprises, thousands of enterprises in the world today. And there is clearly an opportunity for those organizations to be converted to the commercial version, but more importantly then to take advantage of the broader set of Proofpoint capabilities. And so we view the open source community frankly as a feeder to selling those organizations, more sophisticated, security and governance solutions.

Jonathan Ruykhaver - Stephens

And how many organizations use that open source software, I think you mentioned a thousand, is it still thousand?

Gary Steele

And I don’t have the exact number at the top of my head, but it’s thousands of companies.

Jonathan Ruykhaver - Stephens

Okay. Also on the Sendmail acquisition, can you talk about any technology integration plans, will elements of Centrion be integrated into Proofpoint enterprise protection and will that product continue to ship as a standalone product looking out longer term?

Gary Steele

So what we will continue to do is shift Centrion, but you will see convergence between Centrion and the base open source version that Proofpoint has leveraged for a long period of time. And because of the level of similarity that integration work is actually relatively straightforward.

Paul Auvil

Yes. And I would say one of the important goals here is because aside from the thousands of open source accounts, there are number of customers that they closed under perpetual licensing models, which under our go-forward model doesn’t bring us much in the way of revenue, but installed base of users of the Centrion capability and its associated appliances. One of our goals here is to make sure as we drive that roadmap that it’s not disruptive to those existing accounts, so that we can then essentially as they evolve and upgrade their platform, evolve and upgrade to a platform that’s consistent with our legacy capabilities on the Proofpoint side that, that makes it very easy to enable and turn on features to the extent that the customers are interested in buying them of the existing core product line that we sell under the Proofpoint brand.

Jonathan Ruykhaver - Stephens

Right, okay, good. And then my final question, can you just talk about any strategy behind pricing for TAP as a result of Armorize and Abaca. Will you offer different pricing for different functionality? Is this strategy more around just enhancing the feature set to drive greater competitive posture?

Gary Steele

Yes, great question Jonathan. So what you will see from us on TAP is we will continue to add additional capabilities to the core TAP offering. And we will likely price our capabilities incrementally from what people – from the functionality that they have today, so if someone adopt TAP there will be incremental capabilities that are on a per subscriber basis that we made available to them. And then we will obviously offer bundles where people can get all of these capabilities offered as one thing. So you will see more pricing opportunity and value opportunity over time with that because of our Armorize acquisition.

Jonathan Ruykhaver - Stephens

Okay, what is that that pricing change take effect, will we start to see that next year?

Gary Steele

You will start to see things early next year in terms of new capabilities and new price offers.

Jonathan Ruykhaver - Stephens

Okay, good, thanks.

Gary Steele

Thanks Jonathan.

Operator

Our next question comes from Northland Securities, Tim Klasell.

Tim Klasell - Northland Securities

Yes, good afternoon everybody and congrats on the quarter. Most of my questions have been answered, but we had a lot of companies report occasional difficulties over there in Europe. What are you seeing that’s obviously a growth vector for you guys, have you seen any disruptions over there?

Gary Steele

Our presence in Europe is relatively small today. And as a result of that we haven’t seen macro. We haven’t really been impacted by macro disruption. I think that it’s really driven by the fact that what we are selling and the scale of which we are selling today, we are selling something that is a must-have capability, but also our presence is relatively small. So I think we have been insulated from the broader macro situation.

Tim Klasell - Northland Securities

Okay, good. And then early on in the call you were talking about the Mail Distiller acquisition and that’s I will call it maybe a lower segment of the market. Can you give us your feelings about the relative size of that versus the market I sort of think if you guys as sort of higher end if you will?

Gary Steele

Yes, so when you look at segmentation of the market, our primary objective in that acquisition was to give us access to this broader Postini channel. And we needed to set the capabilities that were built into our core product. And that’s what drove the Mail Distiller acquisition. If you do simple segmentation, you can think of the mid-sized and large enterprise where we traditionally play is roughly half the market. And then everything below that to be the other half and then with Proofpoint essentials we are really playing in the top quarter of that half, but it basically gives us 25% more market to go after.

Tim Klasell - Northland Securities

Okay, great that’s very helpful. And then as I am concerned - okay, thank you. I have a quick question then to you Paul, you mentioned the doubling of free cash flow, how do you think about that relative to your contract duration is that a doubling despite contracts durations coming in or do you think you are where you want to be out with contract durations right now?

Paul Auvil

Yes, that’s an excellent question. So when I think about that guide I think about only another fairly modest improvement in contract duration from where we are today. We have been working on this now for over two years and our historical contract duration range public offering was 20 months to 25 months. We are now kind of consistently hanging out in the high teens. And I think this realistically for now I think that’s where we will stay, we may move it down a month or two depending on the quarter, but ultimately for the majority of our markets the customers who are conditioned over the many years to market to look for both one and three year pricing and particularly for customers that were transiting off of whether it’s Postini, Cisco IronPort those various offerings from McAfee or Symantec.

Many of them had historically bought three year contracts, so they had budgeted for three years and so when the renewal comes up they are inclined once they make any technology selection to go with three years. And so it’s kind of hard to break that habit. So it is true with our archiving product we tend to drive more one-year deal. So as archiving continues to grow that helps bring the duration down a bit. But long-winded answer to a short question, which is the guidance that I gave around cash flow assumes duration roughly consistent with what we saw this year.

Tim Klasell - Northland Securities

Okay, great, thank you very much guys.

Paul Auvil

Yes.

Operator

Our next question comes from Sanjit Singh with Wedbush Securities.

Sanjit Singh - Wedbush Securities

Thanks Gary and Paul for taking my question. Regarding TAP and kind of the APT market, you mentioned in your script about potentially targeting more throughout, but can you give us a little color on that? I know e-mail has been the focus, but is there going to be a play on the file side or the web side of the market as well?

Gary Steele

Those opportunities are interesting to Proofpoint. We haven’t announced seeing things specifically as it relates to those opportunities. So one thing that we are finding though is this focus on e-mail has been a very good one, because most organizations recognize that these targeted tax are coming in along that factor. So while there are opportunities to expand to web or file, we will be focused initially in the e-mail side of things and we will continue to add capabilities there first. So that’s what you will see from us first. And then we will decide at the later date whether we want to pursue other growth factors.

Sanjit Singh - Wedbush Securities

Great. And then just a follow-up on the APT side, given that a lot of the vendors are bringing out some offerings to play in this market, how does the customer acquisitions cost qualitatively look versus your other parts of your business or maybe even over time in this segment of the business? So if you are getting more competitive, does it cost more to win new customers, or you are really seeing just TAP being kind of an obvious sale where it is, it’s a pretty?

Gary Steele

What’s really interesting, it’s a great question. One of the things that’s interesting here is because of the heightened level of concern around these threats, there is a level of urgency today for organizations to make decisions and put something in place. I think the classic Chief Information Security Officer today doesn’t want to be unprotected in some way. And what they are really looking for is visibility and capability. And so, interestingly, we actually see shorter sales cycles on the TAP side than we see it in the other areas of our product lines, because there is nothing to replace their budget that has to be found. And people are pretty aggressive in the buying process. So although there is a lot of noise in this segment, we found that because of our focus we have been able to drive relatively efficient sales cycles and we haven’t seen anything changing that over the course of the last six, nine months. I would say we are actually getting better at selling frankly.

Sanjit Singh - Wedbush Securities

Very interesting. And then what drove the early renewals that you talked about in terms of the benefit to billings this quarter?

Gary Steele

Yes, so good question. We have continued to expand the number of people who are involved in driving add-on business for the company. And so part of that role is to of course engage with the existing accounts to talk about add-on, now those folks don’t get paid to do renewals. But as you start to drive add-on related conversations, it starts getting the customer thinking about, well I got a renewal coming up, yes, may be I have to just get that done too. And so I would say that, that ongoing reach and presence in our add-on activity seems to be stimulating a little bit more early renewal activity than we have seen historically. It’s hard to say whether we’ll see it continue quarter-to-quarter, but that was the basic progenitor of that this quarter.

Sanjit Singh - Wedbush Securities

Thank you very much.

Gary Steele

Thanks.

Operator

And our final question comes from Michael Kim with Imperial Capital.

Michael Kim - Imperial Capital

Hi, good afternoon guys. Could you talk a little bit about the go-to market for TAP and the ramp in the partner channel? How – can you maybe just talk a little about the progress on how you have ramped that in the training and the pipeline on that part of the business?

Gary Steele

Sure. So the one thing that we have done to ensure that all of our reps as well as our channel understand the product as we have done a pretty extensive training effort and it’s Tracy Newell, our new EVP of Sales, she joined mid-August. And literally from the moment she walked into the door, she really drove a whole new initiative around enablement, training and enablement. And a lot of that actually got done in the September timeframe. So we have continued to invest to ensure that our reps are capable and there is an ongoing channel initiative to drive more enablement of more partners. It’s clear that from a buyers’ perspective, there is the pretty sophisticated buyer out there. And so one of the things that we want to make sure is that we have all of our people able to converse in a way that it’s super helpful to the customer and drive a very value-added sales cycle, we are going to continue and invest on the training side, both with our employees as well as the channel. So it’s a big focus area for the company.

Michael Kim - Imperial Capital

And just to clarify, does this TAP also extend to the strategic partners and to the IBM channel and also the channel partners for Microsoft?

Gary Steele

It does. And so we are early with IBM, we have done limited training of their employees on TAP. That’s something that we are working on now, but it’s we have had a limited number of folks trained to-date. We frankly had – and then in the Microsoft side, we have already done a whole bunch of trainings for those people. So we have to see how that then translates into revenue over the coming quarters.

Michael Kim - Imperial Capital

Okay, great. Thank you very much.

Gary Steele

You bet. Thanks.

Operator

That does conclude our question-and-answer session. I would like to turn the call over to our speakers for any closing remarks.

Gary Steele - Chief Executive Officer

Great, thank you very much. I just want to take a moment and thank everyone for joining us today. We are excited about our results and we look forward to talking to you again next quarter. Have a great day.

Operator

Again, that does conclude our call and we appreciate your participation.

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