Proofpoint, Inc.
Q3 2014 Earnings Call Transcript

Published: 24 Oct 2014

[Operator:]

Good day. Welcome to the Proofpoint Third Quarter 2014 Financial Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Paul Auvil, Chief Financial Officer. You may begin, sir.

[Paul Auvil:]

Thanks. Good afternoon. Welcome to Proofpoint's third quarter 2014 earnings call. Today, we will be discussing the results announced in our press release that was issued after the market closed today. I am Paul Auvil, Chief Financial Officer of Proofpoint. With me on the call today is Gary Steele, Proofpoint’s Chief Executive Officer. During the course of this call, we will make forward-looking statements regarding future events and future financial performance of the company. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements contained in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in Proofpoint’s most recent Form 10-K and Form 10-Q filed with the SEC and the company’s other filings with the SEC. During this call, we will present both GAAP and non-GAAP financial measures. These non-GAAP measures may exclude stock based compensation expenses, acquisition related costs, accretion of the debt discount and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, costs associated with litigation as well as the amortization of intangibles related to acquisitions, non-recurring income tax benefits other income and 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 third quarter 2014 results, which can be found in the Investor Relations section of our website. In addition, please note that the date of this conference call is October 23, 2014, and any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events. With that said, I will turn the call over to Gary.

[Gary Steele:]

Thanks, Paul. I would like to thank everyone for joining us on the call today. We are very pleased with Proofpoint's strong execution during the third quarter, which resulted in record revenue and billing, both of which were significantly above the high-end of our guidance ranges. Our ability to exceed expectations is driven by the combination of ongoing high demand for world-class security and compliance solutions as well as continued robust add-on and renewal activity. Proofpoint remains well-positioned to maintain this momentum due to the ongoing favorable market trends as enterprises replace their on-premise legacy security solutions with our integrated cloud-based solution to more fully protect their data and lower their total cost of ownership. In addition, we expect to benefit from the acceleration of sophisticated attacks by hackers, who are targeting high-value data such as credit card numbers, logging credentials, healthcare records, Social Security numbers, financial information and intellectual property. Our ability to again grow our targeted attack protection solution more than 100% year-over-year during the third quarter demonstrates this products ability to effectively address the key security needs of enterprises across all industries and throughout the world as the number and type of highly advanced targeted security threats continues to increase. Taking a quick look at our financial results for the third quarter, total revenue increased 46% year-over-year to $50.3 million and was driven by the 45% increase in subscription revenue. This represented our 45th consecutive quarter of sequential revenue growth and highlights the predictability of our SaaS model. We also recorded billings of $62.1 million, up 50% on a year-over-year basis. Both, revenue and billing were significantly above our third-quarter guidance ranges. In addition, we reported positive adjusted EBITDA for the second consecutive quarter and returned to positive free cash flow, which highlights the leverage we are starting to see in our business model. Now, turning to some of our key accomplishments during the third quarter, as I just mentioned, we had another very strong quarter with targeted attack protection as we once again grew the TAP business by over 100% year-over-year in Q3. Demand continues to be driven by the ability to protect enterprises against the increasing number frequency and sophistication of advanced persistent threats. In particular refining the enterprises worldwide, understand the vulnerability and risk associated with malware delivered through email, typically in the form of phishing attacks. The incumbent solutions, often some combination of traditional e-mail security and an antivirus system that employ signature-based detection techniques frequently fail to block these attacks leaving organizations exposed and vulnerable. Our cloud-base TAP solution employs next-generation capabilities that uniquely combine the use of big data systems and dynamic malware analysis to identify and block zero-day and polymorphic malware. In addition, as a cloud-based service, we can protect the mobile user wherever they are in the office or on the road, even when they are not operating on the corporate network. Some of the noteworthy TAP wins during the quarter included a large university, which added TAP in addition to protection for over 60,000 users, a global technology services company with 30,000 users, which added TAP, a large regional retailer also added TAP in addition to protection for over 22,000 users, a leading manufacturer of building materials which bought TAP and Protection for 22,000 users and a global provider of business communications solutions which purchased TAP for 17,000 users. As TAP gains market momentum, we are seeing growing interest in Proofpoint Threat Response, our threat remediation solution that was introduced in mid-May through the acquisition of NetCitadel. We view this is a strategic new capability that provides additional threat verification and containment capabilities via an open platform that unifies threat intelligence from Proofpoint and other vendors. This solution carries a separate price tag and provides another entry point for new business as well as a natural add-on for TAP customers. In our core protection business, our high win rates versus our competition continue to drive momentum in winning new customers. Large and mid-size organizations that had been relying on outdated legacy threat detection and prevention technology which often left them unprepared to handle today's advanced security attacks are switching to Proofpoint's cloud-based solution. Similar to last quarter, the wind down of Google's standalone Postini e-mail security offering once again only nominally contributed to our acquisition of new customers during Q3. While there are still a number of prospects using the Postini platform, we believe the vast majority of Postini's original customer base in the large and mid-enterprise segments have already moved to Proofpoint or other alternative platforms. For the smaller number of remaining users, it appears that there will likely be a long tail of conversions that we will pursue opportunistically over the coming quarters. As such, our third quarter results once again demonstrate our ability to continue to grow our business in a robust manner without the benefit of continued standalone Postini conversions. Here are a few examples of new protection accounts that moved to Proofpoint during the quarter. One of the world's largest financial services companies with 85,000 users, which purchased our Protection and TAP solutions, a global management consulting firm that also purchased our protection and TAP solutions for over 20,000 users. Two large renowned academic medical centers, each with 13,000 users, both of which purchased our Protection and TAP solutions, a large U.S. bank with 11,000 users, which purchased our Protection solution and a global energy company that purchased both, Protection and TAP For 6,000 users. The momentum of our privacy solution has continued as well, with the heightened concern around breaches were seeing increasing demand from organizations to encrypt communications between themselves and their customers, suppliers or even patients in the case of healthcare. A few of the key privacy wins included, a leading regional medical center, which bought our Privacy, Protection and TAP solutions for over 5,000 users. A large information technology company with over 7,000 users which purchased our Protection, Privacy and TAP solutions and a premier global entertainment provider, which added privacy and protection for 14,000 users. I am also pleased to report that we again saw traction selling the entire product line in the context of Office 365 during the quarter, which highlights the value that we can deliver to customers irrespective of their e-mail deployment model. The transition of customers from on-premise exchange deployment to Office 365 continues to be a compelling catalyst for Proofpoint as enterprise customers seek to replicate their former on-premise security and compliance infrastructure in the cloud. As a result, this creates a natural entry point for Proofpoint to displace the incumbent on-premise security and compliance vendors as part of this migration. Some of the Office 365 deals we won in the quarter include a leading financial services company with over 20,000 users that purchased our protection and TAP solutions at a premier global entertainment provider with 14,000 users that purchased our protection and privacy solutions that I mentioned earlier. We also had another strong quarter in our cloud-based archiving business, where a number of key wins included a national government agency with over 15,000 users in addition to a large financial services company with over 4,500 users. During Q3, we also continued to demonstrate our ability to leverage our extensive customer base by selling them additional solutions. During the quarter, we saw add-on strength across the entire product suite evidenced by the wins I mentioned throughout my earlier remarks. Finally, our international operations met expectations during the quarter as we continue to make progress toward further expansion abroad. Some of the deals one include, a Fortune 500 pharmaceutical company, which purchased our Protection solution for 140,000 users and a large global services company, which purchased protection for over 65,000 users. Before I turn it over to Paul, I wanted to mention that we are pleased to announce that we have entered into a definitive agreement to acquire Nexgate, an early innovator in security compliance for social media. As many of you know, we have already begun to broaden the scope of our cloud platform to address the security and compliance requirements of enterprises as they seek to accelerate their reach, visibility and competitiveness in the global marketplace by leveraging new forms of communication collaboration engagement with their customers, employees and partners. We believe that the acquisition of Nexgate will enable us to meaningfully accelerate this initiative. Nexgate provides a cloud-based security and compliance suite for enterprises, social media, communication channels enabling their customer to constantly engaged across these important new channels while not only protecting their brands from compromise, abuse, hacking and malware, but also ensuring that they are operating within their compliance requirements. With this acquisition, Proofpoint customers can effectively protect their online brand presence and social media communication infrastructure by automatically identifying and immediately remediating fraudulent social media accounts, social account hacks and social media content that contains malware, spam and abusive language. In addition, the Nexgate solution monitors authorized accounts and posts for compliance with a wide range of social media regulatory requirements, including FINRA, HIPAA, PHI, SEC ABA and more. By combining the Nexgate platform with Proofpoint's existing capabilities and advanced threat privacy and archiving, we will be able to provide a comprehensive solution that enables enterprises to safely and securely leverage social media across the Internet without putting their brands at risk, while at the same time extending the same world-class security and compliance capabilities currently protecting their e-mail infrastructure to these new forms of engagement beyond the firewall, all in a single unified cloud-based system. We believe that this solution is a must-have capability for all enterprises across all verticals as organizations inevitably adopt social media as a fundamental vehicle to engage with their constituencies. Although it's a young emerging market, we currently believe the TAM in 2014 to be over 125 million and growing rapidly at over 50% annually. Similar to previous acquisitions, Nexgate is the type of acquisition that Proofpoint has successfully completed in the past. A technology related purchase, a company buy a small phenomenal team of developers, who are excited to have their work incorporated in the Proofpoint's SaaS platform. We look forward to providing a robust all-in-one solution for social media to our enterprise customers. In summary, I am very pleased with our strong third-quarter results and the ongoing momentum we continue to see across Proofpoint's entire set of cloud-based data protection solutions. Given our proven ability in defending enterprises against today's advanced security threats, we believe that the company remains well-positioned to gain market share in the $6.7 billion total addressable market. With that, let me turn it back over to Paul.

[Paul Auvil:]

Thanks, Gary. I am very pleased with the continued excellence of our execution during the third quarter as highlighted by our ability to exceed expectations for revenue; billings adjusted EBITDA and free cash flow. Proofpoint continue to benefit from the combination of robust acquisition of new customers, strong demand from existing customers expanding their deployment of additional Proofpoint solutions and a world-class renewal rate that remains well over 90%. Please note that I will be discussing both GAAP and non-GAAP measures, and unless stated otherwise all non-GAAP measures exclude stock-based compensation, acquisition-related costs, accretion of the debt discount and amortization of the debt issuance costs associated with our convertible debt, additions to deferred revenue from acquisitions, costs associated with litigation and amortization of intangibles associated with acquisitions. I will first provide some additional details on our performance during the third quarter 2014 and then conclude with our outlook for the fourth quarter and full year 2014, as well as some primary thoughts regarding our 2015 expectations. During the third quarter, total revenue was $50.3 million, up 46% year-over-year and above our previously announced guidance range of $47 million to $48 million. The strong results were driven by a 45% year-over-year growth rate in our subscription revenue, which included approximately $1.5 million related to deferred revenues from the Sendmail acquisition as I had previously mentioned on last year's fourth quarter call. Without this benefit revenue growth was approximately 40% year-over-year during the third quarter. From a geographic perspective, our growth continues to be largely driven by our strength in the U.S. market, where our revenue grew by 44% year-over-year and accounted for 81% of total revenue compared to 82% last year. Billings for the third quarter totaled $62.1 million, reflecting growth of 50% on a year-over-year basis and exceeding the high end of our previously announced guidance range of $53.5 million to $54.5 million, driven by a combination of strong demand from new and add-on products and the renewal rate well over 90%. In addition, our third quarter billings also benefited from a handful of early renewals as well as slightly higher duration associated with our new and add-on business as compared to prior periods. Excluding these effects, billings growth would have been approximately 40% year-over-year, still well above expectations and consistent with our revenue growth reported for the quarter. Turning to expenses and profitability for the third quarter, on a non-GAAP basis, our total gross margin was 70% during the quarter, which was slightly below are prior guidance due to higher entry costs associated with the opening of our new Utah data center. In terms of operating expenses, we continued our investment in sales and marketing as well as research and development to support future growth. During the third quarter, non-GAAP sales and marketing expense increased 35% over the prior year period to $21.9 million, representing 44% of total revenue, down 45% in Q2 of 2014 and 47% during the same period last year, demonstrating our ability to drive continued growth while also creating leverage with our sales and marketing spend. Research and development expenses increased 34% year-over-year to $10.4 million accounting for 21% of total revenue compared to 23% last year and consistent with last quarter. General and administrative expense was $4.9 million compared to $3.4 million last year, driven primarily by our larger scale as well as the resources needed to accommodate the integration of our recent acquisitions. Non-GAAP net operating loss was $2.2 million for the quarter compared to a loss of $2.4 million during the third quarter of 2013. Non-GAAP net loss was $4.2 million or $0.11 per share based on $37.6 million weighted average shares outstanding and at the high-end of our guidance range of a loss of $0.11 to $0.13 per share. Non-GAAP net loss during the third quarter included an approximate $1.2 million impact from foreign currency translation related to our cash held in local currencies oversees, and hence we were pleased to deliver results at the high-end of our range despite this effect. This compares to a non-GAAP net loss of $2.3 million or $0.07 per share based on $35.4 million weighted average shares outstanding in the year ago period. Third quarter 2014 adjusted EBITDA was positive $0.3 million compared to negative $0.9 million during the same period last year and was better than our original guidance range of negative 1 million to negative $1.5 million, driven by our upside revenue during the quarter, which similar to last quarter outpaced the rate which we were able to productively invest operating expenses. We were very pleased with our ability to achieve positive adjusted EBITDA for the second consecutive quarter, again, highlighting the leverage that we are starting to see in the business model. Note that with the upcoming acquisitions of Nexgate and the associate operating expenses of that business, we do expect spending to catch up with revenue during the current quarter. As such, adjust EBITDA will be negative during the next few quarters we are before turning to positive in the second half of next year as we progress through the process of integrating this acquisition. On a GAAP basis, GAAP net loss for the third quarter totaled $17.3 million or $0.46 per share based on $37.6 million weighted average shares outstanding. This compared to a GAAP net loss of $7.2 million or $0.20 per share based on $35.4 million weighted average shares outstanding in the prior year period. A reconciliation of GAAP to non-GAAP financial measures has been included in our financial tables included in our press release. In terms of free cash flow, I am pleased to report that we generated $8.7 million in operating cash flow and invested $4.4 million in capital expenditures, resulting in positive free cash flow of $4.3 million for the quarter, above our guidance of approximately breakeven and equaling 9% of revenues for the quarter, providing an early demonstration of the degree to which we can create cash flow leverage in the business even at this early stage in the company's development. We continue to expect cash flow for the full-year to be in the range of breakeven to $5 million. Turning to balance sheet, we ended the third quarter with $232.8 million in cash and short-term investments and $160.5 million in debt compared to $226.8 million in cash and short-term investments and $158.7 million in debt as of June 30, 2014. This sequential increase in cash during the quarter was driven by the combination of cash flow generated from operations, ongoing stock option exercises and the contributions to capital from our employee stock purchase plan. We ended the third quarter with an accounts receivable balance of $32.8 million, resulting in DSOs of 49 days during the third quarter. Totaled deferred revenues increase $42.1 million or 42% year-over-year to $143.4 million during the first quarter, up from $101.3 million in the year ago period. Compared to the second quarter of 2014, deferred revenues increased $11.8 million of which roughly $1 million of the increase is in long-term deferred. During the third quarter, the duration of our renewal contract terms remained at the low-end of our historical range of 17 to 22 months, while new and add-on contract duration increased modestly as I mentioned earlier. While we continue to focus on shortening contract duration across our customer base, as I mentioned earlier in my remarks, several large enterprise customers that were first time buyers of Proofpoint's solutions, signed multi-year contracts during the third quarter, indicated the confidence and commitment that these customers have regarded Proofpoint and our market-leading platform. Now, turning to the financial outlook starting with the fourth quarter, we currently expect billings to be $63 million to $64 million, resulting in year-over-year growth of approximately 30% at the midpoint of the range. As a reminder, note that Q4 of this year has a particularly challenging compare year-over-year as our billings grew by almost 20%, sequentially, between Q3 and Q4 of 2013 propelled by our first significant sales of TAP, as well as the benefits of business from the Sendmail acquisition. As a result, we believe that this billings guidance is indicative of the ongoing healthy demand for the Proofpoint platform and the strong renewal rates from our existing customer base. Regarding revenue for the fourth quarter, we are targeting total revenue of $52 million to $53 million or 29% growth year-over-year at the midpoint of the range. Consistent with my comments earlier regarding billings for the upcoming quarter, note that revenues for the fourth quarter of 2014 also have a challenging year-over-year compare as our revenue grew by 43% in the fourth quarter of 2013 propelled by our first significant sales of TAP as well as the benefit of the Sendmail acquisition. More specifically, the Sendmail revenue contribution from their legacy deferred revenue in the fourth quarter of 2013 was $2.8 million, whereas contribution from deferred revenue in the fourth quarter of 2014 will be only $1.3 million, creating a year-over-year headwind to revenue growth of $1.5 million or approximately 3.5% for the fourth quarter of 2014. Hence taking this factor into account, would suggests an organic growth rate of roughly 32% for this quarterly guidance. Note that this revenue outlook includes no material contribution from the upcoming acquisition of Nexgate, since their revenues prior to the acquisition were immaterial in the context of Proofpoint's current revenue run rate. Our plan going forward is to drive organic growth opportunities for Proofpoint by combining the Nexgate social platform with Proofpoint security technology and driving that solution into the broader marketplace. We expect this initiative to take several quarters and hence Nexgate is not likely contribute materially to our billings revenue until late 2015. We expect fourth-quarter non-GAAP gross margin to be approximately 70% consistent with the third quarter. With regard to adjusted EBITDA, we are very pleased to have delivered two consecutive quarters of profitability well ahead of original guidance, but with that said, as I noted earlier, given the upcoming acquisition of Nexgate, we expect spending to outpace revenue during the fourth quarter. As such are currently targeting negative $0.5 million to negative $1 million for the fourth quarter with an expected return of profitability in the second half of 2015. It is important to note that in the absence of the impact of Nexgate, we would be guiding to our third consecutive quarter of adjust EBITDA profitability for the business as this acquisition adds roughly $1.5 million in expenses to our quarterly rate of spend at the time of closing and we do plan to increase our rate of investment to further build out the product platform associated and associated integrations with our existing Proofpoint solutions over the next few quarters post the closing of this acquisition. We expect fourth quarter non-GAAP net loss to be negative $4 million to negative 4.5 million or a loss of $0.10 to $0.10 per share based on approximately $38.2 million weighted average shares outstanding and this assumes an income tax provision exclusive of discrete items of approximately $0.2 million during the quarter. In regards to free cash flow, we expect record at least $5 million for the fourth quarter, consistent with our guidance last quarter. From a full year perspective, we are increasing our guidance above our overall performance in the third quarter, driven by driven by the expected continued strength of the business. Specifically, we now expect billings to be in the range of $221.8 million to $222.8 million, which represents an annual growth rate of 39% at the midpoint of the range. This compares to our previous guidance range of $214 million to $215 million. With this billings performance, we are also increasing our total revenue guidance to a range of $191.4 million to $192.4 million, reflecting an annual growth rate of 39% at the midpoint of the range and this compares to our previous total revenue guidance of $185 million to $186 million. Now, it is important to note that absent the benefit of the Sendmail deferred revenue during the year, our overall growth rate on an organic basis would be closer to 35%. We continue to expect our subscription revenue will account for approximately 97% of total revenue for the year. We expect full year 2014 non-GAAP gross margins to be approximately 70%. Adjusted EBITDA for the full year 2014 is expected to be in the range of negative $1.5 million to negative $2 million, a $0.3 million improvement over the guidance last quarter, driven primarily by the upside of profitability we delivered during the third quarter. We expect full year 2014 non-GAAP net loss to be $15.4 million to $15.9 million or a loss of $0.41 to $0.43 per share based on approximately 37.4 million weighted average shares outstanding and this assumes depreciation expense of approximately $10 million to $11 million and cash interest expense associated with convertible debt of roughly $2.5 million, as well the income tax provision exclusive of potential discrete items is expected to be approximately $0.8 million to $0.9 million for 2014 in total. Similar to prior quarters, I would like to highlight that, again, we are currently generating a net loss and as such our weighted average share count of $37.6 million for Q3 did not include the impact of unexercised stock options. If we were profitable today, our fully diluted share count would have been approximately 41.3 million shares when applying the treasury stock method to outstanding options and restricted stock awards. In addition, if our convertible notes were in the money at the beginning of the quarter, it would approximately 5.2 million shares. Finally, as I mentioned earlier, we continue to expect our free cash flow for the year to be in the range of breakeven to $5 million for the full-year 2014. This cash flow guidance continues to assume capital expenditures of $16 million to $18 million for the full-year. While we are in the early stages of our planning process, I would like to share some preliminary thoughts in terms of a few key characteristics of our model for 2015. We are comfortable providing an estimated initial baseline revenue growth rate of approximately 24% to 25% for our full year 2015, which is identical to our starting point in October of last year. We believe this initial growth rate guidance is a strong starting point given the high growth rates delivered over the course of 2014 and a challenging year-over-year compares of these growth rates set up for the coming year. In addition, there is a combined headwind of approximately three to four percentage points, due not only to the fact there is a $4 million decline in the legacy deferred revenue recognized from Sendmail acquisition in 2015 as compared to 2014, but also the impact of the stronger U.S. dollar. We expect to record a billings growth rate that is a percentage points higher than the stated range of the revenue growth. We believe that this disciplinary 2015 guidance for revenue billings represents a strong growth outlook, particularly considering that it is on top of our just increased 2014 outlook, as well as factoring in the global economic environment and the fact that we are still a few months away from the start of the year. With respect to adjusted EBITDA for 2015, we had originally expected to deliver a positive result for the full-year. However, as noted earlier, the acquisition of Nexgate will add to our overall spend rate for the business with little contribution to revenue. As such, we expect EBITDA to be approximate breakeven for the full-year, generating a loss of approximately $2.5 million to $3.5 million in the first quarter of 2015, with improving profitability across the remainder of the year. As in prior years, the first quarter is always a step backwards in terms of profitability for the company as our first quarter operating expenses include our typical increases in costs early in the year associate with payroll taxes, sales kickoff and initial sales and marketing investments at the start of the year. As I noted earlier, with our upcoming acquisition of Nexgate, we will also have our first full quarter of expenses associated with the integration of this new business as well sequential revenue growth tends to be a bit lower than usual in the first quarter as compared in the fourth quarter given that we employ a daily revenue recognition model with respect to releasing subscription revenues from our deferred revenue accounts. Given that Q1 has only 90 days of revenue to recognize as compared to 92 days in Q4, the results is sequential decline in subscription revenue from existing business of approximately 2%, which equates to roughly $1 million at our current size and scale and works as a headwind against the net new add-on business closed over the course of the fourth quarter. Finally, in terms cash flow, I am pleased indicate that despite our commitment to innovation and ongoing investments to pursue the key opportunities in the market, we currently expect that are free cash flow should be $10 million to $12 million for the full-year of 2015, which we believe is particularly compelling given our current baseline growth rate that we are delivering with a revenue stream that is 97% recurring subscription. Note that we would expect free cash flow in the first quarter to be negative $5 million to negative $7 million as first quarter cash flow includes the annual disbursement of the company's annual bonus program, the higher expense associated with sales kickoff and the payout of some of the commission rates earned by the sales team during the fourth quarter of 2014. This 2015 guidance assumes capital expenditures of $18 million $20 million, depreciation of roughly $13 million and cash interest expense associated with convertible debt of approximately $2.5 million. We do plan to further refine our 2015 forecast as we continue our planning process, integrate our acquisitions and gain additional insights from our extended network of partners in sales channels. As such, we will provide a more detailed update during the fourth-quarter earnings call in January. Note that as in the past periods, to the extent that we can deliver upside to the revenues as outlined in our guidance, we do expect to reinvest most or all that upside back into the company in the form of initiatives that we believe will deliver differentiated solutions for customers and improve long-term growth for the business overall. In summary, we had a record third quarter and believe that Proofpoint remains well-positioned to maintain momentum for the remainder of the year and into 2015, driven by the ongoing strong demand for our integrated cloud-based solution around the world. With that I would like to thank you for taking the time to join us on our call today, and we would be happy to take your questions now. Operator?

[Operator:]

Thank you. (Operator Instructions) We will go first to Rob Owens - Pacific Crest Securities.

[Rob Owens:]

Great. Thanks. Good afternoon guys. Paul, when you talked about some of the extension in deal duration that drove the billings result, but then when I look at the longer-term deferred revenue only being up $1 million, sequentially, maybe help me balance that. Are you telling us that you expect that longer term deferred revenue to come down over time as you are focusing more on one-year deals?

[Paul Auvil:]

Yes. I would expect a long-term deferred. If we continue to be successful in moving toward shorter durations, the long-term deferred revenue balance would naturally decline. It increased this quarter, because we did have in the new business, the new add-on business is slightly extended duration, but we actually did see somewhat modest shortening of duration bringing us all the way to the end of the range on the renewal business. When you net all that out, again it was part of what drove that very large billings number that we recorded for the period, but ultimately we were happy with the way the numbers came together and the effective normalized billings growth rate is closer to 40% when you take the pull in of some of the renewals that otherwise would have been expected to been done later in the year that we finished in Q3 as well as these changes in duration.

[Rob Owens:]

Realizing that's a moving target, and you laid out some billings targets for '15, how are you thinking about duration, consistent more so one year?

[Paul Auvil:]

Yes. That's a good question. When we think about planning, we assume sort of all things in our status quo remain essentially consistent. As a result, think of our duration as not really probing for where we have kind of averaged over the course of the first three quarters of the year. Again, we aspiration - we would like to shorten the duration that could potentially put modest pressure on the billings numbers as I just guided to. I think, we talked about this in a couple contexts in past calls. Being at the low end of the 17-month to 22-month range is about as far as we in the short-term think that things can go. We aspirationally would push to shorter durations, but just given historical context of not only ourselves, but competitors establishing the idea of both, one, two and three-year deals, paid up front, it's not that easy to move people to single-year duration transactions, so we have had some success in doing it, but it is not clear how much further we will from go where we are right now.

[Rob Owens:]

Then Gary, focusing in on the success you are seeing in TAP right now, it seems like a lot of the adjacent security vendors are also talking up their book relative to what they are seeing in APT. Is it more opportunities out there in the marketplace right now or is it increased win rates that you think Proofpoint is seeing?

[Gary Steele:]

I think it's a combination of both of those actually. From macro perspective, there is a heightened concern today in security - sees those office around, what to do about these events, so that is coming and people are evaluating solutions in figuring out how they are going to build the next generation security architecture that is really going to protect them. At the same time, our win rates are quite high. I will say it is not easy to detect zero-day polymorphic malware we are one of the few vendors that can do that and do that effectively in the marketplace, so I think that is also a key contributor for our growth.

[Rob Owens:]

All right, guys, thanks so much.

[Gary Steele:]

Thanks, Rob.

[Operator:]

We will take the next question from Phil Winslow with Credit Suisse.

[Phil Winslow:]

Thanks, guys. Congrats on just a great quarter. First question for Gary, then a follow-up for Paul. Gary, if I look at the billings drove growth even make adjustments for duration and some acquisitions. I mean, it continues to be a very healthy, even accelerated levels than what we have seen in the past and there is even off-book, or is it really strong Q3 '13. I mean, has something sort of changed in particular in the cadence of the businesses. Is it the up-sell of APT products or was it large deal size, international? I mean, is it one thing in particular or is it just sort of all these things adding together and just one quick follow-up for Paul after that.

[Gary Steele:]

I would point to two things. I would point to the continued improved competitive landscape, so we continue to benefit from the fact that other vendors in sort of a core e-mail security market aren't investing and we are able to show prospects, the value of our solution over those comparative incumbent solutions, so that's one. You combined with that, the strength, the capabilities that we are delivering in events threat space, advanced threat capabilities act as an accelerant to their core protection business and they are just working really well together that in combination with the competitive landscape all together is what is driving our growth.

[Phil Winslow:]

Got it. Then Paul, I wonder if you could provide a little more clarity. Could you give us a sense of what the expense run rate is from the acquisition you just announced? Then sort of how you sort of expect it showing up in Q4 versus Q1, just so we get a sense of - organic OpEx growth would look like?

[Paul Auvil:]

Yes. I think what I mentioned in the script and I know it's long and ponderous, so you are not capturing every nuance detail of everything that I read earlier, but what I talked about it adds on a full quarter basis $1.5 million to spend rate to our spending. Now, in this case, here this quarter we don't have an exact projection on close date, but think of it it's likely closing end of October, so we will have two months of that spend rate that will pick up here in Q4, then the full $1.5 million in Q1. The other thing I mentioned in the script or at least tried to intone is the idea that, while they got a great team and we are really impressed with what they have accomplished. We realized that there is some additional investment required to kind of accelerate their roadmap as well as then drive the integration of their pieces and our pieces to create this broader, more holistic platform, so we will be taking up the overall spend rate around our social platform in addition to that $1.5 million run rate as part of completing that investment and creating that comprehensive platform and bring it to market.

[Phil Winslow:]

Great. Thanks, guys.

[Operator:]

We will go next to Nandan Amladi with Deutsche Bank.

[Nandan Amladi:]

Good afternoon. Thanks for taking my question. Gary, first question for you on the Nexgate. It looks like $35 million acquisition with very little revenue. How long would it have taken you to develop this on your own if you had chose to go that path?

[Gary Steele:]

We look closely at what the overall investment would have been had we had to do this. It's really two things. It would have been at least two years to three years. I think the trickier thing and we pointed it out in the script is this is a phenomenal group of people. Hiring these people just on the open market would have been extremely difficult, so actually getting to the timeframe I stated would have all been gated by the fact that we would have had to find the right people with the right expertise. I feel really fortunate that Nexgate is now part of Proofpoint. I think it will be an interesting growth driver for us as we work through '15 and into '16. We fundamentally believe that every organization in the world that employ social as part of their business practices are going to have to do something from a security standpoint and also something from a compliance standpoint. We think we are extremely well positioned with this capability.

[Nandan Amladi:]

Yes. Thanks. Paul, a quick one for you, all through this year we have seen gross margins just trend down, very, very slowly. Is there anything going on in the product mix or anything like that?

[Paul Auvil:]

No. Product mix is continuing to perform as expected. We talked about in the earlier part of the year, the investments that we made in building up the TAP framework. Then here in the most recent quarter, we had the build associated with our Utah data center, so that is actually our fourth data center out in the United States. While we don't have really significant additional costs associated with that, we actually had some in-period costs associated with temporary contract resources among other things that were needed to get that built out up and running in the timeframe that we had targeted, so it was a slightly higher spend rate than we had anticipated when we first set out guidance last quarter.

[Nandan Amladi:]

Okay. Thank you.

[Operator:]

Thank you. Our next question is from Matt Hedberg with RBC Capital Markets.

[Matt Hedberg:]

Yes. Thanks. Congrats on the quarter too from me as well. You guys are having obviously a lot of success with TAP over the last several quarters and some of your archiving products are doing quite well. I am wondering if you could give us a sense for the uplift you are seeing, when a customer adds some of these products. Maybe if you could talk about the penetration TAP in your bases these days that would be helpful.

[Gary Steele:]

Yes. We do typically enter the enterprise selling the protection solution. Then when we are able to add TAP, where we are able to add privacy, those products sell orders of magnitude about the same as the original protection solution, so when I sell an additional add-on product it roughly doubles the value that I get the customer of the order of archiving when we sell it actually has quite a bit more leverage on it, so archiving will typically be two to three times the original price paid on the initial protection price point. We will provide some additional color in the January call as we always do in terms of some of the penetrations rates that we have for customers are buying one, two and three products, so I think everybody have found that data interesting, but the net of it is, we are pleased with the add-on business we were able to sell in the most recent quarter along with the net new customers as well. It's all come together in the most recent quarter quite well.

[Matt Hedberg:]

That's great. Thanks, Paul. Then maybe Gary for you, this maybe a difficult to answer, but given all the breaches, do you think security budget as a whole increased at a faster rate than the overall tech landscape. Maybe I would ask different way. What are key source telling you about their security intention spending next year?

[Gary Steele:]

Yes. I think what we will see is a more mature budgeting cycle as people moving into '15. One of the things we saw if I go back to the early part of '14, is we saw style organization struggling knowing that they needed to do something, but they had not budgeted appropriately going into the fiscal year, so I think we will see a more mature budgeting process. We will see budgets improve. I do believe given the heightened level concern for everybody I talked in Meadville, I do believe that security will see increased budgets at the cost of other IT spending. It is unclear to me those dollars come from. That is not something I have visibility to, but I do believe we will have more maturity in the budgeting process and security will gain broader wallet share within the overall IT spend.

[Matt Hedberg:]

That's. Great. Thanks. Very helpful guys.

[Operator:]

We will go next to Robert Breza with Sterne Agee.

[Robert Breza:]

Hi. Thanks for taking my question. Gary, maybe if you think about the success of TAP, you guys talked a little about continuing to see really good response with the threat response piece. Now you are adding another piece of technology from a social perspective. When you think forward for the next 12 to 24 months, as you think about history of where you have been. How much do you think these new products, these new acquisitions with separate price points et cetera can really amount to. Can that amount to 25% of the buildings 24 months out or how you think like high-level about those new products?

[Gary Steele:]

Yes. I think that the right way to think about it is, we will build demand and build the marquee customer base in '15 and then we will start to see those products scale as we move through '16. As you work our way through '16, I think that is when you are going to start to see the material contribution from a revenue point of view. I don't think it's fair to assume that you are going to see that in '15. I think that is more a '16. What percentage of revenue those new products add, I think it's too early to say, but we are extremely excited about the market potential of each of these capabilities, A, given the success that we are having in the market with TAP, we think these are natural add-ons in that environment.

[Robert Breza:]

Maybe just as a follow-up, and I think you made a point of that saying that these are add-ons are there are separate price point, do you see yourself moving to a bundled strategy in '16 or '17?

[Gary Steele:]

You know, we bundle where appropriate. One of the things we philosophically don't believe in is over bundling where the customer won't want to renew the entire bundle, because they are not getting value or using the capabilities, so we are really careful about not compromise overall long-term value by over bundling. We do get synergy and we bundle where appropriate, but we are careful about it. You won't see Proofpoint selling one big broad bundle. I can't imagine that, because we wouldn't have the renewal rate that we have.

[Robert Breza:]

Perfect. Nice quarter, guys.

[Operator:]

We will take our next question from Craig Nankervis with First Analysis.

[Craig Nankervis:]

Thanks. Congratulations on another exciting quarter. A little bit more to the near-term environment, on the Office 365 migration, I wonder Gary if you might provide a little more color, is this going to be a consistent driver going forward or is it going to move around. Would you maybe perhaps expand your channel to address this if is going to be consistent. Just wonder if you could spell things out more as you see it on this front?

[Gary Steele:]

I would be happy to. We do see significant opportunity in that broader Office 365 movement. Effectively what's going on there, as we indicated in the script is as organizations decided to move their core e-mail, they have to rethink all of their security and compliance capabilities that they traditionally implemented on-premise, so that shift and that migration forces organizations then to rethink all those capabilities and puts us in a very natural position to insert ourselves into those customers. We do believe that this will be an ongoing trend. We do believe that there is opportunity here and we are investing in that broader ecosystem to ensure that we can capture those opportunities as they become available.

[Craig Nankervis:]

Thank you. That's good. Are you willing on the NetCitadel front, can you offer how much, any contribution to the billings performance in the quarter or how you are upraising that opportunity. I think this has been now the first full quarter where you have had the assets under your wings. I didn't care too much in prepared remarks. I wonder if there's anything more you can elaborate on.

[Gary Steele:]

It was our first 90 days, we were really happy with the demand that we are seeing in the market, but it's going to have negligible contribution to revenue in 2014 and the first 2015. We do we do see this broader base of opportunity. Right now, we are focused on getting that broad base of marquee wins that ultimately allow us to scale the business and that is where we have a team focused on, so it is creating great value, we are getting good feedback, but think of it as it is really beginning to drive revenue as we get into the latter half of '15 and into '16.

[Craig Nankervis:]

Is it contributing to billings today?

[Gary Steele:]

It is contributing to revenue with some deals that have been closed. It's contributing meaningfully to the pipeline. The billings contribution in the current period was essentially nil, but we have some interesting things lined up for Q4.

[Craig Nankervis:]

Just lastly, the privacy business, is that something with the uptick in interest in - is that something that you actually would lead with in some accounts or it is really the uptick is coming from existing customers and you are selling as a follow-on or add-on sale for…

[Gary Steele:]

We will lead with it. There are - as an example, we do see a reasonable number of RFIs and RFPs coming out in this particular segment. It's really driven by this broader concern around, okay, how do I protect the sensitive data that I need to either move across the Internet or I need to maintain my environment, so we will lead with this and it gets driven from the customer point of view who have identified. (Inaudible).

[Craig Nankervis:]

Thank you.

[Operator:]

We will take our next question from Jonathan Ruykhaver with Stephens.

[Jonathan Ruykhaver:]

Hey, guys. Nice execution. I am curious within TAP, what you are seeing out of Predictive Defense in terms of adoption trends as the trajectory is similar to what you saw when you first introduced TAP.

[Gary Steele:]

Yes. We have seen a good adoption on Predictive Defense, so what we often time sell today is the combination of URL defense and attachment defense selling out as a single bundle as people think about how do they does want to defend themselves, so that has been a very effective selling strategy for us. As we going to an evaluation, we are basically going to put all of our TAP capabilities online and show our customer the value that we can bring with all the capability. Typically now we see them buying the broader collective TAP instead of capabilities.

[Jonathan Ruykhaver:]

Okay, so it's Predictive Defense being sold as a separate module or is it just being sold as a discrete component, I mean, a component of TAP. IF so, what's the uplift to the traditional TAP price that you talked about?

[Gary Steele:]

Yes. I will let Paul comment on the pricing, but we are selling the broader bundle.

[Paul Auvil:]

Yes. I would say that when we sell the pieces together, I would say it's improving our pricing by 20% to 25%.

[Jonathan Ruykhaver:]

From what you talked about in terms of the original TAP pricing 12 months ago?

[Gary Steele:]

Exactly. Yes.

[Paul Auvil:]

I think that if you just look over time, we actually had seen ASPs that our overall TAP solution going up.

[Jonathan Ruykhaver:]

Okay. Good. Then the other question and I have on TAP is just around channel initiatives tied to TAP. How much of the channel is constrained into a certified. I guess, in general, what the level of channel influence is on those opportunities today?

[Gary Steele:]

We have a pretty significant channel initiative underway to get the channel fully up to speed, getting them in a position where they are confident about pitching it to customers. We have seen an incredible amount of interest from the channel, but we are in the early stages of those initiatives. Ask that question again in a quarter or so, we will have more data to provide.

[Jonathan Ruykhaver:]

Okay. Good. I assume that TAP is really kind of the Trojan horse when you look at new customers and want to try to penetrate with email. Is that correct?

[Gary Steele:]

It's interesting Jonathan, but we do often times is we will go tell the TAP story and we will sell them whatever they have money for and a budget for, so TAP is often times the entry point in terms of the communication we have with a customer, but oftentimes if they haven't budgeted for that yet, we will go start core production, take those dollars out of an incumbent's pocket and then go back and sell TAP when they have budget.

[Jonathan Ruykhaver:]

Okay. It makes sense. The final question I had is just, I am not sure if you mentioned this, but the anticipated timing for revenue associated with Nexgate?

[Gary Steele:]

I think what I mentioned in the script was given the platform integration work to do et cetera, we don't think it will contribute materially to billings or revenue until the latter part of 2015.

[Jonathan Ruykhaver:]

Okay.

[Gary Steele:]

We will certainly close some deals between now and then, but it's not going to really gain momentum. If we look at how we built that momentum around our TAP product line for example, as we look at that product line, that's our current anticipation.

[Jonathan Ruykhaver:]

Yes. Okay. Good. Thanks, guys.

[Gary Steele:]

Thanks.

[Operator:]

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

[Jonathan Ho:]

Hey, guys. Great quarter, just wanted to start out with your guidance. It seems like you have taken another pretty conservative approach. Clearly, you did better than sort of your initial view this year. Just wanted to maybe walk-through a little bit of the assumptions that you have about next year and maybe what you see as the puts and takes around what could drive potential upside or maybe risks relative to your guidance as you look at that.

[Gary Steele:]

Yes. I mean, what I talked about 24% to 25%, a couple of things that I put out there as a caveat, one is, because we have this legacy deferred revenue from Sendmail, which was a much greater contributor in '14 than it will be in '15. That creates a bit of a headwinds year-over-year on the revenue lines that recognized. Then as well I am taking a revised view of where foreign currency rates will be. Then how that also creates a headwind to our revenue growth now - subscription business. It's not quite as extreme as company that recognizes all of its revenue from current balance and current, but nevertheless that's a headwind, so think about in three or four points to my 24% to 25% guide to get to kind of a true organic compare year-over-year. That starting point is actually adjusted for those effects higher than when we started last year albeit on an absolute basis it is at that same level 24% to 25%, so that as we think going forward you know why I would agree that were probably being conservative is we often are as we going into the coming year here standing in October, foreign currency continue could continue to make our lives more difficult rather than less, so that's I would say a negative. I feel like the churn assumptions that we built and they are probably realistic is as typical, so I don't anticipate downside, maybe some upside there if we do better than our more conservative planning assumptions around churn that we use as that initial baseline in October. Then we typically assume that the sales team will be productive at about the same level per (Inaudible) in the future years we had in the current year, so there's room for the sales team to potentially be more productive for a variety of different reasons. It could then help us deliver about that baseline, so those are a few characteristics that hopefully give you a sense what are the puts and takes in the number.

[Jonathan Ho:]

Yes. That's very helpful. Can you also talk a little bit about investments in the international distribution channel? Do you expect to see maybe more leverage from that in '15 as well, just sort of a report card in terms where we stand in terms of those investments?

[Paul Auvil:]

Yes. We definitely continue to put some additional resources to work. In Europe, in particular, our view is given the size of the European market as compared to the U.S. market and that is compared to the other international markets, Europe is first and foremost our number one priority. Now, we do have resources obviously in other geographies as well, Europe is where we really want our shoulder and the way - obviously the increasingly challenging economic outlook for Europe, doesn't portend for a necessarily great set of assumptions for 2015 right now, so we are skewing most of our headcount growth in markets where we are currently seeing good production and a better economic outlook, but that said, we are planning as part of our 2015 process to be investing in Europe in particular as we think it's a great long-term opportunity. Security spend doesn't really drive completely with the typical economic cycle in that even though the economy is down. If you end up in recession, you still have to spend money on security to secure the enterprise, so it's one way of saying, as we look at Europe in particular, it is an area that we are going to make investments on a go-forward basis, but we are subdued about our expectations about what that will produce, particularly in the first part of '15 given the current state of the economies in Europe and Germany in particular, looking like it's potentially backsliding into recession at this stage. With that said, Gary, I don't know if you really want to add anything about to start international initiatives in general?

[Gary Steele:]

I think that one simple thing I would say is, I think we have got the right ingredients in place, but we need some great marquee customer. We are seeing the tradition competitors that have really been here, we are beating them over there, so we are optimistic that Europe to be a nice growth driver as we move through the course '15 and into '16. I think we are thoughtfully conservative about the performance there given the broader macro, but this represent an interesting growth opportunity for the company.

[Jonathan Ho:]

Great. Thank you.

[Operator:]

We will take our next question from Tim Klasell with Northland Securities.

[Tim Klasell:]

Hey, I am throwing my congratulations as well. I wanted to go to the early renewals of some of your large customers. It is typically an unusual behavior. Were they coming in to buy additional product and just want to terminus or maybe you could just walk us through what drove that behavior?

[Gary Steele:]

Yes. It is a combination of both, so we have both customers who in looking to do an add-on deal just decided it's convenient to just get the renewal, let's do it in a coming period out of the way, so it all gets wrapped up together and then we also customers who for budget purposes, they happen to have dollars available, it is just easier for them to get this thing off the desk and move on to other budgeted projects. Now, we don't give people discounts for this activity, so it's not a financial incentive behavior. This is really only done at the customers' convenience, so we had more of that activity this quarter than we have historically seen, so it was a bit of a surprise. That's why I thought it was important give people the normalized billings growth rate to understand the degree to which we would actually be growing year-over-year when you took that effect out. It's hard to think of any other color to add there. Again, it's something that we see sometimes a little bit more of and sometimes a little bit more less of, but it happened kind of as a baseline background activity, but it is not a focus for us as a business to drive that specifically.

[Tim Klasell:]

Okay. Good. Then sort of along that same topic, your deferred revenues obviously were up very nicely on the quarter, probably the best ever since Q4 of last year. Were there many of those deals signed late in the quarter, hence there might be a longer duration of the deferred revenues on the balance sheet right now?

[Paul Auvil:]

We saw that long-term deferred revenue, our net increase by about $ million, so I think Rob Owens maybe asked this question at the very beginning. We actually saw a shortening in duration compared to prior periods of our renewals, so we had some good kind of production driving the number in the direction that we like to see, but then that was offset by the multi-year, new and add-on business, so on net we ended up with about $1 million of additional deferred, so that kind of gives you a sense for how the pieces fit together. One thing that I think is also important, I just want to clarify for everybody on the call, when we do have an early renewal, it sits in deferred revenue and we don't start to take revenue on that against the income statement until the old renewal comes to an end, so if I were to renew just to give an extreme example, if I had a customer that was doing annual renewals year-after-year, year-after-year and with three months left ago they were to revenue for the next year, what would happen is that renewal would sit in deferred revenue for three full months, so we got to the end of that initial amortization of deferred revenue associated with the current year. Then that early renewal would start to tick off the clock that ensuing 12 months.

[Tim Klasell:]

That you. That's very helpful.

[Operator:]

We will go next to Erik Suppiger with JMP Securities.

[Erik Suppiger:]

Congratulations. First off, just want to make sure I understand, in terms of the billings outlook, relatively flat outlook. What would you expect to change going from Q3 to Q4? Is it that you don't expect the same level of renewals or is it that the duration gets shorter in light of some of the dynamics they had this quarter? What is it that is just going to be flat?

[Gary Steele:]

Sure. That's a great question. First, again the early renewals that we pulled into Q3, came out of Q4, so part of what caused the over performance in third quarter also then put some downward pressure on what we otherwise would have expected for the fourth quarter number. As well, as I sort of alluded to earlier, we are assuming a return to normalcy in terms the duration for the new and add-on business, which then with that somewhat lower amount would then lower average duration would cause the sequential comparison to be a little bit off, particularly as you are describing here, so those to.

[Erik Suppiger:]

Okay. Secondly, who are the competitors for Nexgate?

[Gary Steele:]

Yes. It's interesting, because they are early in this space, they are a number of smaller companies. We don't see any of the bigger security players and everybody is familiar with playing in this market today, so we are excited and encouraged by the fact that the players out there are small private companies for the most part. The companies that you have direct competitive products are actually focus more helping organizations sell their product through social media and as part of that they offer some compliance. This is compared to what we have with Nexgate, which it is a dedicated security compliance suite. As we see the sea-saw becoming more and more - playing a more and more active role in these kinds of things, we think this is going to be a must-have for organizations using social, so we are excited about it. We think the competitive landscape is really compelling..

[Erik Suppiger:]

Okay. Then lastly I assume there was no change from the incumbent on=premise competitors that you have been going against is, is that correct in the quarter?

[Gary Steele:]

Erik, it was really very much the same as what we reported last quarter, so again (Inaudible) playing only a marginal role, but reasonable contribution from the other larger incumbent vendors.

[Erik Suppiger:]

Very good. Thank you.

[Operator:]

We will take our next question from Matthew Niknam with Goldman Sachs.

[Matthew Niknam:]

Hey, guys. Thanks for taking the question and congrats on the quarter. Most of my questions have been asked already, but one on the expense structure, I just want to get a sense with some the increase investment in the next year when the expense structure you would see the greatest opportunity for the company to scale and further improve margins from current levels.

[Gary Steele:]

Yes. Good question. I think G&A is about as low as realistically it's going to get. If you look at our numbers on a non-GAAP basis, taking up some of the non-recurring items, what we are sort of 88 percentile as compared to other much larger publicly traded SaaS companies, I think the leverage comes as you see in sales and marketing, we gone from 47% of sales and marketing as a percentage of revenue a year ago, now down to the low 40s. I think there's room for additional improvement there over the coming year, so that one leverage point. I do think R&D, the - of G&A, R&D spend tends to be very high end of the spectrum compared to other SaaS companies and it is because of the very broad product line we have, which is a real strength for the company at this stage, but there is tremendous opportunity for leverage there, so I would definitely expect to see some leverage on the R&D line better than what you saw between '13 and '14 as we look at improvements from '14 to '15.

[Matthew Niknam:]

Got it. Thank you.

[Operator:]

We will go next to Walter Prichard with Citi.

[Unidentified Analyst:]

Hey, Paul and Gary. This is Jim actually on for water. Congrats on the quarter and the acquisition. Paul, this is for you. In last quarter, you guys had said that about half of the new subscriptions was driven by sales of new solutions. What did it do this quarter?

[Gary Steele:]

It was roughly 50-50. We actually saw a little bit more production from add-on than typical, so we were a little off that. It was more 60-40-ish. 60 add-on, 40 new, and that's fine. We want to just deviate kind of plus around that 50-50 range, but 50-50 is the target that we operator to. We had one deal in particular that was quite large where we have talked about a year ago, the Sendmail acquisition we closed, it brought a great customer base to us, so we did a pretty compelling add-on transaction with one of Sendmail's original customers that just further validated the value that we got through that acquisition.

[Unidentified Analyst:]

Okay. Then on the threat remediation side, are any non-current customers approaching you to do remediation or is this really a solution just being sold to the existing base?

[Gary Steele:]

We see opportunities with both, so as we look at demand, we are seeing a high level of interest both, from organizations that are using Proofpoint capabilities as well as organizations that are not, so we will have to see how that that demand in that pipeline converts into actual deals, but we are encouraged by the balance that we are seeing today.

[Unidentified Analyst:]

Okay. Then just one clarification, what was the FX impact in the quarter?

[Paul Auvil:]

A couple of things, I talked about the $1.2 million that showed up in [OID] that was related to basically the revaluation of currencies that we held in non-denominated U.S. dollars, so Euro in particular, that is the dollar appreciated over the course of the quarter. We ultimately had to mark-to-market to lower values. Then also AR held in those currencies as they were collected at the different exchange rates also then caused that amount to be the $1.2 million or so that I talked about. As well, we do pick up then a little bit tailwind on our spending as our Euro and foreign-currency denominated spending gets a little bit cheaper is measured in U.S. dollars that effect is $200,000 a quarter plus or minus. We did not see a full effect of that in the third quarter, because the dollar appreciated during that window, but we will get a little bit more of that benefit on the full effective the dollars stays where it is over the course of Q4. As I also mentioned, while it does also have some effect on billings, it doesn't have an immediate impact on revenues, because all of our billings go into deferred revenue and then get rolled out over whatever the term of any given deal is 12 months, 24 months, 36 months, so it creates with our current average duration being in the kind of high-teens range. You don't really start to see that effect become meaningful until the second half of '15.

[Unidentified Analyst:]

Great. Thanks and great quarter, guys.

[Operator:]

We will take the next question from Gray Powell with Wells Fargo.

[Gray Powell:]

Great. Thanks for working me in. Gary, I just had a couple of questions. If e-mail is roughly 55% of your revenue then I would assume that your market share is only about 3.5% of $3 billion in security market. Fairly roughly speaking, I don't suggest that your flow share of new revenue growth in that market is more like in the low double-digit range. Does that seem about right? Then just given the overall trend to cloud adoption, where do you think your flow share of growth can go over the next couple of years?

[Gary Steele:]

If you look at market today, you really have to dissect the markets very carefully and understand on how the TAM breaks down. You quoted $3 billion in size.

[Gray Powell:]

Yes. Looking at just messaging security, not the total $6.5 billion that you guys quote for all the products.

[Gary Steele:]

Right, I actually think that kind of classic messaging security is lower than that. I actually think that it is about 17.

[Gray Powell:]

Okay.

[Gary Steele:]

Then we will obviously give you, at the end of the year, we will give you the breakdown of how much protection was in our overall numbers. If you look back at, to close the '13 we had 55% of our revenues coming through protection. Obviously it is a market that is growing both single digits. We are clearly growing much, much faster than that. We are taking incumbent share away, but we still have a lot of opportunity as a single-digit player in this overall market, so we see opportunity to continue to grow for a long time given the size of the over TAM if you just sub-segment it down to e-mail security.

[Gray Powell:]

All right, fair enough. I think just a little more question, if I may. I mean, obviously there were a lot of breaches typically at regional companies recently. We are getting pretty close to Q4 holiday selling season for retail. Have you seen companies increased security initiatives in preparation for Q4 mainly to avoid a situation like a target breach, which happened at the peak of the selling season last year?

[Gary Steele:]

I can't say I have. I think we see increased overall urgency, but not overall urgency that would imply crazy activity as you go into Q4. The other thing to think about as you lay out the timeframe for Q4, many companies especially retailers often times see production freeze prior to Black Friday, and they often times hold production freeze all the way through the end of Q4. Although I think there is a very heightened concern, I think it's unrealistic to think that people are going to deploy before Black Friday, so you got to actually look at what is real in terms of what people get that in what timeframes. However, if you look at retailers and others, there is a heightened concern and people are really trying to figure out what they are going to do to better protect themselves. The final point I would make is, just a little color from a recent customer visit, I was a company that I would say is in the transportation industry and yet they think of themselves as the retailer, because they take orders online and so they process credit cards. They are not a retailer, but the people that now think of themselves as having vulnerability like retailers is broad far and wide, because so many organizations today collect payment information store payment information on their systems think of themselves is totally vulnerable. Second example I was at healthcare company and they worry about credit card more than anything else, because yes they need to be HIPAA compliant, but they don't want to have a credit card breach, because people are then paying their medical bills with their credit cards. I think that it is a broader bigger concern. It is not just isolated to the way in which we have traditionally found our retailers, lots of people are collecting payment information today and recognize the fact that they are vulnerable.

[Gray Powell:]

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

[Gary Steele:]

You bet.

[Operator:]

We will go next to Michael Kim with Imperial Capital.

[Michael Kim:]

Hi. Good afternoon, guys. You talked a little about gating against some of the legacy vendors in intentionally Sanders in that it at Postini conversion not contributed significantly, but can you try and update on Cisco IronPort? Are you seeing acceleration in customer conversions there, which expect that to start to pick up in the first half ahead of the end-of-life?

[Gary Steele:]

As I indicated, we definitely have seen reasonable contribution across all of the incumbents. The only one where we have seen kind of a significant decline is Postini as we talked it was marginal on the quarter. We haven't seen specific to Cisco and IronPort. We haven't seen any change in the overall landscape there. I think that are competitors continues to stay quite good. We haven't seen any behavioral change on their part, so we will just have to see how that plays over the coming quarters.

[Michael Kim:]

Do you have a sense of how far along in the conversion process we are at this point?

[Gary Steele:]

They continue to pitch that product, they are out trying to sell solutions to customers that include the IronPort solution. We have had success taking some of their more interesting customers. I suspect we will continue to have some of that success, but there is a lot of incumbency there.

[Michael Kim:]

Great. Then switching on the SMB opportunity, are you seeing sort of a greater emphasis on strengthening vendor. Can you try and update on how ESSENTIALS is progress and if that's answered comparing at the similar pace of large midsize enterprises.

[Gary Steele:]

Yes. I think the urgency in the SMB is different, because the larger companies have these broader security concerns. Essentials met our expectations in the quarter we didn't reference it in the script, but it's a relatively small part of our business it factors into our overall protection suite. We are expanding as we think about middle enterprise and moving into '15, we are continuing to make investments there. We think that is strategic to our business and we think that Essentials will play key role for us there.

[Michael Kim:]

Got it. One quick one for Paul, relatively guidance I think in the past you talked about synergies with Sendmail's installed base of customers. Does that have essentially sort of a neutral impact when you compare that to the deferred revenue headwinds?

[Paul Auvil:]

Let me parse it differently. The deferred revenue as it winds down largely does not get replaced. Much of their deferred revenue was related to contracts of products that were not, say, third-party products that they sold that we are not renewing and having customers going and buy directly from those third parties. Sendmail had built a very nice business around their original mail transportation agent and in the absence of being able to find growth and cash flow elsewhere, became a purveyor of many other third-party technology, so we had ongoing obligations that was sitting in that deferred revenue balance to support those obligations associated with the third-party products that were sold, but as those obligations wind down and as that deferred revenue balance drops, we are renewing those third-party products, because that is not the business that we are in.

[Michael Kim:]

Okay. Got it. Just on the synergy side with a similar level of penetration installed base that we saw last quarter?

[Gary Steele:]

I am not quite sure I understand your question.

[Michael Kim:]

Yes, similar level of expansion into the installed base in this quarter that we saw last quarter?

[Gary Steele:]

Well, I guess, I would say this, which is broadly within the Proofpoint installed bases of over 3,000 customers. I think, as I mentioned earlier, we a saw little bit better add-on production as a percentage of the overall new and add-on business that we booked for the quarter in Q3. We expect that to return more to the 50-50 levels. With Sendmail in particular, we continue to retain all those customers really with the contracts around the MTA technology. Then we do seek to drive that - business to those accounts. As I mentioned, we had a particularly strong deal that we closed here in the third quarter with one of larger customers. We do have a pipeline of those other opportunities some of which may close here in Q4.

[Michael Kim:]

Okay. Great.

[Paul Auvil:]

…consistent over course since we…

[Michael Kim:]

Got it. Great. Thank you very much.

[Paul Auvil:]

Thanks.

[Operator:]

That concludes today's question-and-answer session. Mr. Auvil, at this time, I would like to turn the conference back to you for any additional or closing remarks.

[Gary Steele:]

Great. This is Gary. I just want to take a moment and thank everybody for joining us on call today. We look forward to talking to you in January.

[Operator:]

This concludes today's conference. Thank you for your participation.