Proofpoint's (PFPT) CEO Gary Steele on Q3 2016 Results - Earnings Call Transcript

| About: Proofpoint, Inc. (PFPT)

Proofpoint, Inc. (NASDAQ:PFPT)

Q3 2016 Earnings Conference Call

October 20, 2016 4:30 PM ET

Executives

Paul Auvil - Chief Financial Officer

Gary Steele - Chief Executive Officer

Analysts

Melissa Gorham - Morgan Stanley

Matt Hedberg - RBC Capital Markets

Rob Owens - Pacific Crest

Gray Powell - Wells Fargo Securities LLC

Walter Pritchard - Citigroup

Jonathan Ho - William Blair

Gur Talpaz - Stifel Nicolaus

Kenneth Talanian - Evercore ISI

Steve Koenig - Wedbush Securities, Inc.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Andrew Nowinski - Piper Jaffray

Gabriela Borges - Goldman Sachs & Co.

Tim Klasell - Northland Securities, Inc.

Erik Suppiger - JMP Securities LLC

Catharine Trebnick - Dougherty

Ryan Hutchinson – Guggenheim

Srini Nandury - Summit Redstone Partners LLC

Michael Kim - Imperial Capital LLC

Bill Choi - Wunderlich

Operator

Please standby, we’re about to begin. Good day, and welcome to the Proofpoint’s Third Quarter 2016 Earnings Conference Call. Today’s conference is being recorded.

And at this time, I’d like to turn the conference over to Paul Auvil, Chief Financial Officer. You may begin.

Paul Auvil

Thanks. Good afternoon and welcome to Proofpoint’s third quarter 2016 earnings call. Today, we will be discussing the results announced in our press release that was issued after the market closed. I’m Paul Auvil, Chief Financial Officer of Proofpoint, and with me today 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 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 are more fully detailed under the caption Risk Factors in Proofpoint’s most recent 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 exclude stock-based compensation expenses, acquisition-related costs, accretion of the debt discount and amortization of the debt issuance costs and interest expense 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, non-recurring income tax benefits, interest expense, other expense and income.

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 third quarter 2016 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 October 20, 2016, 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’ll turn the call over to Gary.

Gary Steele

Thanks, Paul. I’d like to thank everyone for joining us on the call today. The third quarter marked another great quarter for Proofpoint. Our ability to exceed expectations across all key operating metrics was once again driven by the strong demand for our advanced threat solutions, as the threat landscape continues to remain one of the top concerns for enterprises around the world, given the high volumes of malicious campaigns, such as ransomware, Dridex and business email compromise.

In addition, during the third quarter, the company continued to benefit from the combination of a healthy growth rate of new customers, a strong cycle of add-on sales to our installed base, and a world-class renewal rate that remains well over 90%. The ongoing momentum of our suite of advanced threat solutions continue to be a key growth driver, as it represented roughly half of the company’s new and add-on business for the quarter.

Looking forward, we believe that a significant opportunity remains to not only add new customers, but also expand our footprint within our existing customer base of over 4,000 accounts, given that TAP is installed in roughly one-third of our total customer base as of our Analyst Day in June of this year.

Some of the noteworthy TAP wins during the quarter included a Fortune 500 multinational conglomerate that purchased Protection and TAP for 60,000 users. A Fortune 500 healthcare provider that purchased Protection, TAP and Privacy for 55,000 users, and a Fortune 500 diversified financial services company that added Protection and Privacy for 25,000 users and TAP for 75,000 users.

During the third quarter, our strong results were also driven by the ongoing demand by enterprises to protect against attacks from what the FBI refers to as business email compromise or BEC, where an impostor spoofs an email set from an executive to a subordinate, directing them to either wire money or send confidential data to a fraudulent account.

According to a recent FBI public service announcement since the beginning of 2015, the identified losses worldwide from this attack vector totaled over $3 billion. Proofpoint is able to find and block these attacks by leveraging over a decade of deep expertise in core email security as these email s are very difficult to detect since they contain no malware and the attacker may send only a few messages per month to any given target.

Given the challenges that our competitors are having in terms of finding and blocking these BEC messages, we expect this attack vector to remain a catalyst that drives demand for Proofpoint’s security solutions for the foreseeable future. To address the challenge of the BEC, we offer our customers two unique and critical capabilities in addition to our basic configuration options.

First, we offer detection capabilities that leverage our machine learning classifier to identify and catch BEC messages at the email gateway. And second, we offer email authentication through the email fraud defense or EFD Solution that we acquired in late August from a Return Path that enables an easy way for our customers to implement and maintain demark authentication for their enterprise, which is an industry standard mechanism.

With authentication in place, enterprises can eliminate domain spoofing, one of the most common forms of BEC for their company, their partners, their suppliers, and their end customers. We believe organizations will combine the capabilities of configuration, detection and authentication to bolster their BEC defenses. With BEC becoming much more prevalent, we see broad potential opportunity for our EFD Solution across large and mid-sized enterprises around the world. And in fact, within a few short weeks, we have seen good early interest and have already closed a handful of deals for this new solution.

Email fraud defense will be sold as a separate module, while we continue to include our basic configuration capabilities and BEC impostor classifier as standard features of our email protection solution. We had another strong quarter in our Protection business, driven by a number of catalysts, including business email compromise, the McAfee transition, and the overall trend of customers migrating to the Office 365 cloud.

A few examples of Protection wins during the third quarter included a Fortune 100 multinational financial services company that added Protection and TAP for 110,000 users. A Fortune 500 healthcare provider, which purchased Protection and TAP for 65,000 users, and a leading university that added Protection and Privacy for 50,000 users.

With regards to our partnership with Intel McAfee, in particular, we continue to be very excited about this opportunity. During Q3, we saw our pipeline from this partnership continue to grow and the contribution to new business closed during the quarter was higher than the past several quarters, marking a new record in terms of business source from the McAfee installed base.

As I indicated earlier, during the third quarter, we continue to benefit from the overall transition to the cloud, driven by the shift in Microsoft Office 365. Examples of wins during the quarter include a Fortune 100 multinational media and entertainment company that purchased Protection, TAP and Threat Response for 75,000 users. A large national retail chain that purchased Protection and TAP for 17,000 users, and a large state regulatory institution that purchased Protection, Privacy and TAP for 7,000 users.

Looking forward, we expect enterprise customers moving to Office 365 to continue to look for additional security capabilities to complement and enhance the baseline solutions provided by Microsoft. In addition, this move to the cloud is continuing to force the displacement on-premise solutions and the need to replace the existing compliance infrastructure that has been deployed on -premise in support of the legacy exchange environment. As a result, we expect this overall transition to the cloud will remain a catalyst that drives demand for Proofpoint’s broader cloud-based security and compliance capabilities for a number of years to come.

Turning to our social media security and compliance solutions, we made good progress during the quarter, as this emerging market continues to evolve. We’re very proud to be named a leader in the recent Forrester Wave Digital Risk Monitoring report, where Proofpoint received the highest customer score for the control and enforcement for covered digital channels, including social, mobile, and the web. Along with that report, we announced our recently granted patent pertaining to the enforcement of policies on social networking activity.

We view these two accomplishments as further validation of our continued dedication to delivering innovative solutions to detect and dramatically reduce this emerging genre of digital risks. A few of the key wins for the quarter included a Fortune 100 diversified technology company that purchased our social discover capabilities to track their social account infrastructure, detect fraud, and authorize unauthorized social accounts.

A significant expansion at a large insurance company, which purchased social compliance to capture and mitigate compliance risks for ages pursuing social media-based client interaction and a large utility that purchased our new threat monitoring capabilities to detect threats against the company and its locations made via social media.

During the third quarter, the growth rate of our cloud-based archiving privacy and governance results improved to 28% on a year-over-year basis. Some of the key deals closed during Q3 included a Fortune 100 financial services company and a Fortune 200 technology company, both of which added archiving for approximately 20,000 users, and a large European-based financial services firm, which purchased archiving for 5,000 users.

Looking forward, the sales cycles for our larger archiving opportunities continue to be longer than our classic security deals. As a result, for the next several quarters, we expect the year-over-year growth rate for this segment to be consistent with the current quarter.

In terms of our ecosystem partnerships with Palo Alto Networks, CyberArk, Imperva and Splunk, we remain very excited about these relationships as all of the partners continue to be very engaged. Notable deals closed during the quarter that were influenced by our ecosystem partnerships included a large manufacturing company that purchased Protection and TAP for 20,000 users. A regional medical facility that purchased Protection and TAP for 6,000 users and a regional community hospital that purchased Protection, Tap and Threat Response for 3,200 users.

I would also like to point out that during the quarter, we were pleased with the momentum of the channel as it once again accounted for over half of the new and add-on business closed for the quarter.

Finally, we continue to make progress towards further expansion abroad with our international business growing 35% year-over-year consistent with last quarter’s performance. Notable international deals closed during the quarter included a large European telecommunications service provider that added Protection and TAP for 30,000 users. A large European consulting company, which bought TAP for 26,000 users, and a large European food manufacturer that purchased Privacy for 9,000 users.

The addressable market outside of the United States in both EMEA and Asia Pacific continues to represent a compelling future growth opportunity for Proofpoint, and we plan to continue to grow market share in these regions.

Before I turn it over to Paul, I want to mention that we have entered into a definitive agreement to acquire FireLayers, an innovative cloud security startup. FireLayers is headquartered in Israel, and through this acquisition, we will expand our presence in EMEA. Like other acquisitions that we have completed, FireLayers brings a phenomenal team of people and great technology to Proofpoint. We intend to use this technology to extend Targeted Attack Protection to SaaS applications to protect the users of these applications from advanced malware.

For example, with this capability, we will be able to detect and block malicious file shared via leading file sharing program, such as Microsoft Office 365 or dropbox, scan files for malware uploaded to customer service applications such as sales versus Service Now or identify malicious links embedded in resumes uploaded into the HCM solution by Workday or Oracle Taleo.

Although FireLayers as an independent company had historically been focused on the CASB cloud access security broker market. We plan to leverage this technology to extend TAP into SaaS applications and do not plan to pursue the standalone CASB market. As with other models of TAP, this will be sold separately and we expect that it will be available in the first-half of 2017.

So, in summary, I’m very pleased with the ongoing strong momentum in our business as the enterprises continue to select Proofpoint’s cloud based advanced threat protection solution over legacy alternatives, given our proven ability in handling today’s advanced security threats. Our ability to generate and meaningfully grow cash flow, while at the same time driving the top line positions the company to gain market share over the extended period of time across an addressable market that exceeds $10 billion.

As a final point, similar to prior quarters, the strong demand we’re seeing continues to be supported by a healthy macro environment. In addition, we still have not seen any signs of the Brexit vote in the United Kingdom has had any impact on buying behavior across the geographies and product categories that we serve.

While other security companies have experienced issues it is important to remember that Proofpoint focuses on a unique market within the security industry and our continued confidence in the macro environment is reflected in the increasing guidance that Paul will walk through shortly for both the remainder of fiscal 2016, as well as the upcoming fiscal year 2017.

With that, let me turn it back over to Paul

Paul Auvil

Thanks, Gary. I’m very pleased with the strength of our execution during the third quarter, as highlighted by our ability to exceed expectations for revenue, billings, profitability, and free cash flow.

During the third quarter, total revenue was $99.8 million, up 44% and above our previously announced guidance range of $93.5 million to $94.5 million. Similar to last quarter, the strong revenue performance benefited from excellent linearity in terms of the timing of new and add-on business booked during the quarter, as well as renewal rate that was measurably better than our recent norms. These factors added several million dollars to revenue during the quarter, as compared to a typical quarter almost all of which directly benefited the profitability recorded for Q3.

Billings for the third quarter totaled $124.8 million, reflecting growth of 47% on a year-over-year basis and exceeding the high-end of our previously announced guidance range of $114 million to $116 million. Adjusted for the impact of early renewals from future periods as well as the impact of similar activity recorded during the prior year period, the normalized billings growth rate was approximately 40% for the quarter.

In terms of billings duration, we were again pleased with our results for the quarter, which came in at the low-end of our historical range of 15 months to 22 months. This trend is clearly reflected in our deferred revenue balances where short-term deferred revenue grew sequentially by $23 million over the prior quarter, whereas long-term deferred revenue grew by only $3 million.

Turning to expenses and profitability for the third quarter, on a non-GAAP basis, our total gross margin was 77%, which was above our expectations and nicely above our long-term original target of 74% to 76% and a solid step towards our 2020 target of 78% to 80%. We were very pleased with our execution for the quarter, but note that the surge in revenue driven by our linearity during the quarter pushed this gross margin figure ahead of the rate of investment needed to support the scale of business in steady-state.

And as such, we do expect a modest decline in gross margin as a percentage of revenue over the next several quarters, as we grow into this accelerated level of revenue achievement. In terms of our operating expenses, we continue to invest in sales and marketing as well as research and development to support future growth. During the third quarter, total non-GAAP operating expenses increased 30% over the prior year to $66.7 million, representing 67% of total revenue, down from 74% during the same period last year.

Growth in spending was primarily driven by growth in personnel, both in R&D and sales as we added talent to both broaden and deepen the capabilities of our product offerings along with sales resources to build core capacity to drive both new customer acquisition, as well as add-on sales to existing customers.

Third quarter 2016 adjusted EBITDA was $15 million, well above our guidance range of $7.4 million to $7.9 million, primarily driven by the upside to revenue coupled with focused spending discipline across our business operations around the world. As well, note that we had expected the Return Path asset acquisition to close earlier in the quarter, and as such, we had deferred spending in other areas of company in order to accommodate these costs within the original guidance that we had provided in July.

As a result, with the delay in the closing of the asset purchase, we ended up with additional savings in terms of spending, which we were unable to otherwise put to good use during the quarter, resulting in additional upside to EBITDA and net income for the quarter. While we were of course very pleased with these results, we believe that this level of profitability is a bit ahead of reasonable baseline, given the current size, scale, and growth rate of the business. And hence profitability is likely to decline modestly on an absolute basis from current levels for the next several quarters, as our rate of investment in the business catches up with this accelerated step up in revenue.

I would like to note that during the earnings call last quarter, I had indicated that our move to deferred commission accounting would have had a favorable impact on our profitability since third quarter of approximately $1.5 million. In fact, the final figure was a favorable impact of only $0.4 million, so under our historical method of commission accounting from prior years, we would have delivered an EBITDA figure of $14.6 million.

As a reminder, we do carry two series of convertible notes on our balance sheet that are due in 2018 and 2020. The first series due in 2018 face annual interest of $2.5 million in two equal installments during the second and the fourth quarter. The conversion price of these notes is $39.02 and if-converted 5.2 million shares will be issued.

I wanted to point out that on the 2018 notes, we have a two-year call option, which starts in December of this year though we have no plans to exercise that call provision at present. The second series due in 2020 pays annual interest of $1.7 million in two equal installments also during the second and fourth quarter, and the conversion price on those notes is $81.23, and if-converted 2.8 million shares will be issued.

Note that, we are now using two different share counts for our EPS calculations here on the call. In cases where we are reporting a loss, we are calculating EPS using the basic EPS methodology with a share count is equally to the weighted average number of shares of common stock outstanding for the quarter, resulting in a figure of 42.1 million shares for the third quarter.

For the fourth quarter, we expect this measure to be $42.6 million and for the full-year 2016, we expect 41.9 million shares. As we look forward to 2017, we expect the share count to increase by approximately 500,000 shares per quarter and the full-year figure should be $44 million. In cases where we’re reporting a profit, we are calculating EPS using the diluted EPS methodology. The diluted EPS share count begins with the basic EPS share count and then adds two elements.

The first element is to apply the treasury stock method to assess the dilutive impact of all stock options and other forms of outstanding equity awards that would serve to dilute the basic EPS figure. This first element adds 4 million shares to the basic figure for the current quarter. The second element is to apply the if-converted method to our convertible notes. The application of this method for the current quarter adds 8 million shares from both the 2018 and 2020 bonds. Hence the fully diluted share count for the third quarter is determined by adding a total of 12 million shares to the basic share count of $42.1 million, resulting in a fully diluted share count of 54.1 million shares.

As a final point and this is important having triggered the if-converted method not only of the shares associated with convertible notes included in the diluted share count, but also the interest expense associated with the notes is added back to the net income as part of calculating EPS. So for the third quarter, the cash interest expense of $1.05 million is added back to net income when dividing into the share count.

For Q4, we expect to again trigger the if-converted method for both series of bonds. And with that in mind, we expect the diluted share count to be $54.4 million and the interest expense to be added back for EPS calculation purposes to net income will be again $1.05 million.

For the full-year of 2016 diluted share count, note that the net income for the full-year does not trigger the if-converted method for either series of bonds when applying the full-year test. And as such, the full-year fully diluted share count is expected to be 45.9 million shares. With this in mind, it is important note that the EPS figures calculated for each of the four quarters of 2016 will not add up to equal the EPS figure as calculated for the full-year, given the if-converted method will not – will only be applied to the third and fourth quarters and not for the full-year.

Looking forward to 2017, we think it is possible that we will trigger the if-converted method for both series of bonds for all four quarters of the year, as well as for the full-year. With that in mind for planning purposes, we recommend starting with the diluted share count in Q4 2016 of 54.4 million shares and increasing the share count by approximately 400,000 shares per quarter over the course of 2017, and for the full-year 2017 using a fully diluted share count of approximately 55.8 million shares.

Also in applying the if-converted method to each of the four quarters of the year, their quarterly interest expense associated with the bonds of $1.05 million should be added back to net income for each of the quarters when calculating the earnings per share, and of course, for the full-year $4.2 million should be added back.

So with all the share count questions aside, in terms of profitability for the quarter Q3, we reported positive non-GAAP net income of $9.4 million, or $0.19 per fully diluted share, our second consecutive quarter of non-GAAP profitability. This result was well above our guidance range of $0.04 to $0.06 per share, driven by the revenue upside delivered during the quarter without a commensurate increase in spending.

On a GAAP basis, we recorded a net loss for the third quarter totaling $18.5 million, or $0.44 a share. In terms of cash flow, during the third quarter, we generated $27.3 million in operating cash flow and invested $9.3 million in capital expenditures, resulting in free cash flow of $18 million. This was well above our guidance range of $8 million to $10 million.

Turning to the balance sheet. We ended the third quarter with $412 million in cash and short-term investments and $361 million in debt, compared to $412 million in cash and short-term investments and $356 million in debt as of June 30, 2016. We ended the third quarter with an accounts receivable balance of $69 million, resulting in DSOs of 56 days. Total deferred revenue for the third quarter was $281 million, an increase of $81 million, or 40% on a year-over-year basis.

Before turning to the financial outlook, I would like to remind everyone that our results in 2016 do reflect a change in how we account for commissions as discussed on our previous earnings calls. As a reminder, we moved from our historical approach of expense commissions during the period in which they were incurred to the accounting policy now used by most larger SAS companies, including Salesforce, ServiceNow, Workday and Ultimate Software, where the commissions are amortized over the term of the revenue contract, providing a better matching between revenue and expenses on the income statement.

During our January call, we indicated that we expected the full-year impact to be a benefit to EBITDA of approximately $4 million associated with this change. As of the first three quarters of the year, the impact has actually been an unfavorable impact of $0.2 million.

For Q4, we do expect a favorable impact of $3.5 million and has an overall favorable impact to the full-year of $3.2 million, so roughly $1 million less favorable than our original estimates back in January.

Now, turning to our financial outlook starting with the fourth quarter, we currently expect billings to be $133.5 million to $135.5 million, resulting in year-over-year growth of approximately 38% at the midpoint of the range. Note that this is – this guidance assumes that our duration remains consistent with our activity in Q3.

Regarding revenue for the fourth quarter, we are targeting a range of $103 million to $105 million, or 39% growth year-over-year at the midpoint. Note that this revenue outlook includes no material contribution from the acquisition of either FireLayers or the Return Path assets since their prior revenues were immaterial in the context of Proofpoint’s current revenue run rate.

Our plan going forward is to drive organic growth opportunities for Proofpoint by using these newly acquired technologies to introduce new products into the market. We expect fourth quarter non-GAAP gross margin to be approximately 76%, a modest decline from 77% recorded in Q3, as our spending begins to catch up with the accelerated revenue delivered during the third quarter.

With regard to adjusted EBITDA, we are currently targeting positive $11 million to $12.5 million for the fourth quarter. We expect fourth quarter non-GAAP net income to be $4.5 million to $6.5 million, or profit of $0.10 to $0.10 per share, a modest decline from Q3, as our level of spending in R&D, cloud infrastructure services, and sales catches up with our accelerated level of revenue. This assumes an income tax provision exclusive of discrete items of $0.4 million, $0.5 million for the quarter.

From a full-year perspective, we are increasing our guidance above the overperformance just reported in Q3, driven by the expected ongoing strength of the business. Specifically, we now expect billings to be in the range of $457.8 million to $459.8 million, which represents an annual growth rate of 42% at the midpoint of the range. This compares to our previous guidance of $445 million to $448 million.

With this billings performance, we are also increasing our total revenue guidance to $371.7 million to $373.7 million, reflecting an annual growth rate of 40% at the midpoint of the range. This compares to our previous total revenue guidance of $361.5 million to $363.5 million.

We expect full-year 2016 non-GAAP gross margins to be approximately 75.5%, which includes the initial costs associated with the build out of infrastructure associated with our two recent acquisitions. With these effects in mind, adjusted EBITDA for 2016 is now expected to be in the range of $35 million to $36.5 million, up from our previous guidance of $24.5 million to $25.5 million.

As a result, we expect full-year 2016 non-GAAP net income to be $13 million to $15 million, or a profit of $0.28 to $0.33 per share, an improvement from our previous guidance of a profit of $2.5 million to $4.5 million, or $0.06 to $0.10 per share. Our new non-GAAP EPS guidance for 2016 assumes depreciation of approximately $16.9 million to $17.2 million, and an income tax provision exclusive of potential discrete items of $1.3 million to $1.4 million.

Finally, given our strong Q3 performance here, we are raising our free cash flow guidance for the full-year to the range of $39 million to $41 million, up from $34 million to $38 million previously. This 2016 guidance assumes capital expenditures of $33 million to $35 million. A reconciliation of our non-GAAP guidance for both the fourth quarter and the full-year 2016 to GAAP can be found in our third quarter release that we issued this afternoon.

While we’re still in the early stages of our planning process, I would like to share some additional details regarding our 2017 outlook. We are now comfortable providing an estimated revenue growth rate of approximately 29% to 30% for our full-year 2017, or $480 million to $485 million using the midpoint of the 2016 range, which is consistent with our starting point last year and an increase from our previously announced guidance of approximately 28% provided on our earnings call in July.

We expect to record a billings growth rate that is several percentage points higher than the stated range of the revenue growth, and note that billings tend to be relatively flat from the fourth quarter through the first two quarters of the following year, given the cyclical nature of demand inherent across the tech industry, as well as the timing of our renewal account base across the four quarters of the year. We believe that this is a very strong outlook for 2016, given the high growth rates that we’ve delivered over the course of 2016.

Note that our current outlook for 2016 EBITDA and net income are well ahead of original expectations. Thanks to the very strong revenue performances delivered in both second and third quarters that outpaced the rate at which we could productively invest in R&D, cloud infrastructure services and sales. While we were very pleased to deliver these upsides in terms of profitability this year, it has set up a relatively challenging comparison heading into 2017, as we do expect over the next several quarters that our rate of spending will catch up with our accelerated level of revenue delivery this year.

With respect to adjusted EBITDA for 2017, our initial range is $49.5 million to $51 million for the full-year, highlighting the ongoing leverage we anticipate seeing in the business and confirming the notion that we have shared over the past several years that EBITDA lacks free cash flow production by roughly one year in our business model.

With regards to non-GAAP net income, we expect full-year 2017 to be in the range of $21 million to $23 million. or $0.45 to $0.49 per diluted share using $55.8 million fully diluted shares outstanding for the year and adding back the annual interest expense on the bonds of $4.2 million.

As in prior years, keep in mind that the first quarter is always a step backwards in terms of profitability for the company, as our first quarter operating expenses included our typical increase in costs early in the year associated with payroll taxes, sales kickoff, and initial sales and marketing investments for the year.

That said, we do expect net income to be modestly profitable on the non-GAAP basis for the first quarter still well below the quarterly average as implied by the guidance for the full-year, and then to improve gradually over the course of the remaining three quarters of the year.

Finally, in terms of cash flow, we currently expect that our free cash flow should be $90 million to $100 million for the full-year of 2017, or a bit more than double the midpoint of our current free cash flow guidance for 2016, when taking into account the one-time payment for the settlement of litigation of $4.3 million in Q2 of this year.

Our initial 2017 free cash flow guidance translates to approximately 20% of revenue, up from a 11% in 2016. We believe that this outlook is particularly compelling, given our commitment to innovation and ongoing investments to pursue the key opportunities in our market, and an excellent step for the target of 25% free cash flow that we outlined as part of our 2020 model during our Analyst Day in June of this year. Also, I would like to highlight that we are producing this cash flow with an average build contract duration in the mid-teens, which highlights the high quality and the recurring cash flow that our business can generate as it scales.

Note that, we expect that our production of free cash flow across the arc of 2017 should be similar to Path, as outlined for net income, with the first quarter being modestly positive and yet well below the quarterly averages implied by the guidance for the full-year and then improving gradually over the remainder of the year.

This 2017 guidance assumes capital expenditures of $40 million to $42 million, depreciation of roughly $24 million to 25 million, cash interest expense associated with convertible debt of $4.2 million and an income tax provision exclusive of potential discrete items of approximately $1.6 million to $1.8 million.

We plan to further refine our 2017 forecast as we continue our planning process, integrate our acquisitions and gain additional insights from our extended network of partners in sales channels. And as such, we will provide a more detailed update during the fourth quarter earnings call in January.

So, in summary, we had a very strong third quarter and believe that Proofpoint remains well-positioned to maintain momentum for the remainder of the year and into 2017, driven by the broad-based success across all of our solutions.

Before turning over to the operator for questions, we would appreciate it if each one of you would ask just one question and get back into the queue in order allow everyone time to ask their questions.

With that, I want to thank everyone for taking the time to join 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] And we’ll take our first question from Melissa Gorham with Morgan Stanley. Please go ahead.

Melissa Gorham

Great. Thanks for taking my question, and congrats on a good quarter. I just wanted to follow-up on the commentary related to the McAfee contribution. I know that you said that you’re seeing a growing pipeline, it seems like it’s maybe starting to contribute. Can you help us quantify to what extent that was a contributor to growth this quarter? And kind of what phase we’re at in terms of the transition to – from McAfee to Proofpoint?

Paul Auvil

Yes, let me start then Gary can chime in. What we talked about in the prepared remarks was that, the contribution from the McAfee installed base was above our historical norms. So think of it is the new and add-on recurring revenue that we booked and brought into the – to the company, again, was above that historical average.

That said, if you think about it across all of the new and add-on businesses that we booked for the quarter, it’s still a relatively small percentage, so, think under 20%. So while we were really excited to bring those customers in, it’s still just one of many factors that drives the business and so, of course, measured in terms of billings, because our billings number includes both new and add-on business, as well as renewals, it’s an even smaller percentage.

And then viewed from a revenue perspective, it has some modest contribution to revenue in the current quarter, and as we talked about, we did have better linearity this quarter that helped push revenue up in the quarter. But of course, the bulk of revenue that we deliver in any given quarter is really the history of business that we booked over the past many years, both new and renewals.

So it will be a nice additional contribution and one more thing that has helped provide a catalyst for our race, both for the fourth quarter of 2016, as well as looking into 2017, but it’s just one of many facts that are driving our business, as Gary talked about extensively in script.

Gary Steele

I would make a couple other quick points. One is, we continue to see great value as deals move over from McAfee. We’re basically converting those Protection dollars, dollar for dollar. But we are having good success in selling additional product capabilities to those customers. So we are upsizing the deals as they move over from McAfee to Proofpoint that continues to be encouraging to us.

And then secondly, we started to see some of those on-prem customers that obviously have five years to move from January 1, 2016. We started to see some of those customers come into the pipeline and a few of those closed. So if you, Melissa, you asked the specific question where are we at? I would put us in the third innings that’s kind of where it feels right now. We were encouraged by some of these on-prem customers moving into the pipeline and some getting completed in the quarter, but we feel like we’re 13-ish at this point.

Melissa Gorham

That’s helpful. Thank you.

Gary Steele

You bet.

Operator

And we’ll go next to Matt Hedberg with RBC Capital Markets. Go ahead please.

Matt Hedberg

Great. Thanks for taking my questions, guys, and congrats from me as well. You guys have expanded your product portfolio nicely over the years and then clearly Paul and Gary you highlighted a number of cross-selling opportunities. I believe formally if a customer took all of your products, it would be roughly $75 easier for you and maybe off slightly there. But I’m curious with all the new products that you’re adding in, could you give us an updated ballpark figure if somebody took all your products, where would that inning spend be on a per user basis?

Gary Steele

Yes, that’s a interesting question, I mean, just looking at the enterprise fraud defense product alone, that’s we think roughly worth the value of protection, which for a 5,000 ceded counts and another $10 a user a year. And then for the three-month products, we certainly think those probably are going to be in the same price range as our Targeted TAP Protection products we’ve already sold, so again another $10 to $15 a user a year although we’re – we haven’t even noticed the product yet, that’s kind of our sense for what is likely worth to the customer.

So one way of saying think about numbers now adding something on the order of $20 to $25 to our historical. And so you get to about $100 if you think about across the arc of all of our product line.

Matt Hedberg

Great. Thanks, guys.

Gary Steele

Yes.

Operator

Well go next to Rob Owens with Pacific Crest. Go ahead please.

Rob Owens

Great, and thank you guys for taking my question. Gary, I want to touch a little bit on the archive and governance opportunity, and you mentioned 28% flat with last quarter. But as the world is moving towards the cloud, there’s an opportunity here. If sales cycles remain consistent, attach rates apparently would be going up, why wouldn’t we see this start to accelerate a little bit? And just where do you think you are in terms of that opportunity with cross-selling with protection? Thanks.

Gary Steele

Yes, I think that it’s interesting. As we said in the prepared remarks, we do have longer sales cycles and the security cycles. The other element that we see today is that, there has been such a high demand for our security products, that’s where our sales reps are spending the bulk of their time. And so that has really pushed the archiving growth rate down somewhat frankly.

But the backdrop is extremely good. And I continue to be very encouraged about the opportunity. As you are all aware, there was a transition in the competitive landscape with the autonomy outsets going to micro focus in the quarter. I think that creates yet again more opportunity for us, as those customers look for next generation solutions. I feel like, we’re at the very beginning of that very significant opportunity, and I feel like this is a – this represents a great long-term growth opportunity for the company.

Paul Auvil

Yes. I think the other thing I’d add is, I think our year-over-year growth rate last quarter was 23%, now we’re up to 28%. And so I think for the next few quarters, we feel like we ought to be bumping around somewhere in the 28% plus or minus range. I think there’s certainly room for that growth rate to then move up as we around the corner into the middle of next year. But we want to see how some of these deals continue to evolve in the pipeline and then, we can update our expectations there. But as Gary said, sales team sold out some of our other products, they are all super busy. So I’m just happy for them to retire quota irrespective of what they sell.

Rob Owens

Thanks.

Gary Steele

Thanks, Rob.

Operator

We’ll go next to Gray Powell with Wells Fargo Securities. Go ahead please.

Gray Powell

Great. Thank you very much for taking the question. Have you seen any early signs of the Palo Alto partnership helping your sales process? And if so, what do you see as the opportunity over the next year or so? Thanks.

Gary Steele

Yes, as we noted in the script, we were encouraged by the influence of all of our ecosystem partners brought to the table, given the fact that our Palo Alto relationships roughly six months older than some of the other relationships. We have a little bit more maturity there. And where we’re seeing opportunity and benefit, we see through the joint marketing efforts, Proofpoint and Palo Alto were generating jointly generating demand that’s creating opportunities for us.

We’re seeing opportunities being brought into existing Palo Alto customers that’s generating demand. And we find it just broadly the message of better together through this integration that we’ve built has been resonating with customers. So we’re very encouraged about the overall opportunity and working with Palo Alto, and we think it could be a long-term influencer on the business.

Gray Powell

Okay, that’s helpful. Thanks for the color.

Operator

And we’ll go next to Walter Pritchard with Citi. Go ahead please.

Walter Pritchard

Thanks. Paul, I think the two quarters now you had renewals the – much better than you expected and drive renewal rate higher and obviously impaired revenue. And I’m wondering that just happened for two quarters. One, why it’s – why you don’t think it’s sustainable? And then two, what is really sort of change in sale process or underlying customer behavior, or the marketplace generally that’s driving that?

Paul Auvil

Yes, and that’s a good question. So couple of things, one, just to make sure everybody on the call is clear. When we have an early renewal, it doesn’t actually affect revenue at all, it just sits on the balance sheet. So it affects our billing number, because we bill for it and so it sits in our deferred revenue balance and since billings are a combination of revenue plus change in deferred, you see the early renewal reflected in our financials accordingly as we report them.

That said, we don’t actually start taking the revenue on it until the existing contract expires. So we don’t get any double count in revenue by renewing the customer early. So just make sure, but it’s on that same page. Now that said, Gary and I have this conversation every quarter when we look at that we have early renewals this quarter if we did, why, if we didn’t, why not. And I don’t think we were ever able to draw consistent conclusions.

As I talked about before some of it is tied to the fact that we’re driving add-on business and the customer decide to renew early to make everything coterminous, sometimes these customers just getting the renewal off the deck, because they know they’re going to renew and began with the current interest rate environment. They’re not really earning much with cash on the balance sheet. So they rather just get this done and move on to other priorities that they have within their budgeting and IT operations.

So, again, as I look at any given quarter, it’s almost impossible to predict whether we’ll have early renewals and hence my guidance always assumes that we don’t for planning purposes.

Walter Pritchard

So the renewal rate was in line, whether you’re expecting this early renewals this quarter not renewal rate?

Paul Auvil

So to be clear, I talked earlier in the script about how we had our renewal rate that was well above our historical norms, that in no way is affected by early renewals. I simply look at all the renewals that we do in the quarter, and what our rate of success in keeping those customers was as a percentage of the value of that recurring revenue early renewals don’t end up entering into the calculations.

Walter Pritchard

So, I guess, the question was, do you think the higher renewal rate is sustainable, Paul?

Paul Auvil

No, I see, got it, i.e., low churn. I never modified my planning expectation around that. So we’re thrilled when we’re able to retain an above the average number of customers. I think we need to see a few more quarters to see whether we would adjust that expectations. But for the last two quarters, we have been well above our historical norms, which obviously is pretty exciting. And I think just know and validates the quality of our technology, but we’re quite proud of the customer service we deliver to our accounts as well. And I think those two things are highly valued by large and mid-sized enterprises that we deliver our solutions to and it’s nice to see a validation of that.

Walter Pritchard

Thank you.

Paul Auvil

Thanks.

Operator

We’ll go next to Jonathan Ho with William Blair. Please go ahead.

Jonathan Ho

Hey, guys, congratulations on the strong quarter. I just wanted to ask from a competitive standpoint whether you guys feel like, you’ve seen any sort of inflection in terms of your win rate and whether Office 365 cloud transition has any anything to do with that type of a shift?

Gary Steele

So I would say that the competitive environment was consistent in Q3 from Q2. I would say, however, that that the broader adoption of Office 365 continues to be a very nice tailwind for the business. And while our competitors some have solutions for that, others don’t. I think that is a – I think we are benefactor just competitively when customers decide to get Office 365.

Jonathan Ho

Thank you.

Operator

We’ll next go to Gur Talpaz with Stifel. Go ahead please.

Gur Talpaz

Great, thanks for taking my question. So I was hoping you talk about the driver behind the client FireLayers here. You said you are not going at the standalone CASB market, have you seen a lot of M&A at this stage just go buy a cloud lock by just taking a one step further basing how you’re seeing the acquisition, which shouldn’t make you more complementary or competitive to your product like Palo Alto aperture? Thank you.

Gary Steele

Yes, I suspect where our complementary to an aperture, essentially what we’re trying to do is extend TAP to SaaS applications. And so what we’re attempting to do is creating an environment where customers can eliminate malicious attacks, where they’re uploading information either to box or dropbox, or they’re uploading files in some other form of SaaS app, and we can look for malicious content in those files. I think that it will be a natural extension of our TAP go-to-market motion.

And so our customers that today that are adopting our Targeted Attack Protection Solution will also be able to take advantage of these benefits. So I think it will feel much more like a natural extension as opposed to waiting off deeply into the CASB standalone market, which we have no intention of doing.

Gur Talpaz

Got it. Thank you.

Operator

And we’ll go next to Ken Talanian with Evercore ISI. Go ahead please.

Kenneth Talanian

Hi, guys, thanks for taking my question. Just wondering, do you have a sense for how far we’re penetrated with Office 365 in the Fortune 1000?

Gary Steele

Yes, really good question. There’s very little market data to answer that question. And one of the things that we struggle with these customers come to us in various stages, as it relates to Office 365. So we get customers that are in their early planning cycle, as we get customers who are basically ready to migrate. We get customers that are doing as part of migration and we get people after they move.

And so we don’t actually see the final results. I mean, look at this really carefully and we can’t get good analytic even on our own customer base, because everyone is such – in such a varied state of migration. I’m guessing that that number is probably 15% to 20% today. But that’s not based on any hard analytics.

Kenneth Talanian

Okay. And just as a follow-up related to that, generally speaking, the customers’ view exchange 2016 is the last on-prem exchange upgrade?

Gary Steele

I don’t think so. I don’t think they do that that. But I – there the value proposition around Office 365 today is better than it’s ever been. And the reason I’d say that is, because there’s broader applicability both to regulated and non-regulated industries. I think there was a period of time, where the regulated folks tell like they can never go many of those hurdles have been overcome by Microsoft. And so, we’re seeing broad acceptance and adoption. I do think the regulated guys will go slower. Most of those folks have plans there are more in the 2018 or later timeframe, but most companies have a plan.

Kenneth Talanian

Okay, great. Thank you very much.

Gary Steele

You bet.

Operator

Thank you. We’ll go next to Steve Koenig with Wedbush Securities. Go ahead please.

Steve Koenig

Thanks gentlemen for taking my question and congrats on the strong quarter.

Gary Steele

Thanks.

Steve Koenig

I wonder if you could give us your observations on to the extent you can on parsing out the impact of Proofpoint’s competitive advantage in email from potentially more dollars flown to email from other vectors in terms of the impact on your results. And maybe more generally just an update on the competitive environment as you see it?

Gary Steele

Yes, I’ll start and Paul probably have comments as well. So one is, as we referenced, we saw no change in macro. And that’s different than what other vendors have cited and you’re aware of all those vendors. And so, what our hypothesis is on this is very simple that the prevalence of issues as it relates to individuals being targeted within the enterprise is very high.

CIOs and CCOs understand that that is a big phishing problem. And as a result of that, they’re looking for a next-generation of solution from what they installed probably 10 years ago, and that’s creating an entry point for us to show the value that we can deliver. We always sell-through proof-of-concepts customers, try our technology. And so I think that what’s happening in the market is, because this has become a high priority, I think, we’ve been less impacted by the affects that other vendors have seen.

Second to that, from a competitive point of view, we really haven’t seen any fundamental shifts in the competitive landscape for the last couple of quarters. And so, we’ve been executing in a very consistent way over that period of time, and I think that’s been beneficial to our sales team.

Steve Koenig

Great. That’s all I have. Thank you very much.

Gary Steele

Thanks, Steve.

Paul Auvil

Thank you, Steve.

Operator

We’ll go next to Imtiaz Koujalgi with Deutsche Bank. Please go ahead.

Imtiaz Koujalgi

Hey, guys, thanks for taking my question. You guys raised the guide for next year. Are you expecting any contribution materially from the FireLayers acquisition for next year?

Paul Auvil

No, I think, Gary alluded to the fact that we expect to introduce some products sometime in the first-half of the year. I think aspirationally, we’ll sell some product next year around this. But I wouldn’t expect it to meaningfully impact either billings or revenue.

Imtiaz Koujalgi

Okay. Thank you, guys. That’s all I had.

Paul Auvil

Okay, good question.

Operator

Well go next to Andrew Nowinski with Piper Jaffray. Please go ahead.

Andrew Nowinski

All right, thanks. So if I pump everything we’ve heard today, the competitive landscape remains consistent in the early innings of McAfee and Office 365, we’ve got some new products coming out next year and the attack environment remains really active from business email compromise attacks. So I guess, why should we think revenue growth would – will decelerate so sharply in 2017 from the 40% during this year?

Paul Auvil

Yes, I mean, I think 40% sets up a tougher compares we look at next year just because we put up such a big growth rate. So we have been investing in sales core capacity for sure. But as we talked about like this the revenue growth rates really slightly both second and third quarter the rate that exceeded the rate at which we could actually invest in sales and marketing. And so we’re going to continue to invest there and we’ll eventually catch up.

But the guide of 29% to 30% is the same guide we provided 12 months ago going into in October, going into 2016. And while I wouldn’t suggest that I think we’ll see a complete repeat performance in 2017 that we did in 2016, as I think everybody knows, we’re always pretty thoughtful about how we put our guidance together and always hopeful that we’ll be able to meet or exceed those numbers.

So I think we’ll come back and revisit again in January and we’ll see where we go from here. But for now, I think, we’re quite comfortable given the competitive landscape, the McAfee opportunity all the things that Gary listed on the phone. We feel 29% to 30% is a good starting point.

Andrew Nowinski

Got it. Thanks.

Operator

We’ll go next to Gabriela Borges with Goldman Sachs. Go ahead please.

Gabriela Borges

Great. Thanks so much for taking my question. Maybe just if you could comment on your international expansion strategy and how you’re thinking about investing in that versus the runway that you have here in the U.S. And is there any difference in how your international customers are thinking about investing in cloud-based email or email more broadly? Thanks so much.

Gary Steele

You bet. As we indicated in our prepared remarks, we were happy with the performance of our international team, specifically, the results that we saw from EMEA. Over the course of 2016, we saw maturity in the ranks of our sales team in the UK, France and Germany. We built great marquee customers. We’ve seen great adoption of our solution. And so we feel like we’re now in a position, where we can continue to invest to drive, figure broader growth in the international market as a result of that.

The second thing that I’m encouraged by is, we’ve seen a different buying perspective from European customers over the course of the last couple of quarters, I think there is a broader understanding, a broader set of concerns, and therefore, broader demand is developing as a result of that. You also have the changing regulations in the EU coming, and I think that’s also bringing a higher level demand.

So we’re very encouraged about the opportunity outside of the U.S. And while we’ve had phenomenal demand in the U.S. itself, we believe that there’s great growth to be had outside the U.S.

Gabriela Borges

That’s helpful. Thank you.

Gary Steele

You bet.

Operator

And we’ll go next to Tim Klasell with Northland Securities. Go ahead please.

Tim Klasell

Yes, good afternoon, everyone. Thank you for taking my question. Just on duration, it continues to come down over time. I know you guys have been concentrating on one-year contract. Where do you think that level go? Because there are going to be some customers that probably do want three-year contract. So can you help us over that? Thank you.

Gary Steele

Yes, for sure, good question. And again when we talk about duration is to build duration, meaning, it’s a mathematical compilation of the build value in advance of one, two or three-year deals. So to your point there are peoples especially in today’s interest rate environment who just feel compelled, because they know they’re committed to the Proofpoint product line to go ahead and pay for two or three years of service in advance even though the discounts we offer these days are reasonably modest.

And I think there will always be some cadre of folks like that. So I think our duration at mid-teens 15 months plus or minus a month probably as low as we’re likely to go, given that so…

Tim Klasell

Okay, great. Thank you very much.

Gary Steele

Yep.

Operator

And we’ll go next to Erik Suppiger with JMP Securities. Go ahead please.

Erik Suppiger

Yes, congratulations on a good quarter.

Gary Steele

Thanks.

Erik Suppiger

So the $3 billion figure that you referenced for BEC, I think, that came out in June. Can you comment on what kind of a recent activity you’re seeing or hearing from customers? And is there anything that comes from the breach that came about just this week with Salesforce that would give your sales force something you talked about with customers?

Paul Auvil

Okay. So with respect to the FBI numbers, those came out earlier in the year and were updated in August. And so those were August numbers. So they’re very current. We’re seeing broad routine in the BEC type campaigns and they’re most typically around wire fraud, or confidential information through HR. But we’re seeing broader proliferation of these kinds of tactics used in other departments. I meet with a lot of customers, and I could give you story after story that are incredibly frightening.

The reality is this tactic is being broadly used by attackers today. And as a result of that, this has become a very, very high priority with management. And oddly because of the kind of data that we’ve got through BEC, these kinds of attacks have much more visibility at the executive level. So that’s why we’re frankly very excited about email fraud defense.

We do believe that more and more organizations will employ authentication. This is – EFD is the fastest interest gaining product we’ve ever released. We’ll have to see how that all translates into revenue. But there has been a phenomenal amount of interest in the solution. And I think it’s indicative of what’s going on.

I’m not sure that we get big bang out of the – what happened with Salesforce. We actually don’t like to ambulance chase on particular breaches. But there is just broad understanding within almost every organization the kinds of risk that BET represents and folks are actively reaching out trying to understand how they can better defend themselves against these kinds of attacks.

Erik Suppiger

Explain just quickly what do you mean that the fraud defense is the fastest gaining interest new product release you’ve had?

Paul Auvil

We just – I would – so the – just to give you timeline again, we announced the acquisition of BFD in August of this year, almost immediately we had customers reaching out to us, trying to understand what that capability was, and how it could be part of the overall BEC solution.

We probably did more quotes in the short period of time that we had that out than we’ve had with other recently introduced products. Obviously, we have to see others translates into revenue. But we’re really encouraged by it, because it speaks to the challenges people have with BEC.

Erik Suppiger

Very good. Thank you.

Paul Auvil

Thanks.

Operator

And we’ll go next to Catharine Trebnick with Dougherty. Please go ahead.

Catharine Trebnick

Hi, thank you for taking my question. There has been a lot of public releases on Office 365 and the potential for that to be deployed throughout the federal government. I’m wondering if you could comment on your plan for certification of the federal ramp, and then what any more color you can provide on this opportunity? Thank you.

Gary Steele

You bet. This is Gary. So Office 365 in the federal state does represent an interesting opportunity for Proofpoint. As you’re probably all aware, our federal presence is relatively minimal to-date. And so we did not – we didn’t say this in our prepared remarks. But the in the federal fiscal 2016 was not something that was particularly eventful for us, because our federal business is relatively small.

However, having said that, we do think federal does represent an interesting opportunity and we are working on the federal certification of our Protection and TAP solutions. We hope to have that capability out in 2017, because we do think that more customers in the federal government will go to the cloud either with Office 365, or some alternative.

Catharine Trebnick

All right. Thank you very much.

Gary Steele

You bet. Thank you.

Paul Auvil

Thank you, Catharine.

Operator

We’ll go next to Ryan Hutchinson with Guggenheim. Go ahead please.

Ryan Hutchinson

Great. Thanks, guys. So as I think about the growth drivers in your business within your net new and add-on business, is anything else approaching TAP or archiving from an ARR perspective? And if it’s not, when would you expect that to occur and what product you think it would be?

Gary Steele

Yes, good question. So the one thing that is interesting and we talked about this on the call last quarter. So we have this category of what we think of internally as emerging products, so mobile, social, treat response. That product category last in Q2 grew on a year-over-year basis a bit over 50%. This quarter in Q3 on a year-over-year basis, it grew well over 50%.

So those new emerging products are definitely starting to see some nice traction, that category includes social as well. So we feel good about how those products are coming along. And of course, as Gary said, the interest in the email fraud defense product is looking – compelling, at least, during the early innings. So, our view is that, while it would be great to have another product that is TAP and generates the kind of demand over the next several years that TAP did.

We feel pretty good that across the collection of these emerging products together, they will likely produce that sort of opportunity for us. And if one of them actually breaks out and really is the next TAP, of course, that would be fantastic. But as I think about our growth curve between now and 2020 and toward that model we shared at the Analyst Day, we don’t need another breakout product with that kind of accelerated success on its own in order to get there, given the portfolio of products that we’ve got.

So long way of saying, we’re really excited about all the emerging products and it’s hard to handicap, which one might be more of a breakout success than the others. But Social had a good quarter. Treat Response had a good quarter. We had some nice opportunities in mobile, all those products are coming along nicely.

Operator

And we’ll go next to Srini Nandury with Summit Redstone. Please go ahead.

Srini Nandury

All right. Thank you for taking my question. Just looking for some color on your McAfee installed base. We will be getting that within the McAfee customer business, some are looking at alternate players, such as Barracuda, is that a concern at all? What are your assumptions regarding the percentage of McAfee customers that you expect to convert to Proofpoint over the next couple of years? Thank you.

Paul Auvil

Yes, great question. So if you look at the McAfee installed base, it’s comprised our customers of all sizes. So from very small SMB type customers all the way to large enterprise. And the area – the market segment that we’re focused on within that installed base are the mid to large enterprise kinds of customers. And the thing that was actually encouraging in Q3 was that, we had some wins that were some of McAfee’s largest customers.

So that’s where we’re focused. And there obviously are other alternative players out there like a Barracuda and others who are probably benefits frankly at the low-end of the market, and so that doesn’t surprise me at all. That’s not an area that we’re focused on kind of the classic SME, SMB type business.

So while we’re still in the early innings of that overall migration, we do feel good about the large deals that we’re winning, and we see the traditional competitors there as you’d expect.

Srini Nandury

All right. Thank you.

Operator

We’ll go next to Michael Kim with Imperial Capital. Please go ahead.

Michael Kim

Hi, good afternoon, guys. Regards to the Privacy business, can you talk about the pipeline if you’re seeing that kind of the continued growth momentum that we observed in Q2? And following customer in the high profile hacks against the DNC and some senior staff, are you maybe starting to see a high-level activity or inbound increase?

Paul Auvil

So with the Privacy product, we had a really extraordinary Q2. Q3 was another great quarter, didn’t quite match Q2’s performance. But we do continue to see strong demand for the Privacy product and it’s not just in regulated spaces like financial services or healthcare, where there are actually financial penalties for inadvertently or otherwise sending out protected data on an encrypted basis in email.

We see an increasing interest from just broad rank and file companies who among other things see it is one more element to help deal with blocking exfiltration threats. So again whether it’s BEC or some other mechanism, where a company gets compromised and people unwittingly send confidential information in email out to the firewall people see our Privacy product is a very elegant and simple solution to deploy to deal with that.

So we’re still very excited about the trends and opportunities there and the attach rate to the existing insalled base is solid, but plenty of add-on opportunity, as well as obviously selling it to net new customers. For the – your question around the DNC hack, I guess, I come back around to what Gary was talking about a little bit earlier.

What’s always been true for Proofpoint is that, while high profile breaches certainly don’t hurt demand for our products, we don’t need those things to propel interest in our product line, because ultimately, when we get it into a customer and we show them a side by side comparison in their production environment of what we can catch versus whatever the existing incumbent solution can do for them, and then while we’re in there, we show what our Targeted Attack products can catch, et cetera. It’s for the most part pretty hair-raising for people and that’s what really drives demand.

So it’s really close quarters fighting in the trenches out there customer by customer. And so this is where our channel has been very important. They now continue to represent over half of the new and add-on business they closed, because they are that we close rather, because they help us get access to the accounts we go and have a conversation run the production eval, and then ultimately get business close.

So the channel has been an important mechanism for us to help drive demand. But again, it’s that production evaluation that really helps get customers interest peaked and then drive a deal over the line.

Michael Kim

Great. Thank you very much.

Operator

We’ll go next to Bill Choi with Wunderlich. Please go ahead.

Bill Choi

Okay, thanks. Gary, when you are going over some of the customer wins, it sounds to me from, at least, the last two quarters, the Office 365 related deals are just the largest over 100,000 TAP end user customers and which brings up the topic of, are we really getting an acceleration here in Office 365? What are the deal size is doing? And how those deal size relate to Office 365 compared to, let’s say, a McAfee or McAfee conversion, for example?

Gary Steele

Yes, I wouldn’t – I actually wouldn’t say that our Office 365 deals are our largest deals. I think they’re – I think the – I think Office 365 penetration has been reasonably well apportioned across the various size of the customers we serve. If I go back and think about all the deals we referenced in the prepared remarks, we had some really nice large McAfee wins. We obviously had some nice large Office 365 wins. We had some nice just on-prem customers who have on-prem exchange looking to buy better defense.

So I would say the size of customer is pretty well represented across all the different opportunities that we had. The one thing I would say though in Office 365 is, it seems that over the course of the last couple of quarters, it’s just gaining momentum broadly. I think more and more customers are looking at that as a good opportunity to get one critical workload into the cloud and the early objections people had going to the Office 365 have been eliminated or significantly reduced.

And so people oftentimes they have a plan. If they don’t – if they haven’t gone today, they have a plan on when they’re going. They may be going in 2018 or late 2017 or something, but they have a plan. So I think we’ll just continue to see it as an opportunity, but I would say it’s the concentration of largest customers.

Bill Choi

You guys give the customer – total customer count for the quarter?

Gary Steele

We didn’t. We do an update at the end of the year. So we’ll provide an updated customer count in January.

Bill Choi

Go it. Okay, thanks.

Gary Steele

Thank you.

Operator

And that does conclude our Q&A session for today. At this time, I would like to turn the conference back over to Gary Steele for any additional or concluding comments.

Gary Steele

Great, thank you. I just want to take a moment and thank everyone for joining us on the call today. We look forward to another good quarter and looking forward to talking to you again in January. Thanks so much.

Operator

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation.

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