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Proofpoint, Inc. (NASDAQ:PFPT)

Q2 2014 Results Earnings Conference Call

July 24, 2014, 04:30 PM ET

Executives

Paul Auvil – Chief Financial Officer

Gary Steele – Chief Executive Officer

Analysts

Phil Winslow - Credit Suisse

Rob Owens - Pacific Crest

Nandan Amladi - Deutsche Bank

Matt Hedberg - RBC Capital Markets

Craig Nankervis - First Analysis

Tim Klasell - Northland Securities

Jonathan Ho - William Blair

Erik Suppiger - JMP Securities

Matthew Niknam - Goldman Sachs

Walter Prichard - Citi

Daniel Ives - Ives

Operator

Good day, ladies and gentlemen, and welcome to the Proofpoint Second Quarter 2014 Financial Results Conference. Today's conference is being recorded.

At this time, I'd like to hand things over to Mr. Paul Auvil, Chief Financial Officer. Please go ahead, sir.

Paul Auvil

Thank you. Good afternoon and welcome to Proofpoint’s second quarter 2014 earnings call. Today we will be discussing the results announced in our press release that was issued after the market closed this afternoon. I’m Paul Auvil, Chief Financial Officer of Proofpoint and with me on the call today is Gary Steele, Proofpoint’s Chief Executive Officer.

During the course of this call we will make forward-looking statements regarding future events and 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 during 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 stock based compensation expenses, acquisition related costs, accretion of the debt discount and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, costs associated with 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 second quarter 2014 results, which can be found in the Investor Relations section of our website.

In addition please note that the date of this conference call is July 24, 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, I'll turn the call over to Gary.

Gary Steele

Things, Paul. I' d like to thank everyone for joining us on the call today. Proofpoint's record second quarter results highlight the strong momentum of our advanced threat solutions, the ongoing favorable competitive trends, and the unique advantages of our cloud-based security and governance solutions.

Our ability to significantly exceed revenue, billings, adjusted EBITDA and EPS expectations was driven by the combination of strong traction with new and existing products, as well as robust add-on and renewal activity.

Let me start by highlighting a few key point from the quarter that is particularly compelling. First, we continue to see excellent progress, converting customers to our cloud-based protection platform is punctuated by Gartner latest update to their Magic Quadrant for Secure Email Gateways, which positions Proofpoint with the highest ranking amongst all of the vendors included in the analysis. Both in terms of completeness of vision and ability to execute.

We view this latest independent analysis as further confirmation of Proofpoint's proven ability to protect organizations from today's unpredictable, highly advanced targeted threats.

Second, our suite of targeted attack protection solutions continues to exceed our expectations establishing itself as the fastest growing product in the company's history and hence a clear demonstration of this product offerings ability to directly address the key security imperatives faced by enterprises across all industries and throughout the world.

And as a final point, the transition of customers from on-premise exchange deployments to the Office 365 cloud is proving to be a compelling catalyst for Proofpoint, as these customers seek to replicate their former on-premise security and governance infrastructure in the cloud and hence creating a national entry point for Proofpoint to displace the incumbent on-premise vendors as part of the migration to the cloud.

I believe that these trends combined with the strong growth and demand that we recorded during the quarter demonstrates that Proofpoint remains well-positioned to gain market share in the $6.7 billion total addressable market.

Taking a quick look at our financial results for the second quarter, total revenue increased 46% year-over-year to 46.4 million and was driven by a 46% increase in subscription revenue.

This represented our 44th consecutive quarter of sequential revenue growth and highlights the predictability of our SaaS model. We also recorded billings of 51.1 million, up 43% on a year-over-year basis. Both revenue and billings were significantly above our second quarter guidance ranges. In addition, we reported positive adjusted EBITDA for the first time in the company's history, which highlights the leverage we're starting to see in the business.

Now turning to some of our key accomplishments during the second quarter. Our high win rates versus our competition continue to drive momentum in winning new customers as large and midsize organizations are switching to Proofpoint's cloud-based solution from legacy providers.

During the quarter growth was well diversified and came from displacements across all major incumbent competitors. I believe it is important to highlight that the flow of opportunities driven by Google's wind down either standalone Postini email security offering have tapered substantially contributing only nominally to our acquisition of new customers during the most recent quarter.

While there are still a number of prospects still using the Postini platform we believe that there will likely be a long tail of conversions that we will pursue opportunistically over the coming quarters as such our results during the second quarter clearly demonstrate our ability to continue to grow our business in a robust manner without the benefit of the shuttering of the standalone Postini service.

Here are a few examples of new protection customers that moved to Proofpoint during the quarter. A leading university with 55,000 users, a large state agency the purchase both our protection and TAP solutions for over 30,000 users, one of the world’s leading publishers with 20,000 users was also purchased both protection and TAP, a large retailer with over 15,000 users which purchased both protection and TAP, a large U.S. based bank with 12,000 users in addition to a global buyout pharmaceutical company with over 8,000 users both of which also purchased our protection and TAP solutions.

We also saw solid sales of Proofpoint solutions into the area of installed basis of customers highlighting the synergies that we continue to see from this acquisition. As an example during the quarter we closed a deal with a Fortune 500 consumer brand which purchased both protection and TAP for over 20,000 users. As I mentioned earlier I'm also pleased to report that we saw momentum selling the entire product line in the context of Office 365 which highlights the value that we can deliver to customers irrespective of their email deployment model.

More specifically we're finding that as customers move from their on premise exchange solutions to Office 365 they need to replicate their former on-premise security and governance infrastructure in the cloud, creating demand for entire suite of products and serving as a natural entry point for Proofpoint to displace the incumbent on-premise vendors.

Some of the Office 365 deals we won this quarter include a worldwide technology company with over 10,000 users that purchased TAP, a large healthcare provider with 7,000 users that purchased Archiving. And one of the largest airports with 4,000 users in addition to a Fortune 1000 specialty retailer with 3,000 users, both of which purchased TAP.

As I alluded to at the start of my remarks, we had another strong quarter with Proofpoint targeted attack protection as we once again grew TAP business by over 100% year-over-year in Q2.

Some of the noteworthy TAP wins during the quarter included a national healthcare organization, which added TAP and Privacy for 65,000 users, a large university with over 50,000 users, which added TAP and Protection, a leading financial services company, which added TAP for 7,000 users. And another national healthcare organization, which added TAP for over 50,000 users.

We remain excited about the recent addition of our threat remediation and response capabilities through the acquisition of NetCitadel in mid-May. We view this as a strategic new capability for our protection solution as it provides additional threat verification and containment capabilities via an open platform that unifies threat intelligence from Proofpoint and other vendors.

The unification of this threat intelligence data combined with automated incident response enables securities professionals to prioritize alerts and respond to threats faster with higher confidence and accuracy.

As a reminder, this product carries a separate price tag and provides another entry point to customers. Since the close of the acquisition we have experienced a high level of interest, and I'm pleased to announce that we’ve already closed our first deal deploying this new capability at a Fortune 50 financial institution.

We also had another strong quarter on our cloud-based archiving business. Similar to past quarters, our social media capability remains an important new driver. During the quarter we had wins with the number of our financial services companies including a Fortune 100 financial services company with over 1000 users in addition to a large real estate services firm with our 3500 users.

We're also excited about our recent announcement with LinkedIn which includes additional capabilities as well as joining it certified compliance partner program. We believe that our social media compliance capability for archiving continues to strengthen our competitive advantage and provides a must-have feature for regulated organizations that embrace social media in their business practices.

Furthermore, the momentum of our privacy solution has continued. A few key privacy wins included a large national education provider which brought our Privacy and TAP solution for 6000 users. Our national healthcare organization which added Privacy and TAP for 65,000 users , that I mentioned earlier.

In addition we continue to be very optimistic about the prospects for our new content control product which will be sold as a separate add-on solution offered to customers interested in our privacy offering.

As a reminder, Proofpoint enterprise content control automatically identifies sensitive information across the enterprise enabling organizations to apply their security and governance policies to this data and delete it from vulnerable locations while moving it to a secure location to enable ongoing access by authorized users hence reducing the risk of compliance violations.

Consistent with the past several quarters, approximately one half of our net new subscription business that we closed during the second quarter was driven by sales of new solutions to our existing customers. We remained very pleased with the statistic as it demonstrates our ability to leverage our extensive and growing customer base by selling them additional solutions hence providing a meaningful and important contribution to our long-term revenue growth.

As an example of the power of our add-on sales strategy one of the key add-on deals during Q2 included a Fortune 100 pharmaceutical company which added our TAP solution for 140,000 users.

Finally, our international operations met expectations during the quarter as we continue to make progress toward further expansion abroad. Some of the key deals one include a large government agency which purchased our protection solution for 35,000 users. And a large bank which purchased protection and TAP for over 5,000 users.

So, in summary, I'm very pleased with our record second quarter results and we are entering the second half of the year with great momentum in the business. We believe that our unique cloud-based platform will continue to differentiate Proofpoint and result in market share gains in our growing total addressable market.

With that, let me turn it over to Paul.

Paul Auvil

Thanks, Gary. We were very pleased with our ability to exceed expectations for revenue billings, adjusted EBITDA and EPS during the second quarter. Proofpoint continue to benefit from the combination of a very healthy growth rate of new customers, a strong cycle demand from existing customers buying additional solutions and a world-class renewal rate that remains well over 90%.

Please note that I will be discussing both GAAP and non-GAAP measures and unless stated otherwise all non-GAAP measures exclude stock-based compensation, acquisition related costs, accretion of the debt discount and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, costs associated with litigation and the amortization of intangibles associated with acquisitions or other components of GAAP metrics.

I will first provide additional details on our performance during the second quarter of 2014 and then conclude with our outlook for the third quarter and full year 2014. During the second quarter, total revenue was 46.4 million, up 46% year-over-year and above our previously announced guidance range of 43 million to 44 million.

These strong results were driven by a 46% year-over-year growth rate in our subscription revenue, which included approximately 1.8 million related to Sendmail deferred revenue.

From a geographic perspective, our growth continues to be largely driven by a strength in the U.S. market where our revenue grew by 45% year-over-year and accounted for 82% of total revenue, compared to 83% last year.

Billings for the second quarter totaled 50.1 million, reflecting growth of 43% on a year-over-year basis and exceeding the high end of our previously announced guidance range of 45.5 million to 47.5 million. Driven by a combination of strong demand for new and add-on products, renewal rate well over 90% and a handful of early renewals.

Turning to expenses and profitability for the second quarter, on a non-GAAP basis our total gross margin was 71% during the second quarter, which was 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 future growth. During the second quarter non-GAAP sales and marketing expense increased 36% of the prior year period to 20.7 million, representing 45% of total revenue, down from 48% last year and 46% in Q1 of 2014.

Research and development expenses increased 40% year-over-year to 9.8 million accounting for 21% of total revenue compared to 22% last year and 23% last quarter. General and administrative expense was 4.3 million compared to 3.1 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 2.1 million for the quarter compared to a non-GAAP operating loss of 2.3 million during the second quarter of 2013. Non-GAAP net loss was 2.9 million or $0.08 per share based on 37.1 million weighted average shares outstanding and was significantly better than our guidance range of a loss of $0.11 t0 $0.13 per share.

This compares to a non-GAAP net loss of 2.5 million or $0.07 per share based on 34.6 million weighted average shares outstanding in the year ago period. The second quarter 2014 adjusted EBITDA was positive 0.1 million compared to negative 0.9 million during the same period last year and was also significantly better than our original guidance range of negative 1 million to negative 2 million driven by upside to revenue during the quarter which outpaced the rate at which we were able to productively invest in operating expenses.

We were very pleased with our ability to achieve positive adjusted EBITDA for the first time in the company's history, highlighting the leverage we’re starting to see in the business model.

Note that we do expect spending to catch-up with revenue during the current quarter and as such adjusted EBITDA will be negative during the third quarter returning to breakeven in the fourth quarter consistent with our guidance originally outlined in October of last year.

On a GAAP basis, GAAP net loss for the second quarter totaled 15.1 million or $0.41 per share based on 37.1 million weighted average shares outstanding and this compares to a GAAP net loss of 2.1 million or $0.06 per share based on 34.6 million weighted average shares outstanding in the prior period.

As a reminder, our GAAP net loss during the second quarter of 2013 included a 3.4 million or $0.10 per share nonrecurring tax benefit related to the release of a deferred tax asset evaluation allowance for the company’s Canadian subsidiary.

The reconciliation of GAAP to non-GAAP financial measures has been provided in the financial statement tables included in our press release. In terms of free cash flow results were lower than our expectation of roughly breakeven for the quarter.

This shortfall this quarter had two primary causes. The first was a growth in our accounts receivable balance due to deals closing a bit later in the quarter than usual impacting cash flow by roughly 4 million during the quarter.

The second was a one-time disbursement of goods and services tax payments associated with our business in Canada which we had expected to pay in early 2015 but instead we are compelled to pay during the second quarter.

And as a final point, acquisition accounting required us to account for roughly $1 million in purchase price associated with our acquisition of NetCitadel as disbursement under operating cash flow rather than cash flow related to investing activities.

As a result, we used 7 million in cash from operations for the quarter and invested 3.7 million in capital expenditures leading the negative free cash flow of 10.7 million during the second quarter.

As we look to the remainder of the year, we expect our capital spending to be somewhat higher than originally anticipated driven by accommodation of cloud infrastructure and support of our higher bookings activity this quarter as well as the signing of the lease for another building on our Sunnyvale campus which recently became available.

All of which will drive $7 million in additional capital expense in the second half of the year as compared to our original outlook. Taking all of these factors into account we now expect our free cash flow for the year to be in the range of breakeven to $5 million for the full year 2014.

Turning to the balance sheet, we ended the second quarter with 226.8 million in cash in short-term investments and 158.7 million in debt, compared to 257 million in cash and short-term investments and 157 million in debt as of March 31, 2014.

This sequential decrease in cash during the quarter was driven by our recent acquisitions and the aforementioned operating cash flow items partially offset by ongoing stock option exercises and the contributions to capital from our employee stock purchase plan.

We ended the second quarter with an accounts receivable balance of 26.3 million, resulting in DSOs of 46 days during the second quarter, higher than the first quarter, primarily due to the timing of deals during the second quarter that I mentioned earlier.

Total deferred revenue increased 37.1 million or 39% year-over-year to 131.6 million during the second quarter, up from 94.5 million in the year ago period. Compared to the first quarter of 2014, deferred revenues increased 3.7 million.

During the second quarter, the overall duration of our contract terms was up slightly from our first quarter results and finished at the low-end of our historical range of 17 months to 22 months. Highlighting our continued focus to shorten contract duration across our customer base.

Now, turning to our financial outlook starting with the third quarter. We currently expect billings to be 53.5 million to 54.5 million, resulting in year-over-year growth of approximately 30% at the midpoint of the range.

Regarding revenue for the third quarter, we are targeting total revenue of 47 million to 48 million or 38% year-over-year at the midpoint of the range. We expect third quarter non-GAAP gross margin to be approximately 71% consistent with the second quarter.

With regard to adjusted EBITDA, we're currently targeting negative 1.5 million to negative 1 million for the third quarter and we expect third-quarter non-GAAP net loss to be negative 4.8 million to negative 4.3 million or a loss of $0.13 to $0.11 per share based on approximately 37.7 million weighted average shares outstanding.

This assumes the 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 do expect free cash flow during the third quarter to be roughly breakeven.

From a full year perspective we are increasing our guidance above our over performance in the second quarter driven by the expected ongoing strength of the business. Specifically, we now expect billings to be in the range of 214 million to 215 million, which represents an annual growth rate of 34% at the midpoint of the range. This compares to our previous guidance range of 207 million to 209 million.

With this billings performance we are also increasing our total revenue guidance to a range of 185 million to 186 million reflecting an annual growth rate of 35% at the midpoint of the range and this compares to our previous total revenue guidance of 178 million to 180 million.

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

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

Adjusted EBITDA for the full year of 2014 is expected to be in the range of negative 2.5 million to negative 1.5 million, a $2 million improvement over the guidance last quarter driven primarily by the upside to profitability that we delivered during the second quarter.

While we will plan to expand our investment in research and development and support our ongoing slate of key product development initiatives as such we continue to expect fourth quarter 2014 to be at least breakeven.

We expect full year 2014 non-GAAP net loss to $15.1 million to $15.4 million or a loss of $0.42 to $0.38 per share based on approximately $37.5 million weighted average shares outstanding. And this is same depreciation of approximately $10 million to $11 million up roughly 50% from 2013.

And cash interest expense associated with the convertible debt of roughly $2.5 million. As well the income tax provision exclusive potential discrete items is expected to be approximately $0.8 million to $0.9 million for 2014.

I would like to highlight again that we're currently generating a net loss and as such our weighted average share count of $37.1 million for Q2 did not include the impact of unexercised stock options. If we were profitable today our fully diluted share count would have been approximately $30.7 million shares when applying the treasury stock method to outstanding options and restricted stock units.

In addition, if our convertible notes or in the money at the beginning of the quarter it would add approximately $5.2 million shares.

Finally, as I mentioned earlier we now expect our free cash flow for the year to be in the range of breakeven to 5 million for the full year 2014 and down from our previous guidance of approximately $10 million driven by the effects I discussed earlier on the call.

This cash flow guidance now seems capital expenditure of $16 million to $18 million for the full year compared to our prior expectation of $13 million to $15 million. While we're not providing guidance for fiscal 2015 at this time, I will state that we're confident free cash flow will increase next year.

So in summary, we had a record second quarter and believe that Proofpoint remains well-positioned to maintain momentum for the remainder of the year driven by the ongoing demand for our integrated cloud-based solutions.

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 at this time. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) First up is Phil Winslow with Credit Suisse.

Phil Winslow - Credit Suisse

Thanks guys and congrats on a great quarter. I got to questions. First of done TAP. Obviously sounds like you've got tremendous momentum there. Would you guys update on sort of where most of your success is coming from? Is it the end of the base or are you also seeing this starting to impact your win rates as far as new customer acquisition goes? And then I just have one follow-up after that.

Gary Steele

Yeah. I think so. Interestingly TAP is about 50/50 today; about half of its going into the install base but about half is with new customers. As we indicated in the prepared remarks, we did a lot of deals where TAP becomes the entry point in the opportunity new customers and it's opening the doors for us. So, I would -- you should think about it as 50/50 today.

Phil Winslow - Credit Suisse

Got it. And then also on the archiving side too, that's always been a big potential cross-sell in our eyes, I wonder if you can give us an update on what you're seeing out there in the archiving market. Thanks.

Gary Steele

Yeah. Interesting, I think that the archiving market continues to be one where customers that have traditionally had on-premise solutions are looking to the cloud. There really are a limited number of option and vendors today and we represents one of those viable alternatives as people think about what they want to do with their archive.

I'm extremely encouraged about the opportunity and I do believe there is inflection point in this market and we're starting to see the opportunity grow on the archiving side.

Some of its driven, as we talked about in the prepared remarks, some of this is driven by social and needs new compliance requirements. So the new compliance requirements effectively force people to rethink what their strategy is and that’s what's really driving and creating the opportunity right now.

Phil Winslow - Credit Suisse

Got it. Thanks guys. Keep up the great work.

Paul Auvil

Thanks Phil.

Gary Steele

Thanks Phil.

Operator

Next we will hear from Rob Owens, Pacific Crest.

Rob Owens - Pacific Crest

Thank you very much. I'd like to talk a little bit about customer acquisition. And you mentioned the pipeline drying a little bit in and around the Google Postini end of life. So the implication is given the growth rate that you guys are doing a better job of -- with customers outside that set.

You mentioned Office 365 and some of the protection archiving business you guys are getting there. So maybe just from a general perspective is this channel leverage, is this broader reach on your part? Number one.

And number two is, we look at Office 365 and some of the capabilities inherent on that platforms that you'd effectively compete with, how are you guys competing effectively? Is that relative to that reseller channel you built out or are those customers coming to you? Thanks.

Gary Steele

Yeah. So let me pull that question apart. First of all in the broader competitive landscape, as we indicated in the prepared remarks what we saw was reasonable distribution of deals across all of those incumbent players.

So, yes, we saw contribution from Postini, but it was not significant in overall numbers. And we are seeing across the board that as the threat landscape change, people are not happy with their existing incumbent vendor, and that’s just creating opportunity.

The reach that we're getting today is a combination of focused and engagement with our channel partners, but also continued growth with feet on the street and our sales organization.

Shifting to the Office 365 question, which is part of this, is as customers -- interesting dynamic that is important with Office 365 is that forces a rethink of what governance -- security and governance capabilities people had built on premise that they need as they move to the cloud.

Microsoft does offer a set of basic capabilities that address some of those issues. But what we're finding is that, the level of sophistication that our customers need is not oftentimes fulfilled by what Microsoft is delivering and therefore as this move to the cloud happens it becomes a catalyst to take a lot of that on premise stuff and find the cloud option. And we appear to be a great option for those customers moving to Office 365

Rob Owens - Pacific Crest

Okay. And for Paul, as we look at the little bit of extension in DSO and an increase relative to where you've been in duration, is this a return of more large deals relative to maybe where you were in the first quarter over this time next year or is it just extended linearity?

Gary Steele

It really is just timing of closure of deals during the quarter. So, we have kind of a historical norm in terms of the amount of business that gets done in month one and month two and we typically collect all of the business that’s done in month one and some meaningful fraction of the business done in month two.

In this case we just had less business that actually came to fruition and actually got closed in April timeframe than we typically see as well as sort of first part of May.

So, interestingly when you look at -- to more specifically your question on deal size, our average deal size was roughly consistent this quarter what we’ve seen historically. And in fact we didn’t have any particularly large deals.

Some times we’ll have one large transaction that Gary will highlight on the call. We actually had an outstanding quarter in the absence of having any sort of mega transactions this quarter, which I actually think was an excellent sign for the business.

Rob Owens - Pacific Crest

Thanks, guys.

Paul Auvil

Thanks, Rob.

Gary Steele

Thanks, Rob.

Operator

Next up, we’ll hear from Nandan Amladi, Deutsche Bank.

Nandan Amladi - Deutsche Bank

Hi. Good afternoon. Thanks for taking my question. Gary, you talked about a couple of the wins you had with the NetCitadel acquisition. Clearly, it’s only a couple of months since you announced the acquisition. But how does the pipeline look and what has surprised you on the positive or the negative side?

Gary Steele

Yeah. As we indicated, we are very encouraged about the level of interest that we’re seeing in that product. Specifically, what we’re finding is that when you look at incident response and how organizations are dealing with those issues today is it’s a highly manual process.

And as a result of that, organizations are willing to explore and are interested in capabilities that help drive down the time to actual remediation of an event and also to simplify what it takes to actually manage all the alerts coming in.

So we’ve got an extremely positive response. We were thrilled. We highlighted one win, which was with a Fortune 50 financial institution, which was in our view great validation of the capabilities that NetCitadel can offer. So while it’s still early, we are very encouraged by what we saw in the quarter and we think that there is a lot of opportunity here.

Nandan Amladi - Deutsche Bank

Thank you.

Operator

From RBC Capital Markets, we will hear from Matt Hedberg.

Matt Hedberg - RBC Capital Markets

Hey, guys. Thanks for taking my questions. And I’ll offer my congrats, as well. I really like the statistics. Half of net new sales are coming from sales of new solutions. You highlighted Content Control on the call as a standalone option. I know it’s still early, but it’s nice to see some early wins there. Can you talk about the ARR uplift a product like that might have on a sale?

Gary Steele

Yeah. So we’d expect Content Control – everything we have is subscription that is priced per user per year. We view the Content Control product is pricing roughly the same as our privacy product line. And so for an existing customer that’s privacy only, that’s a relatively small percentage of our customers. Many privacy customers also have protection.

But it’s essentially on the order of double the amount of revenue that we’re getting from our privacy customer. And so we’re quite excited about the prospects there.

And again we’re just in the early stages of starting to develop pipeline now. And, quite frankly, we’d be exciting to close a deal or two here in the current quarter, Q3. More likely, I’d say, our first customers would probably come together some time between now and the end of the year.

Matt Hedberg - RBC Capital Markets

That’s great. And on the competitive side, I’ll circle back to that. You guys have obviously had a lot of success against some of the legacy vendors in the space. There has been some products announcements from some, I would say, newer vendors on the e-mail security side.

Could you talk about some of the competition there? I mean, you guys certainly seem to have quite a lead here at this point. But can we talk about some of the newer upstart competitors?

Gary Steele

Yeah. There have been a number of announcements in this particular space in the past quarter. But we have not seen any shift in the competitive landscape. It remained identical, if not more favorable, as we worked our way through Q2. And I think that the large incumbent market shareholders today continue to fade. And there has been little response from those larger vendors, and that’s been beneficial to us.

The newer announcements – we have actually see nothing in the field at this point. And so, we've invested a significant amount and obviously of this capabilities. We feel like we have great long-term strategic advantages and I would highlight that fact that if you're a new incumbent not being in the Gardner matrix is going to be a challenge because most of our buyers outside they get their short list from which they evaluate. So we feel like we've got a great lead and we are continuing to innovate it at really rapid pace.

Paul Auvil

Yeah, one thing I would add to that as well is remember that our focus is large in the mid-enterprise. That's very hard market to break into. In that – there's an incredibly high bar in terms of what the expectations are from those customers.

Not only in terms of the quality caliber of the security solution itself demonstrated reliability of your cloud because remember, your processing everybody's mail traffic in real-time so any interruptions of course directly effect the customer and e-mail is one of the most important mission-critical systems in any enterprise.

So in the absence of having any meaningful or measurable track record in that regard it's a big risk for an enterprise of the scale that we typically deal with to pick an unknown, particularly when, again, if you look at the Gardner matrix we are Fergus to the left and the Fergus to North if you will in the matrix and our pricing is as competitive anyone in the market. So it's not clear why you pick an unknown who has recently entered the market when you got Proofpoint as the alternative.

Matt Hedberg - RBC Capital Markets

That's great.? Great color. Thanks guys.

Operator

Our next question comes from Craig Nankervis of First Analysis.

Craig Nankervis - First Analysis

Thanks good afternoon. Great job. Gary, really interesting momentum for TAP, is that due mainly to more awareness about the product or is there something special that the sales organization is doing? Is there any color on specific things that are working well as of this momentum continues to build?

Gary Steele

Yes. I think it's a couple things. I think one is we're continuing to get the message out more broadly that we have this capability. And that’s couple that of the time when organizations are feeling the pain from targeted phishing attacks.

And so I believe is the nice combination of Proofpoint being in market for while now with a fast maturing product at a time when the market is crying out for something like this. And so I think it's a combination that's driving the demand.

Craig Nankervis - First Analysis

And that getting the message out more broadly, that's to the existing base as well as to new prospects. I think it's both sort of both sides of…

Gary Steele

Yes, we are working both sides of that. And on the external side we’re not only working customers but also gaining greater understanding allegiance and momentum with the channel as well.

Craig Nankervis - First Analysis

Okay. The Office 365 color, I want to revisit that for a minute. Talking about how it plays well for your full suite, that to me is a little bit newer color than you provided in the past. Is there a reason why that is starting to happen now versus a few quarters back or just why is that cresting at this point?

Gary Steele

I think its – I think it’s a couple of things. So one is, again, as the security landscape is changed in combination with people moving to Office 365, people want to have the right level of security to protect themselves from these advanced threats.

So I think there's a good amount of momentum for Office 365 they're going to be looking for what they can replace, what was traditionally on premise capabilities with cloud capabilities.

And as I indicated in the earlier answer to my question for Rob Owens that these base capabilities for Microsoft typically don’t satisfy the need in this evolving front landscape.

Craig Nankervis - First Analysis

And then I guess just lastly any early color on the potential for selling TAP and NetCitadel as a combined sale? Is there any thoughts were sharing on that front?

Gary Steele

Yeah. Its a good question. We're a little early to be able to give you much color on that. So effectively what we're doing is going through a process with Proofpoint for that response which was formally NetCitadel of getting our first set of market customers, really understanding to go to market motion, really understanding what the price is going to look like and based on that data Craig, we'll then make bundling decisions. And I suspect we'll probably need a couple of quarters to really mature that go to market motion.

Craig Nankervis - First Analysis

Sure. Makes sense. I think…

Gary Steele

Okay. Thanks Craig.

Operator

Next up is Tim Klasell, Northland Securities.

Tim Klasell - Northland Securities

Yes. Good afternoon everybody. I want to jump in a little bit on your sales force growth. I believe you've always said sort of growth in parallel with topline growth. It appears you're getting more effectiveness, better sales process, new leadership there. Have you thought about accelerating that this year, maybe bringing it above the topline growth?

Gary Steele

Yeah, one of the things I mentioned in my prepared remarks is that revenue grew at a rate that sort of outpaced the rate at which we could productively invest in operating expenses. And so you can see we got some nice leverage on the sales and marketing line this quarter in particular. And a little more leverage than we actually wanted.

And so you will see as I alluded to in the remarks a catch up in spending growth and a lot of that will be in sales and marketing here in the third quarter. But we do intend to get back to breakeven on an even the basis for Q4.

And so, we definitely see opportunity there. We're really excited about how the sales team is continued to evolve in areas where we think we can make some opportunistic investments. But were also committed to driving the production of EBITDA on cash flow as we grow the business and I don’t know Gary wither you have anything you want to add to that?

Gary Steele

Yeah, the only thing that I would add Tim is that, I think one of the interesting aspects of color that we saw in the quarter is we are seeing a growing level of interest from the channel. And we think there's opportunity there and we're pursuing that.

I think it's matching again what the channel is hearing for customers given that they typically want to sell what customers are demanding. So I think there's opportunity there to get leverage in our model through using those partners that know as well.

Tim Klasell - Northland Securities

Okay. Good. And I – maybe you mentioned in your prepared remarks, but I didn't hear anything about essentials. That's obviously a good channel product. How is that doing?

Gary Steele

Yeah, so Essentials, again, focuses on the small size medium-sized business. We've had very good luck signing the key distributors and resellers of Postini. And it’s been interesting. I think we've gotten very good traction with those partners.

But we've also seen that customers are relatively slow to move.

So, I think there's a lot of people holding on, hoping that they can continue to use Postini for a long time. And so it will be interesting to see if there is at some point a notice from Google that they're going to support, but I think a lot of those smaller guys are just going hold on for awhile.

So we'll have to see and as we indicated in the prepared remarks, I think there is a long tail here. And I think we'll be able to take advantage of that long tail with essentials as those customers fully migrate.

Paul Auvil

Yeah. And again to add to that, given the robust growth rate that we’re seeing in kind of our historical target market and larger mid-enterprise, it continues to pacer – outpaced the rate, which were actually getting production of the essentials line.

So, the good news is essentials is growing, it’s contributing to growth and similarly cash flow for the business. Let's more color to it as it gets to be a larger part of the business and sort of deserve some airtime more broadly with the investment community.

Tim Klasell - Northland Securities

Great. Thank you for the color and congratulations on a great quarter.

Gary Steele

Thanks, Tim.

Paul Auvil

Thanks, Tim.

Operator

Next up is Jonathan Ho from William Blair.

Jonathan Ho - William Blair

How you guys think about sort of the international performance this quarter as well as increasing investments there, and what sorts of investments you're making and what sorts of change you expect to see in that area over time?

Gary Steele

Yeah. Great question. So, as we indicated in the prepared remarks, our international business met our expectations for the quarter. We had some great marquee wins. We see products resonating well with the European customers.

We're seeing more and more interest in advanced threat area in particular, and oftentimes the European markets can be somewhat behind the U.S. and thinking about these things, but it seems like there is a high level of interest and positive demand. So, optimistic about the opportunity.

We continue to invest in sales hiring in the core countries and core markets that we're in, which is UK, France and Germany. We're also very focused on engaging with the channel there to get broader leverage beyond just our salespeople. And so it's a focus point for the business and for the company.

Tracey Newell, our VP of sales is spending a significant amount of her time personally ensuring that that is growing at the rate that we wanted to. And I'm very encouraged by what we saw in Q2 and I'm optimistic about the second half.

Jonathan Ho - William Blair

Got it. And as we start thinking about the archival solution, can you talk a little bit about how that’s been performing and sort of the ability to cross-sell or up-sale solutions and not just TAP with core protection, but the ability to add-on some of these other solutions as well, can you maybe give us a little bit of color about those trends.

Gary Steele

Yeah. So, we are having very good success going to our base and selling archiving, we see convergence in the buying centers. So it often times the case that the person that buys, our security solution is also responsible for compliance and, therefore, will be the key decision maker in and archiving decision.

So, we’re optimistic about that. We're also seeing as we talked about Office 365 represents an interesting catalyst where orientations look at that broader security and governance landscape and say, okay what I would do with all of these capabilities that traditionally been on-prem?

And that allows for a broader cross product dialogue with the customer because they are thinking about a broader cloud migration strategy. So, we are getting interesting and nice leverage today.

I think in particular in the archiving market as I indicated before it's one of those natural markets where it's expensive to do on premises and all of innovations today is having in the cloud, which is creating opportunity for us.

So I feel really good about that opportunity and I think there's a number of key market catalysts that will continue to drive demand for our solution.

Jonathan Ho - William Blair

Great. Thank you.

Gary Steele

Thanks, Jonathan.

Operator

From JMP Securities, we’ll hear from Erik Suppiger.

Erik Suppiger - JMP Securities

Congratulations. On the Microsoft archiving relationship, have you seen any private companies coming after that business? I think there has been some partnership with Microsoft has added on the archiving side. Has that made any difference?

Gary Steele

So, again to be clear, we have a legacy relationship that we've had for a number of years now related to their largest customers that are now part of what's known as Office 365.

I think it had a different name four year's ago, that business is still essentially exclusively ours, although as we've talked about in prior calls, they're not closing any net new customers there but that direct bill relationship with Microsoft continues to be prosperous and impact we had modest growth again this quarter in the total revenues associated with that relationship even though they haven't added any net new customers recently.

With that said, in the Office 365 ecosystem, as they now have evolved to go to market where the Microsoft team is no longer closing business that directly under our contract with Proofpoint engages with that Office 365 customer base.

So instead it’s working with different partners and resellers out there and prospects directly to close business. There are other people with other solutions. We don't have that market opportunity exclusively. And there are the people who offer among other things archiving solutions that work jointly with the Office 365 framework.

We don’t see anybody with a viable solution for the large and kind of the upper end of the mid-enterprise segment. We see a few people who were kind of swimming around in the SMB realm and maybe a little bit kind of at the higher end of SMBs.

So couple hundred users and below. And quite frankly we don't pay a lot of attention to that market because it's not a core part of what drive the growth for Proofpoint.

Erik Suppiger - JMP Securities

Okay. And then what do you see Microsoft doing in terms of archiving? Is it similar to the security where it's just not sophisticated enough were what is the latest from that perspective?

Gary Steele

Yes, Microsoft offers them base capabilities in certain levels of Office 365. Those base capabilities can work for some organizations typically smaller size businesses. We continue to see a lot of demand from larger, more complex, more litigation heavy organizations often times in regulated industry that made they need a lot of what Microsoft can offer.

So it’s kind of the typical, it's really equivalent to what's happening in security we use the base capability but it often times doesn't meet the needs of either a regulated industry company or someone with more sophisticated requirements.

Erik Suppiger - JMP Securities

Thank you very much.

Gary Steele

Thanks, Erik.

Operator

Next up from Citi is Walter Prichard.

Walter Prichard - Citi

Hi. Thanks. Paul, just a couple quick ones on our end. You have in the past talk about what percentage of the business or the customers are using two plus products. Any update to that metric

Gary Steele

We typically update that once a year. We did provide a second update at a time of the Analyst Day. We will update it again in January.

Walter Prichard - Citi

Okay. Got it. And then just, I guess, I would love to hear you talk through a bit. you give some color on the Postini basin and where you are on that basis. Is there any other competitive install base where you feel like you're at a turning point either positively or in the case of Postini where you see it sort of winding down, as it relates to low hanging fruit to gain share into?

Gary Steele

Yeah. Interesting, Walter, we saw pretty even distribution across the larger incumbent players. So we did a reasonable amount of Postini, obviously, but we also did a reasonable amount of Cisco IronPort, Symantec, their various products, McAfee as well. So there is reasonable contribution from all of those.

And I think that as the threat landscape has moved and become much more targeted threats or much more difficult to catch we're seeing the customers of those vendors out looking for solutions. So we're actually seeing a reasonable amount of frustration with the vendors that are the bigger market share incumbents.

Walter Prichard – Citi

Got it. And then, Paul, just I want to make sure we had the sort of impact here on the numbers right, for billing perspective. So, you had the Sendmail drawdown on deferred about $2 million,

I think you were expecting. Any detail their on what the contribution was from new business booked from Sendmail? And then, it looks like NetCitadel are pretty small that didn’t expect you really brought on any revenue base or billings there. But just want to get a sense of sort of magnitude of contributions for both.

Gary Steele

Yeah. So on NetCitadel that first transaction was a nice one to get closed. It was, I would say, consistent with our average transaction size, which, think of it as kind of a low six figures transaction. It's in that row, so nice piece of business.

With regards to Sendmail, so to your point, I like to point out the amount that’s coming directly from what we wrote onto to the balance sheet as deferred revenue at the end of last year. Just because that's truly a non-organic element, it's just – it's there, we put it on balance sheet, now we’re taking it off.

And it's a declining amount each quarter. And we provided the details in the October call as to the amounts both for the fourth quarter of 2013 and in the fourth quarter of 2014 it would have an impact.

So when it comes to the actual billings of net new business that we're closing during any given quarter, we don't really break out how much is related to the Sendmail customer base or Sendmail related products versus our protection solution or TAP or Armorize.

We kind of new all that is organic at some level because it's our sales organization going on developing driving and closing the business.

We may, in the January timeframe, depending on the size of it, talk about the MTA business and what percentage that is of our overall business as compared to the protection business, just to give people a sense for how that piece first together. We're still assessing that at this point. It really will depend on whether that business is large enough to be material enough to want a direct commentary.

Walter Prichard – Citi

And then just lastly, headcount, did you give a – I guess, I might have missed that, but what was your headcount – total headcount number for the end of the quarter?

Paul Auvil

No. We typically don't provide that on the call. But we had good net growth in the total headcount. We added – think of it as somewhere in the high 700s.

Walter Prichard – Citi

Okay. Okay. That's good enough. Thanks a lot.

Operator

And next is Matthew Niknam, Goldman Sachs.

Matthew Niknam - Goldman Sachs

Hi, guys. Congrats on the quarter. Thanks for taking the question. Just one on margins, with the increased investment this year, how should we think about the margin trajectory and ramp towards the 18% to 22% cash flow margin range you’ve discussed that I think you expect by 2017? Thanks.

Paul Auvil

Yeah. So, obviously, this quarter you've given the timing on deals closing and the impact to AR and then the disbursement associated with the Canadian GST amounts that we expected to disperse actually in early 2015. We had to take our cash flow expectations down for 2014.

But as we look to 2015 and beyond, we expect good ongoing sequential production of cash flow growth for the business. And so we haven't given an official 2015 guide yet, but we think it will be a nice sequential improvement from 2014, albeit still early at this stage. And we feel good about getting to that 18% to 20% range in the second half of 2017 timeframe. So, we're very much managing the business with that target in mind.

Matthew Niknam - Goldman Sachs

Got it. Thank you.

Gary Steele

Thank you. Next?

Operator

Next from FBR is Daniel Ives.

Daniel Ives - Ives

Hey guys. Just on Office 365 are you doing anything different may be over the next six to nine months now since the big opportunities comes in marketing channel, education, just in terms of sales leads. That seems like a massive opportunity given, [indiscernible] going after this. So, I'm just interested in terms of the go-to-market there.

Gary Steele

Yeah, we're definitely orientating ourselves to align with the go-to-market motion of Microsoft. So, it's focused on their channel and ensuring that we're seeing those opportunities as customers move to Office 365.

So, there is -- it’s a marketing effort, it's a channel effort, it's just a -- how you spend your time in the field efforts. And I think given what we saw in Q2 and the pipeline that we see for the remainder -- the remaining part of the year, we think the big opportunity.

Daniel Ives - Ives

Okay. Thank s guys.

Operator

We'll go next question to Michael Kim, Imperial Capital.

Michael Kim - Imperial Capital

Hi, Gary, hi Paul.

Gary Steele

Hi.

Michael Kim - Imperial Capital

I wanted to just get an update on the uptake for predictive transfer cap and how that's progressing since GA and it's starting to see that essentially as a normal add-on for new customers or how existing base of TAP has been adopting Predictive Defense.

Gary Steele

It's been really good demand acceptance of Predictive Defense deals -- value of the deals that we get on Predictive Defense. But it is a natural part of the solution that we sell in a couple of ways.

One is the bundle it with the other TAP capabilities, that's probably the most common way we sell. And then for some customers would sell it unbundled. So, it's really working as we thought at exceeding our expectations at this point.

Michael Kim - Imperial Capital

And can you frame what the recurring revenue contribution -- incremental recurring revenue contribution would be with Predictive Defense versus the ones without?

Gary Steele

We haven't disclosed anything specific on that, but I can tell you it's -- just in terms of price per user per year it’s a nice boost to what we're essentially selling the baseline TAP product for. So, think of it as TAP selling for essentially the same price as protection. This adds maybe another 30% or 40% to that price.

Michael Kim - Imperial Capital

Okay. Wow. And then just switching gears to privacy and archiving. With the social media capabilities, are you seeing an increase in adoption by non-regulated verticals and where you might be seeing that in addition to your regulated customers?

Gary Steele

Yeah, we're. And so its organizations that adopt social and it becomes kind of a primary communication method and so they need to do it. So, you'll see it in healthcare and pharma, as an example.

You'll see it even in things like state and local government. So the example there would be a lot of cities, for example, use social media to communicate things going on in the community, road closure, blah, blah, blah, and things like that, while the city actually has to catch and archive that. And that's not necessarily intuitive, but all those organizations that begin to use social as a communication medium, they want to be able to capture and archive it.

Michael Kim - Imperial Capital

Okay. And I assume it's still greater waiting towards the regulated customers.

Gary Steele

It is more weighted towards the regulatory customers. And the other piece of color that would provide is we're seeing a reasonable amount of adoption for enterprise social, specifically Chatter. Organizations that are big sales force users and they decide to deploy Chatter, oftentimes they want to be able to capture all that for the purposes of discovery and compliance..

Michael Kim - Imperial Capital

Okay. Great. Thank you very much guys.

Gary Steele

Yeah, thanks.

Operator

And at this time there are no further questions. I'll turn the conference back to management for any additional or closing remarks.

Paul Auvil

Great. Thank you very much. I just want to take a moment to thank everyone for their participation today and we look forward to talking to people next quarter. Thanks so much.

Operator

And again, ladies and gentlemen, that does conclude today's conference. We would like to thank you for your participation.

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Source: Proofpoint's (PFPT) CEO Gary Steele on Q2 2014 Results - Earnings Call Transcript

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