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Proofpoint, Inc. (NASDAQ:PFPT)

Q1 2014 Results Earnings Conference Call

April 30, 2014, 05:00 p.m. ET

Executives

Paul Auvil – Chief Financial Officer

Gary Steele – Chief Executive Officer

Analysts

Rob Owens – Pacific Crest Securities

Phil Winslow – Credit Suisse

Matthew Hedberg – RBC Capital Markets

Craig Nankervis – First Analysis

Jonathan Ruykhaver – Stephens

Tim Klasell – Northland Securities

Sanjit Singh – Wedbush

Michael Kim – Imperial Capital

Eric Suppiger – JMP Securities

Jonathan Ho – William Blair & Company

Walter Prichard – Citigroup

Operator

Good day and welcome to the Proof Point First Quarter 2014 Financial Results Conference Call. Today’s call is being recorded. At this time, I would like to hand things over to Mr. Paul Auvil, Chief Financial Officer. You may begin.

Paul Auvil

Thank you. Good afternoon and welcome to Proofpoint’s first quarter 2014 earnings call. Today, we will be discussing the results announced in our press release that was issued after the market closed today. I am Paul Auvil; Chief Financial Officer of Proofpoint and with me on the call 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 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 stock-based compensation expenses, acquisition related costs, accretion of the debt discounts and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, costs associated before litigation 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 from, 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 first quarter 2014 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 April 30, 2014 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 said, I will 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 once again very pleased with a strong execution during the first quarter which resulted in our ability to exceed the high end of expectations across all of our key operating metrics, particulary our billings and $1.8 million in free cash flow generation.

During the quarter we saw a strength across our entire product line highlighting the high demand for our world class set of security, achieving and governance solutions. In addition, Proofpoint continues to witness a decline in terms of the quality and capability of many of our competitor’s solutions. Consequently we believe the company is well positioned to maintain a momentum and gain market share in the longer term.

Taking a quick look at our financial results for the first quarter. Total revenue increased 39% year-over-year to $42.7 million and was driven by a 45% increase in subscription revenue and this represented our 43rd consecutive quarter of sequential revenue growth. We also recorded billings of $46.6 million up 33% on a year-over-year basis. Both revenue and billings were above the first quarter guidance ranges

Now turning to some of our key accomplishments during the first quarter. Our high win rates versus our competition continued to drive momentum in winning new customers. Larger and mid type organizations that have been relying on outdated legacy detection and prevention technology which often left them unprepared to have upstage advanced security attacks are switching to Proofpoint’s cloud based solution. A few of these competitive wins include a Fortune 500 financial services company with 80,000 users which purchase our protection and privacy solutions.

A global provider of medical technology with 25,000 users which purchase our protection and path solutions. One of the worlds most renowned universities with over 25,000 users which also purchase our protection and TAP solutions. A leading regional consumer goods retailer with 30,000 users which purchase our protection solution and a large US based industrial company with over 13,000 users in addition to a large North American energy provider with 10,000 users both of which also purchase our protection solution.

We are also excited to report that we had another very strong quarter with Proofpoint Targeted Attack Protection as we once again grew the TAP business by over 100% year-over-year in Q1. We are particularly pleased to announce a key deal with a large global enterprise that deploy TAP for over 300,000 users. Due to a corporate mandate that requires the solution to be deployed globally on a very short notice, we successfully deployed TAP across the entire enterprise in less than 48 hours, which we believe demonstrates the power of the cloud as well as the strong execution of our major accounts team.

Some of the noteworthy TAP winds during the quarter included a leading global agricultural cultural supplier which added TAP for 16,000 users. A premiere regional health care provider in North America, which deployed TAP for 13,000 users, a leading global provider of employment services which procured staff for 4000 users and a global medical technology company along with one of the worlds most renowned university each with 25,000 users which deployed both TAP and protection as I mentioned earlier.

We are also excited about the recent addition of our next generation predicted defense for TAP which we launched at the RSA Conference in February. Our ability to effectively identify a block and TAPs before uses are compromised has resulted in good early interest in its enhanced solution and it also creates an additional revenue opportunity for the TAP business.

Furthermore, the momentum of our privacy solution has been 10 years; appear to keep privacy wins included, a large financial services company which brought our privacy solution for 13,000 users. A leading consumer products company which brought our privacy solution for over 10,000 users and a Fortune 500 retailer which brought our privacy solution for 5500 users which also purchased our protection and TAP solutions.

We also had another strong quarter in our cloud based archiving business as evidenced by deals one where a leading urban public school system in the US that purchased our archiving solution for 25,000 users and one of the worlds largest consumer services company which purchased our archiving solutions for 7000 users.

A new important driver in our archiving business is our social media capability where we continue to see traction. During the quarter we had wins with a number of financial services companies, including a large regional bank with approximately 1,400 branches throughout 12 states. We believe that our social media compliance capability for archiving continues to strengthen our competitive advantage and provide net cap feature for regulated organizations that embrace social media and their business practices.

During the quarter we were also pleased with the performance of both our new and add-on business with new bookings roughly square between the two. As a reminder, the number of customers using two or more of our solutions increased to 33% at the end of 2013, up from 30% in 2012 and 26% in 2011, resulted in a substantial opportunity for us to drive revenue growth to continue it out on sales.

Finally, we continue to make progress towards further expansion of broad as we build the foundation to drive our efforts in Europe and Asian Pacific, as evidenced by deals won where one of the worlds largest semi conductor providers which purchased our solution for 30,000 users, a global financial services provider which purchased our protection solution for 7,500 users, a large transportation and logistics company which purchased our protection solution for 8000 users and a leading provider of information technology and communication services which purchased protection for over 20,000 users.

While we are pleased with the solid momentum, we continue to refine our organization strategy and as a result Tracey Newell, our EVP of worldwide sales has made a number of – changes enabling her to take a more hands on approach towards managing our operations in Europe. As a reminder, the addressable market outside the United States in both EMEA and Asia Pacific continues to represent a growth opportunity for Proopoint. And we finally continue to expand our sales and marketing teams in those locations as well as our new channel partners to further grow market share in these regions.

So in summary, I am very pleased with our strong start to the year and the momentum we have seen across Proofpoints entire product line. Enterprises continue to select Proofpoint cloud based data protection solution over legacy solutions given our proven capability in handling today’s advance security for us. As a result, I believe we are well positioned to continue to drive momentum and grow market share.

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

Paul Auvil

Thanks Gary. We were very pleased with our ability to exceed expectations for revenue, billings, adjusted EBITDA, EPS and free cash flow during the first quarter. Proofpoint continued to benefit from the combination of a very healthy growth rate of new customers, a strong cycle of demand from existing customers buying additional solutions and wall --- rate that continues to exceed 90%. Please note that I will be discussing both GAAP and non-GAAP measures and unless stated otherwise, all non-GAAP measures excludes stock-based compensation, acquisition related costs, accretion of the debt discounts and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, cost associated with litigation and the amortization of intangibles associated with acquisitions. I will first provide additional details on our performance during the first quarter of 2014 and then conclude with our outlook for the second quarter and full year 2014.

During the first quarter, total revenue was $42.7 million, up 39% year-over-year and above our previously announced guidance range of $40 million to $41 million. These strong results were driven by a 45% year-over-year growth in our subscription revenue which included $2.4 million related to Sendmail as I mentioned on the fourth quarter call.

From a geographic perspective our growth continues to be largely driven by our strength in the US market, where revenue grew by 38% year-over-year and accounted for 82% of total revenue as compared to 83% last year. Billings for the first quarter totaled $46.6 million, reflecting growth of 33% on a year-over-year basis and exceeding the high-end of our previously announced guidance range of $43 million to $45 million.

Consistent with the past several quarters, approximately one half of the net new subscription business that we closed during the first quarter was driven by sales of new solutions to our existing customers. We remain very pleased with the statistics 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 important contribution to our long-term revenue growth.

In addition, our strategic partners and resellers continue 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 and reflects our ongoing investment in EPT related infrastructure ahead of demand.

Turning to expenses and profitability for the first quarter, on a non-GAAP basis, our gross margins was 71% during the first quarter, which is in line with our prior guidance. In terms of our operating expenses, we continue our investment in sales and marketing as well as research and development to support future growth.

During the first quarter, non-GAAP sales and marketing expense increased 28% over the prior year period to $19.6 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 regeneration programs. Research and development expenses increased 40% year-over-year to $9.9 million accounting for 23% of total revenue reflecting our continued focus on enhancing and expanding our solutions and platform, and sharing the full impact of the R&D spending associated with acquisitions closed during the second half of 2013.

General and administrative expense was 4.1 million compared to 3.3 million last year, driven primarily by our larger scale as well as the resources needed to accommodate the integration of these recent acquisitions. Non-GAAP operating loss was 3.2 million for the quarter, compared to a non-GAAP operating loss of 3.4 million during the first quarter of 2012. Non-GAAP net loss was $4.2 million or $0.12 per share based on $36.6 million weighted average shares outstanding and was significantly better than our guidance range of a loss of $0.21 to a $0.18 per share. This compares to a non-GAAP net loss of $3.9 million or $0.12 per share based on $33.5 million weighted average shares outstanding in the year ago period.

First quarter 2014 adjusted EBITDA was negative 1.4 million, compared to negative 2.1 million during the same period last year and was also better than our original guidance range of negative 4.5 million to 3.5 million, driven by a combination of our upside to revenue during the quarter combined with lower than expected levels of growth in spending for sales and marketing as well as our day.

On a GAAP basis, GAAP net loss for the first quarter totaled $14.4 million or $0.39 per share, based on $36.6 million weighted average shares outstanding. And this compares to a GAAP net loss of $6.4 million or $0.19 per share based on $33.5 million weighted average 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 in our press release.

In terms of cash flow, I am pleased to report we just generated 4.1 million in operating cash flow for the quarter and invested 2.3 million in capital expenditures in support of our ongoing build-out infrastructure for our global SaaS platform. This resulted in positive free cash flow of 1.8 million for the quarter, which was above our guidance range of breakeven and represents a fine start for our overall goal of 10 million for the full year of 2014.

Turning to the balance sheet, we ended the first quarter with 257.2 million in cash and short-term investments and 157 million in debt, compared to 251.8 million in cash and short-term investments and 155.3 million in debt as of December 31, 2013. This sequential increase in cash during the quarter was driven by the combination of cash flow generated from operations, ongoing stock option exercises and the contributions to capital for our employee stock purchase plan.

We ended the first quarter with an accounts receivable balance of $22.3 million, resulting in DSOs of 44 days during the first quarter, lower than the fourth quarter as we continued to have strong collections during the first quarter. Total deferred revenue increased 36.7 million or 40% year-over-year to 127.9 million during the first quarter, up from 91.2 million in the year ago period. Compared to the fourth quarter of 2013, deferred revenues increased 3.9 million.

During the first quarter, the overall duration of our contract terms was down slightly from our fourth quarter results, and finished at the low end of our historical range of 17 to 22 25 months, highlighting our continued focus to shortened contract duration across our customer base. Now turning to our financial outlook starting with the second quarter. We currently expect billings to be $45.5 to $47.5 million resulting in year-over-year growth of approximately 32% at the midpoint of the range. Note that the midpoint of this guidance range is relatively flat sequentially as compared to the first quarter of this year due to the cyclicality of renewal activity over the course of the entire year 2014.

Regarding revenue for the second quarter, we are targeting total revenue of 43 million to 44 million or 37% growth year-over-year at the midpoint of the range. We expect second quarter non-GAAP gross margin to be approximately 71% consistent with the first quarter. And with regard to adjusted EBITDA we are currently targeting negative 1 to negative 2 million for the second quarter.

We expect second quarter non-GAAP net loss to be negative 5 million or a loss of $0.11 to $0.13 per share based on approximately $37.3 million weighted average shares outstanding. And this assumes an income tax provision exclusive of discrete items of approximately 0.2 million during the quarter. In addition, while we do not normally provide quarterly cash flow guidance, I wanted to highlight that we expect free cash flow during the second quarter to be roughly break even.

From a full year perspective, we are increasing our guidance above our over performance in Q1, driven by the expected ongoing strength of the business. Specifically, we now expect billings to be in the range of 207 million to 209 million for the year which represents an annual growth rate of 30% at the midpoint of the range. This compares to our previous guidance range for the year of 203 million to 205 million. With this billings performance, we are also increasing our total revenue guidance to a range of 178 million to 180 million, reflecting an annual growth rate of 30% at the midpoint range, this compared to our previous total revenue guidance of 174.5 million to 176.5 million.

Subscription revenues should continue to account for approximately 95% of our total revenue for the year. And as final point, note that that the Sendmail contribution to deferred revenue in the fourth quarter of 2013 was 2.8 million, whereas that contribution deferred revenue in the fourth quarter of 2014 is only 1.3 million creating a year-over-year headwind to revenue growth of 1.5 million or approximately 3.5% % for the Q4 ‘14 outlook.

We continue to expect full year 2014 non-GAAP gross margins to be approximately 71%, which includes the initial cost associated with the build out of infrastructure associated with our newest Targeted Attack and associated products.

Adjusted EBITDA for full year of 2014 is expected to be in the range of negative 3 million to negative 5 million, a few million dollar improvement over the guidance last quarter, driven by the upside to profitability delivered here during the first quarter of the year. As a reminder, this also includes our plan to plan to modestly accelerate investments in sales and marketing to capitalize on the weakening competitive environment and the rapidly expanding opportunity in the new landscape of advanced persistent threats. In addition, we will continue to expand our investment in research and development to support our ongoing slate of key product development initiatives.

As a result, we continue to expect our EBITDA loss to gradually improve over the course of the full year with breakeven results expected in the fourth quarter of 2014. We expect full year 2014 non-GAAP net loss to be up $15.3 million to $17.3 million or a loss of $0.41 to $0.46 per share based on approximately $37.7 million weighted average shares outstanding. This assumes depreciation of approximately 9 million, up 50% from 2013 and cash interest expense associated with convertible debt of roughly 2.5million, this is a new item for 2014.

As well the income tax provision, exclusive of potential discrete items is expected to be approximately 0.8 million for 2014. I would like to highlight again that we are currently generating a net loss and as such our weighted average share account of 36.6 million for Q1 did not include the impact of an exercised stock options. If we were profitable today, our fully diluted share count would have been approximately 40.7 million shares when applying the treasury stock method to outstanding options in restricted stock units. In addition, if our convertible note were in the money at the beginning of the quarter, it would add approximately 5.2 million shares.

Finally, we are reiterating our free cash flow of guidance of roughly $10 million for the full year 2014, which is an increase of almost 100% from 2013. This cash flow guidance assumes capital expenditures of 13 million to 15 million for the full year, as we continue to build out our cloud infrastructure to support the rapid scaling of our business and our latest product introductions.

As and additional point I would like to remind everyone that over 95% of our revenues come from the current subscription revenues each quarter. This business model when combined with our renewal rates that consistently exceed 90% enable us to enter each quarter with better than 90% visibility into our revenue for the coming quarter, which is uniquely a favorable aspect of our overall business model as compared to any of the other up the trade security companies.

So in summary, we had a very strong first quarter and believe that Proofpoint remains well positioned to maintain momentum throughout 2014 as the worldwide demand for integrated cloud based solutions remain strong. Before turning it over to the operator for questions, I wanted to mention again that we are hosting an Investor Day in New York on the afternoon of Tuesday May 20th.

With that, I wanted to thank everyone for taking the time for joining us on our call today and we’d be happy to take your questions now. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. (Operator Instructions) And we’ll take our first question from Rob Owens with Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Great, thank you very much. Want to focus on the organic, but I know you fully disclosed what Sendmail did but organic subscription was about 36% growth, is all that Sendmail in that subscription line and that accelerated versus the last quarter. And I know you said the second question you had strong renewal activity here in Q1 and some of the guidance for Q2. But if I look in year ago period for Q1, I think you had a $1 million data import which set up a tough comp, and so if I look at that subscription kind of guidance on an organic basis for Q2, looks to be accelerated to about 32%, so just kind of wondering if you could help me resolve that call? Thanks.

Paul Auvil

Yeah and so to your first question, yes on an organic basis subscription growth was roughly 35, 36% when you take into account the Sendmail deferred revenue contribution which was about $2.4 million in the quarter. So that’s correct and that is an acceleration from what we’ve seen historically for organic growth rates. We were very pleased with that number.

In terms of the question on essentially the billings activity in Q1 of 2013 compared to Q1 of ’14 and then what that means when we talk about Q2 of ’14 in our current guide, you are absolutely right we did have that one time benefit in Q1 of ’13 and so I will just remind everyone on the call that there’s complexity in our model because in any given quarter we have a combination of one year deals that are up for renewals, two year deals that are up for renewals from two years prior and then three year deals that are up for renewals from three years prior.

And so as a result, it can be tricky just to do the year-over-year compares on our billings numbers from in this case, Q1’13 to Q1’14, Q2 ’13 to Q2’14 I would say that overall when I look at the guidance we just provided for Q2’14 and considering the renewals that we do in that particular period, I think there is a healthy sequential improvement in the organic new and add on billings that are incumbent in that guide for Q2 ’14. I know it is occasionally a matter of questioning regarding how much of that guide is new and at our versus renewals we don’t historically provide that data, but I can tell you that when it all hangs together and you look at the guidance overall I think one, we had a very strong Q1 which you could see as – pointed out reflected in our strong organic subscription growth rate and we feel good about the guidance that we provided on the billings line for the second quarter and how that comports to the revenue guidance.

Rob Owens - Pacific Crest Securities

Great. Okay and then the second for Gary, you made the comment in the that first we saw the competitive landscape is shifting in your favor and you know looking at the acceleration here in subscription it appears that the velocity of the business is getting that much better given shrinking duration and billings and everything else that is going on. So maybe you talk about A, pricing and you are seeing a competitive response there and B, just what are you seeing kind of on the horizon in terms of potential competition.

Gary Steele

Yeah sure, so as we look at the competitive landscape as we included in this graph, we do see our larger competitors continuing to struggle. And that has created opportunity for us. In the quarter we saw strength across a variety of competitors in terms of our ability to take them out of existing customers. That was very strong and as we look at our you know as we think about our pipeline and the opportunity going forward, we don’t see any short term changes to that competitive landscape. As we look more broadly at the horizon although in the events world where we play with path, there is a variety of companies participating there that’s really more of our share of wallet competitive gain versus a head to head competitive gain. And we are fairing quite well in that getting larger organization to see the value of path and the dot path, while at the same time in the core protection area, our solutions were differentiated when customers cash that on a head to head basis. We can prove that we are that much more effective and that much more value for the dollar.

In terms of pricing and as we go to another part of your question, we do not see degradation in pricing in the quarter, we do see some reactive actions being taken by our competitors trying to save deals that when we get in, when we share the value we are commanding at market or higher prices than we’ve historically seen.

Rob Owens - Pacific Crest Securities

Great. Thank you guys.

Gary Steele

You bet. Thanks Rob.

Operator

And we’ll go next to Phil Winslow with Credit Suisse.

Phil Winslow - Credit Suisse

Hi, thanks guys and congrats on a good quarter. Just wanted to focus in on expanding product portfolio, obviously add on sales were strong this quarter, but what if you can help us to sort of the balance just what you are seeing from this sort of call, you have net new customers, how much sort of not only is it sort of an upsell potential over you existing customer base but how this problem is -- is actually helping you with sort of the color being on just net new customer acquisition.

Paul Auvil

Yeah, great question Phil. So in Q1 similar to the last few quarters, we seen our passes of split basically 50-50 between new customers and add on. So we are using TAP as a key part of our message and story and penetrating new customers. As you heard in the script we also had a lot of solid attach between our customers our new customer who brought TAP he might have also brought protection. So the overall story is playing well together and we are successfully executing the strategy where we’ll go sell TAP and sell protection at the same time to that new customer that’s looking for an improved security solution. And I would just remind you again that half the business is going to new and half is going to existing customers.

Phil Winslow - Credit Suisse

Got it. And then also just what are you seeing as far as just you know pricing and it goes out there and the environment is sort of broadly speaking, when you think about you made the comment a moment ago that your pricing has actually been of – or there were some competitors are even winning on features, but maybe if you just kind of compare this with pricing environment that you are seeing now versus maybe a year or two years ago?

Paul Auvil

Yeah, Phil its Paul Auvil here. I’ll tell you the one thing that we do pretty carefully is we measure pricing across all activity quarter. Just for new and adds on and seeing renewables are kind of a different realm. And we compare that with the prior quarter to five quarter trailing average and the 12 quarter trailing average and I could tell you that you know across those measures pricing continues to be consistently in the median or about median of the past couple of quarters across all customer size ranges, so we’ll kind of break it down by size range to look at the small customers that are under a 1000 and then we’ll look at ranges a 1000 to 5000 users etcetera.

And so, you again it’s something that we give pretty careful attention to across all of our product launch, so we look at for the protection product for the privacy product or archiving and then obviously half as new book you look at it there as well.

So yes, I would say overall as we’ve looked at that data, not only this quarter but you know the past several quarters, we continue to be happy with the overall performance we see in the market in terms of the pricing although relatively steady. I wouldn’t say there is a trend for pricing to move up, but there’s definitely not a trend for pricing maybe down.

Phil Winslow - Credit Suisse

Got it. Thanks guys.

Paul Auvil

Thanks, Phil.

Operator

And we’ll go next to Nandan Amladi with Deutsche Bank

Unidentified Analyst

Hi, it’s actually [Ted] on behalf of Nandan. Two questions, one, you had good performance in this quarter. Were there any large deals that led to that performance?

Gary Steele

You know we didn’t have any monster or whale deals, we again usually have a pretty good stratification of new and add on business. We still have a handful of deals that are high six or low seven figures and then we’ll have a number of deals that are mid six figures and a number of deals that are you know in the 50 to 100,000 range. We don’t disclose those statistics each quarter, but we saw the same kind of general broader granularity of opportunity across all of our sales organizations that we have seen in the past so there wasn’t any specific concentration that helped drive their strength of this particular quarter.

Unidentified Analyst

Got it, thanks. And then you have seen a lot of royalty and see – run rates acquired in the end points base and they will be starting the golf synergies between the AP product and then end point products, what are your talks on that? I mean, do you guys see sort of going into an end point with a security product at some point to complement the TAP offering?

Gary Steele

Yeah, that is an interesting question. Today, where we have focused is we try to find synergy with all the capabilities that we are delivering and trying to find synergy with our specific buyer. I – we don’t have any short term plan; based on that we don’t have any short term plans to do anything at the end point area. I think it will be challenging for some of the companies that entered that area, if you get leverage from where they are selling and so we see lots of opportunities to continue to expand the broader faster print, deliver more value without heading into the endpoint phase.

Unidentified Analyst

Perfect. Thank you.

Gary Steele

Thanks, Ted.

Operator

We’ll go next to Matt Hedberg with RBC Capital Markets.

Matthew Hedberg - RBC Capital Markets

Yeah thanks for taking my questions guys. In the prepared remarks you highlighted social media archiving solution had a lot of nice wins this quarter. Talked about a thing I must have a regulatory – I’m curious are those wins largely organic, are those into your installed base and do you see an opportunity even outside of you know more regulated industries?

Gary Steele

Yeah, great question. So those wins have been spread reasonably evenly between new net on. It is definitely attracting attention because as organizations think about how they are going to adopt social media and basically turn it on for their employees and many financial services companies for example don’t allow access to those particular sites. At work and so as organizations want to figure out how to embrace that in the business practices they have got to buy something to meet their compliance requirements.

And so, it’s opening door and – dialogue that we didn’t have with new accounts and our existing customers are looking for that capability as well. In addition to that, it’s not just financial services, we are seeing demand across other industries that are regulated in different ways, maybe not government regulated but have a much more stringent view of how the capabilities are being used so we have seen demand in healthcare, we have seen demand in energy and other industries.

Matthew Hedberg - RBC Capital Markets

That’s great. And then, as a follow up, your cash balance here north of 250 million, I guess I call evaluations more real now on a security space or in the past few weeks you did, does that changes making on M&A or is it largely sort of more opportunistic as they come along?

Gary Steele

Yeah so a couple of things and Paul probably will have commented to our strategy with respect to M&A hasn’t changed. We do believe that there is opportunity to acquire great technology from all companies, great teams of people with good proof in the market place. And if you look at the acquisitions that we did in 2013 that our strategy to continue to look for the kinds of opportunities in ’14. And so I don’t think you will see anything different from us, we were never in the business of trying to go by big companies or most of the revenue that has not been our point of view and nor will it be in 2014. Paul…

Paul Auvil

I would still say to your point Matt, we do have a strong cash balance and that gives us lot of flexibility but we are very thoughtful buyer. So, even when the product company evaluations got a little bit floppy over the prior four five months, our view is here we were not in a hurry, we are always looking for kind selected unique assets to fit it. And so, as we see instinct opportunities come along at prices that we think are reasonable in the context above our cash balance, our overall capital structure and the evaluation that we can deliver to our investors overtime by creating that business combination you know we’ll execute accordingly, but we are not in any hurry but we do think there is some interesting things out there that could make sense to put together the through points at the right time, at the right price.

Matthew Hedberg - RBC Capital Markets

That’s great guys. Thanks for the question and congrats on the quarter.

Paul Auvil

Thanks, Matt.

Gary Steele

Thanks, Matt.

Operator

We’ll go next to Craig Nankervis with First Analysis

Craig Nankervis - First Analysis

Thanks, good afternoon and congrats on a nice quarter. I guess Gary, I’ll start with – my sense that maybe the outbound privacy business has picked up more recently perhaps because of [NSA] stuff. I wondered it wasn’t simple but I wonder if there is any commentary on what’s happening there and whether it’s a just new or existing customers that are – if there is a – with tackling any compression on that?

Gary Steele

Yeah, it’s an interesting question, Craig. So as we exited 2013, we saw our pipeline build in terms of customers expressing interest in privacy. And so as we move through Q1 we did have a good number of really interesting wins. Our anecdotal view on why that is that given the high visibility breaches that happen, previously there’s a hiding concern among organizations of how they are going to protect consumer data. And so I think people are saying, hey I’ve got to do everything I can within my power to make sure that I am doing what’s required to protect the sensitive data to avoid the potential breach or breach disclosure.

So I think there is a view out in the market place that people want to take more aggressive action here. The deals that I referenced were a mix of both new customers that have not been Proofpoint customers before as well as Add on. We traditionally feel privacy more than add on solution frankly and we saw in the quarter more interest from new customers and we will have to see how that plays out through the end of May end of 2014.

Craig Nankervis - First Analysis

So your sense is what you are seeing is somewhat sustainable through the year?

Gary Steele

We felt good about the deals that we won in Q1 and we don’t see anything changing in terms of pipeline. And maybe see it as very positive, very strong.

Craig Nankervis - First Analysis

I don’t, I might have missed it, but I don’t believe there was comment on you know fiscal and code activity that in sometimes here and I wonder is it sort of the same story you are continuing to make progress disclosing there is there any new color on what’s happening?

Gary Steele

No we felt strange across the competitive landscape this quarter. We didn’t call out in the script this particular quarter specific competitors that we displaced, but we didn’t see any material change either. We felt strength across displacement of the traditional companies those including – Postini, Cisco IronPort, Symantec and others.

Craig Nankervis - First Analysis

In their being on the male to store side, I think basically on the Postini side that continues to work for you as well?

Gary Steele

It does. We continue to make very good progress there and we are in the phase of channel adoption. So we’re getting the organization that had traditionally been distributors or resellers good for Postini to adopt the Proofpoint essential solution and we are starting to see some good traction, but its still very early and so look for more comments in coming quarters in terms of traction on that.

Craig Nankervis - First Analysis

That’s it from me. Thanks a lot.

Gary Steele

Thank you, Craig.

Operator

We’ll go next to Jonathan Ruykhaver with Stephens

Jonathan Ruykhaver - Stephens

Hey guys congrats on another strong quarter of execution. The first question I have is can you talk a little bit about the introduction of the predictive defense capabilities, specifically how does it add to TAPs value and proposition. And I know it’s early but what kind of a tax rate do you anticipate and also maybe if you could put some color on pricing.

Gary Steele

Sure, I’ll start and I’ll let Paul talk a little bit about pricing. So we introduced new capabilities at the RSA Conference that are relatively new. We are seeing very strong interest in adoption. It really becomes a paid for core feature of TAP which we really like. So we expect most customers to want all the capabilities that we are delivering at part of TAP today. And we thing that that continues to give us pricing power and opportunity to continue to drive more value out of the deals that we do a TAP. And I’ll let Paul comment on how to think about the pricing differential?

Paul Auvil

Yeah so when we take predicted defense and a cash for defense together, we see as those capabilities and in the addition to the URL defense capabilities that we had already been offering allows us to increase the overall value of the TAP opportunity by somewhere between 75 to 100% when sold as three elements as opposed to the single URL defense element. Now we do have people despite one capability or another, although so far we’ve had success in closing people on buying all most of the elements as we have introduced these new capabilities, meaning if you are going to buy cash with defense and – defense you also I you are also these things trend all go together. We do still have customers that only buy the URL defense solution and so it’s early now and we’re sort of sorting out what we think the most popular [actives] and bundles will be, but that’s kind of a rough feeling for other pieces put together.

Jonathan Ruykhaver - Stephens

Okay, did you see any evidence to suggest that on the attach rates will be high enough to drive into that number you additionally eluded to before?

Gary Steele

When you say the number I initially wasn’t (indiscernible)

Jonathan Ruykhaver - Stephens

But the demands of some opportunities 75 or 100%.

Gary Steele

You know it’s a little too early right now. It’s hard to tell exactly what the main stream adoption rates will look like since its early and we’ve only got a relatively small handful of deals that we’ve done as compared to the total deal flow of the company, so I’m not quite ready for making official or statement on that just yet.

Jonathan Ruykhaver - Stephens

Okay. And then the second question I had is if you could just provide a little bit more color on that 300,000 user dealer that you referenced with TAPS, specifically on the competitive dynamics for that end and also curious what the sales cycle was like, whether it was recognized in the March quarter?

Gary Steele

Sure. So the organization had been looking for advance [rate] capabilities. They had evaluated our technology for roughly a month and during that period of time we were able to show them the kind of nowhere we were able to uniquely detach. This is an organization with a very sophisticated security that have basically looked at many different capabilities are out there. And again I would characterize this as we were fighting for dollar against the other organizations. As we indicated in the script there is a corporate mandate to do something fast and frankly I think one of the key reasons we were able to get something done in the timeframe was that we were able to deploy with 48 hours. So we have the advantage because we are cloud based solution to be able to meet their very specific, very demanding time line. This was a deal that got booked in the quarter and then obviously revenue gets recognized over the period of that contract.

Paul Auvil

Right. So it’s reflected in our billing number, gross value of the contract is that when a deferred and a small portion of that was recognized as revenue in the first quarter with the remainder to be recognized over the ensuing 11 months going forward.

Jonathan Ruykhaver - Stephens

Okay, perfect. Sounds like a great win. Thanks guys.

Gary Steele

Thanks, Jonathan.

Operator

We’ll go next to Tim Klasell with Northland Securities

Tim Klasell - Northland Securities

Hey – my congrats as well. Quick question on the cross sell-ups. How A, the financial impact of Sendmail but how is that working out in the field as far being able to get into some of the larger customers. Has that been – or could you give any details of how successful has that been for you so far?

Gary Steele

Yeah I can talk to you – so we’ve been very excited about the results that we’ve seen been able to go into the Sendmail install base and sell those customers protection or some other capability. So we had a large technology company that had been a loyal Sendmail customers switch off their competitive solution that Sendmail had been selling to the TruPoint Solution. We had a large insurance company expand their deployment of Sendmail and purchase the Proofpoint protection solution and deploy for many users globally. Those are just a couple of examples where we’ve gotten this traction. We’ve been very very pleased with our ability to go drive additional business and pipeline within the Sendmail install base and we feel very good about that opportunity throughout as we look into the remainder of 2014.

Tim Klasell - Northland Securities

Great. And then just quick follow on, internationally you mentioned you are having, you guys doing some more focus there, how does that do, maybe I missed the numbers, but what percentage of your billing this quarter were international? How does that better [ground].

Gary Steele

We don’t actually pass the (indiscernible) that way we talked about the fact that revenues from North America it was 83% in the quarter and as a result that need international that bulk of which is Europe. So Europe delivered a reasonable quarter, but it just – it needs to get a lot more traction in order to start taking in – representing a larger slice of the overall revenue pie. And I think you know Tracey has rolled up her sleeves and taken a few actions to continue to drive evolution of the organizational structure there to get much more hands on and detailed in how we are driving those actions. But I think we feel good about how pieces are coming together. But as we talked about over the last couple of calls, you know we think it will be probably late this year before we start to see interesting traction there to speak up. It’s a long road of paving the way and driving some additional momentum and activity there.

Tim Klasell - Northland Securities

Okay. Great, thank you very much.

Gary Steele

Thanks, Klasell.

Operator

And we’ll go next to Sanjit Singh with Wedbush

Sanjit Singh - Wedbush

Thank you for taking my questions and congrats guys on a great quarter. Very quick questions. On – what opportunities do you guys see to increase customer value on a per user basis. I think last quarter you guys talked about cancellation of TAPS because you are adding an incremental $3 per user per year. What opportunities do we see on gaining more customer value on a per user basis?

Gary Steele

So we talked about this in a couple of different forms overtime, but you know the most popular initial go to market motion with a new customer is to sell them protection. And so, a large part of our new business in any given quarter is protection although we also have customers who buy privacy is the first product or tab or archiving. So with that said, we then seek to drive out our business around those other products. Privacy historically has been our most popular add on which again if you think about a typical 5000 seat account they might pay you know on the order of $10 a user a year for protection and privacy would sell for an additional 10 to 15 so roughly double the size of the opportunity.

As we have TAP, TAP is now very natural add on to sell along with the protection solution and we’re seeing good uptake there as well. You know it depends on the customer size, but TAP sold even as an add on where it sought of you know thing of it is getting doubled with whatever they are already buying. You know the price is consistently well over $3. Our very large accounts like pay $5 to $10 a user a year for that capability and the smaller accounts obviously pay quite a bit more than that.

And then archiving as we talked about before depending on your storage requirements the duration of retention etcetera their products starts in the – think of it in the 20 to $25 price range per user per year and it goes up from there. So as we drive to add on an archiving those sales cycles are a bit longer and pipeline takes longer to develop, but it creates a meaningful lever over what would have been initially much smaller protect ion sale.

Sanjit Singh - Wedbush

Great. And then just two quick follow ups, from an advertising solution that came up this quarter you know what’s the initial feedback on that product. And I guess philosophically if you are thinking about free cash flow, you guys point to the double free cash flow from 2013, now think about longer term how do we think about free cash flow generation in the context of your growth strategy?

Gary Steele

Sure. We’ve had very good early feedback on that solution, but it’s still very early and I think that as the remainder of Q2 plays out we will have more evidence there but we feel very good about that opportunity and we are doing some very unique things and that’s the kind of feedback that we are getting. But again, very early and I’ll let Paul comment on the free cash flow.

Paul Auvil

Yeah so free cash flow we talked about back at the time of the public offering a couple of years ago now and continue to talk about today in various forms and venues. You know we are looking to drive free cash flow as a percentage of revenue upto 20% or so in a five year timeframe measure the [historic] point being early 2012. So we feel like the 10 million that we are delivering this year which you know think of it in the order of 5% or so is nice staffing in that direction up from the 5 million a year prior. And so we felt like we are making good progress in demonstrating the ability to both grow the component club and generate free cash flow and growth in free cash flow as we do that.

So I would say all systems go I think we are on track to continue to drive towards that free cash flow target over the next couple of years in terms of getting to about 20% of revenues in the you think of it as 2017 timeframe or there.

Sanjit Singh - Wedbush

Thank you for the information. Congrats.

Gary Steele

Thanks.

Operator

And we’ll go next to Michael Kim with Imperial Capital

Michael Kim - Imperial Capital

Hi good afternoon guys. Can you talk about the extension in major – and if you are seeing an acceleration of pipeline it sounds like a little stronger there, you know do you see larger accounts taking a bigger part of the mix and how much that affect the duration?

Paul Auvil

Yeah so let me start then Gary can add some color here. Yeah major accounts are a key part of our web market. And we have a product that works well across all customer sizes. F&B has been a market we largely haven’t spend on, but that kind of midsize, large and then major accounts are all – if you go to market motions we are currently you know sitting at just shy of 20% of the thousands that are having one or more of our products and we have a major accounts team focused on that. You know we find that those customers are the ones that most highly value the unique and differentiated capabilities of our products and so it’s a core area focus and we have a separate dedicated sales organization that goes out to major accounts as opposed to then just sort of large accounts and then what we call [major] enterprise, saw a good production from them here in the first quarter, obviously fourth quarter was a great outcome for them and they had some great numbers in that, typical of what you see in major accounts there is a stronger spending cycle in the fourth quarters compared to the rest of the year, but their pipeline looks good and we feel good about the progress we are making there.

Michael Kim - Imperial Capital

Okay, great. And then switching gears to international, is it your sense that a good portion of incremental spend and selling market maybe focused on building out the APAC and the partnership of the APAC region and how do you see that progressing through the balance of the year?

Gary Steele

Yeah given the fact that Europe is about 80% of the size of the US market most of our investment that is dedicated internationally would be focused on driving growth in the European market. We do our business in APAC, we are actually happy with how those things, that those businesses are coming along, but they are bit less focus for us as compared to Europe. And so, when we look at the sales and marketing dollar growth over the course of this year we are going to continue to put quite a bit fuel on fire in the US because that market is growing very well for us or differentiated products are well received and we have a tremendous opportunity yet on penetrated that again. We are in roughly 20% of the (indiscernible) big opportunity to grow just enough large market met alone for the rest of the North American opportunity.

But we will be putting a nice amount of resource to work in Europe. But Asia Pac we got a handful of additional resources there, but that’s probably an area for strategic investment in a future year.

Michael Kim - Imperial Capital

Okay. Great. Thank you very much.

Gary Steele

Thanks.

Operator

And we’ll go next to Daniel Ives with FBR Capital Markets.

Unidentified Analyst

Yeah thanks guys, this is (indiscernible). Just from a high level can you talk about they – how the security purchase divisions kind of changed over the last year and what you guys are seeing interms of or is it in terms of priorities and strategy at the enterprise?

Gary Steele

Yeah we are definitely seeing much more visibility for Chief Information Officers and how they are thinking about securing the enterprise. That visibility is developing at the board level today and most Fortune 500 boards are actively engaging with the Chief Information Security Officer to ensure that corporate assets are adequately protected to manage the enterprise risk. And all the things that I talked to you literally have to report at every board meeting either to the audit committee or to the general board.

Because of this broader exposure I think that the general penner within the steady community of people are aggressively working to ensure that they are taking all actions so as to protect the enterprise. I do believe that there is a shift in dollars from other IT budget in the security. It’s really hard to characterize a caption that in terms of size, but we are definitely seeing more engagement, more concerned and more openness to have dialogue given the broad based breach exposures that have happened over the last six months.

Unidentified Analyst

Okay, great. Thanks for the color.

Operator

And we will go next to Eric Suppiger with JMP Securities.

Yes. Good afternoon. First off, any update on how the relationship with Office -- with Microsoft and Office 365 is progressing?

Gary Steele

No updates from what we have talked about in the last couple of calls in that as expected the Microsoft Business does continue to grow, but it grows at a slower rate than the rest of revenues. So, you know overtime the Microsoft direct relationship will drop below 10% revenues, but overall the archiving business for us, both through that relationship with those customers that continue to be very productive as well as the variety of other deals that we are doing in the archiving realm, both people who are on the Office 365 platform as well as people continue to running now on premise continues to grow nicely.

Eric Suppiger - JMP Securities

Okay. And then on the free cash flow, you maintain the $10 million outlook for the fiscal year, but you had some good upside in the quarter. Why are you maintaining it as opposed to taking it up, at least by the upside that you have in the March quarter?

Gary Steele

Yeah, part of the – I should have been a little more clear in the script. Part of the reason we have the upside in Q1 as we had a really strong collection cycle and we also spend a little less on CapEx than we had expected, so those two things together gave us a nice positive number, roughly $2 million in the Q1, but as you can see I guided to kind of roughly breakeven in Q2, so there's a sort of an offset there which is who knows how collections will play up, but my guess is we'll had more of a return to normalcy. That provided with some catch up by CapEx will get us to, they will call it $2 millionish for the first half and then we tend to generate a lot of our cash flow in the second half of the year, again, just based on the cyclical nature of the timing of some of our larger renewals that tend to be weighted into the second half of the year.

Eric Suppiger - JMP Securities

Okay. And then lastly, a few other security companies have noted challenges with closing large deals. It doesn't appeal that that was an issue for you at all. Did you have any guess as to what might be going on? Do you think that's an issue of budget allocation, or any guess what others might be seeing?

Gary Steele

It's hard to tell. They are in very different markets that we are. The one thing that we really benefit from that, I think is important for everyone to keep in mind is we're subscription business and we're – in the protection world, you're already spending money with somebody, so you may as well spend it with me. So there's no contention for budget. You are going to write that check to someone, whether it's Symantec or Intel Security or Cisco IronPort or Google Postini. So why don't you just give me the money and I'll do a much better job for you. So that dynamic really helps in that spending doesn't inherently stall. They got to write the check, so as long as we are lined up at the right time with the right opportunity those deals flow no matter what. So we have that benefit.

The other thing that's also true is, as we look at our other products again because we are subscription business that initial price of admission that people have to face up to in terms of that check that they write is relatively smaller as compared to making a decision on the perpetual infrastructure deal where, look, once I write this check I'd better be wedded to it for some number of years because I just put a lot of money behind this. In our case, people are free to buy it for year and you know what, if we didn't meet your expectations and do some great for you, you can move away and so you are not making quite as perilous or life committing a decision to buy ProofPoint when you are buying the one year subscription as you're if you're buying perpetual licenses or a large deployment of boxes. And so I think those things all work in our favor as compared to the other security companies out there.

Eric Suppiger - JMP Securities

Alright, good. Well, thank you very much.

Paul Auvil

Thank you.

Operator

(Operator Instructions) And we will go next to Jonathan Ho with William Blair.

Jonathan Ho - William Blair & Company

Hey, guys. Great quarter. Just wanted to start out with, is there any way that you can maybe quantify some of the improvements that you've seen in your win rates, and particularly, what segments of the market that you're seeing the most improvement in terms of those win rates?

Gary Steele

Yeah, this is Gary, Jonathan. I think that in terms of win rates I believe they're actually relatively consistent. The one benefit that we obviously are seeing is we're a broader sales footprint as we continue to hire. So I wouldn’t say that I would characterize the out performance in the quarter by any change in run rate. I would characterize our success is just touching more customers and driving more business in the deals. Our run rate has always been quite high given the frankly the weakness with our competitors. We as we get more feet on the street and more sales preference will be on the touch more deals that continue to drive demand in that regard.

Jonathan Ho - William Blair & Company

Got it. And then can you talk a little bit about sort of the distribution channel leverage that you are looking for in terms of your partners. Are you seeing sort of a maturation at this point where they are carrying the deals a bit more or can you maybe describe where we are in that process?

Gary Steele

Yeah I would say the engagement model that we have today with our channel partners is essentially the same as it has been historically. I think what we are doing though is working hard to continue to align our selling efforts with those partners – within the security market today. And so, the – thing for us is to make sure that we are getting the profit share of mind with channel partners in that focus on tracing their team. But I don’t think that has changed, going back to your exact question I don’t think that our engagement model has changed but the channel is doing more for us today than they were historically. Our focus is how do we ensure that we are getting the appropriate mindshare and continue to ride business for that tax.

Jonathan Ho - William Blair & Company

Thanks gentlemen.

Gary Steele

Thank you.

Operator

And we’ll take our final question from Walter Prichard with Citigroup.

Walter Prichard - Citigroup.

Hi, thanks. I wanted to talk a little bit about archiving specifically it was sort of the first one of the first add ons that you start selling. And I am wondering if you have seen any sort of (indiscernible).

Gary Steele

No actually we are not seeing any slowdown in terms of archiving the installed base. I think the interesting thing about archiving and we talked about this on previous calls is there is this greater and growing acceptance of archiving that reach to the cloud and we are benefiting from that broader market move. It’s true with new customers, its true with our installed base. So we feel really good about that opportunity simply because we are not fighting the or we have got to convince you of that, if that is the right way to go. I think that that acceptance has really grown within the market place. And I do believe as a result of that we’ll continue to see nice demand, both in the installed base as well as our new GAAP.

Walter Prichard - Citigroup.

And then how are you thinking about archiving I guess penetration of other adds on being quite – in privacy versus archiving. I mean, I guess someone (indiscernible) just trying to figure out as we sort of how we should think about it.

Gary Steele

Yeah a couple of things, one is, with the archiving business we have the special team that works with our general reps to ensure that archiving has paid a lot of attention. Archiving deals sometimes could be a little longer, a little more complicated in terms of the questions and types of engagement we need to do, so that specialist team plays that role. But one interesting convergence element that we are starting to see was that more and more [CSOS] today so it is not uncommon for us to see the individual considering and buying archiving to be the exact same person buying TAP.

Walter Prichard - Citigroup.

Got it. Thank you very much.

Gary Steele

Thanks Walter.

Operator

That concludes today’s question and answer session. Mr. Steele, I would like to turn the call over back over to you for any additional or closing remarks.

Gary Steele

Great, thank you. I do appreciate everyone taking time out to discuss and to join us today. We are very excited about the results that we saw in Q1 and we look forward to talking to you again in Q2. Thanks so much.

Operator

That does conclude our conference. Thank you for your participation.

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