ShoreTel, Inc. Q1 2009 Fiscal Year Conference Call Transcript

Executives

Tanya Chin - Director of Investor Relations

John W. Combs - Chairman, President and CEO

Mike Healy - CFO

Analysts

Sanjiv Wadhwani - Stifel Nicolaus & Company

Troy Jensen - Piper Jaffray

Samuel Wilson - JMP Securities

Jeff Gable - Barclays Capital

Ehud Gelblum - JP Morgan

Rohit Chopra - Wedbush Morgan

ShoreTel, Inc. (SHOR) Q1 2009 Fiscal Year Conference Call Transcript October 29, 2008 5:30 PM ET

Operator

My name is [Chaute] and I will be your conference operator today. At this time, I would like to welcome everyone to the First Quarter Fiscal Year 2009, Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you Ms. Tonya you may begin your conference.

Tonya Chin

Hello, and thanks for joining us today, as we report our first quarter fiscal year 2009 financial results. Joining me on the call today are ShoreTel’s Chairman and CEO, John Combs, and Chief Financial Officer, Mike Healy.

Before we begin, let me inform you that during today’s calls, management may make forward-looking statements within the meaning of the Safe Harbor Provision of the Federal Security Laws regarding the company’s anticipated future revenue, gross margins, operating expenses and other financial and business related information.

These forward-looking statements are subject to risk and uncertainties that could cause actual results to differ materially from those projected.

Additional information concerning the risk factors that could cause actual results to differ materially from those in the forward-looking statements that can be found in the Company’s annual report on form 10-K for the fiscal year ended June 30th, 2007 and the current report on form 8-K furnished today.

The information in this conference call related to projections or other forward-looking statements is based on Management’s current expectations. The company does not intend to update its forward-looking statements should circumstances change.

Now I’ll turn the call over to John Combs, Chairman and CEO of ShoreTel. John

John Combs

Thank you Tonya, and a special thanks to all of you for joining us today. We are very pleased to have delivered revenues of $35.9 million the highest revenue in company history. This is an increase of 3% sequentially and up 12% from the same quarter last year.

Our non-GAAP gross margin came in strong at nearly 65%. Our non-GAAP operating expenses were $22.4 million for the quarter. As a result non-GAAP earnings were $527,000 or $0.01 per diluted share.

This past quarter marks our highest revenue achievement and here at ShoreTel, we are particularly proud of this accomplishment, because the first quarter of fiscal year has historically been a challenging one for us.

Overall, we saw solid growth across our customer base. We grew our new customer account by a record of more than 800 new customers, ending the quarter with over 8,800 total customers. We continue to grow our large market customer base including customers such as the American Cancer Society and Delaware Corporation a manufacturer of original metal and plastic containers with annual sales exceeding $800 million. 48% of our revenues, were from new customers in the quarter.

We saw a broad-based strength from our regional distribution partners which as a Group were up 11% in the quarter. Revenues from our National partners which are AT&T, CDW and Black Box were down 14% during the quarter. This isn't surprising considering the 54% sequential growth in Q4. With international category AT&T's revenue did grow from Q4 to Q1.

Recently, I met with a number of key executives from AT&T, who expressed their satisfaction with the performance of the ShoreTel Unified Communication System and the sales and service support we are delivering.

In general, our revenue distribution from our vertical markets, was consistent with Q4. Our two largest verticals in the quarter, were professional services and higher education. In fact we had two procedures universities in our top ten new customers during the quarter, and saw growth in our 10-K to 12 segment with wins in a number of large school districts.

Earlier this month, I had the opportunity to meet with the CIO and his team from one of our University customers. They told me that in addition to our lower total cost of ownership ShoreTel's event management, ability to integrate with the legacy communication systems, noticeably higher voice quality and superior liability drove in a decision to select ShoreTel.

In light of the challenges in the financial sector, we wanted to highlight that sales in our financial vertical were flat during the quarter and represented approximately 10% of our total sales.

As we begin our new fiscal year, we have re-evaluated the way we report our international revenues. In the past, we only included non-North American countries in our international category. This meant that our sales to Canada and Mexico were not included in our international revenues. So beginning this quarter, we are reporting international revenue as all sales outside of the United States, which is more in line with the direction from the SEC.

With this quarter revenues from outside the U.S. were $2.3 million or 6% of revenue, up from $2 million in Q4. During the quarter I spent two weeks in Europe, visiting five countries and meeting existing and prospective customers, partners and distributors. I remained convinced that international expansion remains a very healthy opportunity for us over the coming quarter. Our EMEA team signed 14 new high quality partners during the quarter, including three EMEA distributors and our sales [funnel] is the largest it's ever been.

In short, I came away from my visiting courage by the strength of our distribution and the caliber of the recent additions to our team. We also made good progress in our Asia-Pacific region with the addition of Aria Technologies as a national distributor for ShoreTel in Australia.

Aria is one of the leading distributors of telecommunications equipment and solutions in Australia and supplies systems to Australia's largest carrier Telstra under the Telstra brand. This new distributor represents a significant opportunity for ShoreTel in Australia and we are excited about this potential.

In September our team returned to EMEA to launch our largest international product release in our history, ShoreTel 8.1. The most important aspect of this new product introduction was the expanded global -- we've send it globally, the availability of the professional communications manager, ShoreTel unified communications desktop client.

ShoreTel 8.1 also increased the number of mobile phone options on which customers can run our Mobile Call Manager. An exciting application that allows users to control their enterprise communications right from the mobile phone. Mobile Call Manager now runs on a Blackberry Pearl, Curve, 8800 and the Motorola Razr, V3 and in Nokia E65. In addition ShoreTel 8.1, introduced a new hardware devices including, ShorePhone IP 230g, a low cost gigabit Ethernet desktop phone and new switching appliance with BRI and E1 interfaces to support international deployments.

ShoreTel 8.1 also expanded our unified communications offering, by initiating support for additional instant messaging platforms, our professional communications manager now uses Microsoft OCS 2007 or ShoreTel Converged Conferencing as the instant messaging presence engine.

With this release, we now support a total of 23 countries including Italy, India and Norway which were added in the quarter and eleven different languages.

We also continued our emphasis on our total cost of ownership by training our partners to use the TCO tool that we discussed in last quarter's call. We found that many of the prospects were struggling to do a comprehensive financial analysis that compares proposals from various suppliers. So we created a tool to help them.

Our TCO tool helps perspective customers capture all of the costs from the various supplier proposals both upfront and overtime and compares them on a financial basis including return on investment, break-even analysis, net present value in total rate of return, using charts and graphs for visual clarity.

Our TCO tool is not marketing collateral, but rather a verifiable analytical tool that is designed to shine the bright light of truth on the financial implications of the proposed solutions from each supplier. We find that the more thorough the financial analysis, the more likely the prospect is to choose ShoreTel because we truly deliver a lower total cost solutions.

I am sure it is not a surprise to anyone on the call today, that the biggest unknown we are facing in the short-term is whether we will be able to grow in this very uncertain economic environment. Our sales [model] continues to be very solid. We are optimistic that we are focused on total cost of ownership; customers will continue to see ShoreTel's Unified Communications as the most necessary part of their IT budget.

A recent JMP IT survey of the [ware] community showed that their customers rank Voice over IP first on their spending priority. While it's too difficult to predict exactly what will happen in the next few quarters, we will strive to outperform the market and continue to grow our market share.

Last quarter, I said we planned to ramp-up our spending in the coming quarters. While we are not putting on the breaks, we have decided that it will be prudent to ease up on the accelerator and slow our spending growth in the near term, while we carefully monitor what is happening in the broader economy. We will continue to selectively invest in key revenue generating areas while balancing with opportunities to cut costs in other areas.

In our sales group, we've continued to invest in our sales team to support our growing partner and customer base. As an example, we recently formed a group directly focusing on selling to the government sector and higher dedicated sales resources in Canada, both are areas we see significant opportunity ahead for ShoreTel.

With regard to research and development, we plan to continue to selectively add to our engineering talent pool and develop new products to enhance our award winning Unified Communications solution. I am extremely excited about our product development releases we've got planned for the next 12 to 18 months.

In general, we delivered two software releases each year, for example, ShoreTel 8.0 and 8.1 in the past 12 months. While these major software releases are delivered to the market approximately every six months. It takes about 18 months between content definition and the actual release of the product to the customers.

To provide an agile response to our customers feature enhancement requests, we promote a lot of almost promising engineering managers to build a team dedicated to providing quarterly feature enhancements. This team will [buy] quick turnaround and customer request that is not available for most of our competitors. This investment demonstrates our commitment to delighting our customers both pre and post sale.

Despite what is arguably one of the most difficult economic environments we’ve seen in the last few decades, I remain very confident about ShoreTel’s long term prospects. Clearly we would all like to see better economic times globally. But I believe that the difficulties facing many of our competitors over the coming quarters will actually offer ShoreTel significant opportunities.

ShoreTel is in the enviable position of having no debt over $100 million in cash, positive cash flow and no significant customer or partner concentration. I believe this financial strength puts us in a position to weather even the most challenging economic storm.

For many of customers the company’s communication system remains a top priority despite budgetary challenges they may face, because it offers the opportunity to cut cost and improve productivity. Using our proprietary TCO tool we can demonstrate to customers the fastest payback in the industry and ongoing cost significantly less than their existing system.

In fact it's typical -- it is typically [cost in cuts] was more money not to switch to ShoreTel Unified Communications system. With that let me turn the call over to Mike Healy for review of our financial performance for the first quarter. And then I will close with some final thoughts. Mike?

Mike Healy

Thanks John. As a reminder I will discuss both GAAP and non-GAAP results throughout this call. And I refer you to our press release for the reconciliation between this GAAP and non-GAAP amounts. Our non-GAAP numbers exclude stock-based compensation charges and the related tax adjustments. We believe that excluding these items gives the management and investors a better indication of our operating result.

As John said earlier we delivered record revenues of $35.9 million which represents growth of 12% over last year and a 3% increase over the last quarter's revenue of $34.7 million. Service and support revenue grew nicely by 12% to $5.8 million which represents 16% of total revenue and a 52% increase year-over-year. Our major accounts program which is designed to service our largest customers grew by 16% sequentially in Q1.

In terms of volume, our end user licenses sold in the September quarter, totaled 84,300, a 7% increase over the last quarter’s volume.

Next let’s discuss outstanding gross margin results. In Q1 we reached record levels on both product and service and support gross margin. Total non-GAAP gross margins increased to 64.6% in the quarter up from 63% in the previous quarter. Product margins were 67% in the quarter and service and support gross margins were a record high, 53%. The increase in total gross margins in the September quarter was primarily due to a nine point improvement in service and support margins as a result of the $600,000 increase in revenue while maintaining flat spending. In addition, improved product cost on our switches and a positive mix shift also helped the product margin grow to 67%.

GAAP gross margins which included $216,000 in stock based compensation charges were 64% on the quarter. Non-GAAP operating expenses were $22.4 million. Our spending in Q1 reflects a sequential increase of $2.4 million, primarily related to $1 million in cost associated with our partner conference in July and increase in our allowance for bad debt and increased labor cost related to the hiring of 15 employees during the quarter.

GAAP operating expenses in the quarter were $24.9 million and included 2.5 million stock based compensation expenses. Even with our increase in operating expenses, substantially less interest income and a higher tax-rate than in Q4, I was pleased we were able to achieve our goal of both positive operating and net income in Q1.

Our non-GAAP net income was $527,000 or $0.01 per diluted share. Diluted share count used in the non-GAAP earnings per share calculation was 44.7 million shares. Our GAAP net loss in Q1 was $2.2 million or $0.05 per share which included $2.7 million in total stock based compensation charges. Our GAAP and non-GAAP tax rate for the quarter was unusually large and will continue to vary at low levels of profitability or losses. However, we are expecting the favorable tax benefit to our overall tax expense in Q2 resulting from the emergency economic stabilization act of 2008, which was signed in early October. This will allow us to take certain research and development tax credits retroactively to January 1, 2008 subject to certain limitation.

Next, let me discuss a few highlights from our balance sheet as of September 30th. We ended the quarter with a $107.1 million in cash, cash equivalents and short-term investments, which is an increase of $4 million over the last quarter. We are very pleased to have generated $5.7 million in cash from operations. Most are resulting from prudent working capital of inventory and account receivable. Accounts receivable declined slightly to $20.1 million and as a result, day sales outstanding or DSO's showed the improvement, reducing two days to 51days.

In terms of credit and customer payments, we were very pleased to meet our DSO and collection goals for the quarter. Looking though, in the face of the tightening credit markets, we are monitoring the credit worthiness of our partner base very closely. We are also ramping up our short-term financial solutions program, which allows our customers to take advantage of different leafing options through a ShoreTel sponsored programs including a technology refresh options, which will further enhance our TCO benefit by eliminating up front cash payments for end customer. By utilizing this program, we believe we can manage our potential credit exposure more effectively.

Inventory decreased $2 million as expected and ended the quarter at $10 million, as our fallen switch inventory levels declined. As a result our annual returns increased slightly to three times per year.

Capital expenditures for the quarter were approximately $468,000 and depreciation and amortization was approximately $450,000. On the liabilities side of the balance sheet, there are no significant changes were a small decrease in accounts payable and accrued liability and a $1.9 million increase in deferred revenues in the quarter, related to deferrals of product revenue and an increase in support contracts, which are recognized revenue over the life of the contract.

Now let's discuss our business outlook for the December 2008, quarter. Let me first begin by saying that we believe our business remains fundamentally sound and certainly our Q1 results backup this belief. In terms of revenues guidance for Q2, we expect revenue to be in the range of $30 million to $35 million. Our sales pipeline at the beginning of the December quarter is stronger than this time last quarter, but our challenge will be converting that pipeline into revenue at the same rate we have done over the past few quarters.

Financial and industry experts admit they can’t predict the timing and what affects the financial crisis will have on the accounting but not everyone seems relieved, there will be an overall slowdown in capital spending in our market. In order to stimulate demand we are providing kind dependent promotional pricing on certain products to instead advise their customers to buy now and not wait until the end of the December quarter.

Naturally, we will continue to encourage our customers to focus on the operational and financial benefits they get them from ShoreTel unified communication solution to continue to drive sales.

This job is made easier by industry leading product offering, the world class customer satisfaction levels and level of total cost of ownership. Still we feel -- we feel, we feel as it best to be prudent and setting our revenue expectation for the December quarter. Given the ongoing economic uncertainty we expect non-GAAP gross margins in the range of 63% to 64% and GAAP gross margins to be 100 basis points lower than the non-GAAP amount because of the stock-based compensation charges.

We expect non-GAAP operating expenses to be between $21.5 and $22.5 million. As John mentioned we will be prudent in the hiring and spending this quarter and to regain better visibility on our revenue achievement. Our GAAP operating expense estimates include two million forecasted for stock-based compensation expenses. And therefore our GAAP outcome expense range for Q2 is expected to be $23.5 to $24.5 million.

In Summary, we're extremely pleased with our financial performances in the first quarter of fiscal year 2009. We net expectations for top line revenue in a top economic environment. We had highest gross margins ever. Operating expenses are in line with expectations which generated over five million in cash from operations and remain profitable.

Looking forward we expected grow our market share and rebuild our rock solid balance sheet will allow us to whether whatever economic condition may come. With that, let me turn it back to John for some closing remarks.

John Combs

Thank you Mike, looking forward it is clear the capital spending will slow. But enterprise communication purchases tend to be strategic from most business so we expect them to be more resilient than other categories. Still we are playing for flat to negative growth in enterprise communications market. Well it is not clear how long a difficult economic environment will last. One thing we do know for sure is that this downturn is part of a cycle. And in time to turn around will come. Real opportunity for ShoreTel is the greater market share and we think this uncertain economic environment presents a chance for us to continue to gain market share.

Our distributor, architecture product has clear cost advantage both in terms of upfront and total cost of ownership over the life of the system, due to dramatically simpler system management and exceptional scalability and reliability.

Which have some two levels, first prior to all of the economic unrest our biggest competitor was not a specific supplier. It was not being considered by the costumer. This is the same challenge we face today, as business takes more time to think harder about significant capital purchases, we believe they will increase the numbers of suppliers that they consider. ShoreTel is a natural choice for them to add to their mix of potential suppliers especially as costumers look for lower total cost of ownership solutions.

And secondly, ShoreTel has a very strong competitive win rate, when we get in an opportunity we tend to win because once a prospect takes some time to understand our distributor architecture, they agree that it is a fundamentally superior approach.

In addition to all of the items, Mike and I have highlighted in the call today, we still have our secret weapon, our raving fans. With the impelling (inaudible) that moves CIO’s to ShoreTel, is out delighting customer base. CIO’s put their jobs on the line, when they select the communication system. There is nothing more powerful than to have a current ShoreTel CIO, share with the perspective CIO, their experience with ShoreTel.

The very expressive and animated way our current customers rave about ShoreTel, is our secret weapon. As I mentioned before, we measure customer satisfaction daily and every quarter for past three years we have been rated by our customers as world class. Let me show a great example, last week I was interviewing sales candidate from a competitor. When I began to break into my customer satisfaction dissertation he headed up to me and said I got it John. I get it from your partners; I get it from your customers that is why I am interviewing with you today.

Needless to say he always receives his Job offer letter.

Another example I had earlier this month, when I was giving a presentation to a large group of current and perspective customers. We began the presentation by inviting existing customers to share their experience toward ShoreTel with the group. The response was overwhelming. I was tempted to pack-up my slides and turn the presentation over to them.

In closing our focus to determine how you can capitalize on this challenging environment and take advantage of our competitive strength, so that we are stronger company emerging from the storm. The enterprise communication category is so large that even in declining market, there is an opportunity for ShoreTel to grow. So, the bottom-line is that we are confident that with our industry leading product, the lowest total cost of ownership, our rock solid financial provision and world class customer satisfaction, will not only whether the storm, but we can advantage of the opportunity to increase our market share and establish ShoreTel as a leading brand.

Now let me ask the operator to begin the question and answer part of the call. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Sanjiv Wadhwani.

Sanjiv Wadhwani - Stifel Nicolaus & Company

Thanks so much. Couple of questions, either for John or Mike. Just to be clear you haven’t seen any slowdown from customers in terms of delaying purchases or suggesting that we had this project in mind that they are going to sort of revisit this lets say in six months, or anything like that?

John Combs

We do a weekly forecast call with our sales team. And we monitor there is metric very carefully. And the number of push-outs that we see is not dis-proportionally higher or hasn’t been higher in this quarter than we have seen in prior quarters.

Sanjiv Wadhwani - Stifel Nicolaus & Company

Got it. So, obviously the guidance is just adding a level of conservatism to what you are seeing around you and on CNBC etcetera?

John Combs

That’s true. What I would say is, as I mentioned our proposal backlog is very strong. I toured, I spent a lot of time out in the field and I am not receiving negative feedback. Just last Friday I was on a conference call with over a 100 of our partners in the South East and I asked them the question what are they seeing and we have a very tight relationship with our partner network. If they saw something negativity they certainly would bring it up and they didn’t bring it up. The challenges I see in terms of our decision to lower the guidance was that I kind of feel like we are standing in middle of the rain-storm and not getting wet. There is so much energy around the negative situation and I'm not quite sure when it's going to affect us.

We do have holidays coming up at the end of the quarter and we've got a lot of promotions and incentives to drive customers to order early. But that always put the question mark out there. We know that access to capital for both our partners and I knew the customers could potentially impact us. And proposal sales tracking pipeline system, really focuses on the customers in the last half of the cycle. So those customers who are going to get closed in October, November and then later in December. We are really focused on near term. So we really track very well, the last half of the proposal cycle, but we don’t have the same kind of visibility up into the number of customers that come in at the top of the pile.

Sanjiv Wadhwani - Stifel Nicolaus & Company

Got it, and you touched on this a little bit earlier in your prepared comment and also in the answer that you just gave, but on the credit side of the equation, any customers, are you seeing any customers struggling to get credit and consequently leading to some push-outs or what about your [volumes] any of your resellers, also struggling to get credit and consequently not able to work effectively with your equipment?

John Combs

The end user customers we haven’t seen, I haven’t seen any of that at this point in time, we have always managed that the credit relationship with our distribution partners very carefully and maybe even Mike wants to comment on who we are seeing there.

Mike Heal

Yeah, I mean, its hard to say that there is not going to be effect in, I have heard a couple instance, for creditors end customers a lot of partners where they have had lines established, and those lines have been reduced or taken away, so we are anticipating some impact and that if we corporate it into our guidance 30 million to 35 million, there will be some impact because of that, its just very hard to measure right now.

Sanjiv Wadhwani - Stifel Nicolaus & Company

Got it, and then one last question and then I will hop-off. On the services revenue, big ramp-up in the quarter any specific reason for that and then should we expect that sort of to be the base line run-rate going forward?

Mike Heal

Yeah, I mean we are thrilled with our results in service support line, lot of it is customers, as we talked about the world-class customers satisfaction and so when they feel that way they renew their support contracts and that business continues to ramp-up, just adding more customers [natural] ramp to support area, and then the other services we have provided whether its professional services or installation services or training continues to ramp-up nicely or managing the business well and cranking up better gross margin so it’s really a combination of extremely high level customer satisfactions for our partners and adding these other services, that are really just kind of ramping up and it could get a lot bigger as we move forward.

Sanjiv Wadhwani - Stifel Nicolaus & Company

So just a model in December, I mean we should effectively model service revenues flattish maybe and then decline really coming on the product side?

Mike Heal

Yeah, I mean, I would expect the support business continues to grow mainly, actually depending on how many new customers we get in the quarter and the renewal rates, but internally we are expecting some growth on the service and support lines.

Sanjiv Wadhwani - Stifel Nicolaus & Company

Got it, all right, thanks so much guys.

Mike Heal

Thank you.

Operator

Your next question comes from Troy Jensen of Piper Jaffray.

Troy Jensen - Piper Jaffray

Congrats on the nice quarter gentlemen.

John Combs

Hey Troy how are you?

Mike Healy

Hey Troy?

Troy Jensen - Piper Jaffray

Very good. I had a follow up on Sanjiv's question, what about on the margin side of services? Do you think you can sustain them here above 50 or do you need to start expanding up the service head count?

Mike Healy

Yeah, so next quarter, the December quarter, our expectation is the margins will go down a little bit; hence one of the reasons for the guidance a little bit lower than we did this quarter. We did keep spending flat but I don’t think we can do that every quarter when you are raising revenue $600,000 or so. So, we'll do a little bit of hiring and spend a little bit money and support. But I would probably [model] a little bit of decline in gross margins. We were trying to shoot for 50 or above kind of long-term there.

Troy Jensen - Piper Jaffray

And Michael could you give us -- let us know how much the legal expense was during the quarter from the Mitel litigation and any update you can give on that side?

Mike Healy

Sure. We're doing a good job in managing our legal expenses. It wasn’t that significant, we don’t break out the cost for a litigation in our P&L externally and in terms of activity its very low activity to talk about both on the Mitel patent case and then our case against Mitel in terms of in Canada for a trade liable. Both cases are progressing; we're spending a little bit of money. I think our forecast calls for a little bit of up tick next quarter in the legal cost in that area.

Troy Jensen - Piper Jaffray

Alright and then one for John, kind of mentioned briefly but on the competitive side there seems to be Nortel struggling here, it reflected in the stock price, Microsoft, OCS, I don’t know if that’s been affective, as effective as some people thought. You're still [it seems] Cisco and Cisco's has updated some of other competitors you compete against?

John Combs

Well once again our biggest competitor is not getting in the game. Just last week, when I was up in the mid-west and we had a chance to visit Troy, I got out really with some of our partners and asked their sales people when was the last time they lost a ShoreTel deal and its very rare when once get in the case. But the Admin said Cisco would be the number one competitor. They do a very good job of managing the accounts and not letting us get in the game. Nortel as you said is struggling, we had a lot of inquires with some of their partners as to what and Black Box is an example of a big Nortel customer that we picked up as a distribution partner. Avaya has made some significant management rearrangements and changes, so I think there is a lot of things changing it at Avaya these days. We compete to -- we continue to compete favorably with them. But they seem to seemed to have gone private, they’re little bit tougher to crack.

Troy Jensen - Piper Jaffray

Alright, keep up the good work guys.

John Combs

Thank you Troy.

Mike Healy

Thanks Troy.

Operator

Your next question comes from Samuel Wilson of JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon. Few small questions. Can you give me some sense what linearity was in the quarter anything unusual there?

Mike Healy

No nothing unusual as we've talked about in the past the typical linearity is 50% in the first two months and 50% in the last month. Then September quarter was around that.

Samuel Wilson - JMP Securities

Okay, overall just your best guess. Do you think the markets for Voice over IP grew overall in the third quarter?

John Combs

I think Sam it went down. I think it dropped. And I think its declining more in this quarter.

Mike Healy

Yeah what we know is June in U.S. was about 7% increase on a worldwide basis 3.5. And that was lower than some of the industry experts had predicted. But our gut feel is we haven’t seen any data that it was flat to down and certainly we can't expect that in December as well.

Samuel Wilson - JMP Securities

Alright and then just two last questions. Something easy one Mike. For the December quarter you told the R&D tax credit the rest of R&D tax credit coming to (inaudible). Do you expect a negative tax rate because you've said that's probably what you will achieve in the December quarter?

Mike Healy

No, I haven’t got and qualified and subject to AMT limitations and lot of other calculations. I don’t think it will make our tax revision credit that depends on a lot of other variables. But it will have a good impact of bringing it down.

Samuel Wilson - JMP Securities

Okay and then for John sort of a freebie here. But I’d love to get your sense on ShoreTel how is customer adoption been with the economic environment are they slowly adopted and historically faster to adopt? I noticed you mentioned you are sort of increasing the amount of features that you want to put into the products per quarter, just a sense for how ShoreTel has gone so far?

John Combs

It’s really been outstanding. But remember Sam the way it works is that customers don’t pay one price for six and one price for seven and one price for eight. Once we got eight everybody gets eight.

Samuel Wilson - JMP Securities

Right.

John Combs

So basically 100% of our new sales that we shipped last quarter were 8.0 and going forward this quarter it will be on 8.1. So everybody gets it. And the adoption, the personnel call manger comes as part of the package. So, the adoption rate and using the UC services, et cetera is very, very high.

Samuel Wilson - JMP Securities

I guess what I am getting at a little bit is do you think maybe better than expected performance in the September quarter could it all have been a little bit of pent-up demand for ShoreTel 1 over an 8 or do you think its just great execution.

John Combs

That’s a freebie. It’s a bit of both

Samuel Wilson - JMP Securities

All right, thanks guys.

John Combs

Thanks Sam.

Operator

Your next question comes from Jeff Gable of Barclays Capital.

Jeff Gable - Barclays Capital

Yes thanks very much for taking the question. I was wondering if you could help me understand a little bit about the driver behind offering promotional plan and supporting demand in to the December quarter instead of letting it just through drift in to March.

John Combs

It’s not so much pulling it in. It is to give our partners an impending event to encourage the customer to move forward sooner or rather than later. Large capital purchases can always drag on in a company, but if we provide our CIO we have a tool to be able to go with an organization and say my price is going to go up if I don’t get this thing approved now. It helps to bring, so its not necessarily pushing stuff into the December that would have gone into January but helping to provide the customers an incentive to buy now at the specific rate till later.

Jeff Gable - Barclays Capital

Okay, all right.

John Combs

That makes sense to you?

Jeff Gable - Barclays Capital

It does, I guess I hadn’t heard of that from you guys before or is that something that you have done in the past and do it from time-to-time?

Mike Healy

Jeff we are trying to learn a little bit from our experiences in that last December. We didn’t really have a company sponsored promotion and that also affected us a little bit and we weren’t able to close as much as we expected those last two weeks in December with the holidays in the way and everything else. So, we didn’t want to have that experience obviously again and so we’ve got these promotions in place there earlier by the bigger discounts you get kind of thing and so just trying to move the rating game up from December and get it into October and November.

Jeff Gable - Barclays Capital

Okay all right. thanks very much.

John Combs

Thank you, Jeff.

Operator

Your next question comes from Ehud Gelblum of JP Morgan.

Ehud Gelblum - JP Morgan

Hi guys thanks very much.

John Combs

Hi, how are you?

Ehud Gelblum - JP Morgan

I am doing well. Couple of questions, first on the cost cutting for being more prudent in your expenses, as you moved to try and get international revenue in the past imagining you are keeping this off just going and looking to continue to get some more international. At what point do you cutback from an international expansion and focus more on domestically and perhaps in different parts of the U.S. as opposed to going internationally? How much is that costing? When you look at midpoints of the guidance put your operating margin obviously for next quarter at a negative margin? If that continues how long do you feel comfortable running the company at a negative operating margin and what are the parts that you are going to change in the OpEx structure to bring it back?

John Combs

So, let's first start with international piece. We made some investments in the international market. We may not expand or grow those as rapidly as we planned. We have no plan to pull those back. And in terms of what we are doing with the operating expenses, as I mentioned we have taken our foot of the accelerator, but we are not stopping it. We are not looking to run the business for the near term but we are looking to maximize the business over the long term. And I do believe that with our current situation to market, we have an opportunity to really step ahead. But, we do monitor it very carefully and we look at it week-to-week, if not day-to-day and we make the adjustments as necessary. If they were our complete recession, we obviously have to react and drop our operating expenses, but my expectation is that the storm is not going to last that long and so we want to be able to work our way through it and maintain the momentum we have.

Mike Healy

Ehud the other color I would add on international versus U.S.is they are pretty inter-related in that. A lot of international revenue we get in the short term, it's really from our U.S. customers expanding the offices overseas, so thus we continue to expand in the China and Japan where our customers have offices that may limit and truly explosive on the (inaudible). So we got to continue to do that

Ehud Gelblum - JP Morgan

Okay, so if I go out and I will say that it's not a matter, if we go into recession maybe we can define it however we want but if the negative operating environment continues for sometime, where would you look to cut back and how difficult would that be, is it mainly in head count or other areas that can be brought under control? How flexible is the [OpEx] line.

John Combs

The [OpEx] line has almost all employees. There is just regeneration activities there is branding activities, there is trade shows we go to. There is just other dollars but the vast majority of it is in headcount.

Ehud Gelblum - JP Morgan

And so if we look and take away the million dollars for the conference this quarter and looking at the mid point of guidance just roughly flat quarter-over-quarter is the concept that you will guide it to continue to be flat until you know one or two directions either has to come down more revenues and step back up again is that how we should look at it?

John Combs

That's a good way to look at it.

Ehud Gelblum - JP Morgan

Okay interested AT&T and Blackbox, you stuck with them when they were down some and they were strong in the prior quarter shouldn’t they just be sequentially up what I am just trying to get my arms around why they would be down and why as you expand your channel distribution in those two channels partners. Why it doesn’t sequentially continue to go up?

John Combs

Well remember I said in the script that AT&T did go up from Q4 to Q1.

Ehud Gelblum - JP Morgan

Okay.

John Combs

So AT&T did have sequential growth. Blackbox and seen that they we are down slightly but also keep in mind that during Q4, that category of customers went up 54% so they had a huge increase in the June quarter and basically tune dropped slightly in AT&T continue to grow during Q1.

Ehud Gelblum - JP Morgan

As a group do you expect that to go at least AT&T lets look at it now and that seems to be the most exciting of the group. You expect that could be growing, just as you get I would expect as more of sales people and partners within that organization learn about ShoreTel that just a pure extra penetration would offset in the decline in the environment that and is that a decent way to look at it or you think that at this point you penetrated the account and then it would go up and down with the market?

John Combs

We are far, far from penetrating the account. We have had dedicated sales resources on the AT&T account helping to educate their team I would say we are probably 20% of our way into that whole process. We built a good credit rating with AT&T origination in terms of our products performances the quality of installation the customer satisfaction the sale support we offer and the service support so I feel like everything is going the right direction I will continue to see that account grow and I wouldn’t underestimate the Blackbox and the CVW those have been very strong partners for us and both of them are in the maturing phase as well.

The bulk of Blackbox has been historically with Nortel as I mentioned. Bargained that will begin to gain share within their origination that they grow and CVW as well has been a group that look a year-over-year substantial increase in their ShoreTel revenue.

Ehud Gelblum - JP Morgan

Okay I appreciate it thank you.

John Combs

Okay take care.

Mike Healy

Thanks.

Operator

Your next question comes from Rohit Chopra, of Wedbush Morgan.