Proofpoint, Inc.
Q2 2016 Earnings Call Transcript

Published: 22 Jul 2016

[Operator:]

Please standby, we're about to begin. Good day, ladies and gentlemen, and welcome to today's Proofpoint's Second Quarter 2016 Earnings Results Call. Today's conference is being recorded. And at this time, I'd like to turn the floor over to Paul Auvil, Chief Financial Officer. You may begin, sir.

[Paul R. Auvil:]

Thank you. Good afternoon and welcome to Proofpoint's second quarter 2016 earnings call. Today, we will be discussing the results announced in our press release that was issued after the market closed. I am 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 the future financial performance of the company. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements contained in the press release and this conference call. These risk factors are described in our press release and 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 and other income and other expense. These non-GAAP measures are not intended to be considered in isolation from, a substitute for, or superior to our GAAP results, and we encourage you to consider all measures when analyzing Proofpoint's performance. A reconciliation of GAAP to non-GAAP measures is included in today's press release regarding our second quarter 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 July 21, 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 L. Steele:]

Thanks, Paul. I'd like to thank everyone for joining us on the call today. We had a great second quarter, which was supported by a healthy macro environment and strong broad based demand for Proofpoint suite of cloud-based solutions, all of which resulted in our ability to once again exceed expectations and for the first time surpass $100 million in quarterly billings. Our revenue upside was driven by very strong linearity at new and add-on business booked during the quarter coupled with the renewal rate that was well above our recent norms enabling us to deliver positive non-GAAP EPS for the first time in the company's history. During the quarter, we had success on multiple fronts, as Proofpoint is executing well across the business. This was driven primarily by three key factors. First, we continue to experience strong overall demand for our advanced threat solutions propelled by TAP as cybercriminals continue to have success stealing sensitive data from companies by targeting individuals, not infrastructure on email, social and mobile. Second, the competitive environment continues to evolve in our favor as large and midsized organizations are switching to Proofpoint's cloud-based solutions and away from legacy providers. In particular, during the second quarter our core protection business benefited from our new and faster (3

[Paul R. Auvil:]

Thanks, Gary. We were very pleased with our ability to once again exceed expectations for revenue, billings and profitability, including reporting non-GAAP profitability for the first time in the company's history. Proofpoint 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 remains well over 90%. During the second quarter, total revenue was $89.9 million, up 41% year-over-year, and above our previously announced guidance range of $83.5 million to $84.5 million. These strong results were driven by a 41% year-over-year growth in our subscription revenue. As Gary mentioned earlier, our revenues recorded during the period benefited from exceptional linearity in terms of the timing of new and add-on business booked during the quarter, as well as a renewal rate that was measurably better than our recent norms. These factors added over $2 million in revenue during the quarter, as compared to a typical quarter, almost all of which directly benefited the profitability recorded for Q2. Looking at the revenue breakdown by segment, during the second quarter our protection and advanced threat segment comprised 72% of total revenues, growing 50% annually, while our archiving privacy and governance segment made up the remaining 28%, growing 23% year-over-year. Billings for the first quarter totaled $101.2 million reflecting growth of 34% on a year-over-year basis and exceeding the high end of our previously announced guidance range of $94 million to $96 million. We are very proud of our ability to surpass the $100 million level in quarterly billings, which highlights the ongoing broad based momentum we are seeing in the business. 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 $12.6 million over the prior quarter, whereas long-term deferred revenue declined slightly. Turning to expenses and profitability for the second quarter, on a non-GAAP basis, our total gross margin was 75%, which was above our expectations and at the midpoint of our original long-term target of 74% to 76%. We were very pleased with our execution, particularly since it highlights the leverage we are starting to see from our cloud infrastructure investments to support growth. 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 second quarter total non-GAAP operating expenses increased 36% over the prior-year period to $63.8 million representing 71% 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 quota capacities to drive both new customer acquisition as well as add-on sales to existing customers. I would also like to highlight that our non-GAAP G&A expense, at approximately 6% of revenue, represents best-in-class performance in terms of administrative efficiency for SaaS companies of our scale in growth rate. Second quarter 2016 adjusted EBITDA was positive $7.7 million, well above our guidance range of $2 million to $2.5 million, primarily driven by the upside to revenue coupled with focused spending discipline across our business operations around the world. I would like to note that during the earnings call last quarter, I indicated that our move to deferred commission accounting would have a favorable impact to our profitability for the second quarter of approximately $0.5 million. In fact, the final figure was a favorable impact of $0.9 million, so under our historical method of commission accounting, we would have delivered an EBITDA figure of $6.8 million. Note that for purposes of our EPS calculations, I wanted to highlight that we are now using two different share counts here on the call. In cases where we were reporting a loss, we are calculating EPS using the basic EPS methodology, where the share count is equal to the weighted average number of shares of common stock outstanding for the quarter, resulting in a figure of 41.6 million shares for the second quarter. 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 our stock options and other forms of outstanding equity awards that would serve to dilute the basic EPS figure. This first element added 3.5 million shares to the basic figure for the current quarter. The second element is to apply the, if converted, method to our convertible senior notes. We determined that the application of this method would have been anti-dilutive to the second quarter EPS calculation, and hence no shares were included as a result of this second element. Hence the resulting fully diluted share count for the second quarter was determined to be 45.1 million shares. So, in terms of profitability for the quarter, we reported positive non-GAAP net income of $2.5 million or $0.06 a share, our first quarter of non-GAAP profitability in the history of the company. This result was well above our guidance range of a loss of $0.07 a share to $0.08 a share, and highlights the leverage we are seeing in the business. On a GAAP basis, we recorded a net loss for the second quarter of $38.3 million or $0.92 a share, and note that these GAAP results included $13.5 million in expenses related to the defense and final settlement of the Finjan patent litigation. In terms of cash flow, during the second quarter, we generated $8.3 million in operating cash flow and invested $8.4 million in capital expenditures resulting in roughly breakeven free cash flow, which was in line with our guidance. This, in spite of a $4.3 million cash payment to Finjan related to our recent settlement of litigation, an event that was not anticipated when we gave this guidance in April. Hence we handily beat our original guidance for the quarter when considering this unexpected one-time item. Turning to the balance sheet, we ended the second quarter with $412 million in cash and short-term investments and $356 million in debt compared to $410 million in cash and short-term investments and $351 million in debt as of March 31, 2016. Now as a reminder, we carried two series of convertible notes on our balance sheet that are due in 2018 and 2020. The first series due in 2018 pays annual interest of $2.5 million in two equal installments during the second quarter and the fourth quarter. The conversion price on the notes is $39.02 and if converted, 5.2 million shares would be issued. The second series due in 2020 pays annual interest of $1.7 million in two equal installments also during the second quarter and fourth quarter, and the conversion price on these notes is $81.23 and if converted, 2.8 million shares would be issued. We ended the second quarter with an accounts receivable balance of $57.8 million resulting in DSOs of 53 days. Total deferred revenue increased $70.4 million or 38% year-over-year to $254.4 million during the second quarter, up from $183.9 million in the year ago period. Before turning to the financial outlook, I'd 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 expensing commissions during the period in which they were incurred to the accounting policy used by most larger SaaS 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 the January call, we indicated that we expected the full year impact to be a benefit to EBITDA of approximately $4 million. As of the first half of this year, the impact has been an unfavorable impact of $0.6 million. For the remainder of the year, we expect that Q3 has a favorable impact of $1.5 million, in Q4, it has a favorable impact of $3 million. Hence, an overall favorable impact to the full year of $3.9 million consistent with our original estimates back in January. Now, turning to our financial outlook, starting with the third quarter of 2016. We currently expect billings to be $114 million to $116 million or a year-over-year growth rate of 35% at the midpoint of the range. Note that this guidance assumes that our duration remains consistent with our activity in Q2. Regarding revenue for the third quarter, we are targeting total revenue of $93.5 million to $94.5 million or 36% growth year-over-year at the midpoint of the range. We expect third quarter non-GAAP gross margin to be approximately 75.5% reflecting ongoing sequential improvement in the leverage in our operating model. With regards to adjusted EBITDA given the unique factors that drove our outsized revenue and profitability performance this quarter, we are currently expecting roughly flat performance with the second quarter at $7.4 million to $7.9 million. We expect third quarter non-GAAP net profit to be $1.8 million to $2.7 million or profit of $0.04 to $0.06 per share based on approximately 45.4 million weighted-average diluted shares outstanding. And, this assumes an income tax provision exclusive of discrete items of $0.2 million to $0.4 million during the quarter. And, as a final point, we expect free cash flow during the third quarter to be $8 million to $10 million. From a full year perspective, we are increasing our guidance above the over-performance just reported in Q2 driven by the expected ongoing strength in the business. And specifically, we now expect billings to be in the range of $445 million to $448 million, which represents an annual growth rate of 38% at the midpoint of the range and this compares to our previous guidance of $435 million to $438 million. With this billings performance, we are also increasing our total revenue guidance to $361.5 million to $363.5 million, reflecting an annual growth rate of 37% at the midpoint of the range. This compares to our previous revenue guidance of $350.5 million to $353.5 million. We expect full year of 2016 non-GAAP gross margins to be approximately 75%. With these effects in mind, adjusted EBITDA for 2016 is now expected to be in the range of $24.5 million to $25.5 million, up from our previous guidance of $15.5 million to $16.5 million, so a significant improvement, even when considered in the context of our over-performance here in the second quarter. As a result, we expect full year 2016 non-GAAP net income to be $2.5 million to $4.5 million or profit of $0.06 per share to $0.10 per share, an improvement from our previous guidance of a net loss of $5.4 million to $6.4 million or a loss of $0.13 per share to $0.15 per share. Our new non-GAAP EPS guidance for 2016 is based on approximately 45.3 million weighted average diluted shares outstanding and assumes depreciation of approximately $16.9 million to $17.2 million and cash interest expense associated with convertible debt of roughly $4.2 million as well as an income tax provision exclusive of potential discrete items of approximately $1 million to $1.2 million. The combination of our full year and third quarter guidance implies that we expect to also report positive non-GAAP net income and EPS for the fourth quarter of 2016. Finally, given our strong performance here in the first half of the year, we are raising our free cash flow guidance for the full year to the range of $34 million to $38 million or an increase of $6 million at the midpoint after adjusting for the Finjan settlement payment which was not anticipated when we gave guidance in April. This 2016 guidance assumes capital expenditures of $31 million to $33 million, a few million higher than our previous guidance due to the higher billings and revenue figures now expected for the full year. A reconciliation of our non-GAAP guidance for both third quarter and the full year of 2016 to GAAP guidance can be found in our third quarter release that we issued this afternoon. As a final note, while we historically haven't provided initial forward year outlook until the third quarter earnings call in October. We thought it would be helpful to provide our initial thoughts on fiscal 2017 revenue growth given the current dynamics of the business, specifically given the strength that we are seeing across the arc of 2016, these results setup a somewhat challenging comparison for 2017. And with that in mind, we believe that a reasonable starting point is initial growth target of 28%, which is at the low end of our annualized growth range based on the 2020 target that we shared with investors at our Analyst Day this June. It is important to note that this outlook is paired with today's updated 2016 revenue guidance, where we increased full year guidance by almost $10 million at the midpoint, adding 400 basis points of additional growth for the full year of 2016. So in summary, we had a very strong second quarter and believe that Proofpoint remains well positioned to maintain momentum for the remainder of the year, given the broad-based success across all of our solutions. Before turning it over to the operator for questions. We would appreciate if you would each ask just one question and a follow-up and get back into the queue in order to allow everyone time to ask their questions. So with that, I want to thank all of you for taking their time to join us on the call today and we'd be happy to take your question. Operator?

[Operator:]

Thank you, sir. And our first quarter today comes from Rob Owens with Pacific Crest.

[Rob Owens:]

Thank you guys for taking my question. Checks throughout the quarter indicated that customer acquisition is running strong and results obviously evidence that. You mentioned on the McAfee front, it was smaller customers and you haven't seen those larger ones transition yet, so in that light, who are you displacing most and how has this changed? And then number two when do you think you will see some of those larger McAfee customers transfer over?

[Gary L. Steele:]

Yeah. Hi, Rob. This is Gary. So from a McAfee perspective, what we were seeing is – as we noted in the script, we saw it basically in line with what we've seen in the last couple of quarters, lots of smaller customers, good value being driven by our ability to add TAP or privacy. We see a lot of planning happening as it relates to migration of those larger customers and we do believe we'll start to see those in the second half of the year, but as a reminder many of those large customers are on premise and they have a full five years to make that transition. We continue to believe that those customers will make that transition in the front half of that five years, but they are going through a pretty extensive planning to make that happen. The other part of your question was who are we displacing? I would say our displacements in Q2 were representative of what we seen historically across the legacy incumbent. So, not unlike other quarters where we saw a mixed year of the legacy players contributing share to Proofpoint.

[Rob Owens:]

And as a follow-up for Paul, with the better linearity. Is channel aiding that, was that just the pace of the quarter relative to what you guys saw maybe just a little bit more color and then the contribution was – you mentioned an incremental $2 million for the quarter?

[Paul R. Auvil:]

Yeah. From a revenue perspective, given the accelerated linearity of timing of the business, is it booked for new and add-on combined with our better churn rate, that total effect was about $2 million of revenue contribution in the quarter that we otherwise wouldn't have expected. Certainly, we're very pleased with how the channel is executing but I wouldn't attribute to the channel per se. And we've been public now for – on the order of 4.5 years. And I think statistically you're occasionally going to have a quarter where everything lines up and so you end up with sort of a preponderance of a business that cascades into the quarter sooner than your historical norm. So, I certainly wouldn't look at this and say that it's a new normal, we are of course, very pleased to see the new business come in at the pace that it did. But I certainly, for planning purposes, wouldn't expect this to recur again in the future.

[Rob Owens:]

Great. And so does that imply – sorry for the third. But does that imply compressing sales cycles, Paul? And I'm done after that.

[Paul R. Auvil:]

Yeah. I wouldn't say it's compressing sales cycles. I think the pipeline has grown meaningfully over time. And so, again different deals have a different cadence and it depends very much on the customer and the nature of what they are facing off out in the marketplace. I certainly think that the imposter email problem has certainly accelerated urgency in some cases with customers and I think that that may have been one of the catalysts that helped accelerate some of the business into the earlier part of the quarter in Q2.

[Gary L. Steele:]

Yeah. And I would just characterize it as we saw a very robust demand across the product line throughout the quarter, and the robust demand was not hampered at all by any macro effects. We actually saw absolutely no effects from macro.

[Rob Owens:]

Thank you.

[Gary L. Steele:]

Thanks, Rob.

[Operator:]

All right. And moving to the next questioner in queue, we have Matt Hedberg with RBC Capital Markets.

[Matthew George Hedberg:]

Yeah, thanks for taking my questions, guys. Congrats on the quarter. Obviously the billings were spectacular. The margins to me really stood out. The model is certainly starting to inflect a spike and Paul you mentioned increased sales and marketing, and R&D hires. Do you plan on increasing that rate of hire in the back half to absorb some of the strong pipeline or is this just natural leverage that you guys have been talking about for the last few Analyst Days?

[Paul R. Auvil:]

Yeah, I mean, I think you saw kind of an accelerated natural leverage here in the current quarter compared to our expectations because of among other things, there's better linearity producing more revenue from the new and add-on business in the quarter than we otherwise would have expected. Hence, we are guiding roughly flattish EBITDA between Q2 and Q3. I think that as we look at how things are coming together in terms of pipeline and the business overall, I think honestly our hiring plans are essentially unchanged just compared to where we were at the beginning of the year. So we continue to execute on building out what we think is a world class sales team. We are very pleased with the quality of the people we're bringing over both as individual contributors as well as leaders in that organization. And so as we look go forward, we don't see a reason or a need to necessarily accelerate sales hiring above the original planning metrics, which again given the overall performance that we saw in the quarter has allowed us to raise our expectations in terms of both revenue and billings for the remainder of the year, and then as we look at how all that flows through, producing incremental profit leverage in the second half of the year as compared to the guidance 90 days ago.

[Matthew George Hedberg:]

That's great and then maybe one for Gary. It's really nice to hear the add-on products doing so well. And I know you called out social with a few wins, a Fortune 500 media company and a consumer company as well. Are you to the point now where we're seeing more standardized pricing on social or is it still more one-off in nature?

[Gary L. Steele:]

I think our pricing is beginning to mature somewhat. I would say that the markets still has maturity to go, because organizations are still working on how they will deploy social as part of their selling and marketing practices. And so, I believe our business will track the evolution and maturity of that broader social market. And I feel like we still – as that market matures we will learn more about pricing, but I think it's been relatively stable.

[Matthew George Hedberg:]

Great. Thanks, guys.

[Operator:]

And our next question comes from Melissa Gorham with Morgan Stanley.

[Melissa A. Gorham:]

Great. Thanks for taking my question. I would just, maybe to start like an update on some of the recent partnerships maybe to start with Palo Alto, I know at the Analyst day, you said that it was contributing to a solid pipeline and some positive channel commentary. But I'm just wondering if the deals in the pipe have actually converted into sales at this point? And then some of the newer partnerships like Splunk and CyberArk. What has the customer feedback been like?

[Gary L. Steele:]

Yeah. So, with respect to Palo Alto, as we reference in the script, we've actually closed a handful of deals that were influenced by the Palo Alto relationship, and we are very pleased, given the relatively short period of time that we've had that relationship with Q2 being our first full quarter of selling, to seeing deals actually convert. So, we feel very good about that, good pipeline and a good handful of initial deals converting as result. With respect to Splunk, CyberArk and Imperva, we're just getting started, so we're mobilizing the sales and marketing machines and getting that infrastructure in place. Early feedback has been quite good, I have to say, and so we're starting to see deals move to the pipeline as a result of those relationships, but we're really early, and we like the early signs that we're seeing.

[Melissa A. Gorham:]

Okay. Great. And then, just one follow-up on the international business, you're seeing an acceleration in growth there. I'm just wondering if you've done anything different from a sales perspective or accelerated investments internationally? And then, are you seeing any benefit at all from the upcoming change in the data protection laws in Europe?

[Gary L. Steele:]

Yeah. So, there's been no change in execution strategy with respect to Europe, and there has been no change in investment profile. I think what we're seeing is maturity in our selling efforts, one, and I do believe the market continues to more broadly recognize the need to buy advanced threat solutions. So, I think we're benefiting from that. And, I do believe that this impending change of the EU data protection laws, and the broader understanding today in the EU about their risks and issues is driving more awareness and buyer demand. I think it's actually really good for us, frankly.

[Melissa A. Gorham:]

Okay. Thank you.

[Operator:]

All right. And, next from William Blair, we'll hear from Jonathan Ho.

[Jonathan F. Ho:]

Hey, guys. Congratulations on the strong quarter. Just wanted to start out with the privacy piece. Can you talk a little bit about what drove the strength there, and maybe the type of growth that we could expect for that piece of the business going forward?

[Gary L. Steele:]

Yeah. What we saw was that in regulated industries, organizations concerned about protecting private or sensitive data. So, for example, we had good production of business in healthcare, where they're concerned about private health information. And, a lot of – I would characterize it as organizations that frankly had been behind somewhat on some of these initiatives getting technology in place to better protect that information. We saw almost all in regulated industry. So, healthcare, financial services specifically. And, you had a follow-up question, Jonathan?

[Jonathan F. Ho:]

Yeah. Just in terms of the transition to Office 365, can you maybe talk a little bit about, where we are there in terms of the larger companies? And in particular, we see Microsoft maybe engaging a little bit more discounting and bundling activity, can you talk a little bit about whether you're seeing any shift in that dynamic?

[Gary L. Steele:]

Yes. I would say in the quarter, we continue to see larger organizations begin to move to Office 365. And so the range of organization that we're selling to today is kind of across our entire size of customer that we serve from mid size to large. And, we do see a very robust level of activity within the Office 365 community. And so, we continue to believe that will be a very nice tailwind for us for years to come. We didn't see pricing on behalf of Microsoft to have any impact on us. More bundling, I would suspect that there is more bundling going on, but it's had no impact on us.

[Jonathan F. Ho:]

Great. Thank you.

[Operator:]

All right. And our next question comes from Walter Pritchard with Citi.

[Walter H. Pritchard:]

Hi, thanks. Paul, I'm wondering if you could talk about the renewal rate, that sounded like ticked up in the quarter. What do you attribute that to, and do you think that will continue at that pace or is that more of a one-time factor do you think?

[Paul R. Auvil:]

Yeah. From quarter-to-quarter, the renewal rate varies, from low 90%s to high 90%s, and so the last couple of quarters – anything over 90%, given the way we measure, it's a great number. So, the last couple of quarters, we were pinging around more, call it the low-90%s, and then this quarter, we had a renewal rate that was at the very high end of that range. Obviously, for planning purposes, we always use a low range number, but then when we end up with a quarter, where the numbers are much stronger, again, it definitionally produces revenue within the quarter. So, as I look going forward, I think, we continue to be really pleased with the expected renewal rate for the remainder of the year. Part of the reason why we had raised our billings guidance back in April, was that as we work through and thought about all the customers, and done our initial engagements with the largest businesses that were up for renewal for the year. It was clear that we were expecting strong renewal cycles with them and so, raised the billings guidance accordingly. I would say as we look go-forward from here, we continue to be very pleased with what we see in terms of the expected renewal rate across the customer base. But, I'd be surprised if again, say in third quarter, we had such an extraordinary performance as compared to Q2. It was a little bit unique, but just like the timing of linearity, it can be really hard to predict in any given quarter, exactly where you're going to land until all the paperwork comes through. So...

[Walter H. Pritchard:]

And then, Paul, you've indicated, I think, that you thought archiving would accelerate in the second half of the year, you're starting to see that happen in Q2. Do you expect that archiving accelerates further from the types of growth rates you're seeing right now?

[Paul R. Auvil:]

I think as we work our way through the second half of the year, there's room for the numbers to move up from here. I think the good news is that, as Gary I think referenced in the script, we're seeing good production across a number of different products. The privacy product did really well in the current quarter, protection did well, TAP did well, we had some good production of archiving business, social had a nice contribution. And so, we love all of our products and our children equally, but some perform better in any given quarter than others. So, I would describe it as – as we look at the second half of the year, we feel very good about the ability of the broader product line to perform and produce results. I do think that, as I look at the pipeline specifically in archiving, those numbers are looking good. And, we feel very optimistic about some of the deals we expect to close. But, we'll obviously have another checkpoint in October where we can talk about how those numbers specifically came together.

[Walter H. Pritchard:]

Great. Thank you.

[Paul R. Auvil:]

Thanks.

[Operator:]

And, our next question comes from Gray Powell with Wells Fargo Securities.

[Gray W. Powell:]

Great. Thanks for taking the question. See, maybe back on the financial leverage side, can you help us think through the leverage in your business model in Q2? I mean, specifically you beat revenue guidance by just over $5 million, which is obviously very good. And then, pretty much all the upside flowed through to EBITDA. So, where do you feel like you're getting the most efficiency from a cost perspective? And then, how sustainable do you think that is?

[Gary L. Steele:]

Yeah. So, one of the things that we've talked about on and off in the past is, that, we have a very large R&D spend. For example, as compared to most companies our size because we have a very broad product line. And I think, again, kind of linking it back to the other broader performance of success with multiple products in the current quarter, the Q2 just ended. I think that we're getting to the point where, while we're going to continue to invest in R&D and add world-class talent to the team, I think we're at that point, where we can start to expect leverage on that R&D line, as we scale from here. As well, honestly on the sales and marketing line, as we continue to add world-class people around the world. That's great, it's added quarter capacity, but particularly that lever around renewal activity with our very low cost for our new customers given the way we structure the organization. I do think we're at that point where we should expect to see year-over-year improvements in sales and marketing spend as we grow up from here. With G&A running on a non-GAAP basis at about 6%, I don't see more leverage there. But I also do think realistically, as we work our way across the remainder of the year and into next year, we will continue to see improvements in the gross margin as we get better leverage on our – I think of it is manufacturing efficiencies of how we manage scale and operate the cloud.

[Gray W. Powell:]

Got it. Thank you very much.

[Operator:]

All right. Next from Stifel, we have Gur Talpaz.

[Christopher Speros:]

Hi. This is actually Chris Speros on for Gur. First of all, congratulations on the quarter, guys. Can you talk about the percentage of new and add on sales generated through the channel in Q2? And what we should expect this to look like going forward?

[Gary L. Steele:]

Yeah. So, the channel performed fairly consistently with what we saw in the second quarter, which was a little bit over half of the new and add-on business that we brought in for the company, came from the channel. And so, that's spot on with our expectations, obviously we aspire to continue to move that number up from here. But at this stage, given the size, scale and the scope of how we're operating the business, we think, that's a good balance as we continue to make investments in the channel. So, I can't remember the second part of your question related to that.

[Christopher Speros:]

All right. Can you also talk about, what kind of traction you are seeing, with Threat Response? And when you think, excuse me, when you expect this product to being to meaningfully contribute to the top line?

[Gary L. Steele:]

Yeah. So, we talked about in the prepared remarks that, the emerging product segment had done quite well in the quarter and Threat Response was one of those solutions that – where we had very good performance. While we are still at the early stages of revenue production with that particular solution, we feel very good about the traction we're getting. And so, as we move into the second half of the year, we anticipate we'll see, continued good traction. And I think, real meaningful revenue production happens further up, probably in 2017, but not probably in the next couple of quarters, but we feel like we're tracking well, taking share, wining our shared deals and there seems to be lots of opportunity there. So, we'll continue to report back on our progress with that particular product.

[Christopher Speros:]

All right. Thanks guys.

[Gary L. Steele:]

Thanks.

[Operator:]

All right. And moving on we have Gabriela Borges with Goldman Sachs.

[Gabriela Borges:]

Great. Thank you for taking my question. Paul, just one for you on the full year guidance – the preliminary guidance for next year, that's up 28% number. I know the business model lends itself very well to visibility. But, maybe if you could just comment a little on what are the one or two swing factors that you spent the most time on internally, when you were coming up with that forecast? Thank you.

[Paul R. Auvil:]

Yeah. I think, one thing in all condor is, we're always very thoughtful about setting a reasonable expectation, especially at this stage, as we look out to next year. And so, the most important factor for us being on just strong demand in the very healthy environment that we see in terms of spending is, we look at the core capacity that we've currently got built out and the teams that we plan to add across the course of the remainder of the year. Because really it's where we end up at the end of the year, that's sets the course for what we realistically are going to close for business spend in the following year. And so, as we look at that quarter capacity and our overall performance year-to-date in terms of average productivity that gave us a reasonable amount of confidence in a minimum growth rate number, 28%. I think that 28%, I think is particularly important to think about in the context of the over-performance we had here in the second quarter, and the rates for the remainder of 2016. So, when we talked about, at our Analyst Day, this notion of growing the company on a compound growth rate between 2016 and 2020 at 28% to 32%, think about the fact that at this point, we've basically put a growth rate out there for 2016, that's mid-30%s, slightly better for revenue. And so, we're starting with a low point at 28% here for next year. Obviously, we aspire to do better than that, but for now, when I think about my quarter capacity, I think about the overall outlook around the products, I think about our overall performance geographically, that's a number that we feel comfortable with at this stage.

[Gabriela Borges:]

That's helpful. Thank you. And as a follow-up maybe, for Gary. You mentioned the momentum that you are seeing as customers consider moving to the cloud, whether that's Office 365 or even broader? I would love to hear anecdotally, when you speak to customers about their plan for the cloud, do you find that the security roadmap and the cloud roadmap sort of moving in locked step together or do you find that one of them holds up the other?

[Gary L. Steele:]

Yeah. What we typically see is that, as organizations are planning their broader move to the cloud, the security teams now are playing an integral role in helping make that decision because oftentimes it's security that is the number one hurdle that they have to get comfortable with, before they'll make that broader decision. And so, one of the things that we've seen is customers engaging with us very early in their process now as they are planning their cloud transition. And it's giving us an opportunity then to work with them, frankly, in advance of them making their broader move to the cloud. And I think, that will be the more common theme in the coming quarters. But security clearly is the number one thing people are worried about before they make the jump into the cloud.

[Gabriela Borges:]

I appreciate the color. Thanks guys.

[Gary L. Steele:]

Thanks Gabriela.

[Operator:]

All right. Next from Wedbush Securities, Steve Koenig.

[Steve R. Koenig:]

Hi, gentlemen. Thanks for taking my call. Congratulations on the quarter. I want to ask you about early renewals, was there any significant upside from those apart from the linearity, you mentioned that helped the revenue? And then I'll just draw one quick follow up here. I would love to just get some color on your thinking about your decision to bundle imposter classification with basic products and kind of what motivated that move?

[Paul R. Auvil:]

Sure. So, on early renewals, we didn't see a market activity in net early renewals here in the second quarter of 2016 and hence we didn't call it out in the script. Every quarter is a little different in this regard and so when we see a material activity in that regard, it's something that we'll call out, but in this case, it wasn't really worth pointing out. We did have some, but it was a – when you net it against, we inherently always had some renewals that are also late for some reasons the customers can't get their paper work together and we're not going to cut them off, but they are showing good intention to get the process completed and so that net effect there was roughly kind of a zero. So in terms of a decision to bundle imposter email, the business email compromise solution, I'll let Gary to talk about it.

[Gary L. Steele:]

Yeah. There is kind of two factors. One is, you think about our new customers and then you think about our renewal base, our existing customers. Our view was, it was critical that our existing customers have this capability and so going back to our install base and asking them to pay for this did not seem like a rational way to approach it. And secondly, we view this as a critical catalyst opportunity to drive turnover in the marketplace. And so by including it, we actually think we're driving higher demand because we can't for basically the same subscription dollars turn people over and give them a capability they don't have today. So it's become a nice catalyst for us in going out to the market. I do think if we had a separate price on it, we would probably have more friction in the selling process.

[Steve R. Koenig:]

Got it. Great. Well that's helpful. Thanks a lot guys.

[Gary L. Steele:]

Thanks, Steve.

[Operator:]

All right. Moving on, we have Fred Grieb from Nomura Securities.

[Fred T. Grieb:]

Hey, thanks guys. Two from me, first there have been a few press reports about Intel potentially talking to the banks about selling their security business. I'm wondering if they were to sell off this business, if that could have an impact either on the end-of- life of the email security solution or your partnership with them?

[Paul R. Auvil:]

Yeah. We don't expect any change. If there was a different state of Intel Security, we don't think they would have any change at this at all.

[Fred T. Grieb:]

Got it.

[Gary L. Steele:]

Yeah. I think the one thing I'd add is, we have a pretty clear well-documented partnership that's executing really well. And, I think actually benefiting both parties as expected. So, whether that were to end up in the hands of another company or private equity were to buy it out, I think that well functioning set of machinery is something that's actually of value as part of our how that enterprise is operating right now.

[Fred T. Grieb:]

Got it. That makes a lot of sense. And then, just as a follow-up, I'm wondering if you can give us some color on the proportion of brand new customers, who are purchasing both TAP and email together rather than purchasing email security separately? I'm guessing it's greater than 50% but I'm wondering if you have a rough estimation for us?

[Gary L. Steele:]

Yeah. Anecdotally, it's really high. I don't have that number, I thought that maybe public, but anecdotally it's quite high and it is over 50%. Yeah.

[Fred T. Grieb:]

Got it. Thanks.

[Paul R. Auvil:]

It's natural that the customers would buy both things together, as they're looking to improve the quality of the email security solution that defends their email infrastructure whether it's on-premise or in the Office 365 cloud. So...

[Fred T. Grieb:]

All right. Thanks a lot.

[Paul R. Auvil:]

Thanks, Fred.

[Operator:]

All right. Next from Deutsche Bank, we have Taz Koujalgi.

[Imtiaz Koujalgi:]

Hey, guys, thanks for taking my question. I'm looking at the OpEx lines. It seems that for the time ever, your sales and marketing in absolute dollars went down sequentially from Q1 to Q2. And, your R&D had a big jump from Q1 to Q2, which seems a bit atypical compared to previous Q1 to Q2. Any color on why that R&D had a big jump, and why sales and marketing went down?

[Gary L. Steele:]

Yeah. With sales and marketing, keep in mind that we have among other things our sales kick-off in the first quarter. And so, that tends to something that will spike our spending a little bit. I think I even presaged that idea in the January earnings call, where I was talking about expectations for spending for the first quarter. As well, we do tend to frontload a little bit of our – what I call discretionary marketing spend, so the dollars that we spend on things that drive lead gen and demand for the company. And so, that's essentially the effect you're seeing in the sales and marketing trend. With R&D, there is – each quarter is a little bit different in terms of the timing of – as we add people and staffing and other expenses. But it's mostly driven by people. So, I guess I would just leave at that.

[Imtiaz Koujalgi:]

Got it. So, is it fair to assume that there is more front-end hiring, (55

[Gary L. Steele:]

I think we'll continue to add folks. But, yeah, I would say that the sequential growth rate in R&D as you look into third quarter and fourth quarter will probably be a bit lower than what you saw between Q1 and Q2.

[Imtiaz Koujalgi:]

Got it. Cool. That's very helpful. Thank you.

[Operator:]

All right. Moving on from Piper Jaffray, we have Andrew Nowinski.

[Andrew James Nowinski:]

All right. Thanks. Just a high level question on your protection business. You had 50% growth this quarter, which is the highest growth rate that you've had in nearly two years. And it's not coming off an easy comp. So I'm wondering if you can give us any color as to why you're starting to see an inflection in your growth rates now, as compared to last year when the market – the overall market was much stronger. And then, just wondering how sustainable that inflection is?

[Gary L. Steele:]

Yeah. I'll dive in and Paul may add some commentary as well. So a couple of things, so one is, again, I would emphasize the fact that we see no change in macro. So the buying environment today and the buying environment a year ago for us has been pretty much the same. Secondly, as we indicated this whole (56

[Andrew James Nowinski:]

Okay. And then just a follow-up question on your FY 2017 guidance. I know you said that this was essentially a starting point, but you've been beating and rising every quarter. So, is it fair to assume that the 28% growth rate is baking in further upside to your current FY 2016 guidance?

[Paul R. Auvil:]

No. I would say simply that given where we stand today, the 28% is a number that we're comfortable with as we look at a combination of what we've put out there for the remainder of 2016 and the current 2016 revenue guidance we provided, as well as that and what we think we can accomplish in terms of a growth rate in 2017 against that backdrop. Obviously, we're always aspiring to outperform in any given quarter, and that's certainly possible given our history of outperformance. But, we don't actually have that built in per se to how we think about the numbers.

[Andrew James Nowinski:]

Got it. Thank you.

[Paul R. Auvil:]

Thanks.

[Operator:]

Our next question comes from Craig Nankervis with First Analysis.

[Craig Nankervis:]

Thanks. Good afternoon and I echo the congratulations on the exciting tone of business. I was struck Gary, I think, I counted five – no, four Fortune 50 wins, three of them with north of 300,000 users. I don't recall hearing such a frequency of Fortune 50 wins in a single quarter before. Does this mean anything for you? Is there a new level of awareness among the largest companies out there of Proofpoint? Or was this sort of coincidental that all these deals came together – large deals came together in this quarter?

[Gary L. Steele:]

Yeah. Craig, I would say we had success across all the segments that we're targeting and selling to. And while we did have some just spectacularly nice wins, I would say it was very representative of every segment that we're serving. And again, I'd go back to the fact that we saw no change in macro, and we have a lot of conditions in the marketplace that are forcing people to rethink what they are doing, whether it be business email compromise or move to the cloud. All of those are fundamental catalysts for organizations large and small. And so, we feel very good about the future opportunity given the tailwinds we're experiencing.

[Craig Nankervis:]

So, it's more catalyst only – only means better things for you, perhaps at the high-end, is that a fair translation?

[Gary L. Steele:]

I think those catalysts apply equally to those large customers.

[Craig Nankervis:]

Right.

[Gary L. Steele:]

And those large customers obviously are big targets for business email compromise that are forms of threat. And they recognize that they need to modify their security position, and are willing to take the dollars they are spending with an incumbent vendor and give those dollars to Proofpoint.

[Craig Nankervis:]

Yeah. Thanks a lot. Good deal.

[Gary L. Steele:]

Thanks, Craig.

[Operator:]

Our next question comes from Tim Klasell with Northland Securities.

[Tim E. Klasell:]

Yeah. Thank you for taking my question. Just two quick ones here. First as far as your overall coverage in North America and Europe, obviously you are adding in a lot of heads, and what have you – do you feel you are 25%, 50% covered or, how much more room do you have to grow to fill in the white space?

[Paul R. Auvil:]

I honestly think it's very significant, even in North America quite frankly, we're hugely under distributed compared to the opportunity, whether we look at the Fortune 100, the Fortune 1000, enterprise, all those markets that we serve. And so, we'll continue to make investments to build out sales and core capacity to go after it. And again as you well know, given that we're mostly not in a Greenfield market, and given the fact that even in the markets that are more greenfield, it's a subscription business where we can ultimately go in and convince customers to move from whatever they've purchased over to the Proofpoint platform over time, which is really how we've been operating since almost the founding of the company. Yeah, we're comfortable with the idea that we don't have to be there first to a customer. We'll get there eventually, we'll pitch the world-class solutions we have, and then we'll ultimately persuade the customers to move over. So, hence we're able to essentially grow our sales investment in a methodical and thoughtful way, without feeling like it's a land grab or we have to be there first. So, as we look at Europe, for example, we're just fractionally represented in terms of the investment in sales infrastructure and quota capacity there as compared to the bigger, long-term opportunity. So, again, we have the opportunity to continue to methodically invest. In the last couple of quarters, we've really seen Europe come into its own with some very strong results. And, it gives us the confidence to go ahead and add more resources to that team to continue to kind of parlay and build on top of what they've now got as a nice momentum operating in that theatre.

[Tim E. Klasell:]

Okay. Great. That's very helpful. And then, on the product side, particularly on Threat Response, that's coming to its own, and maybe other emerging – any of the other emerging products. But what are you seeing there for pricing, because some of your earlier introductions had different pricing, what are you seeing for pricing for particularly Threat Response?

[Gary L. Steele:]

Yeah. I – Threat Response is roughly equal to the value of protection, roughly. And that's where we go in, we may discount a little bit off that, but that's roughly it. I would say we're still early in our price exploration, and we'll continue to update as we see more maturity in the pricing around that.

[Tim E. Klasell:]

Okay. Great. Very helpful. Thank you.

[Gary L. Steele:]

Thanks, Tim.

[Operator:]

We'll move onto Erik Suppiger with JMP Securities.

[Erik L. Suppiger:]

Yeah. Thanks for taking the question and congratulations.

[Gary L. Steele:]

Thanks.

[Erik L. Suppiger:]

Question on Palo Alto and McAfee. You've had a couple of quarters to assess the relationships, and I understand they are early, but if you look out maybe a year or maybe a couple of years, do you have a sense at this point whether or not the Palo Alto opportunity is similar or larger or smaller than what you think the incremental opportunity would be associated with the McAfee business?

[Gary L. Steele:]

Yeah. That's a great question, I mean, we're really pleased with how things have gone so far. And the one thing that is fundamentally true is that when it comes to the number of customers that Palo Alto in general has for their firewall solution, it rivals the number of and actually exceeds the number of e-mail security customers that the Intel security team has. And so if you think about – if the relationship really continues to gain steam and we can really drive this notion of a standard where the customer buys the Palo Alto firewall and definitionally also buys the Proofpoint e-mail security in advanced threat capability, and we get a very high attach rate there. You can make a pretty plausible argument that the Palo Alto opportunity over time is equal to or potentially, measurably bigger than what we see in front of us with the Intel Security/McAfee opportunity.

[Erik L. Suppiger:]

Okay. Very good and then secondly, did you say what the split between direct and indirect sales were in the quarter?

[Paul R. Auvil:]

We didn't, but for the new and add-on business, it was roughly, 60% came from channel, and about 40% came from direct, and again we look to move that number up over time. If you look at total bookings, there is a lot more total bookings that still come direct, simply because of our legacy of having established direct relationships and so we – of the earlier years of the business that keeps renewing year-over-year. And so that renewal base has a much higher representation in direct at this stage.

[Operator:]

All right, moving on, we have from Dougherty & Co., Catharine Trebnick.

[Catharine A. Trebnick:]

Hi. Thanks for taking our question, nice quarter. Coming to this McAfee, on the transition, when do you see the inflexion point of this. We've talked about where you are in the process, but where would you be on an inflexion point with this? And then the other question is, are you seeing more of the conversion coming from the SaaS or the premise base, McAfee installed base? Thank you.

[Paul R. Auvil:]

Yeah. So, let me start, and then Gary can add some color. So, to your point on the inflexion point, the last couple of quarters we've been at the high-end of the range of what we've historically seen in terms of business coming from McAfee incumbents. I can't really make a specific call on when we might break out of that range to a higher level. Pipeline going into the second half of the year is really solid. As Gary intimated earlier, the biggest customers who are mostly on-premise were given five years to move over. I think with this new migration tool that we've released, that might help, be one more catalyst to kind of accelerate that, but I guess while I know it's a bit of a non-answer, we will check back in October and give you more color there. But we're pleased to be operating at the high-end of our historical norms and feel like that's very good production now. In terms of where the customers are coming from, again, there is a much shorter timeframe on shutting down their SaaS business, which was very S&B focused with a smaller number of customers that were really relevant to the Proofpoint space. But we certainly saw very good production of opportunity as those customers, because of their – the time pressure, moved over. But we also closed some on-premise customers as well in the period. I don't actually have a specific number on that. But I think we're seeing good production from both areas right now.

[Catharine A. Trebnick:]

All right. Thank you very much.

[Paul R. Auvil:]

Thanks.

[Operator:]

All right. Next we have Ken Talanian with Evercore ISI.

[Ken Talanian:]

Hi guys. Thanks for taking my question. Just wanted to touch on renewals again here. I was wondering if the performance that you saw in the quarter, gives you any reason to believe that this will accelerate the inflection in cash flow that we typically see with SaaS models?

[Paul R. Auvil:]

I think, again, our renewal range; we always kind of confirm that it's above 90%. But the renewal rate does vary very much quarter-to-quarter. This quarter we were at the extreme high end of the range, which then really helped drive some additional revenue production and some cash flow, to your point, during the quarter. As I look going forward, we're going to continue to return to our planning norms at this stage, unless I see something would suggest otherwise. But with all that said, I think when you look at the fact that we raised our cash flow guidance for the full year, by several million dollars as compared to last quarter, and that that guidance, the $34 million to $38 million, at midpoint of $36 million is meaningfully above the $19 million last year. And then you think about some of the things that we talked about at our Analyst Day in June, around how we expect cash flow to track between 2016 and 2020, I think we're absolutely in the midst of that inflection point for the company, as you point out. As you look at SaaS models that have scaled from this state up to a $1 billion and there actually aren't that many publicly traded companies that have done that. But if you look at how they scale, it is this 12 months to 24 months period, where we should, if we execute well and things come together, should start to produce meaningful additional expansion in cash flow as we continue to grow the top line.

[Operator:]

All right. Moving on, we have Michael Kim with Imperial Capital.

[Michael Wonchoon Kim:]

Hi, good afternoon, guys. With the expansion in the product portfolio and especially with the growth in emerging products that you called out. Are you seeing a material increase in average deal size? Is that – a lot of activity being driven by large enterprise or are you seeing a sort of equivalent growth in midsize?

[Gary L. Steele:]

Yeah. So we don't talk about deal sizes externally, but I can tell you that, how should I say, we continue to do a lot of deals that are just a single product. I would say that anecdotally there are more deals that are coming through, where there is a two product deal initially mostly production and TAP. So likely that's driving people back as compared to a couple of years ago. The average deal size for any given customer, whether you're talking about a 1,000 seat account or a 5,000 seat account or 10,000 seat account or 100,000 seat account, that average initial deal size is likely trending upward, although we haven't talked about any of the numbers externally. And I think that's helping to drive some productivity with our sales organization, among other things. And more importantly, we believe it makes the customers that much stickier when they're applying two or more products as opposed to just a single solution.

[Michael Wonchoon Kim:]

Okay. Great. And then just on the Palo Alto partnership. A handful of deals that you closed in the first full quarter, were they all net new customers to Palo Alto and yourselves? Were number of those deals also part of the installed base?

[Paul R. Auvil:]

So they were, from just memory, and I don't have the list of customers in front of me, but they were essentially net new customers to Proofpoint who were already customers using the Palo Alto firewall and as a result of the partnership and seeing the benefit of – it's as we've talked about before, it's one more good reason to move off of whatever your legacy email security solution is and to move over to Proofpoint because you not only get world-class email security, but you then get that benefit of the integration between Proofpoint's email solution and their WildFire capabilities and so that's so far been our experience of what we've seen.

[Operator:]

All right. At this time, we have nothing further from the audience; I'd like to turn the floor back to management for any additional or closing remarks.

[Gary L. Steele:]

Great. Thank you very much. I just want to take one moment and thank everyone for joining us on the call today. We're very excited about the results from Q2 and we look forward to speaking to you in October for our Q3 results. Thank you so much.

[Operator:]

And that does conclude today's conference ladies and gentlemen, we appreciate your participation. You may now disconnect.