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Executives

Tonya Chin - Director, Investor Relations

Peter Blackmore – CEO

Mike Healy – CFO

Kevin Gavin - Chief Marketing Officer

Analysts

Sanjiv Wadhwani - Stifel Nicolaus

Barry McCarver – Stevens, Inc.

Greg Burns - Sidoti and Company

Mike Latimore - Northland Capital

Dimitry Netis – William Blair

ShoreTel,Inc. (SHOR) F2Q13 Earnings Call January 30, 2013 5:00 PM ET

Operator

Good afternoon. And welcome to the ShoreTel Second Quarter Earnings Conference Call. All participants will be in listen only mode. If you need assistance, please signal a conference specialist, by pressing the star key followed by zero.

After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions)

Please note this event is being recorded.

I would like to turn the conference over to Tonya Chin. Please go ahead.

Tonya Chin 

Thanks for joining us today as we report our second quarter fiscal 2013 financial results. Joining me on the call today are ShoreTel’s CEO, Peter Blackmore; and Chief Financial Officer, Mike Healy. Additionally, Kevin Gavin, Chief Marketing Officer is joining us for participation in our question-and-answer session.

Before we begin, I will remind you that during today’s call management will make forward-looking statements within the meaning of the Safe Harbor provision of Federal Securities Laws regarding the company’s anticipated future revenue, gross margin, operating expenses and other financial and business related information. These forward-looking statements are subject to risks 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 can be found in the company’s annual report on Form 10-K for the fiscal year ended June 30, 2012, the company’s quarterly report on Form-10Q for the quarter ended September 30, 2012, and the current report on Form 8-K furnished today.

The information in this conference call related to the projections or other forward-looking statements is based on management’s current expectation. The company does not intend to update its forward-looking statements should circumstances change. As a matter of policy, ShoreTel does not comment on financial guidance during the quarter unless it’s done in a public forum.

We will be discussing both GAAP and non-GAAP results throughout this call, and I ask that you refer to our press release issued today for the reconciliation between these amounts.

Our non-GAAP numbers exclude stock-based compensation charges, amortization of acquisition related intangibles, and other adjustments, which we do not feel are core to evaluating our operating results.

Finally, ShoreTel management is planning on attending several conferences this quarter, including the Stifel Nicolaus Technology Conference in San Francisco on February 7, the Wedbush Technology Conference in New York City on March 6, the Northland Security’s Tech Conference in New York City on March 13, and finally, the [inaudible] conference on March 19, also in New York City.

Now, I’ll turn the call over to Peter.

Peter Blackmore

Thank you, everyone for taking the time to review our second quarter results with us today. In the second quarter, revenues of 74.6 million were up 29% from the second quarter of fiscal 2012. We managed our operating expenses down slightly from last quarter, while continuing to invest more resources in the Cloud business, increasing our work force in that division by 12% quarter-over-quarter.

Now let me give you a few more specifics, starting with the highlights of our Cloud business. ShoreTel Sky had a strong second quarter with revenues of 17.1 million, up 9% sequentially and up 14% from the second quarter of 2012, driven by continued strong bookings, steady installations of our backlog, and our continued low turn rate.

A monthly revenue turn continues to be one of the best in the industry at 0.3% for our monthly revenues. Additionally, the month of December was the strongest bookings month in our Cloud business history. We continued to have very solid growth with bookings up 22% annually.

Our ShoreTel Sky business also added the most new customers in its history with 178 additions. Our average number of seats per customer, once again increased to 36, up from 35 last quarter. Many of our new ShoreTel Sky customers have come to us after being dissatisfied with competitive Cloud solutions.

One notable new Cloud customer is Web Direct Brands, an online retailer of specialty products. Web Direct Brands selected ShoreTel Sky for a highly customizable solution. Web Direct Brands participated in the beta program for ShoreTel Sky new graphical Call Flow Editor, and has been a strong advocate for this new feature.

We held a very well attended meter event in Boston, in November, which took place at the TD Garden during a NBA game, featuring the Boston Celtics and the Brooklyn Nets. This was an exciting event for us, as the Boston Celtics are a great new ShoreTel premise customer, and the Brooklyn Mets are a great ShoreTel Sky customer.

We use their [inaudible] matchup as an opportunity to highlight our capability to provide customers a choice UC solutions, by the Cloud or premise, all delivered with a world-class customer experience.

ShoreTel Sky continues to be recognized as a leader in the unified communications as a service market. Gartner recently published it’s Magic Quadrant ratings for unified communications as a service. We were very pleased to have been positioned by Gartner in the leaders quadrant. And while we’ve been recognized as a visionary by Gartner before, we view our positioning in the leaders quadrant, further demonstrates our strong reputation with a fast growing Cloud telephony market.

In November, we received further industry recognition when Frost and Sullivan presented its 2012 North American Customer Value Enhancement Award, in the Hosted IP telephony and Unified Communications services market to our Cloud division.

This award recognizes our strong focus on enhancing our customer experience, which in turn drives both customer attention and expansion.

Now, let’s turn to the premise business. As you know, over the past several quarters, improving our premise sales productivity has been imperative for the company. In early January, we made a number of changes to our premise sales organization, including the elimination and redistribution of sales and channel management positions, and changes to our partner service model that will result in annualized savings of approximately $4 million.

These changes will strengthen our partner collaboration, simplify layers of management and sales, and also maximize the use of digital communication tools, such as online training.

These improvements in sales compliment the reductions we made in July that reduced our research and development spending in the premise division, to 16% of revenue in the second quarter. Our premise research and development cost are expected to decrease approximately 5 million in fiscal 2013, when compared to fiscal 2012. As a result of these actions, we are well positioned to show profit leverage in fiscal 2014.

Next, let me review the financial highlights from our premise business during the quarter. Premise revenues of 57.5 million, went down 3% from the prior quarter, and down 1% from the year ago quarter. We annualized our results for the quarter in detail, and in particular, we looked at the top 60 deals that were expected to close by quarter end that slipped. Only seven of these deals were lost to competitors, reinforcing our continued strong win rate. The majority of deals were pushed out to the March quarter for a variety of reasons.

These starts of push-outs occur every quarter, but in the December quarter, we estimate they occurred at about three times our normal rate. We expect the majority of these deals to close in the March quarter. In fact, we have already closed the largest deal that slipped, that was approximately $1 million.

Turning to our international business, which was 13% of our premise revenues in quarter two. We saw good growth in our EMEA region, which grew 26% of the quarter to a fiscal 2012. We again illustrated our ability to win larger accounts with a recent addition of the Cheshire Police Department, with over 3,000 users. International revenues represented 30% of premise revenues and were up 8% of quarter two fiscal 2012.

Our service and support organization continued to perform well, with revenues up 2% sequentially, and 17% year-over-year. We have increased our service revenue by extending our services to include the option for customs to pay for dedicated technical account managers that assist with more complex installations, as well as detailed network assessment programs.

We also continued to have a very high renewal rate of 87% on our support contracts, which helps to drive our outstanding gross margins of over 70% in this area of our business. We had several notable wins during the quarter, including the Los Angeles Dodgers, for both the Dodger Stadium and their training facilities in Arizona. The Dodgers choose ShoreTel Solution for its ease of use for 750 employees in two locations.

This was a competitive win over Cisco Systems, and we are very pleased to have the Dodgers on board as a ShoreTel customer. They join our already impressive roster of professional sporting organizations, including the San Francisco giants, the Miami Marlins, the St. Louis Rams, the Boston Celtics, the Brooklyn Mets, the NHLs Buffalo Sabres, and the Verizon Center, home to the capitals and wizards.

We are also expanding our relationship with the Brunswick Company to include the land and sea, the largest distributor of marine parts and accessories in North America. Our engagement with land and sea was a competitive win against [inaudible], and is a great example of how we can grow enterprise customers following an initial installation.

We also recently signed the Farmers and Merchant Bank, which has over 700 ShoreTel users across 22 locations. The ShoreTel Solution will play some existing Cisco co-managed deployment, to prove too costly to maintain when compared to a new ShoreTel Solution. Prior to selecting ShoreTel, the bank compared, evaluated Mitel Microsoft Lync for expanding their Cisco investment. After a thorough [inaudible] analyzes, the bank selection committee choice ShoreTel.

As we shared with you last quarter, mobility continues to have a positive impact on both Cloud and on premise communication system sales. Today, having this strong mobility solution is the key consideration in almost all deals. We are very pleased to see strong mobility sales in the quarter, up significantly from the prior quarter.

In November, we hosted over 1,200 enthusiastic attendees at our annual partner conference, which was in Orlando, Florida. The highest attendance in our company history. The participants came together for three days of key note presentations, break-out sessions, training, and networking.

We introduced our Cloud solution to our premise channel, which resulted in a lot of interest from these partners. Approximately 50 premise partners, already able to refer or sale our Cloud solution.

In addition, we highlighted the hybrid roadmap, which allows a ShoreTel premise PBX customer to enable ShoreTel Sky applications. This solution, which we are calling ShoreTel Connect, will be rolled out this summer, and received huge interest from our partners.

We also announced an incentive program that encourages our most successful partners to extend their operations in those U.S. regions where we are still under [inaudible]. We will also continue to target and find new partners, but with a very selective approach, to ensure we keep the coverage model well balanced.

On the product front, we recently announced mobility 5.0, which incorporates instant messaging, visual voice mail, and co-handling capabilities. This new release also adds seven new Android models, as well as international call reporting, enabling customers to better track telecost to optimize savings.

Additionally, we introduced ShoreTel collaboration solutions to Apple iOS, now available on the Apple app store, which allows iPhone and iPad users to easily share and view shared slides and documents from any location, all simultaneously, while using the same devise of ShoreTel Mobility.

Looking forward, I’m really excited about the next couple of quarters as we have a number of new hardware and software introductions planned, including enhancements to our ShoreTel Sky service offering, ShoreTel Enterprise Contact Center 8, which incorporates more functionality for large enterprises and ShoreTel 14. A major new release of our IP telephony unified communication solution.

In summary, we are positive about our ability to continue to grow our revenues and drive leverage to our bottom line. Our Cloud results continue to be strong. In premise, while we saw some orders slip at quarter end, we expect to close the majority of these deals in the March quarter.

We also took important actions towards improving sales productivity in our premise business. These actions, coupled with our reductions in R&D expenditures, we are well positioned to deliver good leverage going forward.

We are confident that we will end the year with a profitable fourth quarter, and then further extend that profitability in to fiscal 2014.

With that, I will turn the call over to Mike.

Mike Healy

Thanks, Peter. Okay, let me get in to some more specifics of our Cloud and premise businesses, and then our review the balance sheet. In the second quarter, total revenues were 74.6 million, down 1% from Q1, and up 29% from the second quarter of fiscal 2012. Total recurring revenues of 26.2 million, grew to 35% of our total business, up from 33% in the prior quarter. As a result, we now have a run rate of over $100 million of annual recurring revenues, which we expect to grow substantially going forward, primarily driven by our Cloud business growth.

Specific in our Cloud business, revenues of 17.1 million were very strong. Up 9% sequentially from Q1, and up 14% year-over-year. Monthly recurring revenue, which is subset of the total revenue, increased 25% year-over-year, reflecting continued progress in growing our recurring revenue base.

Our monthly average revenue per user, or RPU, was $60, and our average number of seats per customer increased to 36. Our MRR backlog at the end of December was again above $500,000, which gives us strong confidence about ending our Cloud revenue goals of at least 20% revenue growth for the year.

Our Cloud revenue this quarter also included the first meaningful recurring revenue from our partners, who have traditionally sold ShoreTel Premise Solution, this is a good step towards capitalizing on one of our key synergies from them five acquisition.

Specifically in our premise business, we saw a 5% decrease in product revenues to 43.8 million over Q2 of fiscal 2012. Service and support revenues increased nicely to 13.8 million, while we continue to increase our gross margins in this business.

From a channel perspective, revenue from our larger regional partners was lower than our expectations. And our service providers grew nicely to 12% of premise revenue. In terms of our North America two tier value added distributors, fillings increased slightly quarter-over-quarter, and represented close to 40% of total premise volume in the December quarter.

I’ll also note that our gross margins from our bad business increased by 130 basis points to an all-time high. We sold over 120,000 licenses to our premise business, and shipped over 1,100 new customers in the period.

In terms of our vertical markets, the professional and finance verticals are our largest Cloud verticals. In our premise business, the financial, professional services, retail and entertainment verticals continue to be the strongest in the quarter.

Our combined non-GAAP gross margin was 61.8% in the second quarter. Our non-GAAP gross margin in the Cloud business was 43.3%, down slightly from Q1 as a result of additional telecom regulatory fees.

I will discuss these in more detail in a few minutes. To better demonstrate the quality of our Cloud gross margins, it is notable that if we do not resell any transport circuits in the second quarter , our gross margin and our Cloud business would have been close to 60%.

We resell these transport circuits, including [inaudible] T1s, as an additional service to our Sky customers. This enables better overall Call quality for our hosted service.

As we continue to sell to larger enterprise customers, many of which have the capabilities to manage their own networks, we expect revenue from the resell of these circuits will decline over time, thereby improving our gross margins.

Additionally, our gross margins were impacted by the hiring of over 20 support headcount resources during Q2.

Total premise non-GAAP gross margins grew slightly quarter-over-quarter to 67.3%. Breaking that number down a little further, non-GAAP product gross margins were 66.2%, and support and service non-GAAP gross margins were 70.7%, marking an all-time high.

We are pleased to be able to maintain our product gross margins by holding our discounting flat last quarter. Our sales force continues to do an excellent job of selling the ShoreTel value proposition, along with our guaranteed lowest total cost of ownership.

Second quarter non-GAAP operating expenses were 48.2 million. Operating expenses decreased by $800,000 from last quarter driven by decreases in incentive compensation, and lower labor related cost in the premise division. This was partially offset by the cost of our partner conference in November, which was in an access of $1 million.

And finally, we had a non-GAAP net loss of $2.6 million or $0.04 per-share.

In the December 2012 GAAP P&L, we recorded a $2.2 million charge for a change and estimate of sales used in telecom taxes related to the Cloud business. That charge, coupled with our non-cash stock-based compensation charges of 3.5 million, 1.9 million in non-cash amortization of acquisition-related intangibles, and non-cash interest expenses of .5 million, resulted in a GAAP net loss of 10.4 million, for a loss of $0.18 per-share.

In addition, pursuit of the terms of our purchase agreement with M5, we have a $10 million earn out that will be paid in mid-March. This earn out, was based on reaching certain revenue goals for the year ended December 31, that our Cloud division achieved, and another 3.7 million will be due in payable next year.

The total earn out liability of approximately 13.7 million was included in our balance sheet as of the buyback acquisition date, which was March 2012.

Next, let me review some of the balance sheet highlights. Cash and short-term investments were 52.1 million, and we generated approximately 1.1 million in cash flow from operations. Accounts receivable of 31.8 million were up 5% due to linearity within the quarter.

Despite that, our days sales outstanding were again fantastic at 37 days. Inventory increased by $1.3 million to 20.4 million due to a number of customer shipments pushing out at the end of the quarter.

Deferred revenue was up 3% for 1.7 million to 51.9 million, primarily due to increases in our support maintenance contracts. Capital expenditures were approximately 4.6 million, including the capitalization of certain R&D activities. These were higher than in previous quarters, due to the cost related to the relocation of our Cloud division headquarters in December.

Depreciation and amortization were approximately 3.9 million in the quarter, of which 1.9 million is related to acquisition-related intangibles. We ended the quarter with 965 employees, up 23 from the previous quarter, with that entire increase coming from a 12% sequential increase in our Cloud division headcount.

Now let me address the tax liability that we recorded this quarter. This liability relates to an adjustment we made to reflect a change in estimates that we’re making in our December financials, related to taxation and regulatory fees for telecommunication services.

We have updated our estimated liabilities for these fees and taxes related to our Cloud business for the time periods, both before and after the acquisition. The result of these changes required us to record an additional charge of 2.2 million in our GAAP income statement in the December quarter, of which 1.9 million is related to prior quarters.

In addition, we recorded an identification asset for $7 million, and increased accrued liabilities by $9.2 million on the balance sheet.

Next, our discuss our outlook for the March 2013 quarter. Based on our backlog, billings, current forecast and business book to date, we expect revenue to be in the range of 73 to $79 million. The low end of this guidance reflects our normal seasonality in the premise business in the March quarter. While the high end of the guidance assumes closing a substantial number of deals that pushed out from the December quarter.

We expect non-GAAP gross margins to be in the range of 62 to 63%, and GAAP gross margins are expected to be approximately 200 basis points lower, due to the inclusion of 1.2 million for the amortization of acquisition-related intangibles and stock-based compensation charges.

We expect non-GAAP operating expenses to be in the range of 49 to $50 million. And we expect GAAP operating expenses to be in the range of 53 to $54 million, including approximately 3.3 million in stock-based compensation and intangible expenses, as well as expected severance related cost of $700,000.

In closing, I believe we have taken the appropriate steps to manage the balance between continuing to grow revenue, while also carefully managing cost that position us well for meaningful profits in fiscal 2014, which starts, by the way in July of this year.

Before I turn it over to Peter, let me just wish the San Francisco 49ers good luck in the Super Bowl on Sunday. Over to you, Peter.

Peter Blackmore

Thanks, Mike. With industry experts estimating that at least 40% of the telephony market sales will be Cloud solutions by 2015, clearly we are more convinced than ever, that our entry in to the Cloud market a year ago was ideally timed.

We continue to be pleased with the momentum in our Cloud business. We have also taken the appropriate actions in our premise business to ensure good leverage to the bottom line over the coming quarters.

I’m looking forward, we’re excited about the planned introduction of our hybrid solutions ShoreTel connect, which will allow our customers complete freedom of choice. We are well positioned to take full advantage of the rapid changes that are clearly happening in the unified communications market, and to drive meaningful profits in fiscal 2014.

With that, we will open the call to your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions). And our first question comes from Sanjiv Wadhwani at Stifel.

Sanjiv Wadhwani – Stifel Nicolaus

Thanks so much. Several questions, just wanted to get some clarity on some questions. On the premise side with the deals getting pushed out from December, could you elaborate on which sectors they were concentrated in and whether fiscal cliff had anything to do with it or was it sort of just general macro situation that led to those push outs?

Peter Blackmore

Okay, I'll take that. They were across all sectors. So the large $1 million deal happened to be a public sector that I referred to in the script. Most of them were sizable deals. So we're tracking them very carefully. So we're confident that they'll [inaudible].

I'm not trying to put the blame on any particular external rather factor. It would be too easy to do that. Our job is to lever numbers. And if something slips out, our job is then to close quarters, which is what we're focusing on.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. And Peter, on the sales force actions, can you sort of give us a little more detail on what exactly are the changes? And are they all done? Are there still come to come?

Peter Blackmore

All right, this came from the productivity analysis, which David Petts our Global Head of Worldwide Sales has been doing since he arrived. And obviously, he will review them carefully with me. But I think they're all very appropriate. And the aim was to take advantage of the fact that he is particularly strong and very well experienced man in the industry. So we were able to take our management layers with this capability. So that has been done.

We also simplified the organization in a number of areas of channel managers improving productivity by doing more automated things, which we've been working on over the last six months, which clearly saves headcount.

But the net is, we're very confident that the changes, which by the way are complete, will enable productivity and will not slow down at all our ability to hit the revenue targets this quarter.

Sanjiv Wadhwani – Stifel Nicolaus

Got it, okay, and then Mike, just on the financials, when you look at the gross margins for the Sky business as you mentioned, it was down sequentially. I'm curious whether you expect it to kind of go back to that $45, $46 range for March.

And then looking at profitability in the June quarter, what's the combination that we're looking at? Are we looking at, I'm guessing gross margins overall don’t change much between now and June. Are we looking at OpEx actually moving down between now and June to get to that profitable goal?

Mike Healy

So let me answer the first one, gross margins. So yes, the decline was down from $46.7 last quarter. These are non GAAP numbers to $43.3 in the cloud. And that was all due to the regulatory fees we had to book this quarter. So going forward, I still think we'll be able to manage around the mid-40's plus or minus a little bit. We've obviously got some work to do on these fees and what we're going to do going forward.

So in terms of profitability for the cloud division, you've heard me say it would be nice if we can get to profit by the end of the year, our fiscal year. That's not our plan of record because we do have some investments to make on the infrastructure side and the operations side. So I don’t expect the cloud expenses to decline over the next couple quarters. They will continue to increase as we invest more there and hire there. But if we get some surprises and beat the revenue plan, there's a chance we could get close to profitability in cloud by the end of the quarter, end of the year, Q4. And we were close, reasonably close to profitability this quarter, the March quarter because we did under spend a little bit more than we expected on the cloud side.

Sanjiv Wadhwani – Stifel Nicolaus

Got it, but just as it relates to the whole company with cloud in premise just to getting to profitability for Q4 and the June quarter, I mean I think that still remains a target, right?

Mike Healy

Yes, certainly given our current revenue expectations, we'll be profitable in Q4 with the actions we've taken in our revenue expectations. I'll remind you, our June quarter is usually very strong on the premise side. And usually, bookings ramp up pretty significantly. So we're expecting that again. And that will kind of push us into year '14 where we think we've got the cost basis structured appropriately. And with some modest revenue projections for the next year in premise, we'll be profitable for all of fiscal year '14.

Sanjiv Wadhwani – Stifel Nicolaus

Got it, so the trend just to confirm in terms of total OpEx between now and June, is that sort of turning down? Are we kind of looking at flattish? What's the trajectory of total OpEx for the company between now and June I guess?

Mike Healy

I mean you have the guidance for this quarter, which the midpoint is up about $1 million from what we spent. And that's all coming from the cloud side.

And then the following quarter, we do expect expenses will go up given our recurrent revenue expectations.

Sanjiv Wadhwani – Stifel Nicolaus

Got it, okay. That's helpful. Thanks so much.

Peter Blackmore

One thing, we have a program to drive margin improvement in cloud. Notwithstanding, we've made it very clear that the telephony contribution to cloud, which we think is very valuable for customer performance does lower margins. But that aside, we're working on gross margin improvement program because we know that we can get it up over time.

Operator

Our next question comes from Barry McCarver at Stevens, Inc.

Barry McCarver – Stevens, Inc.

Good afternoon, guys. Just following on that last comment you made, Peter, kind of what is your longer term outlook for margins on the cloud business? I mean where do you think kind of possible ceiling is for that business let's say just over the course of the next couple of years?

Peter Blackmore

It depends on the mix of telephony business because as Mike was careful to point out in his remarks, if you took that out or it's 60% margins, which makes us very competitive right across the industry, the reason we have that telephony in there is that it still provides a better service. But we expect over the next two years more and more people will accept the pure web without the addition of those telephone contacts. And therefore, our margin will naturally migrate plus with scale. And margin improvement programs such as looking for more automation and provisioning, we're very confident we can drive the margins up. So I don’t want to give you an exact number, but I want to give you a lot of confidence that strong margins can come from cloud.

Barry McCarver – Stevens, Inc.

Okay, very good. And then on your cloud business during the quarter, any of that from your existing channel partners before the acquisition? Or is that primarily coming from the direct sales force you inherited with the acquisition?

Peter Blackmore

Well, we have 50 premise partners signed up. A lot of them are very recent. Therefore, we're delighted they're signed up. And I think that's a forward indicator. It didn’t impact this last quarter much because they all signed up pretty recently.

And remember that we're also planning to go through the completion of our beta test program with these partners. And then open it up to the broader premise rank all partners by July. So that will be again a forward indicator. So this last quarter was due to the cloud sales marketing organization inside sales, which has been in place for a while. But we're certainly expanding that organization as well as we ramp.

Mike Healy

Yes, clearly the majority of bookings this quarter came from the existing cloud partners and the direct sales force. And the majority comes from the partner base on cloud and it lasts from the direct sales force.

Barry McCarver – Stevens, Inc.

Okay, great, and then just lastly, could you remind me of the details of the $2 million earn out to be paid in March? Was that the maximum earn out they could earn?

Mike Healy

Yes. The $3.7 is earned and it just delayed for a year for the payment too.

Barry McCarver – Stevens, Inc.

Okay, great. Thanks a lot, guys.

Mike Healy

Okay, thank you, Barry.

Operator

The next question comes from Greg Burns at Sidoti.

Greg Burns – Sidoti and Company

Good afternoon.

Mike Healy

Hey, Greg.

Greg Burns – Sidoti and Company

I just wanted to ask about the growth on the cloud business. I think it was up 14% this year. A little bit below I think one of your competitors reported earlier in the week or last week. And a little bit below I think kind of the targeted market growth rate. So why is that? And maybe like you said it's accelerating the back half of the year to kind of get it back to that 20% plus target that you have out there?

Peter Blackmore

Remember, the bookings grew 22%. And I think if you compare – yeah, I'm guessing which competitor you're comparing it to, but if I'm right, that was higher bookings than they did. So the revenue is not the forward indicator because bookings are the forward indicator. So at 22%, we're pleased with that. And we see us staying above 20% for the complete financial year. So does that clarify it?

Greg Burns – Sidoti and Company

Yes, and I know the past quarters have been a little bit of a bottleneck in terms of turning on some of the new customers on the cloud side. Have you made any progress in terms of the investments needed to kind of speed up the reporting process?

Peter Blackmore

I didn’t quite catch that.

Mike Healy

What did you say, Greg?

Greg Burns – Sidoti and Company

Speed up the activation process of the new subscribers in the cloud side.

Peter Blackmore

Yes, we're working that all the time. The backlog stayed about $500,000, so it hasn’t come down much. That's indicative of the strong bookings. But we did do a good job. We want to improve the provisioning. So we added 22 people in the provisioning support area. We'll continue to ramp that. We're also looking at further automation tools to enable us to go faster. So you're on a key area that we are working on and we'll drive.

Mike Healy

Greg, back to revenue just a little bit. We want to make sure we're clear. So our 14% revenue, that's total revenue growth including the MRR and the non-recurring, or NRR. And the NRR, remember, we had to kind of restate our install fees. Our NRR revenue is down substantially quarter-over-quarter because of the new accounting treatment. So that's why I pointed out the monthly recurring revenue, which is the bulk of the cloud revenue was up 25% year-over-year, which was much greater than the one competitor you're probably referring to.

And then sequentially, we're up 9% quarter-over-quarter, which was again greater than the one competitor you may be referring to.

So the way I looked at it is the base revenue, which was the recurring revenue was healthy 25% year-over-year growth. And bookings was just below that at 22%.

Kevin Gavin

The other point to keep in mind is that we compete more up-market than they. Our average seats is 60. And that end of the market is certainly growing quickly. But at the low end where they compete, I think that segment of the market is growing more quickly. So from an apple-to-apples in terms of market share and the market we are targeting, we continue to maintain market share.

Mike Healy

And our average seat size is 30, ARPU at 60.

Greg Burns – Sidoti and Company

Okay, and in terms of the market share on the premise side, I don’t know if you mentioned the numbers this quarter. But do you feel like you gained share, lost share? And how do you feel the overall market is? What's the outlook for the overall market growth?

Peter Blackmore

The market growth estimates from the analysts is coming down. So our forecast looking out is very modest growth in the premise market. But we particularly buck that trend to do better than the market.

But clearly, the premise market is slowing down. And that's very clear to everyone, which is why we're very focused on leverage because what we've always said to you is if the market was growing fast and we could grow fast, we keep investing. But once the market slowed down, which it has, we're going to drive much more leverage to the bottom line in the premise business.

Mike Healy

Yes, we haven't seen any December market data yet, Greg. So it's hard for us to call that. I don’t think any of our competitors from a premise side have announced anything big in terms of increases. So we're waiting to see what the market did in the quarter.

Greg Burns – Sidoti and Company

Okay, thank you.

Mike Healy

Thanks, Greg.

Operator

Your next question comes from Mike Latimore at Northland Capital

Mike Latimore - Northland Capital

Hey, thanks. Just a question on the cloud business. You touched on it a little bit, Mike, but MMR, what percent of cloud revenue is MMR nowadays?

Mike Healy

It’s 80-something percent of the revenue.

Mike Latimore - Northland Capital

Okay.

Mike Healy

In our usage fees, that kind of thing, and regulatory stuff, but the MMR is, you know, kind of what we bill the customers every month.

Mike Latimore - Northland Capital

Yeah. And then the backlog you talked about, how much of that do you think you’ll get deployed during the March quarter?

Mike Latimore

Well, we’re hoping to get almost all of it deployed, but it depends, you know, how big the customers are that are in that backlog and how long it takes. I would say we’d get it all deployed, you know, we could book – and it’s all in the same quarter too, so it’s kind of apples to oranges. But we normally estimate a 90-day window between booking and installation, so you could presume all 500K could be installed, but you know, it depends on the customers and their timing requirements.

Mike Latimore - Northland Capital

Great. And then on the cloud bookings kind of in absolute dollar terms, did that grow sequentially?

Mike Latimore

Yes.

Mike Latimore - Northland Capital

So did you see any, well, obviously cloud bookings were strong, but did you see any hesitancies or slower activity perhaps around the data center outage during the quarter or did that not really impact bookings?

Peter Blackmore

Well, clearly our salespeople didn’t have offices during that time, so there was bookings impact for a couple of weeks until we got back in our office. It took us about ten days to get back in our office, but our customers were up and running apart from a very brief period and I think the team did a very good job to hit 22% bookings. Remember, December was our strongest bookings month ever.

Mike Latimore - Northland Capital

Okay.

Kevin Gavin

So October and November were pretty slow and they did a hell of a job to come back and close December very strong. You remember, we moved the office in the middle of the month and we were still recovering from Sandy and all those things. So we were very pleased with how well we closed December and we’ll keep that momentum going into the March quarter.

Mike Latimore - Northland Capital

When will you have ShoreTel phones available for the cloud service?

Peter Blackmore

That is – reminding everybody, that is coming with the P-series, which is, you know, not too far away but we haven’t confirmed the date. But the idea was waiting for the P-series that is our SIP-enabled phone and we did not want to sort of spend the engineering on the legacy phone which that series will replace. So we’ll give you the date as soon as it’s getting out for public launch.

Mike Latimore - Northland Capital

Thanks a lot.

Mike Healy

Thanks, Mike.

Peter Blackmore

Thank you.

Operator

Our next question comes from Dimitry Netis at William Blair.

Dimitry Netis – William Blair

Hey, guys. Can you hear me?

Mike Healy

Yeah, Dimitry. How are you doing?

Dimitry Netis – William Blair

How are you doing? So just a clarification here on the – the fact that you, you know, have those [inaudible] enhancements and you called out some reduction in management layers, some channel account managers were also [inaudible] the headcount additions, 23, came from the cloud side of the business. So what was the headcount in the Prem business? Have you actually reduced the headcount in the Prem business?

Peter Blackmore

Yes, we have. Mike will give you the details, but we clearly reduced actual headcount in the Prem business. Yes.

Mike Healy

Yes, so let me be clear. The actions we took in the sales organization took place in the middle of January and so those are all out. But clearly they were in our December numbers, total headcount and the severance associated with that will be recorded in the March quarter, about 700K in our GAAP P&L. But for the most part, yeah, our Premise headcount has come down over the last couple of quarters even without that reduction we made in sales in January.

Dimitry Netis – William Blair

Do you care to tell us what it was or vis-a-visa, kind of the total number?

Mike Healy

Yeah, the total Premise headcount at the end of December was 717 employees.

Dimitry Netis – William Blair

Okay. Thank you very much for that. And then the other question I have with the – whether you have considered taking a more drastic change in terms of, you know, driving profitability on the Prem side? I know you’re doing some productivity enhancements, but have you considered maybe to really taking a stance and, you know, you increasing OpEx, I know is mostly coming from the cloud side, but when are you basically going to take a stance and be profitable on the Prem side of the business, particularly as you just sort of mentioned that the market activities have been flowing and, you know, the growth is sort of, obviously, isn’t there as it used to be maybe a year ago? So have you considered taking a more drastic change is basically the question?

Peter Blackmore

We took a significant change in January. It was significant, you know, $4 million run rate reduction is significant and we don’t have a large sales and marketing organization so you’ve got to look at it relatively. And that, together with the reduction in R&D, which we mentioned as well, positions us for good profitability in 2014. We’ve done a lot of actions related to the productivity study we’ve had ongoing. The productivity study is not complete yet. We may be able to further improve our productivity. And the last statement I’ll make, which is very clear, we want a very profitable Prem business next year so as we assess the market going forward, we’ll all know more by the end of March in terms of what’s happening, then we’ll take the right actions. We’re going to drive a lot of profitability in the Premise business.

Dimitry Netis – William Blair

Okay. Thank you.

Operator

(Operator Instructions). We have a follow-up question from Greg Burns at Sidoti.

Greg Burns - Sidoti and Company

Just a question about the channel program. It’s 50 partners now, do you have any kind of targets for how many additional partners you’d like to add in the next couple of quarters and is there any kind of – what is the gating factor to adding?

Peter Blackmore

It’s a good question. There’s no gating factor other than we’re testing the certification and training program with the people that we’re rolling out and once we know we’ve got absolutely as we want it and as they want it, we would open wider and we’ve told the partners that by July we’ll have opened it and we’ll keep looking at that day. If we can do it earlier, we will. And then in terms of how many partners will sign up, remember, we have 600 Premise partners of which 200 are Gold and Silver partners, the bigger ones, so that’s the ones we really want to target. We’re still evaluating how many, but the vast majority have shown interest so time will tell. But we’re obviously keen that they join the ability to sell cloud as well as sell Premise. So that’s our objective.

Greg Burns - Sidoti and Company

Okay. Thank you.

Operator

Our next question comes from Mike Latimore at Northland Capital

Mike Latimore - Northland Capital

Yeah, just take us back on the cloud business for a second. Through the month of January here, has the churn rates still been about the same, no real change there?

Mike Healy

Yeah, no noticeable change in churn to date.

Mike Latimore - Northland Capital

Okay. And then how about on the product revenue, what percent of kind of product sales came from new customers?

Mike Healy

On the Premise side of the business the new customer billings were about 41% of the total, that was the same as last quarter, it was 41%. You know, typically in this quarter it’s a little stronger than that, but you know, we feel like as we get bigger and more volume on the Premise side. You know, it’s hard to get 50% of your revenue coming from new customers just from the law of numbers. So you know, I still believe that 41% is way higher than any other of our competitors in terms of new business they get every quarter.

Mike Latimore - Northland Capital

And just last, on the maintenance renewal rate, is that similar to what it’s been in prior quarters?

Mike Healy

Yes. High 80s, almost to 90% is the renewal support rate. So that business continues to do fabulously well. You know, the revenue keeps just cranking out just like in the cloud business and we were about 70% gross margins now in that business.

Mike Latimore - Northland Capital

Okay. Thank you.

Operator

At this time, there are no further questions. I would like to turn the conference back over to management for closing remarks.

Peter Blackmore

Well, thank you. And thank you all for participating. I look forward to talking to you next quarter.

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