Proofpoint, Inc.
Q3 2018 Earnings Call Transcript

Published: 26 Oct 2018

[Operator:]

Good day, and welcome to the Proofpoint Third Quarter 2018 Earnings Results Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jason Starr, Vice President-Investor Relations. You may begin.

[Jason Starr:]

Thanks, James. Good afternoon, and welcome to Proofpoint's third quarter 2018 earnings call. Joining me on the call are Gary Steele, Proofpoint's Chief Executive Officer and Chairman of the Board; and Paul Auvil, Proofpoint's Chief Financial Officer. Today, we'll be discussing the results announced in our press release that was issued after the market close this afternoon, a copy of which is available on the Investor Relations section of our website. During the course of this call, we'll make forward-looking statements regarding future events and future financial performance of the company, which are subject to material risks and uncertainties that could cause actual results to differ materially. We caution you to consider the important risk factors contained in the press release and on this conference call. These risk factors are also more fully detailed under the caption Risk Factors in Proofpoint's filings with the SEC, including our most recent Form 10-Q. These forward-looking statements are based on assumptions that we believe to be reasonable as of today's date, October 25, 2018. We undertake no obligation to update these statements as a result of new information or future events. Of note, it is Proofpoint's policy to neither reiterate nor adjust the financial guidance provided on today's call, unless it is also done through a public disclosure, such as a press release or through the filing of a Form 8-K. Additionally, we will present both GAAP and non-GAAP financial measures on today's call. These non-GAAP measures exclude a number of items as set forth in our release. 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 and a list of the reasons why the company uses these non-GAAP measures are included in today's press release. Also, I would also like to remind everyone that we have adopted ASC 606 as of January 1, 2018, under the full retrospective method. And as such, all of the comparisons to prior financial periods discussed on today's earnings call and outlined in today's press release are made in reference to our retrospective financials as revised in accordance with the ASC 606 accounting standard. Please refer to our comments during our Q1 call as well as our filings with SEC for greater detail regarding some of the impacts and differences in our reporting under this new accounting standard. So with that said, I'll turn the call over to Gary.

[Gary L. Steele:]

Thanks, Jason. I'd like to thank everyone for joining us on the call today. I'm pleased to report that we had another excellent quarter, beating our guidance on all of our financial metrics and demonstrating our ongoing strategy to drive attractive growth, paired with expanding free cash flow margins. Our overall business momentum remains strong, driven by the continuing demand for our next-generation cloud security and compliance platform, the ongoing migration to the cloud, and the rapidly evolving threat landscape. As we've shared on our prior calls, attackers increasingly target people, not infrastructure, to infiltrate a company. And while employees are every organization's greatest asset, when it comes to security, they are also every organization's greatest weakness. As bad actors continue to innovate their tradecraft to exploit this human vulnerability, our people-centric approach to cybersecurity has become a crucial strategy for enterprises to embrace in order to more effectively protect their employees, their sensitive data, their customers, their supply chain and their brand. This is especially true as more applications and sensitive data move to the cloud, where traditional approaches to security must evolve to protect critical targets and people. The foundation of the people-centric solution requires a compressive platform that spans the full breadth of the employee experience beyond the firewall, including e-mail, SaaS applications, cloud files shares and social venues. This broad scope of coverage, when combined with real-time threat intelligence and compliance capabilities, enables an enterprise to ensure that every employee is protected, whenever they interact with systems and content, whether or not they are operating behind the firewall and whether or not they are using a company-owned endpoint. Since over 90% of targeted attacks begin with a malicious e-mail, this vector remains a critical entry point for an enterprise to secure. And given the rapidly evolving threat landscape, many legacy solutions are unable to provide enterprises with a sufficiently capable defense due to their lack of focus and innovation. In fact, today's bad actors often use multiple techniques to evade detection and achieve their objectives, including the delivery of malware through weaponized documents or malicious URLs as well as increasingly through other forms of targeted deception such as the use of spoofed emails, look-alike domains or compromised user accounts on cloud services such as Office 365, all of which are designed to exploit human vulnerabilities and circumvent internal controls for financial gain. The cost of these attacks can be material. For example, just last week, the Securities and Exchange Commission issued a new report of investigation, warning publicly-traded companies about the risks of cyber-related fraud, and the importance of implementing effective internal controls and conducting enhanced training in order to prevent cyber fraud and to maintain compliance with federal securities laws. This investigation focused on the internal controls of nine companies across multiple industries that were victims of spoofed or manipulated communications, be it either a business email compromise or account takeovers. It was disclosed that each lost a minimum of $1 million and that collectively, they lost nearly $100 million through these attacks, and that the vast majority of these losses were never recovered. As we noted in our earnings call in July, we've seen a significant increase in the number of Office 365 account takeovers by bad actors, where the attacker hacks a user's login credentials and then logs into the system masquerading as a legitimate employee. Once his account control is established, the attacker has nearly unlimited opportunity to cause harm throughout the affected company by triggering its employees, customers, and supply chain vendors into fulfilling fraudulent and malicious requests or attacking them outright with malware and ransomware internally. Our recently introduced Cloud Account Defense, or CAD, can help organizations detect and remediate these compromises. Additionally, we have recently introduced an enhanced version of our Internal Mail Defense solution, or IMD, which applies all of our capabilities of TAP and Protection to detect malicious e-mail content sent internally, further mitigating the impact of account takeovers. As Gartner analysts noted in a recent report titled How to Build an Effective Email Architecture (sic) [How to Build an Effective Email Security Architecture], "moderate email security more than ever requires innovation". We couldn't agree more, and our commitment to innovation has been a hallmark of our culture for nearly 20 years, which is further demonstrated by Proofpoint's significant and sustained investment in research and development over the many years of scaling our business. Now, turning to our some of our key operating results during the third quarter, our suite of advanced threat solutions, including our Targeted Attack Protection or TAP offering, continues to be an important contributor to the growth of our business. We had a number of noteworthy TAP and Protection wins this quarter, including a Fortune 500 transportation and logistics company that purchased Protection, TAP, and Threat Response for 130,000 users; a Fortune 200 real estate services company that added Protection, TAP, EFD or Email Fraud Defense, and Threat Response for 100,000 users; and a Fortune 500 engineering firm that purchased Protection, TAP, Threat Response and IMD for 80,000 users. Beyond the broader threat landscape, the ongoing transition to the cloud and the shift to Microsoft Office 365 in particular continues to be a long-term catalyst that is helping drive demand for Proofpoint full suite of security and compliance solutions as companies cannot rely on existing on-premise infrastructure to solve these requirements in the cloud. Examples of deals won this quarter where we displays legacy on-premise security appliances as part of our – as part of the migration to Office 365 included a Fortune 500 healthcare company that added Protection, TAP, EFD and Threat Response for 115,000 users; a Fortune 100 airline that purchased Protection, TAP, Privacy and Threat Response for 100,000 users; and a global business process automation company that purchased Protection, TAP and Privacy for 15,000 users. We also continue to effectively demonstrate the strength of Proofpoint's products when compared to the baseline security solutions provided by Microsoft as part of their Office 365 bundle. In fact, in Q3, we had a record quarter in terms of new recurring revenue that was driven by customers upgrading their security for Microsoft to Proofpoint. And importantly, we also saw an increase in these new customers, executing multi-year prepaid contracts demonstrating their long-term commitment to the Proofpoint solution. Examples of customers, who had moved to Office 365 and subsequently decided to upgrade their security capabilities with Proofpoint during the third quarter included a Global 2000 insurance company and already an existing Wombat customer that purchased Protection, TAP and Threat Response for 40,000 users; a large privately-owned health insurance provider that purchased Protection, TAP, Privacy, EFD and Threat Response for 30,000 users; a Fortune 500 apparel maker that purchased Protection, TAP and Threat Response for 15,000 users; a wholly-owned subsidiary of a Global 2000 automobile manufacturer that purchased Protection, TAP and Threat Response for 10,000 users; and a financial services company that purchased Protection, TAP, Privacy and Threat Response for 6,500 users. Overall, the competitive environment remains favorable and we continue to experience high win rates coupled with a world-class renewal rate that remains above 90%. We are also pleased with the ongoing success of our add-on sales, which contributed nicely to our growth this quarter. Specifically, we are very encouraged by the ongoing strength in demand for our emerging products. As we have mentioned in the past, these new offerings have expanded our TAM by over $5 billion, and are proving to be an excellent source of growth. They also provide an important competitive advantage as they uniquely enable us to holistically defend the enterprise from methods of attack across email, cloud and social vectors in a way that is unmatched by the competition and serve as an important differentiator when competing in the marketplace. The growth of our emerging products continues to meaningfully outpace the rest of our product portfolio and contributed over 30% of the total new and add-on business closed during the quarter, led by strong demand for Email Fraud Defense and Threat Response in particular. Also as noted earlier, given the increasing number of Office 365 account takeovers, we also saw good early demand for our CAD, CASB and internal mail defense offerings, all of which address this problem. Finally, our browser isolation solution is trending well as well with several wins in the quarter. A few of the key emerging product wins in Q3 included

[Paul R. Auvil:]

Thanks, Gary. We were pleased with our operating results this quarter and, in particular, we had a very strong linearity during July and August which served to boost revenues, net income, and cash flow reported here in Q3. Revenue totaled $184.2 million, up 37% year-over-year and above our guidance range of $180 million to $182 million. Note that adjusting for the impact of our recent acquisitions as well as the effects of ASC 606, the underlying organic growth rate was approximately 28% for the quarter. Billings for the third quarter were $221.4 million, an increase of 33% year-over-year and above the high end of our guidance range of $218 million to $220 million. As I explained in detail on our Q1 call, under ASC 606, the derivation of our billings metric now requires adjustments to reflect unbilled accounts receivable activity during the quarter, as well as any right of refund liability. For Q3, the adjustment related to these two items was an impact of $3.1 million. We saw a rebound in duration of roughly 10% this quarter, a modest reversal from the record low durations recorded during the first half of the year, reflecting an uptick in customers choosing to pay in advance for three full years of service and demonstrating their commitment to our platform. This trend in terms of duration is further reflected in our deferred revenue balances, which ended the quarter at $525.3 million, up $34 million sequentially with short-term growing by $18 million and long-term increasing by $16 million. Our duration remains in the lower half of our targeted range of 14 to 20 months and continues to underscore the high quality of our free cash flow generation. It is also worth noting that on a year-to-date basis, our total increase in long-term deferred equals 3% of total billings, which is actually down slightly from the 3.2% recorded over the same period last year. And note that the long-term deferred revenue balance represents 15% of total deferred revenue, consistent with our 2017 results. Hence over the course of the first nine months of 2018, our duration and the relative overall contribution to billings from long-term deferred revenues is essentially the same as it was over the same period in 2017. During the third quarter, our advanced threat segment grew 39% year-over-year and represented 75% of revenues; and our compliance segment grew 32% year-over-year and represented 25% of revenues. We expect growth in this latter segment to remain at these levels in the near-term as the larger archiving deals in the pipeline continue to mature. Turning to expenses and profitability for the third quarter, on a non-GAAP basis, our total gross margin was 78%, in line with our expectations, driven primarily by our strong revenue performance during the quarter. During the third quarter, total non-GAAP operating expenses increased 36% over the prior period to $121.7 million, representing 66% of total revenue. As Gary mentioned earlier, growth in spending and sales was lower than planned, driven primarily by slower hiring trends in our international operations and as well R&D spending was less than expected due to slower hiring over the summer months and also benefited from the elimination of certain costs associated with the decommissioning of our legacy SaaS cloud system. In terms of profitability for the quarter, we reported non-GAAP net income of $22.6 million, well above the guidance range of $14 million to $16 million, driven by both revenue outperformance as well as the lower-than-expected spending in both sales and R&D. Moving on to EPS, non-GAAP earnings per share for the quarter was $0.40 per fully diluted share, above our guidance range of $0.25 to $0.29. Note that the EPS calculation applies the if-converted method to our convertible notes and as such adds back $309,000 in cash interest associated with the convertible debt, and uses 57 million fully diluted shares for the quarter. We have included a section in our press release entitled Computational Guidance on Earnings Per Share Estimates, which is intended to provide additional details on this topic, and to explain the resulting differences in share count used in these calculations based on our results. On a GAAP basis, we recorded a net loss for the third quarter of $36.1 million or $0.69 per share based on 52.2 million shares outstanding. As a reminder, in August, we called our 2020 convertible bonds, which were settled for 2.9 million shares of common stock. Going forward, these shares will be included in our GAAP and non-GAAP EPS share count for both Q4 as well as the full year. In terms of cash flow, we generated $64.7 million in operating cash flow and invested $6.5 million in capital expenditures, resulting in free cash flow for the quarter of $58.2 million, well above our guidance range of $45 million to $47 million. Note, that much of this over performance was due to the better-than-expected billings linearity in the quarter that I discussed earlier, and is reflected in our lower DSOs, during Q3 when compared to the previous quarter. Before shifting to guidance, you may have seen the 8-K that we filed this afternoon, documenting an 11-year lease for office space here in Sunnyvale beginning in the second quarter – second half rather of 2020. While our existing Sunnyvale campus has surfaced well since we moved here back in 2007, we will have outgrown our current location when the lease expires in 2020. With that in mind, we are pleased to have found a larger facility just a few blocks from our current location that can accommodate our planned growth over the coming decade, enabling us to continue the scale the business without disrupting the commuting pattern for any of our employees. There will be no impact to our financials in 2018 or 2019 from this transaction, other than a balance sheet item reflecting a modest rent deposit of roughly $1.2 million. With that said, in 2020, we do expect to invest in tenant improvements as part of bringing the facility into compliance with our office standards. We expect this cost to be moderate as compared to many other projects undertaken by companies here in Silicon Valley in recent years with an expected tenant improvement budget of roughly $25 million to $30 million. Now, let's turn to the financial outlook starting with the fourth quarter. We currently expect billings to be $266.5 million to $268.5 million, a slight increase at the midpoint resulting in year-over-year growth of 42% at the midpoint. As noted on last quarter's call, and given seasonal Q4 buying trends, there are several multiyear deals expected to renew in Q4, and so we're assuming that billings duration remains consistent with Q3's results. Regarding our revenue outlook, we expect a range of $191 million to $193 million, or 31% growth year-over-year at the midpoint, and a growth rate of roughly 27% when adjusted for acquisitions, and the impact of ASC 606. We expect fourth quarter non-GAAP gross margin to be just under 78%. We expect fourth quarter non-GAAP net income to be $18.5 million to $20.5 million, or $0.33 to $0.36 per share. And this also assumes an income tax provision, exclusive of discrete items, of approximately $0.8 million during the quarter, depreciation of approximately $8.5 million, and a share count of 56.9 million fully diluted shares outstanding. In terms of free cash flow, given the strong linearity during the third quarter, the cash collections that otherwise would have been expected in Q4 were accelerated into Q3. So with that said, we expect Q4 free cash flow to be $43 million to $45 million, which translates to an increase of $1.5 million in terms of our expectations for free cash flow for the full year 2018. This fourth quarter guidance includes capital expenditures of roughly $7 million. From a full year perspective, we are increasing the midpoint of our billings guidance for the full year and we now expect billings to be in the range of $872 million to $874 million, which represents an annual growth rate of 37% at the midpoint of the range. In terms of revenue guidance we are raising our estimates to a new range of $709.5 million to $711.5 million, an annual growth rate of 37% at the midpoint as compared to our most recent guidance of $705 million to $709 million. When taking into account the impact of our recent acquisitions for the full year in conjunction with the headwinds from the transition to ASC 606 accounting, we estimate that the underlying organic growth rate associated with this guidance is roughly 28%. We expect full year 2018 non-GAAP gross margins to be roughly 78%, and within our 2020 target range of 77% to 79%. As a result, we expect full year non-GAAP net income to be $71.9 million to $73.9 million, or $1.29 to $1.32 per share, an improvement from our previous guidance of $62.5 million to $66.5 million, or $1.12 to $1.19 per share. This full year guidance assumes an income tax provision, exclusive of discrete items, of approximately $2.4 million to $2.8 million, depreciation of approximately $32 million to $34 million, a share count of approximately 56.7 million fully diluted shares outstanding, and adding back $1.2 million in cash interest expense for the convertible debt as prescribed under the if-converted method. For 2018 free cash flow, we are raising our guidance to the range of $149.6 million to $151.6 million, an increase of 41% year-over-year and representing 21% of revenue. This assumes capital expenditures of roughly $30 million for the full year. It is important to note that we are producing this cash flow with an average billed contract duration in the mid to low teens based on a model with over 95% recurring revenues and renewal rates over 90% which highlights the high-quality of the recurring cash flow that our business generates. While we're still in the early stages of our planning process, I would like to share a preliminary view regarding our 2019 financial outlook. Overall, our business remains well positioned with competitive environment favorable and the strong secular drivers of the move to the cloud and an active threat landscape are firmly in place. Given the various components embedded in our 2018 results, I would like to share some factors to keep in mind, when comparing our initial 2019 guide to our current year. First, while we continue to see strong growth in our core and emerging products businesses, the inorganic contributions to our 2018 revenue performance set up a challenging year-over-year compare on a reported basis, given the growth rates at or near 40% that we have recorded over the first nine months of the year. Additionally, as our remaining on-premises customers continue to migrate to the cloud, ASC 606 creates a nominal headwind of roughly 50 basis points next year. As well, recall that the primary driver for our acquisition of Cloudmark was gaining access to the rich threat intelligence data derived from the roughly 400 million mailboxes under protection. As we've shared, we have been facing out all Cloudmark's OEM relationships over the course of 2018, serving to reduce the revenue heading into 2019, which when coupled with negligible growth across the rest of the revenue base, results in the headwind of approximately 100 basis points as we execute across the arc of 2019 with the biggest impact in the first part of the year. Finally, as Gary mentioned, our international sales hiring has been slower than expected. And when we plan to invest in 2019, it does take time for reps to reach full productivity. And additionally, while we've made substantial investments in our Americas quota capacity since 2016, over the past several quarters the marginal productivity from new hires has been somewhat below our internal targets and we plan on slowing the pace of further expansion over the next couple of quarters, while we optimize the go to market for that existing team. With all these factors in mind, we are taking a thoughtful approach to our initial views regarding 2019. And with that as a backdrop, our preliminary view on 2019 is as follows

[Operator:]

Thank you. And we'll take our first question today from Matt Hedberg with RBC Capital Markets.

[Matthew George Hedberg:]

Hey, guys. Thanks for taking my questions. Paul, as usual, very thorough early look into 2019. Maybe just a couple quick sort of questions on that just for clarification purposes. The color on the Cloudmark and ASC 606 headwind was helpful. I'm wondering if you could comment also on what that impact is from an international – the hiring perspective. Is there any way to kind of think about what impact that has on 2019? And then any thoughts on bill duration, sort of the embedded assumption for duration in 2019? And I guess with the premise that it would seem to me that a lot of these one-time – these items that you call (37

[Paul R. Auvil:]

Yeah. Those are all really good questions. So, in terms of the impact from the European hiring and a little bit of slowness there, I think we're not breaking that out specifically. But I can tell you that we're pleased with the way the current team is executing, and we think there's a tremendous amount of promise internationally and in Europe in particular. And so again, it's very early in our planning stages. And in fact, we haven't even completed a plan that's been officially approved by the board, but as we looked at the numbers at this stage, the feeling was that certainly that slower hiring is impacting our overall quota capacity as we start our journey into 2019, we thought it was worth calling out. So, I think we'll probably provide some additional color over the next couple of quarters as we continue to execute there. But again, the European market is very significant and we have very little market share there today. And yet the customers that we have closed, many of them some of the largest enterprises in Europe, demonstrate that the needs for our solutions there are as significant in Europe as they are in the U.S. So, to your question on duration, I would say that we've historically kind of operated in the mid-teens. And as we kind of think about our guidance for next year, it's in that realm that we think about the guide and how the pieces fit together. Gary, I don't know whether you have any other comments you want to add there?

[Gary L. Steele:]

No. I think you covered it. I think we're very optimistic about the international opportunity but we also want to be thoughtful as we provide guidance given the timing that it takes to get people on board.

[Matthew George Hedberg:]

Sure. Thanks, guys.

[Paul R. Auvil:]

Thanks.

[Operator:]

Next, we'll hear from Phil Winslow with Wells Fargo.

[Gary L. Steele:]

Phil, you out there? Are you on mute?

[Operator:]

Mr. Winslow, if you're using a speakerphone, depress your mute function or pick up your handset.

[Jason Starr:]

Want to go to our next caller, James?

[Operator:]

Certainly. We'll hear from Andrew Nowinski with Piper Jaffray.

[Andrew James Nowinski:]

All right. Thanks a lot. I'd first like to extend my congratulations to Manish on his new role. Then, I understand the headwinds from the acquisitions you cited and the international hiring issues. But given your comments on the record recurring revenue from Microsoft boomerang wins, which I would think is your single largest catalyst, I guess I'm struggling to understand your 2019 guidance and the slowdown in growth, because the headwinds you described seemed fairly insignificant. So maybe can you just give us any more color on the size of the remaining opportunity within the Microsoft installed base that you're seeing?

[Paul R. Auvil:]

Well, let me first address your question, and then Gary can jump in. So, yeah, I think the bigger issue for us is you've got some very big top line prints that we put up over the first several quarters of the year, and so that creates a tough year-over-year compare. Keep in mind that we added quite a bit of revenue inorganically, which I think we've been pretty transparent about. But obviously, we aren't (40

[Gary L. Steele:]

Yeah. Andrew, to your point, we did have a phenomenal quarter seeing customers that were using the Microsoft-based capabilities move to Proofpoint. We don't see that changing. We think that is a broad trend and opportunity for the company. It's true both in Europe and across the U.S. and so we think that growth catalyst remains in place for a long time.

[Andrew James Nowinski:]

Thanks a lot.

[Operator:]

Our next question comes from Melissa Franchi with Morgan Stanley.

[Anjelo D. Austria:]

Hi. This is Anjelo Austria in for Melissa. Thanks for taking the question. I just wanted to ask, just with the new sales leadership, should we expect any material changes in the go-to-market? And just broadly about sales productivity, you mentioned the sales productivity expectations as a product of new hires. Broadly, how did sales productivity trend in line with your expectations in the quarter?

[Gary L. Steele:]

Go ahead.

[Paul R. Auvil:]

Yeah. I was going to say, in terms of sales productivity and expectations, I would say that overall the team delivered on their numbers as usual. But, again, there's a whole separate analysis that we go through as we're thinking about our planning for the coming year where we look at not only the team that's already in place, but how are we doing as we're adding new folks. And I think what we're finding is that there is some work that we need to do in ensuring that we get better productivity and execution around the new employees that we're bringing in on the margin on the Americas team. And so, yeah, there are a couple of key things that we want to go pursue in that regard. One of which is improving how we're handling enablement for those new hires so that they can go execute more effectively. And another is making sure we're really thoughtful about how we're breaking down territories as we are adding more folks and thinking about which accounts should those new people handle. I think that as we looked at the pattern over the last year, there's certainly work to be done in both of those areas. And so, it's not a complex fix, but it's something that's going to borrow (43

[Gary L. Steele:]

Yeah. And to your question regarding more strategic changes in our go-to-market with the promotion of Blake Salle, I think one of the phenomenal things about Blake is he's been with the company for 18 months. He knows the organization. He understands our products. And so he really does have the ability to hit the ground running. I would view any modifications that he makes as fine-tuning. So, as Paul indicated, one of the focus – one of the areas of focus for Blake will be how do we drive broader enablement programs so we can get on board people faster. That's obviously key to productivity. Two is we're seeing very good receptivity on the channel. We think there's more that we can do with the channel to drive channel opportunity and growth over the coming year. And three is just how do we refine and drive the hiring process to ensure we are always getting on top of our hiring numbers every quarter. So, we're super excited about Blake. I think he brings a phenomenal amount of energy to the job and the role. He is incredibly enthusiastic. I think that he will be a world-class leader to help us drive growth over the next 5 to 10 years.

[Anjelo D. Austria:]

Great. Thank you very much. Super helpful.

[Gary L. Steele:]

Thanks.

[Operator:]

Next, we'll hear from Alex Henderson with Needham.

[Alex Henderson:]

Thanks. I was wondering if you could just talk a little bit about the two metrics. One is where we are in terms of penetrating the market for conversion from people from on-premise email system is – I think that's still heavily on-prem. And then, second, have you seen any change in pricing conditions in the field?

[Paul R. Auvil:]

So, I could speak briefly of pricing, and then Gary can talk a little bit about the status of the customers moving in their journey to cloud-based e-mail and Office 365 generally. So in terms of pricing, yeah, we do an analysis every quarter. And I can tell you that, yeah, looking at the data for the third quarter, it indicates no change from Q1-Q2, and in fact, in certain segments, in terms of user accounts, maybe an ever-so modest improvement. But again any given quarter, I'm not sure I can apply any overly significant statistical weight to those numbers. But I would just say in general, as both Gary and I talked about, the competitive environment continues to be, we view as reasonably benign and so it sets up a really nice opportunity for us to go out and drive execution, close net new customers as well as some more add-on product to the existing installed base.

[Gary L. Steele:]

Yeah. And then, with respect to the transition to the cloud and the move from an on-premise environment to a cloud environment, we're still in relatively early innings. While Microsoft Office 365 and Google G Suite has had great success and great momentum, we're still relatively early. We're probably in the third or fourth inning of that whole experience. And while the numbers and the stat that do sometimes come from Microsoft, those customers aren't all implemented. There's a lot of work that is required and time that takes to get customers from the on-prem environment to the cloud. So, we view that opportunity of capturing customers moving from on-prem to cloud to be with us for three to five years. So, there's a very nice runway here to continue to capture share as customers move from on-prem to cloud.

[Alex Henderson:]

Would you mind just converting that from innings to percentage of the market that you think is still on-prem versus that has moved to the cloud?

[Gary L. Steele:]

Yeah. If you – so let me give you a backdrop, I'll answer your question. So, when we look at the market, and we look at where we've had opportunities, so again we're very much focused on large enterprise. We do a lot of work in financial services, which is our largest vertical. You look at like financial services large customers, very, very, very few of those accounts have actually moved to a cloud-based environment. I think there's full intention to do that. It's part of their roadmap. They're not there yet. And so, we're just guessing in a qualitative way. It looks to be 35%, 40% that have done at this point. There's a 60% less, and I think the when we are seeing here 10 years from now, you're still going to have some reasonable portion not there yet. So, a lot of work to be done. And we're excited about that broad opportunity and that shift.

[Alex Henderson:]

Thank you.

[Operator:]

Phil Winslow with Wells Fargo has our next question.

[Philip Winslow:]

Hi. Hopefully, you guys can hear me this time. I just got a question on the sales productivity front. Is there anything that you can actually guess target towards there? I mean was this sort of upsell, your kind of new logos, just anything kind of color you can give on the sales productivity, particularly in the U.S. and kind of what are things that you're kind of thinking about right now that could do to sort of put that back on the previous run rate? Thanks.

[Paul R. Auvil:]

Yeah. One of the obvious, easiest things, Phil, and it's very much something we're investing in is, taking people that are newly hired and then getting them up to speed on this broad product line. So, there's a couple of things we're working on there. One is the broad area around enablement. So, that just simply means how do you get a person who is new to the company to fully understand the broad product line and make them effective in front of a customer. We have a broad program to drive that, and that is something we put in place basically a quarter and a half ago, and it's really ramping up now. The other thing we're doing, which we think helps address the complexity of a broad product line is we're getting more affected at bringing our products together in bundles, so it's easy to digest for a sales rep, but it's also easy to digest for a customer. So, we think both of those very specific things are simplifying the selling process, and doing work to get wrapped up to speed we think will have a meaningful impact on overall productivity.

[Philip Winslow:]

Got it. And then, how would you think of sort of our going forward? I mean assuming the productivity levels return to the levels that we previously saw, would you expect into reaccelerate hiring? Is that sort of the thought process behind also seeing reacceleration in the second half of 2019? Or is the reacceleration in the second half of 2019 is just purely from expectation of productivity improves?

[Paul R. Auvil:]

So, to be clear, in the baseline numbers that we've talked about as the guidance, it's really more about seeing improvements in year-over-year growth rates, because the overhang of high growth rates in the prior year and the inorganic contributions associated with that weighing in in Q4, as you look at our Q4 numbers that we'll be putting up. So with all that said, I think that there is room for improvement in the numbers for 2019 as we re-accelerate hiring and see step-up in productivity, but the current baseline outlook doesn't reflect that.

[Philip Winslow:]

Got it. Thanks, guys.

[Paul R. Auvil:]

Yeah. Thanks, Phil.

[Operator:]

We'll move on to Jonathan Ruykhaver with R.W. Baird.

[Jonathan B. Ruykhaver:]

Hey, guys. Good afternoon.

[Gary L. Steele:]

Hey.

[Jonathan B. Ruykhaver:]

I'm curious just regarding the deceleration in organic growth from fiscal 2018 to fiscal 2017. Can you just talk about which products are maturing the fastest and is this a reflection of both Protection and TAP hitting maturity? And then just looking at the emerging products set, are those products, sort of, scaled to offset the lower growth for mature products or will that take to build that scale there?

[Paul R. Auvil:]

Yes. So, good question. I would, say first of all, our new account acquisition, particularly, in the enterprise continues to pace. But, as you sort of scratching at, one of the things that we saw as a significant cycle for the company over the last several years was driving sale of TAP add-on products into our install base. And of course, as we sold more and more of that, that particular factor as a contributor to our growth has waned over time. But we have seen a really nice pickup in the emerging products that that are kind of picking up where that's leading off. So, again, overall, we feel like the emerging products we think are well positioned to pick up where that TAP growth cycle leaves off. But as we talked about on prior calls, the other thing to keep in mind is, when we close a net new deal, it's almost always both Protection and TAP. So, TAP continues to be a very important part of how we win business and also an important element of the ASP, the average price per user per year that we drive in net new account acquisition. And, of course, the emerging products are now becoming more and more of that as we see customers not just buying two but three, four, five products in that initial sale. So, the net of it is, that TAP cycle has started to wane, but we are absolutely seeing and as we talked about, the emerging products were a 30% of the new and add-on business that we closed in the current quarter. So, we feel very good about how emerging is contributing to the businesses as the TAP add-on cycle comes to kind of a natural completion.

[Jonathan B. Ruykhaver:]

Okay. All right. Good, understood. Thanks, guys.

[Paul R. Auvil:]

Thanks.

[Operator:]

Next, we'll hear from Rob Owens with KeyBanc Capital Markets.

[Rob Owens:]

Great. Thanks for taking my question. Feeling a little bit handcuffed here with only one question, but I'll try and do my best. This one's for Paul. If we look at kind of what we would call short-term billings and some of the deceleration there, maybe you answered it in the last question that TAP has kind of played out relative to attach rate, so you're not getting an incremental ACV you need that you did before. But could you address – I understand you've got that unbilled component that also makes up billings. But if we just look at short-term kind of billings as a function of velocity, why is it slowing at this point, especially so much sequentially and kind of what you're seeing on that front. So maybe there's some accounting behind it, where we're not completely accurate, but I would guess them with the unbilled portion we're seeing some slowing there.

[Paul R. Auvil:]

Yeah. And I think if you kind of go back to somewhere in the very sense of the script that we just went through, one of the things that I talked about is that we had very short durations in the first couple of quarters of the year. And then, here in Q3, durations were a little bit longer. But on a year-to-date basis, if you look at the percentage increase in long-term deferred as a percentage of the total billings year-to-date, here in 2018, that's actually a 3%. So, it's actually a little bit down from the 3.2% in the prior year, and as well long-term deferred sits at about 15% of total deferred revenue here at the end of Q3, almost identical to where it was at the end of Q3 of 2017. So, the aggregate duration over the arc of the three-quarters of the year is essentially the same 2017 to 2018. We did see, as we talked about, a handful of larger multiyear deals paid in advance that we executed here in the third quarter that drove up that long-term deferred revenue balance. But I think that overall, we're pleased with that. We generally don't drive for longer duration but it just demonstrates the commitment that customers have to wanting to run our platform not just one year at a time, but with three year commitments to running our technology. And then, of course, it creates a platform for people to then go ahead and consider adding additional products as we move from just an e-mail security solution to this people-centric security and compliance story that we've been driving across our installed base.

[Rob Owens:]

Thanks.

[Paul R. Auvil:]

Thanks.

[Operator:]

Next, we'll hear from Ken Talanian with Evercore ISI.

[Kenneth Talanian:]

Hi, guys. Thanks for taking the question. I was wondering if you could give us a sense for how much visibility you have into 2019 pipeline versus what you're looking at this time last year into the 2018 pipeline?

[Paul R. Auvil:]

Yeah. So, it's relatively similar, right? It ties back a little bit to the comment I just made to Rob, which is if you look at what percentage of the overall deferred revenue is long-term deferred, it's about 15%. Meaning, by definition, 85% is short-term deferred. So, that gives us a very strong setup for revenues that are essentially already baked in for 2019. And of course, then there's dependency of closing out a strong fourth quarter and then closing business each quarter over the course of 2019. But I would say that our setup going into the start of the year, as I look at 2019 here at the end of October, is reasonably similar to what we saw in the prior year. The one thing, of course, to keep in mind is that we then had kind of step function change after our October early guide when we closed, first, the Cloudmark transaction. And then, in early 2018 we closed the Wombat transaction, which then creates some complexity in this year-over-year compares, as we worked our way through 2018. But again, the net of it is, we feel good about visibility that we have going into the start of 2019.

[Kenneth Talanian:]

Great. Thanks very much.

[Operator:]

Our next question comes from Gabriela Borges with Goldman Sachs.

[Gabriela Borges:]

Good afternoon. Thanks for taking my question. Either for Gary or Paul, there's been a lot of consistency over the last two, three years and how you'll have thought about expanding the sales force and ramping the productivity of the sales force. So my question is what do you think changed that's driving that delta in marginal productivity in the last couple of quarters versus maybe the prior three years? And just to ask a question exclusively for Paul, what are you assuming for productivity in fiscal 2019 guidance? Are you assuming it stays the same or gets better or gets less? Thanks.

[Paul R. Auvil:]

Yeah, let me answer that question first. And then, Gary can jump in to a little bit more detail. But when we do our planning, we always assume productivity that's relatively consistent with what we're seeing in the current year. We don't make assumptions around improvements. And while we're obviously driving for improvements, we don't think it's prudent to plan for improvements that aren't proven. So as you look at the guidance that we just shared for 2019, it reflects productivity levels that are roughly consistent with what we've seen here year-to-date in 2018.

[Gary L. Steele:]

Yeah. And Gabriela, I think the only thing they're different, one is just scale the broad number of people that we're hiring require more enablement than the structure that we've put in place in the past. We now have structure in place to help us support that effort. And then, we have clearly broadened the product line, so the work required for a new sales rep today to adjust the broader product line, it takes more effort. And so, with this broad enablement and the bundling that we talked about, the combination of those two things give us confidence that we can improve new hire rep productivity, but those are the two things that are different today from two years ago or three years ago. Those are pretty straightforward.

[Gabriela Borges:]

That's helpful. Thank you.

[Operator:]

Our next question will come from Gregg Moskowitz with Cowen and Company.

[Gregg Moskowitz:]

Okay. Thank you very much, and good afternoon, guys. Can you elaborate on why the sales capacity overseas hasn't ramped as you were expecting it to? For instance, was there perhaps less focus on it than there should have been internally? Was it more challenging to find the talent that you require? Any color there would be helpful.

[Gary L. Steele:]

I think it's a couple of things. So, one is the – as the hiring numbers in Europe have gotten bigger, it needs a different level of discipline and focus, which we've now put in place, but that I think is something that is required as you get to much bigger numbers. And then, two, there's just these natural things, notice periods and things like that tend to be longer. And so, time to actually – time to productivity tends a little longer in Europe, and both those of things have had an impact on us.

[Gregg Moskowitz:]

Okay. Thank you.

[Operator:]

Next, we'll hear from Erik Suppiger with JMP Securities.

[Erik Suppiger:]

Thanks for taking my question. You didn't comment on Wombat in particular. Can you give us an update on how that acquisition is progressing and if it had any changes to your thoughts for the contribution in fiscal 2019?

[Gary L. Steele:]

Yeah. So I'll dive in. So, as we noted in the script, we were very pleased with the results we've seen. The good early technical integration that we've done has been very well received by customers. The demand that we're seeing across both the Europe and the U.S. has been incredibly healthy. So, we are extremely optimistic. We still have some integration work to finish up, but we've made very good progress to-date. Do you have anything to add, Paul?

[Paul R. Auvil:]

No, I don't think so. I think we're very excited about it. I think the team in Pittsburgh, sales team that we picked up through the acquisition, I think is executing along in a nice clip, and we've done an integration done between that team and our broader global sales team that I think seems to be moving along nicely. So, as we look at 2019, I feel that product line will be a meaningful contributor to our business potentially, but it's a little early to tell.

[Erik Suppiger:]

Thank you.

[Operator:]

We'll now hear from Steve Koenig with Wedbush.

[Steve R. Koenig:]

Hi, gentlemen. Thanks for taking my questions. I'd like to ask you guys about what are you seeing in terms of channel partner productivity trend in the field as they engage in new opportunities in their pipe? And if I may, I'd also just like to ask for our modeling, as we to think about where free cash flow can go, say beyond fiscal 2020, do you guys – the overachievement in the Rule of 40 that you guys have been posting, is that sustainable? Is there something about your model that makes that sustainable in the out years? And that's all I have. Thanks very much.

[Gary L. Steele:]

I'll start with channel productivity question, Steve. So, one of the things that we are encouraged by is we're seeing continued greater adoption by our existing partners and we've seen a lot of interest in very interesting regional partners around the globe that want to drive business for Proofpoint. The opportunity for us is enabling the channel to more broadly sell all of our products. And one of the efforts that we have underway, as I indicated in one of the other questions, but we are working on some level of bundling to just simply make it easier for the channel to digest our products and then make it easier for them in their go-to-market motion with customers. So, I think we are very excited about what we're seeing from an interest level and enthusiasm in the channel. Our metrics for the channel in Q3 were very positive, and so we're encouraged as we think about Q4 and then looking into 2019, we think we've got a very good trajectory with the channel.

[Paul R. Auvil:]

Yeah. And on your Rule of 40 question, I think this year, obviously, we're sitting at around 50% on that Rule of 40 metric, which is revenue growth. To be clear, the organic revenue growth for the business combined with our free cash flow percentage. And while our early guide's a little bit to step down at 45%, what we're excited about is at 45%, we're literally in the top quartile of all SaaS companies that are publicly traded. So, we think that's quite frankly a pretty impressive statistic, particularly that this is our early guide going into the year. So, with all that said, to your question about what happens beyond 2020, we haven't specifically guided beyond that. But I can tell you, we very much believe, as we think about our overall model and the mechanics of it, that we should be able to consistently operate nicely above 40% as we see an ongoing maturity in the business, the business gets larger, putting up bigger (01

[Steve R. Koenig:]

Great. Thanks a lot, guys.

[Gary L. Steele:]

Thanks, Steve.

[Operator:]

Next, we'll hear from Tim Klasell with Northland Securities.

[Tim Klasell:]

Yeah. Hey, guys. My question has to do with the emerging products. Obviously, that's beginning to get some traction. When we look at your initial guide out for next year, what are you thinking that could be? And will Wombat be leading the charge? If you had to pick two or three products that will show the most growth next year in that group, what would you point towards? Thank you.

[Paul R. Auvil:]

Yeah, Tim, great question. I would point to three things. One is, if you look at the momentum that we noted in our prepared remarks today, Email Fraud Defense and Threat Response have done phenomenally well. And then, Wombat, we're very early on in, but in its first two full quarters of selling, we've been incredibly impressed. So, we think that those three emerging products really deliver interesting growth as we think about 2019 and beyond.

[Gary L. Steele:]

And I think the thing that I'd add, and it's probably more of a late 2019 and then coming into 2020 effect, but our CASB offering, we've seen some nice uptick on that early. And there's some very unique things that we can do that no one else in the space can do given the deep integrations between our cloud threat intelligence and the elements tied into e-mail and what we can then deliver for CASB threat capabilities along with compliance. And so, one of the things that I think may be a little underappreciated about Proofpoint over the next couple of years is that while I know, for example, identity and access management is a very hot topic today and you see several companies, I think, executing quite nicely in terms of delivering growth there, we believe that CASB is another big opportunity for growth that will kick in inevitably in a cycle, but it's probably measured in the next year or two, not quite now. But we've had some really good early adoptions around that product and that platform and I think these differentiated capabilities that we can bring to bear, which are a combination of the threat platform and other cloud capabilities that we've built for e-mail and bringing them over to these other cloud venues, we think is quite interesting opportunity over the next few years.

[Tim Klasell:]

Okay, great. And then, just a quick follow-on. CAD, we've been hearing a fair bit of that on our channel checks. I know it's very early, but could that be meaningful or is that just not priced at a point where it could be meaningful? Thank you.

[Gary L. Steele:]

So, it can absolutely be meaningful. With CAD, we've had one full quarter of selling. And in that one full quarter of selling, we've had tremendous interest because of the pervasive issues surrounding compromised accounts. And so, Tim, I think what you're hearing is it's a huge problem out in the marketplace as it relates to compromised accounts and we're really the only vendor today that's tackling this problem head on. And so, I didn't note CAD as one of those products that's going to deliver long-term growth, because we're one quarter into this. And so, while the trajectory looks awesome and this is a problem that people absolutely have, we're super optimistic. It's just one quarter in.

[Tim Klasell:]

Sounds good. Thank you, guys.

[Gary L. Steele:]

Thanks.

[Operator:]

Gray Powell with Deutsche Bank has our next question.

[Gray Wilson Powell:]

Great. Thanks. So maybe – I think you guys were – you touched on this before but I just want to make sure I understand it correctly. How should we think of the organic billings growth on the legacy Proofpoint business versus the contribution from Wombat and other acquisitions both in 2018 and within your 2019 guidance?

[Paul R. Auvil:]

Yeah. So, we really haven't broken out organic and inorganic in the billings. So, it's a little hard to officially comment on that. But again, I would come back to the fact that we feel like the underlying production and output of our sales organization continues to execute well. I think I'd bring you back to the comment I made a little bit earlier, which is, if you look at the total growth, organic growth of our business in 2018, and then you look at the growth that we're expecting in 2019, which again, has no inorganic component in it to speak of and is essentially all driven by our sales team, the fact that in our initial guide that number in 2019 is larger than 2018 we think essentially makes the point around the question that you're asking, which is, we feel like the scale of our team and their ability to go deliver, we've got a good setup going into 2019. And so, obviously we need to complete Q4 and then we'll drive on from there. But overall, the billings capacity and the output capacity of the Proofpoint sales team selling both our core products as well as that broader emerging product set, we think that they're set up to do quite well in 2019.

[Gray Wilson Powell:]

Okay. So, just to make sure I understand, on an absolute dollar basis, are you expecting more billings to come in organically in 2019 than what came in 2018?

[Paul R. Auvil:]

Yeah, absolutely. Yes.

[Gray Wilson Powell:]

Okay.

[Operator:]

Next, we'll hear from Catharine Trebnick with Dougherty.

[Catharine Trebnick:]

Thank you for taking my question. Could you – it's a two-part question. What percent of the revenue this quarter was from the channel? And with the change in leadership in part of your going forward strategy to tweak the sales organization, do you plan or bringing on a channel chief to help with the sales enablement? Thanks.

[Paul R. Auvil:]

Yeah, two great questions. So, in terms of business touched by the channel is over 60%. And we feel – as I noted earlier in answering one of the other questions, we feel excited about the opportunity to drive more business through the channel. And to your second question related to channel chief, the way we've been driving the channel is through senior theater leadership on channel. So, we have senior theater leader in the U.S. and we have a senior theater leader in Europe as well as in Asia Pacific. So, it is unlikely that we'd hire a global channel leader given that we've got really good people driving what is local to the channel. So, I think we're well served in the organization that we have. With Blake Salle's appointment, Blake is a very focus on driving productivity in the channel and leveraging the work, the foundational work that's already been done. So, we feel like there's very good trajectory and opportunity in front of us there.

[Catharine Trebnick:]

All right. Thanks, and all the best to Manish.

[Gary L. Steele:]

Thanks.

[Operator:]

Next, we'll hear from Patrick Colville with Arete Research.

[Patrick E. Colville:]

Thanks for taking my question. Can I just double-check, on the Cloudmark phasing out of the OEM relationships, are you guys going to phase out all the OEM relationships?

[Gary L. Steele:]

Yes. We're phasing them all out, because they were all competitors to Proofpoint and our broader product line, and so obviously, it didn't make sense to enable people who we view as competitors in the marketplace to have access to the Cloudmark threat intelligence and other intellectual property.

[Patrick E. Colville:]

Got it. And can I just double check, so the headwinds you pointed out to FY 2019 revenues, you mentioned 50 bps headwinds and the 100 bps headwinds. Do you mind just clarifying what they were?

[Gary L. Steele:]

Yes. So the 50 basis point headwind was related to the ongoing evolution of customers, who were still on-premise customers of Proofpoint that are moving to our cloud. And as they do, the ASC 606 revenue that's recognized upfront for an on-premise customer becomes a subscription revenue recognized ratably. And so, there is a headwind there as you convert from one to the other comparing revenues recognized in priori year versus a future period. So that's that. And then, on Cloudmark, the element is again just eliminating their OEM business. And the fact that not only are we not getting any growth from the Cloudmark platform, but it's actually declining, as was originally intended, there's no surprise here. And I think we shared even at the time of the acquisition that this was our plan with that business.

[Patrick E. Colville:]

Okay. Thank you so much.

[Gary L. Steele:]

Yeah. Thanks, Patrick.

[Operator:]

Our final question will come from Gur Talpaz with Stifel.

[Gur Yehudah Talpaz:]

Okay. Thank you for squeezing me in. Just in the wake of Manish's departure, how do you think about M&A going forward? And if you look into 2019, how do you think about the idea doing more acquisitions to fill out the product set versus digesting what you have and what you acquired more recently? Thank you.

[Paul R. Auvil:]

Yeah. So, we remain enthusiastic about the potential of M&A. Even in Manish's absence, we are constantly looking at various opportunities and thinking about what might be next. We feel no urgency to do anything, but we've had great success with M&A in the history of the company, and we will continue to pursue that. As we think about 2019, we look at opportunities where we can extend value to customers, bring great challenges to the company and basically complement the existing products that we have. We are not looking for something large and transformational. We're just looking for the same kind of profile of things that we brought into the company in the past and we're confident that we'll have a replacement for Manish in the short-term.

[Gur Yehudah Talpaz:]

Okay. Thank you.

[Paul R. Auvil:]

You bet.

[Operator:]

That will conclude today's question-and-answer session. I'll now turn the conference over to Gary Steele, Proofpoint's CEO, for any additional or closing remarks.

[Gary L. Steele:]

Thanks. I wanted to just take a moment and thank everyone for joining us on the call today. We're pleased with the Q3 results, and excited about our continued progress and believe we are well positioned as we begin to shift our attention to our 2019 operating plan. We look forward to talking to you on our next call and seeing many of you in the conference circuit in the quarter. Thanks so much for joining us today.

[Operator:]

That does conclude today's conference call. Thank you for your participation. You may now disconnect.