TMCnet News
PROOFPOINT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2012 included in our Annual Report on Form 10-K for fiscal year 2012, or 2012 Annual Report on Form 10-K. This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These statements are often identified by the use of words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," or "continue," and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled "Risk Factors", set forth in Part II, Item 1A of this Form 10-Q and in our other SEC filings, including our 2012 Annual Report on Form 10-K. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. Overview Proofpoint is a pioneering security-as-a-service vendor that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. Our security-as-a-service platform is comprised of an integrated suite of on-demand data protection solutions, including threat protection, regulatory compliance, archiving and governance, and secure communication. We were founded in 2002 to provide a unified solution to help enterprises address their growing data security requirements. Our first solution was commercially released in 2003 to combat the burgeoning problem of spam and viruses and their impact on corporate email systems. As the threat environment has continued to evolve, we have dedicated significant resources to meet the ongoing challenges that this highly dynamic environment creates for our customers. In addition, we have invested significantly to expand the breadth of our data protection platform: • In 2004, we launched our Regulatory Compliance and Digital Asset Security solutions, designed to prevent the loss of critical data. These Data Loss Prevention, or DLP, solutions apply our proprietary machine learning and 20-------------------------------------------------------------------------------- Table of Contents deep content inspection technologies to screen outbound email to prevent the theft or inadvertent loss of sensitive or confidential information. • In 2005, we launched Proofpoint Secure Messaging, our first email encryption solution. • In 2006, we combined our email encryption and DLP technologies to develop a new solution for policy based encryption, enabling each outgoing message to be inspected for confidential content and automatically encrypted accordingly. • In 2007, we began selling our software based virtual appliance, enabling our customers to deploy our solutions in a private cloud configuration. We also invested in international expansion by establishing a team in the United Kingdom as a precursor to the build out of our data center infrastructure, and launching operations in Germany and the Netherlands to support our customers outside of the United States. • In 2008, we introduced Proofpoint Enterprise Archive, a cloud based email archiving solution that enables businesses to securely archive both their email and instant message conversations while enabling real-time access to the entire repository for quick and easy electronic discovery, or eDiscovery. • In 2009, we launched Proofpoint Encryption, a proprietary email encryption solution that improved the level of integration across our data protection suite and allowed us to phase out technology licensed from a third party. We also introduced a cloud based email messaging service. • In 2010, we evolved our solutions to address new forms of messaging and information sharing in the enterprise such as social media and Internet based collaboration and file sharing applications. • In 2011, we achieved FISMA certification for our cloud based archiving and governance solution, enabling us to serve the rigorous security requirements of U.S. Federal agencies. We also introduced an integrated security offering in conjunction with VMware for its Zimbra Collaboration Server. • In 2012, we introduced Proofpoint Enterprise Governance, an information governance solution that provides organizations the ability to monitor and apply governance policies to unstructured information across the enterprise. We also introduced Proofpoint Targeted Attack Protection along with Proofpoint Secure Share. Proofpoint Targeted Attack Protection is a solution that uses big data analysis techniques to identify and apply additional security controls to suspicious messages. Proofpoint Secure Share allows enterprises to securely exchange large files with ease in a cloud-based environment. Our business is based on a recurring revenue model. Our customers pay a subscription fee to license the various components of our security-as-a-service platform for a contract term that is typically one to three years. At the end of the license term, customers may renew their subscription and in each year since the launch of our first solution in 2003, we have retained over 90% of our customers. We derive this retention rate by calculating the total annually recurring subscription revenue from customers currently using our security-as-a-service platform and dividing it by the total annually recurring subscription revenue from both these current customers as well as all business lost through nonrenewal. A growing number of our customers increase their annual subscription fees after their initial purchase by broadening their use of our platform or by adding more users, as evidenced by the fact that these sales consistently represent 15% or more of our billings each year since 2008. As our business has grown, our subscription revenue has increased as a percentage of our total revenue, from 89% of total revenue in 2010, to 95% in 2012. We market and sell our solutions to large and mid-sized customers both directly through our field and inside sales teams and indirectly through a hybrid model where our sales organization actively assists our network of distributors and resellers. We also derive a lesser portion of our revenue from the license of our solutions to strategic partners who offer our solutions in conjunction with one or more of their own products or services. Our sales and marketing operation consists of sales people and associated marketing resources, each of whom are assigned to a specific geographic territory. Their mission is to grow additional revenue within their respective territory in whatever manner is most efficient, either by obtaining new customers or by working with existing customers to expand their 21-------------------------------------------------------------------------------- Table of Contents use of our solutions. Our sales teams are compensated equally for sales to new customers or sales of additional solutions to existing customers, and we do not allocate sales and marketing resources between activities related to the acquisition of new customers and activities associated with the sale of additional solutions to existing customers. We invoice our customers for the entire contract amount at the start of the term. The majority of these invoiced amounts is treated as deferred revenue on our consolidated balance sheet and is recognized ratably over the term of the contract. We invoice our strategic partners on a monthly basis, and the associated fees vary based upon the level of usage during the month by their customers. These amounts are recognized as revenue at the time of invoice. Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. For those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data, we offer various training and professional services. In some cases, we provide a hardware appliance to those customers that elect to host elements of our solution behind their firewall. Increasing adoption of virtualization in the data center has led to a decline in the sales of our hardware appliances and a shift towards our software based virtual appliances, which are delivered as a download via the Internet. Our hardware and services offerings carry lower margins and are provided as a courtesy to our customers. We expect the overall proportion of revenue derived from the hardware and services offerings to generally remain below 10% of our total revenue. The substantial majority of our revenue is derived from our customers in the United States. We believe the markets outside of the United States offer an opportunity for growth and we intend to make additional investments in sales and marketing to expand in these markets. Customers from outside of the United States represented 17% and 18% of total revenue for the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013, we had in excess of 2,700 customers around the world, including 28 of the Fortune 100. In terms of customer concentration, there was one partner that accounted for 17% of our total revenue in the three months ended March 31, 2013, although the partner sold to a number of end user customers. There were no other single partners or customers that accounted for more than 10% of our total revenue in the three months ended March 31, 2012. We have not been profitable to date and will need to grow revenue at a rate faster than our investments in cost of revenue and operating expenses in order to achieve profitability, as discussed in more detail below. Key Opportunities and Challenges The majority of costs associated with generating customer agreements are incurred up front. These upfront costs include direct incremental sales commissions, which are recognized upon the billing of the contract. The costs associated with the teams tasked with closing business with new customers and additional business with our existing customers have represented more than 90% of our total sales and marketing costs since 2008. Although we expect customers to be profitable over the duration of the customer relationship, these upfront costs typically exceed related revenue during the earlier periods of a contract. As a result, while our practice of invoicing our customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are limited in the period where these sales and marketing costs are incurred. Accordingly, an increase in the mix of new customers as a percentage of total customers would likely negatively impact our near term operating results. On the other hand, we expect that an increase in the mix of existing customers as a percentage of total customers would positively impact our operating results over time. As we accumulate customers that continue to renew their contracts, we anticipate that our mix of existing customers will increase, contributing to a decrease in our sales and marketing costs as a percentage of total revenue and a commensurate improvement in our operating income. As part of maintaining our security-as-a-service platform, we provide ongoing updates and enhancements to the platform services both in terms of the software as well as the underlying hardware and data center infrastructure. These updates and enhancements are provided to our customers at no additional charge as part of the subscription fees paid for the use of our platform. While more traditional products eventually become obsolete and require replacement, we are constantly updating and maintaining our cloud based services and as such they operate with a continuous product life cycle. Much of this work is designed to both maintain and enhance the customers' experience over time while also lowering our costs to deliver the service, as evidenced by our improvements in gross profit over the past three years. Our security-as-a-service platform is a shared infrastructure that is used by all of our more than 2,700 customers. Accordingly, the costs of the platform are spread in a relatively uniform manner across the entire customer base and no specific infrastructure elements are directly attached to any particular customer. As such, in the event that a customer chooses to not renew its subscription, the underlying resources are 22-------------------------------------------------------------------------------- Table of Contents reallocated either to new customers or to accommodate the expanding needs of our existing customers and, as a result, we do not believe that the loss of any particular customer has a meaningful impact on our gross profit as long as we continue to grow our customer base. To date, our customers have primarily used our solutions in conjunction with email messaging content. We have developed solutions to address the new and evolving messaging solutions such as social media and file sharing applications, but these solutions are relatively nascent. If customers increase their use of these new messaging solutions in the future, we anticipate that our growth in revenue associated with email messaging solutions may slow over time. Although revenue associated with our social media and file sharing applications has not been material to date, we believe that our ability to provide security, archiving, governance and discovery for these new solutions will be viewed as valuable by our existing customers, enabling us to derive revenue from these new forms of messaging and communication. While the majority of our current and prospective customers run their email systems on premise, we believe that there is a trend for large and mid sized enterprises to migrate these systems to the cloud. While our current revenue derived from customers using cloud based email systems continues to grow as a percentage of our total revenue, many of these cloud based email solutions offer some form of threat protection and governance services, potentially mitigating the need for customers to buy these capabilities from third parties such as ourselves. We believe that we can continue to provide security, archiving, governance, and discovery solutions that are differentiated from the services offered by cloud based email providers, and as such our platform will continue to be viewed as valuable to enterprises once they have migrated their email services to the cloud, enabling us to continue to derive revenue from this new trend toward cloud based email deployment models. We are currently in the midst of a significant investment cycle in which we have taken steps designed to drive future revenue growth and profitability. For example, we plan to build out our infrastructure, develop our technology, offer additional security-as-a-service solutions, and expand our sales and marketing personnel both in the United States and internationally. Accordingly, we expect that our total cost of revenue and operating expenses will continue to increase in absolute dollars, limiting our ability to achieve and maintain positive operating cash flow and profitability in the near term. With the majority of our business, we invoice our customers for the entire contract amount at the start of the term and these amounts are recorded as deferred revenue on our balance sheet, with the dollar weighted average duration of these contracts for any given period over the past three years typically ranging from 18 to 23 months. As a result, while our practice of invoicing customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are realized over an extended period. As such, our efforts to improve our profitability require us to invest far less in operating expenses than the cash flow generated by our business might otherwise allow. As we strive to invest in an effort to continue to increase the size and scale of our business, we expect that the level of investment afforded by our growth in revenue should be sufficient to fund the investments needed to drive revenue growth and broaden our product line. Considering all of these factors, we do not expect to be profitable on a GAAP basis in the near term and in order to achieve profitability we will need to grow revenue at a rate faster than our investments in operating expenses and cost of revenue. We intend to grow our revenue through acquiring new customers by investing in our sales and marketing activities. We believe that an increase in new customers in the near term will result in a larger base of renewal customers, which, over time we expect to be more profitable for us. Sales and marketing is our greatest expense and hence a significant contributing factor to our operating losses. Given that our costs to acquire new revenue sources, either in the form of new customers or the sale of additional solutions to existing customers, often exceed the actual revenue recognized in the initial periods, we believe that our opportunity to improve our return on investment on sales and marketing costs relies primarily on our ongoing ability to cost effectively renew our business with existing customers, thereby lowering our overall sales and marketing costs as a percentage of revenue as the mix of revenue derived from this more profitable renewal activity increases over time. Therefore, we anticipate that our initial significant investments in sales and marketing activities will over time generate a larger base of more profitable customers. Cost of subscription revenue is also a significant expense for us, and we expect to continue to build on the improvements over the past three years, such as in replacing third-party technology with our proprietary technology and improving the utilization of our fixed investments in equipment and infrastructure, in order to provide the opportunity for improved subscription gross margins over time. Although we plan to continue enhancing our solutions, we intend to lower our rate of investment in research 23-------------------------------------------------------------------------------- Table of Contents and development as a percentage of revenue over time by deriving additional revenue from our existing platform of solutions rather than by adding entirely new categories of solutions. In addition, as personnel costs are one of the primary drivers of the increases in our operating expenses, we plan to reduce our historical rate of headcount growth over time. Key Metrics We regularly review a number of metrics, including the following key metrics presented in the unaudited table below, to evaluate our business, measure our performance, identify trends in our business, prepare financial projections and make strategic decisions. Many of these key metrics, such as adjusted subscription gross profit, billings and adjusted EBITDA, are non-GAAP measures. This non-GAAP information is not necessarily comparable to non-GAAP information of other companies. Non-GAAP information should not be viewed as a substitute for, or superior to, net loss prepared in accordance with GAAP as a measure of our profitability or liquidity. Users of this financial information should consider the types of events and transactions for which adjustments have been made. Three Months Ended March 31, 2013 2012 (in thousands) Total revenue $ 30,764 $ 24,619 Growth 25 % 31 % Subscription revenue $ 28,452 $ 23,269 Growth 22 % 45 % Adjusted subscription gross profit $ 21,181 $ 17,287 % of subscription revenue 74 % 74 % Billings $ 35,085 $ 23,882 Growth 47 % 25 % Adjusted EBITDA $ (2,109 ) $ (783 ) Subscription revenue Subscription revenue represents the recurring subscription fees paid by our customers and recognized as revenue during the period for the use of our security-as-a-service platform, typically licensed for one to three years at a time. We consider subscription revenue to be a key business metric because it reflects the recurring aspect of our business model and is the primary driver of growth for our business over time. The consistent growth in subscription revenue over the past several years has resulted from our ongoing investment in sales and marketing personnel, our efforts to expand our customer base, and our efforts to broaden the use of our platform with existing customers. Adjusted subscription gross profit We have included adjusted subscription gross profit, a non GAAP financial measure, in this report because it is a key measure used by our management and board of directors to understand and evaluate our operating results, core operating performance, and trends to prepare and approve our annual budget and to develop short and long-term operational plans. We have provided a reconciliation between subscription gross profit, the most directly comparable GAAP financial measure, and adjusted subscription gross profit. We believe that adjusted subscription gross profit provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management and board of directors. Our use of adjusted subscription gross profit has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, you should consider adjusted subscription gross profit alongside other financial performance measures, including subscription gross profit and our other GAAP results. 24-------------------------------------------------------------------------------- Table of Contents The following unaudited table presents the reconciliation of subscription gross profit to adjusted subscription gross profit for the three months ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 (in thousands) Subscription revenue $ 28,452 $ 23,269 Cost of subscription revenue 7,829 7,211 Subscription gross profit 20,623 16,058 Stock based compensation 232 129 Amortization of intangible assets 326 1,100 Adjusted subscription gross profit $ 21,181 $ 17,287 Billings We have included billings, a non GAAP financial measure, in this report because it is a key measure used by our management and board of directors to manage our business and monitor our near term cash flows. We have provided a reconciliation between total revenue, the most directly comparable GAAP financial measure, and billings. Accordingly, we believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management and board of directors. Our use of billings as a non-GAAP measure has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for revenue or an analysis of our results as reported under GAAP. Some of these limitations are: • Billings is not a substitute for revenue, as trends in billings are not directly correlated to trends in revenue except when measured over longer periods of time; • Billings is affected by a combination of factors including the timing of renewals, the sales of our solutions to both new and existing customers, the relative duration of contracts sold, and the relative amount of business derived from strategic partners. As each of these elements has unique characteristics in the relationship between billings and revenue, our billings activity is not closely correlated to revenue except over longer periods of time; and • Other companies, including companies in our industry, may not use billings, may calculate billings differently, or may use other financial measures to evaluate their performance all of which reduce the usefulness of billings as a comparative measure. The following unaudited table presents the reconciliation of total revenue to billings for the three months ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 (in thousands) Total revenue $ 30,764 $ 24,619 Deferred revenue Ending 91,180 75,503 Beginning 86,859 76,240 Net change 4,321 (737 ) Billings $ 35,085 $ 23,882 25-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA We have included adjusted EBITDA, a non GAAP financial measure, in this report because it is a key metric used by our management and board of directors to measure operating performance and trends and to prepare and approve our annual budget. We define adjusted EBITDA as net loss, adjusted to exclude: depreciation, amortization of intangibles, interest income (expense), net, provision for income taxes, stock based compensation, acquisition related expense, other income, and other expense. We believe that adjusted EBITDA is useful to investors and other users of our financial statements in evaluating our operating performance because it provides them with an additional tool to compare business performance across companies and across periods. We believe that: • Adjusted EBITDA provides investors and other users of our financial information consistency and comparability with our past financial performance, facilitates period-to-period comparisons of operations and facilitates comparisons with our peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results; and • It is useful to exclude certain non-cash charges, such as depreciation, amortization of intangible assets and stock based compensation and non-core operational charges, such as acquisition related expenses, from adjusted EBITDA because the amount of such expenses in any specific period may not be directly correlated to the underlying performance of our business operations and these expenses can vary significantly between periods as a result of new acquisitions, full amortization of previously acquired tangible and intangible assets or the timing of new stock based awards, as the case may be. We use adjusted EBITDA in conjunction with traditional GAAP operating performance measures as part of our overall assessment of our performance, for planning purposes, including the preparation of our annual operating budget, to evaluate the effectiveness of our business strategies and to communicate with our board of directors concerning our financial performance. We do not place undue reliance on adjusted EBITDA as our only measures of operating performance. Adjusted EBITDA should not be considered as a substitute for other measures of financial performance reported in accordance with GAAP. There are limitations to using non-GAAP financial measures, including that other companies may calculate these measures differently than we do, that they do not reflect our capital expenditures or future requirements for capital expenditures and that they do not reflect changes in, or cash requirements for, our working capital. The following unaudited table presents the reconciliation of net loss to adjusted EBITDA for the three months ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 (in thousands) Net loss $ (6,393 ) $ (4,753 ) Depreciation 1,273 1,017 Amortization of intangible assets 404 1,279 Interest (income) expense, net (12 ) 60 Provision for income taxes 142 79 EBITDA $ (4,586 ) $ (2,318 ) Stock based compensation expense 2,071 1,501 Acquisition related expense 39 3 Other income (2 ) - Other expense 369 31 Adjusted EBITDA $ (2,109 ) $ (783 ) 26-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that can have significant impact on the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. We base our estimates, assumptions and judgments on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. On a regular basis we evaluate our estimates, assumptions and judgments and make changes accordingly. We believe that the estimates, assumptions and judgments involved in revenue recognition, deferred revenue, stock-based compensation and accounting for income taxes have the greatest potential impact on our Consolidated Financial Statements, and consider these to be our critical accounting policies. Historically, our estimates, assumptions and judgments relative to our critical accounting policies have not differed materially from actual results. The critical accounting estimates associated with these policies are described in our 2012 Annual Report on Form 10-K, under "Management's Discussion and Analysis of Financial Condition and Results of Operations." There have been no material changes to our significant accounting policies as compared to the significant accounting policies described in our 2012 Annual Report on Form 10-K for the year ended December 31, 2012. Components of Our Results of Operations Revenue We derive our revenue primarily through the license of various solutions and services on our security-as-a-service platform on a subscription basis, supplemented by the sales of training, professional services and hardware depending upon our customers' requirements. Subscription. We license our platform and its associated solutions and services on a subscription basis. The fees are charged on a per user, per year basis. Subscriptions are typically one to three years in duration. We invoice our customers upon signing for the entire term of the contract. The invoiced amounts billed in advance are treated as deferred revenue on the balance sheet and are recognized ratably, in accordance with the appropriate revenue recognition guidelines, over the term of the contract (as more fully described in our 2012 Annual Report on Form 10-K under "Management's Discussion and Analysis of Financial Condition and Results of Operations"). We also derive a portion of our subscription revenue from the license of our solutions to strategic partners. We bill these strategic partners monthly. Our subscription revenue as a percentage of our total revenue was 92% of total revenue in the three months ended March 31, 2013. We expect our subscription revenue will continue to grow and remain above 90% of our total revenue. Hardware and services. We provide hardware appliances as a convenience to our customers and as such it represents a small part of our business. Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. For those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data, we offer various training and professional services. We typically invoice the customer for hardware at the time of shipment. Effective January 1, 2011, we adopted the revenue recognition guidance of Accounting Standards Update (ASU) 2009-13 and ASU 2009-14, which mandate that our revenue derived from the sale of hardware be recognized at the time of shipment. Prior to the adoption of this new accounting guidance, hardware revenue was recognized ratably over the duration of the contract. We typically invoice customers for services at the time the order is placed and recognize this revenue ratably over the term of the contract. On occasion, customers may retain us for special projects such as archiving import and export services; these types of services are recognized upon completion of the project. The revenue derived from these hardware and services offerings increased as a percentage of our total revenue from 5% of total revenue in the three months ended March 31, 2012 to 8% of total revenue in the three months ended March 31, 2013 due to the recognition of a major professional service contract completed during this period. We expect the overall proportion of revenue derived from hardware and services offerings to generally remain below 10% of our total revenue. Total Cost of Revenue Our cost of revenues consists of cost of subscription revenue and cost of hardware and services revenue. Personnel costs, which consist of salaries, benefits, bonuses, and stock based compensation, data center costs and hardware costs are the most 27-------------------------------------------------------------------------------- Table of Contents significant components of our cost of revenues. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business. Cost of Subscription Revenue. Cost of subscription revenue primarily includes personnel costs, consisting of salaries, benefits, bonuses, and stock based compensation, for employees who provide support services to our customers and operate our data centers. Other costs include fees paid to contractors who supplement our support and data center personnel; expenses related to the use of third party data centers in both the United States and internationally; depreciation of data center equipment; amortization of licensing fees and royalties paid for the use of third party technology; amortization of capitalized research and development costs; and the amortization of intangible assets related to prior acquisitions. Growth in subscription revenue generally consumes production resources, requiring us to gradually increase our cost of subscription revenue in absolute dollars as we expand our investment in data center equipment, the third party data center space required to house this equipment, and the personnel needed to manage this higher level of activity. However, our cost of subscription revenue has declined in recent periods as a percentage of its associated revenue as we have replaced third party licensed technology with our proprietary technology, and we expect the benefit of these initiatives to continue in future periods. Cost of Hardware and Services Revenue. Cost of hardware and services revenue includes personnel costs for employees who provide training and professional services to our customers as well as the cost of server hardware shipped to our customers that we procure from third parties and configure with our software solutions. Effective January 1, 2011, in conjunction with the adoption of the new revenue recognition guidance, the cost of hardware is expensed at the time of shipment. Prior to the adoption of this new guidance, these hardware costs were recognized ratably over the duration of the contract with which they were sold. Our cost of hardware and services as a percentage of its associated revenue has been relatively consistent from period to period in the past. With the adoption of our new accounting guidance we expect that cost of hardware and services revenue may gradually increase as a percentage of hardware and services revenue in future periods, as the remaining deferred costs are amortized over remaining contract terms. Operating Expenses Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs, which consist of salaries, benefits, bonuses, and stock based compensation, are the most significant component of our operating expenses. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business. Research and Development. Research and development expenses include personnel costs, consulting services and depreciation. We believe that these investments have played an important role in broadening the capabilities of our platform over the course of our operating history, enhancing the relevance of our solutions in the market in general and helping us to retain our customers over time. We expect to continue to devote substantial resources to research and development in an effort to continuously improve our existing solutions as well as to develop new offerings. We believe that these investments are necessary to maintain and improve our competitive position, however, over the longer term, we intend to monitor these costs so as to decrease this spending as a percentage of total revenue. Our research efforts include both software developed for our internal use on behalf of our customers as well as software elements to be used by our customers in their own facilities. To date, for software developed for internal use on behalf of our customers, we have capitalized costs of approximately $0.4 million, all of which was incurred during 2011, and is being amortized as cost of subscription revenue over a two year period. For the software developed for use on our customers' premises, the costs associated with the development work between technological feasibility and the general availability has not been material and as such we have not capitalized any of these development costs to date. Sales and Marketing. Sales and marketing expenses include personnel costs, sales commissions, and other costs including travel and entertainment, marketing and promotional events, public relations and marketing activities. All of these costs are expensed as incurred, including sales commissions. These costs also include amortization of intangible assets as a result of our past acquisitions. Reflecting our continued investment in growing our sales and marketing operations, both domestically and internationally, headcount increases were reflected in higher compensation expense consistently with our revenue growth. Our sales personnel are typically not immediately productive, and therefore the increase in sales and marketing expenses we incur when we add new sales representatives is not immediately offset by increased revenue and may not result in increased revenue over the long-term if these new sales people fail to become productive. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue will affect our future financial performance. We expect that sales and marketing expenses will continue to increase in absolute dollars and be among the most significant components of our operating expenses. 28-------------------------------------------------------------------------------- Table of Contents General and Administrative. General and administrative expenses include personnel costs, consulting services, audit fees, tax services, legal expenses and other general corporate items. As a result of our operational growth transitioning from a non-public to public company, we expect our general and administrative expenses to increase in absolute dollars in future periods as we continue to expand our operations, hire additional personnel and transition from being a private company to a public company, although we expect these expenses to decrease as a percentage of total revenue. Total Other Income (Expense), Net Total other income (expense), net, consists of interest income (expense), net and other income (expense), net. Interest income (expense), net, consists primarily of interest income earned on our cash, cash equivalents and short term investments offset by the interest expense for our capital lease payments and borrowings under our equipment loans. Other income (expense), net, consists primarily of the net effect of foreign currency transaction gains or losses. Provision for Income Taxes The provision for income taxes is related to certain state and foreign income taxes. As we have incurred operating losses in all periods to date and recorded a full valuation allowance against our deferred tax assets, we have not historically recorded a provision for federal income taxes. Realization of any of our deferred tax assets depends upon future earnings, the timing and amount of which are uncertain. Utilization of our net operating losses and research and development credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Analyses have been conducted to determine whether an ownership change has occurred since inception. The analyses have indicated that although an ownership change occurred in a prior year, the net operating losses would not expire before utilization as a result of the ownership change. In the event we have subsequent changes in ownership, net operating losses and research and development credit carryovers could be limited and may expire unutilized as a result of the subsequent ownership change. 29-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table is a summary of our consolidated statements of operations and results of operations as a percentage of our total revenue for those periods. Three Months Ended March 31, 2013 2012 Amount % of revenue Amount % of revenue ($ in thousands) Revenue: Subscription $ 28,452 92 % $ 23,269 95 % Hardware and services 2,312 8 1,350 5 Total revenue 30,764 100 24,619 100 Cost of revenue: Subscription 7,829 25 7,211 29 Hardware and services 1,239 4 1,169 5 Total cost of revenue 9,068 29 8,380 34 Gross profit 21,696 71 16,239 66 Operating expense: Research and development 7,562 25 5,881 24 Sales and marketing 16,128 52 12,175 50 General and administrative 3,902 13 2,766 11 Total operating expense 27,592 90 20,822 85 Operating loss (5,896 ) (19 ) (4,583 ) (19 ) Interest expense, net 12 - (60 ) - Other income (expense), net (367 ) (1 ) (31 ) - Loss before provision for income taxes (6,251 ) (20 ) (4,674 ) (19 ) Provision for income taxes (142 ) - (79 ) - Net loss $ (6,393 ) (20 )% $ (4,753 ) (19 )% 30-------------------------------------------------------------------------------- Table of Contents Comparison of the Three Months Ended March 31, 2013 and 2012 Revenue Three Months Ended March 31, 2013 2012 % Change (in thousands) RevenueSubscription $ 28,452 $ 23,269 22 % Hardware and services 2,312 1,350 71 Total revenue $ 30,764 $ 24,619 25 % Subscription revenue for the three months ended March 31, 2013 increased $5.2 million, or 22% as compared to the corresponding period last year. This increase was primarily due to a $4.3 million increase in revenue contributed from the United States and, to a lesser extent, for the same period, a $0.9 million increase from our international operations. The increase was due to our ongoing investment in sales and marketing resources, including net headcount increase in sales and marketing personnel, coupled with an ongoing improvement in economic conditions in the United States, resulting in improved demand for our platform worldwide. We believe that the shift in the overall threat landscape, the growth of business-to-business collaboration as well as the consumerization of IT led to the increase in demand for data protection and governance solutions. Hardware and services revenue for the three months ended March 31, 2013 increased $1.0 million, or 71% compared to the corresponding period last year. This increase was primarily from the United States, contributing $1.1 million, offset by $0.1 million decrease in international locations. The increase in U.S. revenue was primarily attributable to the timing of services revenue recognition of $1.2 million in professional services revenue upon completion of the service during the three months ended March 31, 2013. This increase was offset by a decrease of $0.1 million from hardware appliances revenue due to our adoption of new revenue recognition guidance (as more fully described in our Critical Accounting Policies) effective January 1, 2011 under which revenue from sales of hardware appliances began to be recognized when sold. Cost of Revenue Three Months Ended March 31, 2013 2012 % Change (in thousands) Cost of revenue Subscription $ 7,829 $ 7,211 9 % Hardware and services 1,239 1,169 6 Total cost of revenue $ 9,068 $ 8,380 8 % Cost of subscription revenue for the three months ended March 31, 2013 increased $0.6 million, or 9%, compared to the corresponding period last year. This increase in cost of subscription revenue was primarily due to a $0.8 million increase in customer support service personnel related expense to support the ongoing growth. The increase was further offset by a $0.2 million decrease in operations related expense primarily due to a reduction of the intangible assets amortization for the developed technology related to a prior acquisition in 2008. Royalty expense decreased by $0.1 million due to replacement of third-party licensed technology, as well as improved economic terms associated with other ongoing license agreements. 31-------------------------------------------------------------------------------- Table of Contents Cost of hardware and service revenue for the three months ended March 31, 2013 increased $0.1 million, or 6%, compared to the corresponding period last year. This increase was primarily due to an increase in cost of professional services personnel related expense of $0.4 million related to an increase in professional services revenue, offset by a decrease in appliance costs of $0.3 million. Operating Expenses Three Months Ended March 31, 2013 2012 % Change (in thousands)Research and development $ 7,562 $ 5,881 29 % Percent of total revenue 25 % 24 % Research and development expense increased $1.7 million, or 29% for the three months ended March 31, 2013 as compared to the corresponding period last year. This change was primarily due to increased personnel costs as a result of headcount increase during the three months ended March 31, 2013 compared to the corresponding period last year. Three Months Ended March 31, 2013 2012 % Change (in thousands)Sales and marketing $ 16,128 $ 12,175 32 % Percent of total revenue 52 % 50 % Sales and marketing expense increased $4.0 million, or 32%, for the three months ended March 31, 2013, as compared to the corresponding period last year. Headcount increase on a worldwide basis resulted in increased employee compensation related expenses of $ 2.7 million, coupled with an increase of $0.6 million related to facilities and corporate expenses. In addition, travel expense increased $0.5 million and marketing program spending increased $0.2 million as a result of our continued investment in lead generation programs, trade shows and our corporate branding programs. Three Months Ended March 31, 2013 2012 % Change (in thousands) General and administrative $ 3,902 $ 2,766 41 % Percent of total revenue 13 % 11 % General and administrative expense increased $1.1 million, or 41%, for the three months ended March 31, 2013 as compared to the corresponding period last year. This change was primarily due to an increase in net headcount resulting in increased personnel costs of $0.5 million and outside services of $0.6 million over the respective three month comparative period, as we continued to fill additional roles in our transition to being a public company. Total Other Income (Expense), Net 32-------------------------------------------------------------------------------- Table of Contents Three Months Ended March 31, 2013 2012 % Change (in thousands)Total other income (expense), net $ (367 ) $ (31 ) 1084 % Total other income (expense), net decreased $0.3 million for the three months ended March 31, 2013, as compared to the corresponding period last year. The change was primarily due to foreign currency transactions. Provision for Income Taxes Three Months Ended March 31, 2013 2012 % Change (in thousands) Provision of income taxes $ 142 $ 79 80 % Total income tax expense increased $0.1 million, or 80% for three months ended March 31, 2013, as compared to the corresponding period last year. The increase was due primarily to a discrete charge in the current period for accrued withholding tax on non-permanently reinvested earnings. As of March 31, 2013, due to recent net cumulative losses and other negative evidence, a valuation allowance of approximately $4.0 million remains on certain non-U.S. deferred tax assets that are not more-likely-than-not to be realized. We evaluate our deferred tax asset valuation allowance position on a quarterly basis. As a result, management believes a reversal of a significant portion of our valuation allowance on non-U.S. deferred tax assets is possible in the next 12 months. Liquidity and Capital Resources Since our inception, we have relied principally on sales of our preferred stock to fund our operating activities. To date, we have raised $92.8 million from the sale of preferred stock. Additionally, we have utilized equipment lines to fund capital purchases and in April and May 2012, we raised net proceeds of $68.3 million in our initial public offering. We entered into a new equipment loan agreement with Silicon Valley Bank in April 2011 for an aggregate loan principal amount of $6.0 million. Interest on the advances is equal to the prime rate plus 0.50%. As of March 31, 2013, the interest rate on the outstanding advances was 4.50%. We had the ability to draw down on this equipment line through April 19, 2012 and no longer have the ability to draw on this equipment line. Each drawn amount is due 48 months after funding. Borrowings outstanding under the equipment loan at March 31, 2013 were $3.6 million. Equipment financed under this loan arrangement is collateralized by the respective assets underlying the loan. The terms of the loan restrict our ability to pay dividends. The loan includes a covenant that requires us to maintain cash and cash equivalents plus net accounts receivables of at least two times the amount of all outstanding indebtedness. As of March 31, 2013, we were in compliance with this financial covenant. We plan to grow our customer base by continuing to emphasize investments in sales and marketing to add new customers, expand our customers' use of our platform, and maintain high renewal rates. We also expect to incur additional cost of subscription revenue in accordance with the resulting growth in our customer base. We believe that the combination of our ongoing improvements in gross margins, the benefits of lower sales and marketing costs associated with our renewal activity, and the fact that our contracts are structured to bill our customers in advance should enable us to improve our cash flow from operations as we grow. Based on our current level of operations and anticipated growth, both of which are expected to be 33-------------------------------------------------------------------------------- Table of Contents consistent with recent quarters, we believe that our existing sources of liquidity will be sufficient to fund our operations for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, and the timing and extent of spending to support product development efforts and expansion into new territories, and the timing of introductions of new features and enhancements to our solutions. To the extent that existing cash and cash equivalents and cash from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. We may also seek to invest in or acquire complementary businesses, applications or technologies, any of which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Cash Flows The following table sets forth a summary of our consolidated cash flows for the periods indicated: Three Months Ended March 31, 2013 2012 (in thousands) Net cash provided by operating activities $ 1,195 $ 236 Net cash provided by investing activities 435 1,047 Net cash provided by financing activities 3,770 1,525 Net Cash Flows Provided by (Used in) Operating Activities Our net loss and cash flows from operating activities are significantly influenced by our investments in headcount and data center operations to support anticipated growth. Our cash flows are also influenced by cash payments from customers. We invoice customers for the entire contract amount at the start of the term, and as such our cash flow from operations is also affected by the length of a customer contract. We generated $1.2 million of cash from operating activities in the three months ended March 31, 2013. This generation of cash was the result of a net loss of $6.4 million, offset by non-cash expenditures of $4.0 million, which included depreciation, amortization, accretion of investments and stock based compensation expense. These non-cash expenditures increased due to capital expenditure and headcount growth, primarily related to continued investment in our business. Cash generated from operations was further due to an increase in deferred revenue of $4.3 million related to timing of revenue recognition. Additional fund contributions were due to the net change in certain working capital items, most notably an increase in accounts receivable of $2.4 million, an increase in inventory of $0.2 million, and a decrease in accrued liabilities of $0.1 million related to timing of accrued payables, an increase of $0.1 million in prepaid expenses and other assets, and an increase in accounts payable of $1.7 million related to timing of accrued payables paid during the period. Cash generated from operating activities in the three months ended March 31, 2012 of $0.2 million was the result of a net loss of $4.8 million, offset by non-cash expenditures of $3.8 million, which included depreciation, amortization and stock based compensation expense, due to headcount growth and investment in the business. This was further offset by a decrease in deferred revenue of $0.7 million and a decrease in deferred product costs of $0.4 million. Additional contributions were due to net change in working capital items, most notably a decrease in accounts receivable of $1.5 million due to strong collection efforts and timing of increased sales, an increase of $0.2 million in inventory, a decrease of $0.4 million in prepaid expenses and other assets, and net decrease in accounts payable and accrued liabilities of $0.7 million, related to timing of inventory, data center obligations, and employee compensation accruals. Net Cash Flows Provided by (Used in) Investing Activities Our primary investing activities have consisted of the purchase and sale of short-term investments and capital expenditures in support of expanding our infrastructure and workforce. As our business grows, we expect our capital expenditures and our investment activity to continue to increase. 34-------------------------------------------------------------------------------- Table of Contents Cash from investing activities provided $0.4 million of cash during the three months ended March 31, 2013. This was primarily due to proceeds of $21.8 million from sales and maturities of the short-term investments, offset by purchases of short term investments of $20.4 million. In addition, we used $1.0 million to purchase equipment for infrastructure expansion. These expenditures were primarily for replacement and upgrade of equipment to lower the cost of deployment as well as to improve the efficiency for our cloud based architecture. Cash provided by investing activities in the three months ended March 31, 2012 of $1.0 million was primarily from net proceeds of $2.3 million from sales and maturities of the short term investments, offset by $1.3 million of equipment purchases used for infrastructure expansion and other fixed assets. Net Cash Flows Provided by (Used in) Financing Activities Cash provided by financing activities in the three months ended March 31, 2013 was $3.8 million. This was primarily related to $4.2 million of proceeds from the exercise of stock options, partially offset by $0.4 million in repayments under our equipment financing loans. Cash provided by financing activities in the three months ended March 31, 2012 was $1.6 million. This was primarily related to $1.6 million of proceeds from the exercise of stock options. Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We are therefore not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in those types of relationships. |