Proofpoint, Inc.
Q3 2017 Earnings Call Transcript

Published: 20 Oct 2017

[Operator:]

Good day, and welcome to the Proofpoint Third Quarter 2017 Earnings Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jason Starr, Vice President, Investor Relations. You may begin.

[Jason Starr:]

Thanks. Good afternoon, and welcome to Proofpoint's third quarter 2017 earnings call. Joining me on the call are Gary Steele, Proofpoint's Chief Executive Officer; and Paul Auvil, Proofpoint's Chief Financial Officer. We will be discussing the results announced in our press release that was issued after the market closed today, a copy of which is available on the Investor Relations section of our website. During the course of this call, we will 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 also based on assumptions that we believe to be reasonable as of today's date, October 19, 2017. 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 not reiterate or adjust the financial guidance provided on today's call unless it is also done through a public disclosure such as a press release or with the SEC on 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. So that said, I'll turn the call over to Gary.

[Gary Steele:]

Thanks, Jason. I'd like to thank everyone for joining us on the call today. The third quarter marked another great quarter for Proofpoint. We exceeded expectations across all of our key operating metrics and these results were once again driven by enterprise cloud migration, the rapidly evolving threat landscape, and our proven ability to identify, block, and remediate advanced threats. As we highlighted at our recent Analyst Day, the threat landscape remains highly active. Attackers are increasingly targeting people, not infrastructure through socially-engineered phishing attacks and email spoofing techniques, all of which are driving strong demand for our advanced threat solutions. In fact, an interesting trend that will be highlighted in our Q3 threat report next week is the tremendous increase in the use of Malicious URLs to distribute both Ransomware and Banking Trojans as compared to the prior quarter, with overall message volume increasing 85%, and Malicious URL campaigns up nearly 600%. Over the course of Q3, there were several high profile breaches that further reinforced the challenges that organizations face today. Given the nature of our cloud-based subscription driven business model, it is important to note that these episodic events do not contribute directly to our near-term results including those reported here in the third quarter. However, these highly visible incidents do create increased awareness at every level across every enterprise, which helps to drive long-term demand for our world-class solutions as Company seeks to protect their employees, their customers, and their suppliers in this increasingly perilous environment. Now turning to some of our key accomplishments during the third quarter. Our suite of advanced threat solutions including our Targeted Attack Protection, or TAP offering, continues to be important contributor to the growth of our subscription business. As a reminder, TAP is a cloud-based system that identifies and block messages with malicious attachments and URLs by uniquely combining the application of big data analytics and dynamic malware analysis to identify and block zero-day and polymorphic malware. We had a number of noteworthy TAP wins this quarter, including a Fortune 100 healthcare services company that added TAP for 265,000 users. A Fortune 500 medical equipment company that purchased Protection and TAP for 75,000 users, and a Fortune 500 engineering services company that purchased Protection, TAP, Threat Response, and Email Fraud Defense or EFD for 60,000 users. Beyond the broader threat landscape, the overall transition to the cloud and the shift to Microsoft Office 365 in particular continues to be a long-term catalyst that is helping to drive the demand for Proofpoint’s broader security and compliance solutions. Examples of deals won this quarter where we displaced on-premise security appliances as part of the migration to Office 365 included a university that purchased Protection, TAP, Privacy, EFD, and Threat Response for over 27,000 users, a large media company that purchased Protection, TAP, and Threat Response for 62,000 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 bundles. Examples of customers who had moved to Office 365 and subsequently decided to upgrade their security and compliance capabilities during the third quarter included

[Paul Auvil:]

Thanks, Gary. We were very pleased with our ability to once again exceed expectations across all of our key financial metrics during the quarter. Third quarter revenue totaled $134.3 million, up 35% year-over-year and above our previously announced guidance range of $130 million to $132 million. Billings for the third quarter were $166.5 million, an increase of 33% year-over-year and also above the high end of our previously announced guidance range of $162 million to $164 million. As expected, contract duration remained at the lower end of our historical range of 14 months to 20 months. And this trend is reflected in our deferred revenue balances, which ended the quarter at $392.5 million in total, up $32.2 million sequentially with short-term growing by $27.7 million and long-term growing by only $4.5 million. Turning to expenses and profitability for the third quarter. On a non-GAAP basis, our total gross margin was 78%, which was above our expectations driven by the revenue upside delivered during the quarter, coupled with our ongoing improvements in the efficiency of our cloud operations. During the third quarter, total non-GAAP operating expenses increased 37% over the prior year period to $91.6 million, representing 68% of total revenue. Growth in spending was primarily driven by hiring in sales as we continue to add key talent to drive new customer acquisition and add-on sales to our existing customers, while spending in R&D was less than expected due to slower hiring over the summer months with growth likely to return in Q4 as our hiring activity picks up. In terms of profitability for the quarter, we reported non-GAAP net income of $13 million, above our guidance range of $8 million to $9 million driven by the revenue upside delivered during the quarter without a commensurate increase in spending. I would like to note that $1.2 million of this upside performance when compared to our guidance for the quarter came from other income and expense as a result of favorable currency adjustments and higher interest income, and as such, when adjusted for these effects, we delivered $11.8 billion in net income still a very nice result when compared to our guidance. Non-GAAP earnings per share for the quarter was $0.25 per fully diluted share, above our guidance range of $0.16 to $0.18. Note that EPS calculation applies the “If-Converted” method to both series of convertible notes, and as such, adds back the $1.06 million in cash interest associated with the convertible debt and uses 55.4 million fully diluted shares. We've 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 totaling $22 million, or $0.49 per share based on 44.4 million shares outstanding. In terms of cash flow, we generated $44.2 million in operating cash flow and invested $11.9 million in capital expenditures resulting in free cash flow for the quarter of $32.3 million, or 24% of total revenue. This result was above our guidance range of $26 million to $28 million driven by another strong quarter of billings and collections activity. We ended the third quarter with $460 million in cash and short-term investments and $381 million in debt, compared to $420 million in cash and short-term investments and $378 million in debt as of June 30, 2017. This sequential increase in cash during the quarter was driven primarily by cash generated from operations as well as contributions to capital from stock option exercises. Now turning to our financial outlook starting with the fourth quarter of 2017. We currently expect billings to be $180 million to $182 million resulting in year-over-year growth of approximately 31% at the midpoint. We are targeting a revenue range of $138 million to $140 million, or 30% growth year-over-year at the midpoint. We expect fourth quarter non-GAAP gross margin to be approximately 77.5% relatively consistent with the third quarter. We expect fourth quarter non-GAAP net income to be $9.5 million to $10.5 million, or $0.19 to $0.21 per share, a modest decline from Q3 as our level of spending catches up with our revenue performance along with the absence of contributions from fluctuations in foreign exchange rates. This assumes an income tax provision, exclusive of discrete items of $0.9 million to $1 million during the quarter. Depreciation of approximately $7 million and a share count of 55.7 million fully diluted shares outstanding, and of course, adding back the quarterly cash interest expense of $1.06 million for our two series of convertible notes as prescribed by the If-Converted method. I would like now to provide some additional commentary on the assumptions that are included in our guidance for fourth quarter for the cash flow. First, we've started to transfer the intellectual property developed by the team at FireLayers from Israel to the United States, which we expect will result in a one-time tax payment of approximately $4 million in the fourth quarter. Second, we expect capital spending to be approximately $13 million this quarter, which includes an additional $3 million for a combination of investments in the ongoing expansion of our next generation SaaS cloud system that was described last quarter as well as facilities expansions for our operations in Canada and Israel. With this in mind, we expect free cash flow to be in the range of $25 million to $27 million, or 19% of revenue at the midpoint. Turning to our financial outlook for the full-year. We are increasing our annual guidance driven by our Q3 over performance and the expected ongoing strength of the business. Specifically, we now expect full-year 2017 billings to be in the range of $630 million to $632 million which represents an annual growth rate of 36% at the midpoint of the range. This compares to our previous guidance of $625 million to $628 million. We are also increasing our total revenue guidance with a new range of $508 million to $510 million representing an annual growth rate of 36% at the midpoint. This compares to our previous total revenue guidance of $503 million to $506 million. We expect full-year 2017 non-GAAP gross margins to be approximately 77% demonstrating ongoing progress toward our 2020 target range of 77% to 79%. As a result, we expect full-year 2017 non-GAAP net income to be $36.1 million to $37.1 million, or $0.73 to $0.75 per share, an improvement from our previous guidance range of $30 million to $31.5 million, or $0.62 to $0.64 per share. Our new non-GAAP EPS guidance for 2017 is based on approximately 55.4 million fully diluted shares outstanding and adding back the $4.2 million in cash interest expense as prescribed under the If-Converted method. Our guidance also assumes depreciation of approximately $24 million and an income tax provision, exclusive of potential discrete items of approximately $3.7 million to $3.8 million. Finally, let me provide some additional color on our free cash flow guidance for the full-year given some of the moving parts. Recall that last quarter, we provided a range of $100 million to $107 million which did not anticipate the previously described $4 million tax payment for the transfer of intellectual property from Israel to the U.S. Adjusting for this effect, last quarter's guidance range for the full-year would have been $96 million to $103 million. So in this context, we are raising our free cash flow guidance for the full-year to $101.5 million to $103.5 million representing a $3 million increase to the midpoint of the previous range and equating to roughly 20% of annual revenues. As previously noted, this guidance also reflects a modest increase in our full-year capital spending to approximately $48 million, up from our previous guidance range of $44 million to $46 million. As a reminder, we are producing this cash flow with an average billed contract duration in the mid-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. As we look to 2018, we believe that we are well positioned to build on our momentum this year and demonstrate continued progress against our goal to generate over $1 billion in revenues in 2020. While we are still in the early stages of our planning process, I would like to share a preliminary view regarding our 2018 financial outlook. Note this outlook reflects our current accounting methodologies and as such does not include any potential impacts to either revenue or net income associated with the pending adoption of ASC 606. As already indicated in our 10-Q filings, we do plan to adopt ASC 606 using the full retrospective method which will enable investors to view our historical trends in the context of this new accounting methodology when we report results in April of 2018. We currently estimate 2018 revenues to be in the range of $644 million to $648 million representing 27% growth for the midpoint of our updated guidance, consistent with the low end of the range in terms of the growth required to achieve the 2020 targets that we shared at our Analyst Day in September. We expect billings to be in the range of $798 million to $802 million, up 27% at the midpoint of the range and in line with our expected revenue growth rate assumptions. Given the timing of the renewal activity in our installed base, we do expect billings to be down sequentially from Q4 to Q1 and then to gradually increase over the course of the year. With regards to non-GAAP net income, we expect growth of almost 50% from this year's midpoint with a range of $50 million to $54 million, or $0.96 to $1.3 per diluted share using 56.3 million fully diluted shares outstanding for the year and adding back the annual interest expense on the convertible bonds of $4.2 million. Finally, we currently expect our free cash flow to grow by more than 30% year-over-year to approximately $135 million or 21% of revenue demonstrating good progress toward our 2020 free cash flow target of 24% to 26% revenues. We believe that this outlook is particularly compelling giving our commitment to innovation and the ongoing investments we are making to pursue the key opportunities in the market. This 2018 guidance assumes capital expenditures of approximately $45 million. The guidance assumes depreciation of roughly $30 million to $32 million, cash interest expense associated with convertible debt of approximately $4.2 million, and an income tax provision exclusive of potential discrete items of approximately $2 million to $3 million. Similar to past years, we do plan to further refine our 2018 forecast as we complete our planning process and gain additional insights from the extended network of partners and sales channels. Also keep in mind that the first quarter is always a step backward in terms of profitability and cash flow for the Company as our first quarter includes seasonal increases in costs associated with payroll taxes, sales kickoff, initial sales and marketing investments for the year, as well as the timing of payment to the Company's annual bonus program. A reconciliation of our GAAP to non-GAAP guidance for the fourth quarter and the full-year 2017 can be found in our release that we issued this afternoon. So in summary, we have a very strong third quarter and believe the Proofpoint remains well positioned to maintain momentum for the remainder of the year and into 2018. Now before turning it over to the operator for questions, I would like to request that everyone limit themselves to just one question to help reduce the duration of our call and to ensure that everyone has a chance to be included in today's discussion. Thank you for taking the time to join us on the call today. And with that, we'd be happy to take questions now. Operator?

[Operator:]

Thank you. [Operator Instructions] We will go first to Walter Pritchard with Citi.

[Walter Pritchard:]

Hi, thanks. Gary, I'm wondering maybe you could talk about as you look into next year, the sales hiring you did that kind of build out the investments you made during 2017. How are those changes as you look to make some of those investments now and into early 2018 to build the base to be able to grow?

[Gary Steele:]

Yes. And a great question. We will continue to grow our team here in the U.S. We will grow across both our inside sales organizations as well as our field organization, and we clearly see a tremendous opportunity internationally and specifically, we will grow our EMEA team at a reasonable clip.

[Operator:]

[Operator Instructions] We will go next to Matt Hedberg with RBC Capital Markets.

[Matt Hedberg:]

Hey, thanks for taking my question guys. Gary, given the high-profile breaches we saw this last quarter, I'm wondering did you see any sense in change, call it urgency in buying behavior. And then any comment on federal spending for this past quarter?

[Gary Steele:]

Yes, so with respect to the high-profile breach et cetera that happened in the quarter, what I think we continue to see is executives and companies understanding their risk associated with these breaches. And I don't know whether there is urgency, but there's just a general increase in awareness. And as we indicated in our prepared remarks, we don't see these episodic events as something to drive short-term business for us, but we do see the broader visibility of cybersecurity becoming a much – continue to be a high priority for organization. So we think that it fundamentally fuels great long-term demand. And the second question, remind me Matt?

[Matt Hedberg:]

The federal, any thoughts on federal spending?

[Gary Steele:]

Yes. So our federal business is relatively small. If you look across those federal government spending as well as state and local, we're mid single digits in terms of overall percentage of business. So it's relatively small. And so we didn't really – we weren’t broadly distributed enough to have much comment in terms of what we saw in federal. What we’re excited about though is we are seeing nice pipeline build and some of the initiatives within federal, one, broader move into the cloud, and two, there is a broad movement towards authentication of email. There's a number of initiatives that we see in federal that we think will fuel nice growth in 2018 for Proofpoint.

[Matt Hedberg:]

Thanks guys. Great quarter.

[Gary Steele:]

Thank you.

[Operator:]

We will take our next question from Melissa Franchi with Morgan Stanley.

[Melissa Franchi:]

Hey, thank you for taking my question. Gary, Office 365 continues to be a driver for you. I was just wondering at what point do you think we are in terms of the maturity curve in Office 365 adoption within enterprises and have you seen a change at all in your selling process around Office 365 in terms of just like the conversion of your solution when enterprises adopt Office 365?

[Gary Steele:]

Yes, a great question. So first on adoption, I think there's – what we see is broad resonance across enterprise buyers today that they believe that they're going to go into cloud. And the question is how far along are we in terms of people actually having gotten there? And just from a qualitative point of view, I would say it's kind of in the 20%, 25% range, and I think we still have a very long way to go. And in particular, there's a number of verticals that have been slow to go that represent a lot of seeds like financial services. In terms of the buying process of those organizations considering cloud, I think one of the things that we see is a better understanding of the security concerns as it relates to the move to the cloud, and so I think we're being brought in more frequently and I think that bodes well for us. The typical process though is customers typically want to test our core capabilities against the core capabilities on Microsoft. And so the thing is encouraging to me as we continue to see customers be more knowledgeable and wanting to bring us in earlier in that process as opposed to going to Office 365 and trying it out before they rethink it.

[Melissa Franchi:]

It makes sense. Thank you.

[Gary Steele:]

Thank you.

[Operator:]

We will take our next question from Gray Powell with Deutsche Bank.

[Gray Powell:]

Great. Thanks for taking the questions. So on the margin side, you guys saw some pretty good margin leverage in Q3. Can you talk about the main drivers there particularly on the gross margin side and then just the sustainability of that going forward? Thanks.

[Paul Auvil:]

Yes. I mean, I would say, first of all, we had a great revenue quarter and so we delivered results that were a bit above where we expected to be even kind of at the high end of where we thought things might reach too. And so you've got that going on against your current level of spending and investment. But I think the margin expectations we talked about on a gross margin basis for 77.5% in the Q4, I think is the right target for us to be operating to. As I think some of the spending does start to kind of catch up, but again the fact that for the full-year, we're talking about being at 77%, which is the low end of our 2020 model with 77% to 79%. I think it demonstrates that we are seeing some nice ongoing leverage out of the model. We've seen a nice improvement in gross margins over the last year and year and a half. And so again, if you think about the guidance that we just provided for 2018, what we didn't guide specifically to gross margin, we do expect to see ongoing modest incremental improvements sort of quarter-to-quarter. Some quarters up a little bit, some quarters not up quite so much depending on some of our timing of investments, but we feel like we've got a good trajectory on gross margin here over the next several years towards that 2020 target.

[Gray Powell:]

Understood. Thank you very much.

[Paul Auvil:]

Thanks.

[Operator:]

We will take our next question from Jonathan Ho with William Blair.

[Jonathan Ho:]

Can you hear me okay.

[Gary Steele:]

Yes.

[Paul Auvil:]

Yes.

[Jonathan Ho:]

Perfect, so I just wanted to start out with a question in terms of the level of investments that you need to make to support some of the emerging products particularly for 2018?

[Paul Auvil:]

Yes. So from a capital spending perspective, I’ve talked a little bit about this next generation SaaS platform. It's not really related too much to the new products. It's more – think of it’s sort of a reimagination with some of the core elements of how we're operating our cloud at scale right now, which I think we'll see some nice leverage on as we work our way into 2018. For the newer products whether it's the Email Fraud Defense product, Domain Discover a lot of those – they're sort of they build on large datasets that are already kind of fixed costs that we operate. So while there are some variable costs as we scale, we do see very nice incremental margin fall through on those as we close customers and drive additional revenue against that that fixed cost component.

[Gary Steele:]

Again, all those things integrate to the Nexus platform and the Nexus platform basically has a pretty steady cost profile. So we're getting leverage as Paul described. So we're pretty excited about all of these will contribute to the growth and profitability of this whole cohort of emerging products over the next couple of years.

[Operator:]

We will take our next question from Ken Talanian with Evercore ISI.

[Kenneth Talanian:]

Hi, guys. Thanks for taking the question. So I was wondering if you can rank order the growth drivers and any changes in your expectations around the contribution from renewals that are factored into your 2018 billings guidance.

[Paul Auvil:]

Yes. From a renewals perspective, we continue to expect the same kind of performance that we've seen historically. Renewals rates consistently over 90% as measured on a recurring revenue basis. We had another very solid year in that regard here so far in 2017 and don't expect to see any changes in that as we look to 2018. In terms of rank order and things that drive growth, obviously the emerging products are – or the margin, a nice catalyst for driving growth, but our core TAP product continues to be a meaningful contributor to the new and add-on business. And Gary…

[Gary Steele:]

Yes. I think it’s actually really two simple things that echo what Paul said that it move to cloud, so this broad movement to the cloud is it's fundamentally creating displacement and disruption that we're taking advantage off, and two the threat landscape is extremely challenging and so it allows us to go in and sell Protection and TAP to all those customers. So those two things are really the primary two key growth drivers for the Company and everything falls behind that.

[Kenneth Talanian:]

Great. Thanks very much.

[Gary Steele:]

Thanks.

[Operator:]

Our next question will come from Phil Winslow with Wells Fargo.

[Philip Winslow:]

Hey, thanks guys. I just had a question on the just sort of the competitive/pricing environment. Just anything that you've been seeing out there in terms of the change in dynamics sort of as we move into the second half year versus the first half, or over last year, and just kind of how are you thinking about those pricing dynamics going forward when you were contemplating the 2018 guidance? Thanks.

[Gary Steele:]

Yes, I'll start and Paul will jump in. We saw the competitive dynamic very much steady from the first half into the second half. But one thing that we have benefited from and saying that though is because of the success of the emerging products and you could hear it in the examples we gave. We're having very good success in customer engagements where we're not only selling Protection and TAP, but we're adding those emerging products on to those transactions. So the net effect of that, Phil, is we're seeing bigger transactions than we saw say in the first half as the ramp of the emerging products has really come on. So we're super encouraged by that and then we think about how that that plays out in 2018, we do believe that we're going to continue to see that benefit and that uplift from these emerging capabilities bolted on or tacked on to transactions wherein – with the Protection and TAP deal originally. Would you add anything to that Paul?

[Paul Auvil:]

No, I think that’s well said.

[Operator:]

Our next question will come from Andrew Nowinski with Piper Jaffray.

[Andrew Nowinski:]

Thanks. I just wanted to ask about your win rates versus Microsoft and whether you could give us any color on your win rates in the quarter in two scenarios. So number one, where the customer chose Microsoft initially and then came back to Proofpoint. And then two, where the customer move to Office 365 and chose Proofpoint anyway instead going with the Microsoft Solution? Thanks.

[Gary Steele:]

Yes, I think in both of those scenarios, our win rates are extremely high. So when someone taps us head to head against Microsoft, our win rate is just extremely high like well over 90. The place obviously where we balance that is we have to insert ourselves into that decision when they go to Office 365, so one of the things we continue to focus on is not missing those opportunities through expansion of channel et cetera. But our win rate when tested, it’s really high.

[Andrew Nowinski:]

Thanks.

[Operator:]

Our next question will come from Steve Koenig with Wedbush Securities.

[Steve Koenig:]

Thank you. Hey, Gary. I wanted to pick up on the last theme in the channel. Being present in the Microsoft decisions, it sounds clearly an important goal. Maybe beyond that at an even higher level, as you're working to expand your channel, I believe you decentralized it early this year, can you talk a little bit about qualitatively what goals you're trying to accomplish in the channel this year? And any sense of kind of what sorts of metrics you're managing to, whether it's percent, fulfilled through partners percent of influence, how should we think about that?

[Gary Steele:]

Yes. I'll jump in here and Paul will probably have some comments as well. So one of the things that we have done a phenomenal job on is driving great relationships with big national resellers, like an Optiv, and that has worked phenomenally well for us. Over the course of the last year to year and a half, we've now been engaging more frequently with the regional resellers that have very good relationships either in particular verticals or a particular set of accounts. And so we're growing our channel presence through growing relationships with those regional providers giving us broader and deeper reach across the U.S. and more broadly internationally. So as we think about there's a number of metrics that we use, but one of the key metrics that we use internally is just simply looking at what – how much business the channel is bringing us. And that continues to show great progress quarter-over-quarter. Do you add anything to that Paul?

[Paul Auvil:]

No, that's right on.

[Steve Koenig:]

Great. Thanks a lot guys.

[Operator:]

Our next question will come from Sarah Hindlian with Macquarie.

[Sarah Hindlian:]

Thank you very much. I wanted to talk a little bit with you guys about the duration. It continues to trend towards the lower end of that 14 to 20-month range, you’re seeing? And it would be really helpful to kind of understand what the dynamics there are that are driving that trend.

[Gary Steele:]

Yes, and that’s a good question. And honestly, the dynamics driving that trend are how we're running the business and quite frankly, how we incent our sales people to go out and structure and close contracts. Our view is that with shorter duration contracts in terms of billing terms, we get better pricing in terms of price per users on the various products that we sell them. And so given our very, very high renewal rate, it drives a much higher lifetime value of the customer for us. And so our goal obviously would be possible to get to 12 months, but we're always have customers that when they look at the products, they really like what they see and they just choose to make a commitment and write a check for two or three years of paid service in advance. We offer very, very nominal discounts for that, but there are some customers who in this interest rate environment view that as attractive and we will opt for that. That’s fine. We're happy to do that, but our preference is always do one-year deal. And again, above and beyond just the opportunity to drive more lifetime value from the customer, obviously every year when there's a renewal, it creates yet another international entry point to drive that on sales, which is a key part of how we drive growth for the business and also make those customers that much stickier in terms of the strategic value that we provide and hence, the role they view us is playing in the enterprise.

[Sarah Hindlian:]

That’s very helpful.

[Gary Steele:]

Thanks.

[Operator:]

Our next question will come from Tim Klasell with Northland Securities.

[Tim Klasell:]

Yes. Good afternoon, everybody, and thanks for taking my question. Just a quick question, I didn't hear as much around archiving and wondering how that is doing and how the margin structure on the archiving product is when compared to the security side currently.

[Paul Auvil:]

Sure. That’s a good question. As we had talked about in the past calls, we did expect our archiving governance and privacy segment to decline in terms of year-over-year growth rates, and so you saw that in the numbers this quarter where the growth rate number in the 20%-ish range year-over-year for that segment. Archiving continues to be one, very important because we have very large customers that are committed in using that and driving really nice revenue streams for the business. It’s also incredibly sticky as you could imagine. But as Gary mentioned, I think in the prepared remarks, it also helps to round out this comprehensive portfolio of being able to provide all of our customers, the full suite of everything that they need to move their email to the cloud and deal with all their security and compliance needs, not only for email operating the cloud, but their compliance needs when they're allowing their employees to interact in social venues for example Box, Dropbox content shared through those venues. We can archive all of that and of course provide our DLP compliance there. So that's suite is a really important part of what helps our customers view us as a full service provider. The ongoing march of closing and driving growth there as we've again sort of foreshadowed in the last several quarters on the call is kind of a long, slow, steady ramp, but we're excited about where it's going and have some really interesting deals in the pipeline that we hope to close sometime over the next couple of quarters. So with that said, I think in terms of the margin question, it's a little bit below your current average margin which you see reported for the quarter, but it's very compelling when you net out of the gross margin dollars and contribution to cash flow, which I think is the probably most important metric to think about as the company grows above or beyond just our revenue growth rate.

[Tim Klasell:]

Great. Thank you.

[Operator:]

Our next question will come from Gur Talpaz with Stifel.

[Christopher Speros:]

Hi. This is Chris Speros on for Gur. You saw a nice growth in your international business in Q3. Can you talk about the primary drivers of this growth, and if GDPR related spend played any role?

[Paul Auvil:]

Yes. I think that we're very pleased with the results from an international team with putting on nice growth. We continue to see ourselves winning nice marquee accounts across the territories we serve. We're excited as we look forward to 2018 and the opportunity that we can drive across EMEA. We have been engaging with customers as it relates to their GDPR requirements. I think it's very early and I don't think we're getting GDPR sales yet, but I do think as we work our way into 2018 and we get too closer to the GDPR deadline. I do think that it will be a longer term catalyst for growth in the EMEA area.

[Christopher Speros:]

Thank you.

[Operator:]

Our next question will come from Anne Meisner with Susquehanna.

[Anne Meisner:]

Hi, thanks. Nice quarter. Just a quick follow-up on the federal side, Gary, I think you alluded to this, but with respect to the news that without the other day about the DHS directive that requires other federal agencies to enable DMARC and some other basic email security protocols. First of all, I assume that many of them are already compliant with that maybe that's a bad assumption, but maybe you can elaborate on whether you would expect the response to be simply enabling more encryption and other standard email protocols or would you expect the agency to sort of re-evaluate their broader email initiatives as a result of this threat security initiatives? And then if so I assume there would be some implications for Proofpoint?

[Gary Steele:]

Yes. Great question, and it’s super early to try to figure out exactly how this is going to flow through, but just a couple comments. So one on the authentication side, so the requirement to get to the DMARC standard. There's very few organizations ever got there. So that's a big hurdle for these federal agencies to jump over. We view this is an opportunity for Proofpoint frankly given the capabilities that we offer with Email Fraud Defense or EFD. We think we can be a great partner to those federal agencies to help them get to that standard. So that and itself I think will drive some demand for us still early to understand the magnitude of that, but we're excited about it. With respect to the encryption side of things, some of that can be handled relatively easy through a standard configuration in their e-mail environment. I don't know that that in particular is much of a catalyst for growth. But I do believe broadly speaking that these kinds of initiatives bring greater visibility to what we do and I think will be more involved with customers decisions and take a more consultative role to help organizations figure out and the federal government what they need to do to be conformant. So I don't know that there's a short-term hit here into the positive, but I do think it does drive great demand in the federal space where we've been investing and we're hoping to take advantage of it.

[Anne Meisner:]

Very helpful. Thank you.

[Gary Steele:]

You bet.

[Operator:]

We'll take our next question from Gabriela Borges with Goldman Sachs.

[Gabriela Borges:]

Great. Good afternoon. Thanks for taking my question. Gary, you touched on the prepared remarks a little bit on some of the displacement opportunities from on-premise email security has cost as move to the cloud. I’m hoping you can also comment on where you see opportunity from taking share as customers already have pushed to switched to SaaS Email Security, if they switch with another Email Security provided and then come back to Proofpoint. I guess it touch us a little bit on the Microsoft question that was asked earlier?

[Gary Steele:]

Yes. No, and one of the things we noted in a prepared remarks, is we do see a reasonable number of customers that make that move to the cloud from some on-premise solution. They utilize the solutions by that particular cloud provider whether that be Microsoft Office 365 or Google G Suite and then it's oftentimes the case either because of advance threads getting through or email spoofing happening that they then make the decision to go to something else and that's creates a great opportunity for Proofpoint. And so that's been a very common case and it happens and we actually noted it specifically in our prepared remarks because that’s such a common case.

[Anne Meisner:]

Thanks, appreciate the color.

[Operator:]

We'll take our next question from Erik Suppiger with JMP.

[Erik Suppiger:]

Yes, thanks for taking the question. With regards to Google, can you talk a little bit about the discussions that you having with them and your new board member might of the fact that they acquired posting a few years back and that seem so G Suite is starting to become more of a catalyst, are they acknowledging that posting is not sufficient for their customers or how are they looking at their security capabilities.

[Gary Steele:]

Yes, I’ll start one we're thrilled to have Kristen join the board. We think she'll be a great addition to the board given her operational and strategic experience. We think that she'll be a quite critical role as we think about going to business $2 billion and beyond. Having said that, the correlation between Kristen joining the Board, and discussions with Google are not related, we do see that the Google G Suite opportunity continues to exist. We see customers that go to G Suite and then they look for something additional in the way email security. We've done phenomenally well with those customers. We have seen a greater presence of Google in the marketplace and we do see our target customer as a result number of our target customers adopting Google G Suite over Office 365. And so we think that is and interesting in market but there shouldn't be any interpretation between Kristen joining the Board in that market opportunity.

[Erik Suppiger:]

Good, thank you.

[Operator:]

We'll take our next question from Patrick Colville with Arete Research.

[Patrick Colville:]

Hi, there. The Deloitte email hack though was not necessarily this month. Could any of Proofpoint's products done anything to prevent the insurance and or lessen the impact of that breach?

[Gary Steele:]

It is always difficult to fully understand exactly what happened there environment. So I would be very hesitant to make any prognostication about exactly what went on there. We do understand though it was email related, phishing related attack and it's one of the things that we excel at. So it does clearly great an opportunity for us.

[Patrick Colville:]

Okay, thank you.

[Gary Steele:]

Thanks.

[Operator:]

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

[Gregg Moskowitz:]

Great. Thank you. Paul, I just had a question on the 2018 guidance. If we back out the one-time tax payment in Q4 associated with FireLayers expected free cash flow margins are flat in 2018 even though operating margins are expanding in CapEx is expected to be just a bit lower next year? Can you walk through why you're not currently expecting to see some free cash flow margin leverage next year?

[Gary Steele:]

Yes, I think it's a good way of thinking about the problem, if you take the fourth quarter numbers adjust for that one-time item and then annualize it. In the current guidance we're adding roughly $80 million to our billings number and we're increasing the cash flow number by a little under 20% of that, I think honestly as we just step back it's October at this point and we kind of think about the different moving parts in terms of investments and making assumptions around sales efficiencies here early in the planning cycle. We thought this was the right place to start. But I do feel that even with the guidance as presented as I think about the ongoing margin evolution from results as we expect them to come out here in 2017, current guide for 2018 and in the March toward 2019 and 2020. We continue to feel good about getting to that 24% to 26% range that we talked about in 2020.

[Gregg Moskowitz:]

Okay. Great thanks.

[Operator:]

Our next question will come from Alex Henderson with Needham & Company.

[Daniel Park:]

Hi, this is Dan Park on for Alex. Thanks for taking my question. So I just want to hear your thoughts on the partnership with Palo Alto and our future partnership that opportunities, especially as a transition their business model to a data link driven platform they announced during the Analyst Day?

[Gary Steele:]

Yes, great question. So we've had great success working with Palo Alto and we've been thrilled with the results from that particular partnership. We've seen great the basis for that relationship has been strong technical integration between our Targeted Attack Protection solution and their WildFire solution. It’s really resonating with customers and I find that it's played and frankly a much bigger role that we ever thought it would. It is worked really well. Having said all that, we follow Palo Alto innovation closely and we're always looking for additional areas where we can provide integration and so that's something that will clearly evaluate and look at to see whether are there other critical integration point that would be of value to our customers. So we are excited about what they're doing and we think that the work that we're doing here dovetails quite nicely with it. In terms of other partnerships outside of Palo Alto today, our partnership have been limited to Palo Alto, CyberArk, Imperva and Splunk. I do think there's opportunity to select some more we're being very cautious about this and trying to identify people where we think that there's great customer overlap and opportunity and over the course the next 12 months we'll likely announce a couple more partnerships.

[Operator:]

We'll take our next question from Jayson Noland with Robert W. Baird.

[Jayson Noland:]

Okay great. Paul, I wanted to ask on FX what do you have baked into the FY 2018 guidance and then what's the impact on revenue versus billings, which we expect there?

[Paul Auvil:]

Yes, so I wouldn't pretend to know more about the FX markets and the guys that trade currency everyday. So we're using current exchange rates is the assumptions for both fourth quarter 2017 and then into 2018. So there's a – as you know that the – there was a significant change in valuation between the dollar and the euro going back a couple of years now roughly. And now you see in the euro make a little bit of a comeback. So there is a very modest positive impact to both billings and revenue in the 2018 timeframe, but literally think of that is like $1 million maybe $1.5 million, it's not significant. And then on the cost line again a small nominal impact against our cost basis of people located on the continent as well as the team in the London. So it's small enough that I just I didn't bother to call it out as unique factor, but we will keep an eye on exchange rates if they move more meaningfully that might be something that will call out specifically as we did several years ago when the euro first made its big move.

[Jayson Noland:]

Okay. Thank you.

[Paul Auvil:]

Thanks.

[Operator:]

We'll take a question from Michael Kim with Imperial Capital.

[Michael Kim:]

Hi, good afternoon, guys. You called out Threat Response on the highlights the merging products category and just kind of curious and a number of vendors talked about orchestration and automation recently and like to get your perspective on market maturity and if you're seeing more head-to-head evals? Or is it still relatively Greenfield opportunities for you?

[Gary Steele:]

Great question. We have seen a significant increase in demand and it's really played through our numbers. We're very excited about the results that we reported in current quarter. Where we've seen the traction has been with a specific use case in our Threat Response environment. So we call it TRAP, so Threat Response Auto-Pull. It’s the capability that allows someone in a security operations center to be able to pull out one or multiple copies of messages, they got delivered that we know at a later date is malicious. And so it then automates and shortens the time for which you can remediation that particular action. And it's that specific use case that has been driving the demand. And to your point about the orchestration and automation space, it is relatively new, it is very Greenfield, and the theme that we continue to hear is that customers are looking to create more automation and efficiency given the lack of headcount and resources that they have. And so we've really played on that and driven success around this specific use case because it's a clear winner in terms of automating things that have traditionally been super manual.

[Michael Kim:]

Got it. Great. Thank you very much.

[Gary Steele:]

You bet.

[Operator:]

Our next question will come from Catharine Trebnick with Dougherty.

[Catharine Trebnick:]

Thanks for taking the question. Competitively, we haven't talked about Cisco, Symantec or even Mimecast. And you did say in some of the early remarks that you're really pushing forward and building out your regional market, and in the regional markets are there any particular competitors that you're coming up against more than others? Thank you.

[Gary Steele:]

Yes, I would say our competitive landscape is very consistent, so we obviously run into the incumbents. The people like Cisco and Symantec that have wide market share and so we clearly see them. As we've noted earlier in the call, when customers move to the cloud, they were obviously running up against Microsoft. And then Mimecast clearly has a role at the low end of the market. We haven't seen them move up significantly in the marketplace, but we obviously run into them at the low end of the market.

[Catharine Trebnick:]

All right, thanks.

[Operator:]

Our final question will come from Howard Smith with First Analysis.

[Howard Smith:]

Yes. Thank you. So another slant on the competitive question, but this time around archiving and governance. Your analyst event is almost real time responding to CA end of life and some of their product there. I know it's still relatively new, but I was wondering if you've been able to do anything around marketing or formulate plans kind of to take advantage of that or any update on the competitive environment around that product?

[Gary Steele:]

Yes. Great question. So again, one of the events that happened in the month of September is CA announced the end of life of their Orchestria solution. Orchestria is used by financial institutions to supervise email and due to that end of life there has been customers basically raising their hands, trying to figure out what they're going to do next. And so it has been build, it’s has been really an opportunity for us to build pipeline. And so we look at this as a pretty interesting opportunity. While it's not huge, it gives us access to some very important customers in something that is mission critical on how they drive compliance. So we're excited about that. We think it plays out in the 2018 timeframe and we've already mobilized our marketing efforts and I think we're already making progress in building pipelines. Those deals probably run six to nine months. It doesn't happen overnight. So we're all over this. We're excited about it.

[Howard Smith:]

Great. Appreciate the color.

[Gary Steele:]

You bet. End of Q&A

[Operator:]

It appears there are no further questions at this time. At this time, I’d like to turn the conference back to Gary for any additional or closing remarks.

[Gary Steele:]

Great. Thanks so much. I wanted to take a moment to thank everyone for joining us on the call today. We are very excited about the results that we reported and we look forward to talking to you on our next call. Thanks so much.

[Operator:]

This concludes today’s call. Thank you for your participation. You may now disconnect.