ShoreTel, Inc. F3Q09 (Qtr End 03/31/09) Earnings Call Transcript

ShoreTel, Inc. (SHOR)

F3Q09 (Qtr End 03/31/09) Earnings Call

May 7, 2009 5:30 pm ET

Executives

Tonya Chin - Director, IR

John Combs - Chairman, President and CEO

Mike Healy - CFO

Analysts

Troy Jensen - Piper Jaffray

Sam Wilson - JMP Securities

Sanjiv Wadhwani - Stifel Nicholaus

Steve O’Brien - JPMorgan

Lynn Um - Barclays Capital

Rohit Chopra - Wedbush Morgan

Presentation

Operator

Good afternoon. My name is Stephanie and I’ll be your conference operator today. At this time, I would like to welcome everyone to the ShoreTel Third Quarter Fiscal 2009 Earnings Announcement. 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)

And now I’d like to turn the call over to Miss Tonya Chin, Director of Investor Relations. Go ahead ma’am.

Tonya Chin

Hello and thanks for joining us today as we report our third quarter earnings. 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 remind you that during today’s call, management may 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, 2008 and its 10-Q for the quarter ended December 31, 2008, 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 thanks to all of you for joining us today. Revenue of 31.2 million in the third quarter was within our guided range of 30 to 35 million. This performance was consistent with our revenue of the same period last year and down 12% from last quarter. Non-GAAP gross margins were strong at over 64%, and our non-GAAP loss was $800,000 or $0.02 per share.

During the quarter, we saw significantly less than expected demand in the months of January and February, both of which were lower than the same periods last year. This was followed by a relatively strong March, particularly in the last two weeks of the quarter. During the first 60 days of the March quarter, many companies seemed frozen with layoffs and reorganizations, with budget-setting activities taking priority. In March we saw several factors including the rebound in the stock market positively influence decision makers to move ahead with capital purchases.

We believe that when the March 2009 quarterly data is published, the U.S. and worldwide market for Voice over IP will once again have declined from the December quarter. However, we are hopeful that the March 2009 quarter will mark the low point of IT capital spending and that our customers will gain more confidence in the months ahead, resulting in increased purchasing activities.

Consistent with the prior quarter, our quoting activity and number of new opportunities remains promising. We are pleased that we continue to experience a win rate well in excess of 50% competitively. Our clear total cost of ownership advantage and best return on investment in the industry helped significantly, but we are seeing opportunities take longer to close.

International revenue grew to 8% of our revenues and was 2.4 million for the quarter. In March, we were pleased to record our first China sales in the final weeks of the quarter. We now are approved to sell in a total of 26 countries worldwide.

Internationally, we took a significant step forward this week with the official launch of Telstra. Telstra is a dominant supplier of voice products in Australia. Under the Telstra agreement, ShoreTel will have access to more than 780,000 small and mid-sized business customers through the Telstra Business Systems program as well as another 1,500 potential customers in the large enterprise and government sectors. Our sales and business development executives are in Australia and New Zealand this week, meeting with customers, our distribution partner, Aria, and attending the Telstra product launch meetings. We are very pleased with the Telstra relationship, and we expect it to give our international market share a boost.

We also continue to make good progress in building our broad-based distribution network. We signed a record number of new partners worldwide, many of them representing Nortel partners that are looking to expand their offering as concern over Nortel’s future viability continues. New partners signed during the quarter include GTSI, an $800 million organization that specializes in government sales, PremCom and Vanguard Integrated Solutions serving the UAE market, Connect NZ, New Zealand’s only solution provider offering voice, image, data and multimedia technology, Integrated Technology with multiple offices in Southern California and AlasConnect, in Fairbanks, Alaska. In addition, we’ve added 10 new partners in Canada over the last two quarters.

Revenue from new customers as a percent of total revenues were 41% for the third quarter. We added approximately 600 new customers and passed a milestone in our total number of customers. We now hold to over 10,000 total customers. We expect to pass through the million end users using ShoreTel to manage their communication system in the current quarter.

We announced several notable large enterprises customers, many of them over 1,000 lines, during the quarter, including the Verizon Center in Washington D.C., home of the NBA’s Washington Wizards and the NHL Stanley Cup contenders Washington Capitals with over 1,500 lines; the City of Lakewood in Lakewood, Colorado; Energy Transfer, a publicly traded partnership, owning and operating diversified portfolio of energy assets; and Synaptics, a publicly traded developer of human resource interfaces for mobile computing, communications and entertainment devices.

We also hit a home run with the San Francisco Giants and their AT&T Park, the most recent sports franchise to select ShoreTel for their communications system, over Cisco, Avaya and Nortel. If you happen to catch San Francisco Giants’ game on TV, be sure to look for the ShoreTel brilliantly simple communication logo on the banner behind home plate, which is part of our increasing focus on brand awareness.

Next let me give you competitive update. We are seeing more and more Nortel customers deciding to cap their investment in Nortel Systems and instead adopt to make future UC purchases with ShoreTel. This is an area which we have a strong advantage over our competitors as our systems integrate extremely well with the existing Nortel Solutions.

Our cap and grow strategy for existing Nortel customers has been positively received. This allows the customers to do a phase migration over time rather than a complete rip and replace of their current solution. We typically replace existing solutions on a site-by-site basis, but we’ve also been replacing Nortel’s voicemail solutions using standard protocols for customers that need to upgrade their legacy voicemail system prior to completing a switch change over.

Let me share me with you a great example, Altru Health System located in Grand Forks, North Dakota serves more than 200,000 residents, Altru network is made up of 2,400-seat hospital, a cancer center and 15 specialty clinics, employing over 3,000 health professionals. Last summer, Altru was facing an expensive upgrade of its Nortel system. Altru decided to explore other UC solutions. They considered Cisco Avaya and ShoreTel as potential alternatives. Our ability to integrate with their existing Nortel PBX and pass caller name and number were key requirements. After installing a small ShoreTel pilot system, Altru was pleasantly surprised to see how easy ShoreTel is to manage compared to their legacy Nortel system. Based on their pilot experience, Altru decided to move forward with the ShoreTel and purchased 300 phones for their first phase of their rollout.

Next, let me upgrade you on our growing U.S. and worldwide market share. After our earning call in January, Synergy Research published their IP telephony market share results for the December 2008 quarter. According to its Q4 Enterprise Voice Share reports, the worldwide enterprise IP telephony market declined 12% sequentially from the third calendar quarter and the U.S. market declined 19%. Despite this very challenging market condition ShoreTel was able to post its largest quarterly market share gains, since becoming a publicly traded company in July of 2007. Based on Synergy’s data, we estimate that our U.S. market share in the Pure IP space is approximately 6.6%, up from 5.6% in the September quarter. Additionally, our worldwide market share grew 3% in the December quarter.

As many of you know, one of the fundamental drivers of our exceptional customer satisfaction has been our Personal Call Manager or PCM as it’s commonly known. This capability was a core ingredient in the first ShoreTel system released over 10 years ago. In the early days, our PCM enabled end users to dial by name from both the company directory and their personal contacts, track their last 1,000 phone calls, provide visual voicemail, SoftPhone and presence information.

More recently, we’ve added additional unified communication features such as the ability to make any phone in the world the user’s office deskphone, desktop video-to-video conferencing, instant messaging capabilities as well as personalized call handling. The key difference between the ShoreTel PCM solution and competitor solutions is that our competitors charge extra for the desktop client and provide them through a separate application server, which needs to be independently managed. The real breakthrough for ShoreTel is ShoreTel’s ability to provide these services through an application that has been integrated, part of our fabrics within our system from day one and comes included with every software license.

In March, Synergy Research published their first unified communications market share report. ShoreTel was ranked number one in 2008 for worldwide UC desktop shipments in the small and medium sized business market with 19% market share. While not surprised, we were thrilled to have ShoreTel recognized as a worldwide leader in the area of UC desktop shipments reported and validated by an independent research firm.

Despite the market share gains and clear traction in the market place, our challenge is to invest in our business in the areas that are necessary to grow while containing our overall costs. After thorough analysis of our market opportunities and business needs over the coming quarter, we made a decision to bring down our operating expenses to optimize our workforce for the current market conditions, while continuing to ensure the highest levels of customer satisfaction, a key differentiator from us.

In early April, we announced a restructuring plan that affected 9% of our workforce as well as many contractors on the staff. The impact will result in reduction of our quarterly expenses of between 1.5 and $2 million. In March we participated in the VoiceCon conference, our industry’s largest annual conference. It was a very successful show for ShoreTel as we had two of the busiest booths on the Shore floor.

At the conference, we demonstrated our integration with, both Microsoft OCS and IBM Lotus Sametime and the IBM Lotus Foundations product. This unique integration with Lotus Foundations delivers a highly reliable yet easy-to-use fully integrated IP and unified communication solution for the SMB branch offices. The feedback we received regarding this product combined with the customers and partners alike was extremely positive.

Once again, ShoreTel was honored with the Best in Show award for our Release 9 software among all vendors including Cisco Avaya and Siemens. The award was solely based on the votes collected from the VoiceCon conference attendees who were all IT professionals. This marks our third straight win for this prestigious award and we were thrilled that the attendees keep voting for us and continue to recognize us for our leadership in unified communications.

While at VoiceCon we launched our newest version of software, ShoreTel 9, which represents an evolution of our unified communications solutions for large enterprises and adds Microsoft Active Directory support and other enhancements to our unique distributor architecture. With this release, we further extended our distributed architecture advantage with an enhancement to our n+1 redundancy model. Prior to this release, our customers were able to add a single switch at each location to provide a complete redundancy at this site. With Release 9, customers can now add just one switch anywhere in their network and their entire system now has full redundancy. This could save our customers, with several locations, a significant amount of investment while still offering them the highest levels of availability in the industry. Our competitors’ current technology does not allow for this capability.

ShoreTel 9 complements our Contact Center 5 software released announced in February, which double the capacity from 300 to 600 agents and introduced new numerous enhancements for enterprise deployments and customer reporting capabilities.

Release 9 allows for personal call routing configured by our award-winning Professional Call Manager unified communications client. This simple-to-use feature allows a user to set rules for who can reach them regardless of their location. For example, users can now set a rule that after certain hours a select list of individuals can automatically be forwarded to their mobile phone, whereas all other callers will go to voicemail.

We further raised the bar with the introduction of our GPS location informed enabled Mobile Call Manager client for Windows Mobile 6, Blackberry and other devices. This feature allows the system to automatically change their Office Anywhere settings to ring their cell phone when the GPS in the user phone indicates that they have move outside the office.

Release 9 also includes interoperability between ShoreTel’s integrated UC solutions and Microsoft OCS Release 2. We can enable a customer to simultaneously deploy, both our PCM and the Microsoft Office Communicator client, both of which offer ShoreTel telephony presence and IM capabilities for Microsoft OCS. This integration offers customers greater flexibility and make ShoreTel more appealing for Microsoft-centric organizations.

After talking with many partners and customers during the quarter, there is a consensus that January and February were two of the toughest months that many in the industry have ever seen. Based on early feedback, this may mark a low point in IT spending. Looking forward, I am very optimistic about our long-term future as we continue to grow our distribution channels and continue to delight our customers with the best solution and customer satisfaction in the industry.

With that I’ll turn the call over to Mike. Mike?

Mike Healy

Thanks John, I’ll be discussing, both GAPP and non-GAAP results throughout this call and I’ll ask that you refer to our press release for the reconciliation between these amounts. Our non-GAAP numbers exclude stock-based compensation charges, our legal settlement with Mitel that was announced today, restructuring charges related to our reduction in workforce, one-time contract termination costs and the related tax impact for these adjustments. We believe that excluding these items gives management and investors a better indication of our true operating results.

Third quarter revenues were $31.2 million. Product revenues were $24.7 million, representing a 15% sequential decline and a 7% decline from last year. Service and support revenues continue to grow with a 5% sequential increase to $6.5 million for the quarter. Service and support revenues now represent 21% of our total revenues up from 18% last quarter. International revenues were 2.4 million and increased to 8% of total revenues. One bright spot was our average large deal size, which increased 24% over last quarter, further demonstrating traction with large enterprise customers.

Revenues from our national partners were up 74% sequentially, mostly due to a one-time benefit of approximately $700,000 in product revenue. The $700,000 was product revenue from one customer that was deferred in prior quarters in accordance with our revenue recognition policies.

In terms of our vertical markets, we saw an increase in the financial vertical as we won some large deals with mid-size banks. The education vertical also increased in the quarter, due to several sales to school districts and universities. In fact, our largest deal this quarter over $800,000 came from a school district in Texas. Offsetting, these increases with was a six-point decline in our professional services vertical. Going forward, we are focusing more of our sales efforts into some of the public sector markets that continue to receive government stimulus fund, such as education and federal state and local government institutions.

End users licenses sold in the March quarter were 69,000. As John mentioned, we expect to pass the one million mark in end user licenses sold during the June quarter.

Next, I will review our gross margin performance for the quarter. Our non-GAAP margins were 64.3%, slightly above our guided range of 63 to 64%. Product gross margins were 65%, consistent with last quarter. I was pleased we’re able to maintain our product margins despite some aggressive pricing tactics from our competitions during the quarter. Our service and support gross margins hit an all time high of 61%, a sequential increase of over four points in margin percentage. Service and support margins have continued to improve as we actively manage our costs while continuing to serve a larger installed base of satisfied customers.

GAAP gross margins also increased to 63.8% and included $158,000 in stock-based compensation charges.

Non-GAAP operating expenses were $21.6 million, representing a decrease of $400,000 or 2% from Q2 levels. Non-GAAP operating expenses include approximately $800,000 of legal costs primarily related to the Mitel litigation. Non-GAAP operating expenses exclude stock-based compensation charges of 1.7 million, our Mitel litigation settlement of 4.1 million, restructuring charges of $501,000 related to the 9% reduction in force we announced in April and a one-time contract termination charge.

You will also notice our stock compensation expenses declined about $400,000 from the December quarter. This was primarily due to the reduction in workforce and a related change in forfeiture rates, which decreased overall stock-based compensation expenses.

Next, let me discuss the $4.1 million charge related to our litigation settlement with Mitel as reported in the joint press release that was issued this afternoon. In April ShoreTel settled all outstanding litigation with Mitel by reaching a settlement, including the cross-license agreement to pay certain fixed amounts over the next four years. Taking our cases all the way to trial would have cost significantly more than the settlement amount regardless of the outcome of that trial. Therefore we felt it was in the company’s best interest to settle our outstanding litigation. We have recorded the entire obligation to this settlement and cross-license agreement in our March 2009 financial statements. The specific terms of the settlement agreement are confidential.

Next, let me move on to some other one-time events that occurred during the quarter. First, in February, we announced the successful completion of our employee stock option exchange program. The exchange was approved by more than 87% of the shares voted. As a result, ShoreTel accepted 3.2 million shares of its common stock for exchange representing approximately 42% of total outstanding in options as of December 31, 2008. Most of the elements of the exchange program were ISS-friendly, including requiring restart investing with a minimum of one year cliff, allowing only options priced at 950 or higher to be eligible to participate and reducing the length of the option term.

In addition, while shareholder approval was not required according to our option plan, we voluntarily elected to obtain such approvals. The exchange is estimated to add approximately $200,000 per quarter of stock compensation expenses or less than $0.01 of EPS impact to our GAAP earnings. We expect a favorable exchange out of long-lasting employee retention benefits.

In early April, we announced the restructuring that impacted approximately 9% of our workforce and resulted in a $501,000 charge related to severance and other employee benefits. All costs associated with this restructure are excluded from our March non-GAAP results as is customary with restructuring actions. We estimate that the savings in operating expenses associated with these actions along with other expense reductions will result in approximately 1.5 to $2 million decrease in the June non-GAAP operating expenses.

Including the one-time charges I have just discussed, our GAAP operating expenses in the quarter were $28.1 million. Therefore, our GAAP net loss in Q3 was $7 million, or $0.16 per share.

Other income and expense was positive this quarter as foreign exchange losses of only $39,000 were offset by our interest income of $188,000, resulting in net benefit of $149,000 in the other income and expense line.

Our annual effective yield on our cash balances this quarter was under 1%, and I encourage you to model a similar yield on our cash balances for the foreseeable future.

Our GAAP tax benefit for the quarter was a credit of $1.1 million and our non-GAAP tax benefit was a credit of $540,000, or 40% for the quarter. The tax provision this quarter was a result of current quarter losses and an impact evaluation allowances on those losses. At continued low levels of profitability or loss, we will have fluctuations in our tax rate due to stock compensation, tax legislation and other factors that may have a material impact on, both GAAP and non-GAAP tax rate.

Next, let me review a few highlights from our balance sheet as of March 31. We ended the quarter with $108.1 million in cash, cash equivalents and short-term investment, a decrease of only 1.6 million from last quarter. We have negative cash flow from operations of $750,000 in the quarter. Accounts receivable decreased 4 million to 19.3 million and day sales outstanding or DSOs remained constant at 53 days. Capital expenditures for the quarter were $450,000 and depreciation and amortization was approximately $480,000 in the quarter.

Next, let’s discuss our outlook for the June quarter, the June 2009 quarter. We are seeing signs of stabilization in our market, but there is still significant uncertainty in the economy. Given these concerns, we expect revenue to be in the range of 29 to $34 million. Our order bookings flow for April was only slightly ahead of January as we are still seeing customers delay purchasing decision. We are also carefully monitoring the possible work stoppage within one of our largest national partners.

For the June 2009 quarter, we expect non-GAAP gross margins to be in the range of 63 to 64%. GAAP gross margins are expected to be slightly lower perhaps 50 to 75 basis points due to the inclusion of approximately $150,000 of stock-based compensation costs. We expect non-GAAP operating expenses to be significantly lower than the March quarter due to the head count, legal and other expense reductions we have recently made. Therefore, we expect our Q4 non-GAAP operating expenses to be in the range of 19 to $20 million. GAAP operating expenses are expected to decline about approximately $7 million, due to the one-time events in the March quarter. We expect GAAP operating expenses to be in the range of 20.5 to $21.5 million, including approximately 1.5 million in stock-based compensation expenses.

In conclusion, I am pleased we’re able to deliver revenue within our guidance range in one of the most difficult sales environments in the last few decades. We have taken actions to drop our operating expenses to reflect today’s current environment and we’re still very optimistic about the future.

With that, let me turn it back to John for some closing comments.

John Combs

Thanks Mike. We’ve just finished a very difficult quarter, perhaps one of the most difficult the industry has seen. Despite these challenges that this market brings, I’m confident that we’re laying the foundation for a bright future for ShoreTel. With growing market share, expanded distribution, the introduction of ShoreTel 9 and 14 quarters in a row of world class customer satisfaction levels, we’re building the foundation to sustain an accelerated growth as the economic environment approves.

Now, let me open up the call up to questions. Stephanie?

Question-and-Answer Session

Operator

(Operator Instructions) And the first question is from Troy Jensen from Piper Jaffray. Your line is open.

Troy Jensen - Piper Jaffray

Hello. Can you guys hear me all right?

John Combs

Wow, Troy, you sound really good today, buddy. Anything new?

Troy Jensen - Piper Jaffray

Must be my new ShoreTel phone.

John Combs

There you go. Awesome.

Troy Jensen - Piper Jaffray

Hey, a couple quick questions. John, how about for you? OpEx down with the head count here. I guess kind of curious why not step on the gas right now. You guys seem to be doing better than the competition. There’s a lot of potential market share you guys could capture right now. So what’s caused the decision to cut the OpEx here?

John Combs

We’ve seen things in the marketplace that would normally be indicators of a more positive booking levels, such as higher backlog, consistent close rate, etcetera, but the degree to which the customers are postponing their decision is significant.

We’ve got a number of major account customers that are rolling out ShoreTel systems, that are committed and it’s going to happen in time, but we see them postponing and holding off some of these decisions. So we did it as a way to ensure that going forward, we can be profitable, and we also did it in a way, Troy, to minimize the impact on the long-term growth of the company.

Troy Jensen - Piper Jaffray

Could you give us a little more color? Was the cuts more on G&A, COGS side? Where exactly did the cost reductions come from?

John Combs

From a head count perspective it was across the board, evenly distributed between all the major functions in the organization.

Mike, you want to cover the specialty areas and the operating expense outside of the head count?

Mike Healy

Yeah, Troy, we cut some employees, contractors and made some other pretty aggressive expense reduction that will contribute to, like we said, 1.5 to $2 million reduction from March into the June quarter. And again, those cuts were across the board, but it wasn’t just handing out a number, it was more what do we need to do going forward operationally to make sure we have the right people in the right places so there may be some movement around of head count, those kind of things. So it wasn’t just across the board without some thought about what we need going forward.

Troy Jensen - Piper Jaffray

Got it. How does it relate to the service gross margins? That was surprisingly strong this quarter. Was there just fewer service and support people to drive that margin higher?

Mike Healy

Yeah, that mean part of it is we continue to grow the revenue besides the support revenue, its training installation and professional services and that continues to go well. The VP of the managers group is fanatical on cost and keeps cost down so we did do a little bit of reduction there. And we’ve lowered our cost basis. But at the end of the day, what really is driving that is the great customer satisfaction we have and customers renewing their support contracts at a very high rate.

John Combs

Yeah, Troy, we had our third highest customer satisfaction rating in the quarter we’ve had to date. So while the margin’s improving, we’re not sacrificing our customer satisfaction metrics, and we won’t.

Troy Jensen - Piper Jaffray

And one last question and I’ll get out of the queue here. Deferred revs were down, I think this is the first time that they’ve dropped on a sequential basis. Can you just give us some color to what drove the decline?

Mike Healy

Sure, so on deferred revenue we had some reductions in the product piece of deferred revenue. Every quarter we may have some instances where we have to defer revenue according to our revenue recognition policy. So we certainly had some of that at the end of December that we deferred and therefore March cleared through. And then we had a kind of a one-time benefit for a catch-up as we were deferring revenue for one national partner where we do the installation for and we didn’t have the SOE until this quarter. So we were able to obtain the SOE and therefore recognize that revenue. And that was about a $700,000 one-time help to revenue this quarter. Those things drove the decrease in deferred revenue, and it was all on the product side rather than the support side.

Troy Jensen - Piper Jaffray

Understood. Keep up the good work, gentlemen.

John Combs

Thanks, Troy.

Mike Healy

Thanks, Troy.

Operator

And the next question is from Samuel Wilson from JMP Securities. Your line is open.

Sam Wilson - JMP Securities

Hi. Good afternoon. First, can you tell me a little bit about Australia? And you mentioned Telstra, and how should we think about expectations there over the next few quarters?

John Combs

Well, Telstra is basically the telephone company in Australia and the leader, the major provider of communications in the market and then clearly the dominant provider there. So we are in a good position. They have a unique model, that they have a variety of manufacturers. They offer out through a distribution network they have. And it’s difficult for me to assess what the near-term revenue impact is going to be, because we’re just launching it, Sam. In the next quarter, we should be able to give you an idea of what the proposal backlog looks down there. But overall, it’s very encouraging because they’ve really gotten behind this. I think we did a six or seven city tour this week with all the executives launching it out to their distribution partners.

Sam Wilson - JMP Securities

Do you think it could be the size of one of your U.S. national resellers over time?

John Combs

Certainly they could, based on our current penetration into the national resellers we have in North America. But the potential in an AT&T or a CDW or a Black Box is probably 2 or 3x of what the Telstra will be. But it’s like winning the biggest communications provider in the country.

Sam Wilson - JMP Securities

I wanted to follow up on something you said. You said you signed up a record number of new VARs in the quarter. Can you give us some sense as to how many VARs the company has now?

John Combs

We don’t hand out that number, Sam, and the reason why we don’t is because one VAR could be AT&T and 100 VARs could be some very small group. So it’s really not very pertinent. It was a record number. I would tell you that the mix in general has been about the same in terms of large versus small going forward. We are continuing to get a number of the Nortel partners are coming our way who are generally on a higher size.

Sam Wilson - JMP Securities

And I want to follow up on that comment that you mentioned also. Can you talk a little bit about what the market dynamic is right now with Nortel? What are the Nortel customers doing? Are they waiting and hoping they’re going to come out of bankruptcy? Are they moving forward and what are the Nortel VARs doing? Are you getting inbound calls? What’s the dynamic there?

John Combs

First of all, the natural tendency of everybody is to wait and see, but then as they begin to see that their clock is ticking and the bankruptcy is proceeding, that there is a lot of nervousness on both the side of the Nortel’s partners or distribution outlets as well as their end user customers.

So we’re seeing quite a few opportunities come our way. We know that the bankruptcy case is going to allow somebody to buy the base over time. We think that that’s really good because regardless of who buys the base it’s going to open up all those customers because at the end of the day, I think it’s very improbable that somebody who buys the company is going to maintain two product lines assuming they’re already in the business and I think that would be a good assumption at this point in time.

So the customers are all going to be changing out over time, and it’s going to be providing opportunity for anybody who buys the base as well as the rest of us to participate in that change-up.

Mike Healy

And Sam, I can give you one other real life story I was involved in. A pretty major city in California had a Nortel network installed. And they were moving along to put in their Nortel VoIP solution and the city manager kind of raised his hand and said, well, stop; let’s look at this, and this is before Nortel went into bankruptcy, and they said, well, let’s open it up. So they called us along with a couple other major competitors, threw a bake-off. I drove down there one night to get in the final meeting just to save money instead of flying. And the key there was just showing that we could operate with the Nortel network so we bought in our own Nortel switch, plugged our phone system in, had dial tone in the meeting, within a half hour, and I think our sales team closed the deal within a week after that because of our ability to interop with the Nortel system network. So I think that’s probably a microcosm of other activities we are seeing all over the country.

Sam Wilson - JMP Securities

And then lastly Mike, I wanted to follow up on something you said, which was aggressive pricing in the market. Can you talk about who is doing the aggressive pricing?

Mike Healy

Yeah, I mean it was the same major competitors. Everyone’s aggressively going after the Nortel space. As we heard from Cisco they were down significantly year-over-year, quarter-over-quarter, a little bit more than we were. And so everyone was out there trying to close business and be aggressive and we saw that. We didn’t back away. At the end of the quarter we finished pretty strong as you heard. And I was happy we’re able to keep our gross margins up even with we’re pretty aggressive on pricing too. So I was pleased to see our product gross margins remain at 65%, even though it was a little tougher out there in terms of pricing, there was everybody.

Sam Wilson - JMP Securities

Got it.

John Combs

But I would say it’s fair to say that Cisco is the most erratic.

Mike Healy

Yeah

John Combs

They are the group that will start at this price and go to 50% plus off in the course of the battle. So they are the ones that have the most erratic pricing policy.

Operator

Our next question is from Sanjiv Wadhwani from Stifel Nicholaus. Your line is open.

Sanjiv Wadhwani - Stifel Nicholaus

Thanks. Mike, could you talk about the national partners. Were they up or down sequentially?

Mike Healy

Yeah the national partner revenue, which is AT&T, Black Box and CDW was up substantially 75% quarter-over-quarter, and like I said some of that was due to this one-time benefit of 700K from bringing back some deferred product revenues. So I don’t want you to get overexcited.

Sanjiv Wadhwani - Stifel Nicholaus

Got it.

Mike Healy

We’re excited about all three of those guys, sometimes they are lumpy where they are in their fiscal year.

Sanjiv Wadhwani - Stifel Nicholaus

Right.

Mike Healy

But that was the increase.

Sanjiv Wadhwani - Stifel Nicholaus

And so if that 700 hadn’t hit this quarter, it would have hit in December, which would have put December quarter up sequentially quite a bit compared to September for the national accounts?

Mike Healy

Yeah, I mean, all 700 wouldn’t have hit December because it was an accumulation of product revenue over a couple quarters that’s...

Sanjiv Wadhwani - Stifel Nicholaus

Got it, okay.

Mike Healy

...another way to look at it.

Sanjiv Wadhwani - Stifel Nicholaus

All right. And then second question, you might have mentioned this on the call, but I might have missed it but pipeline going into June versus going into the March quarter, any color over there?

John Combs

It was up about 5% quarter-over-quarter, roughly.

Sanjiv Wadhwani - Stifel Nicholaus

Got it. All right, and then last question, as far as the guidance is concerned, if you look at the lower end of your revenue number at 29 million, should we assume then in that situation that your service revenues would still be up sequentially or in that situation you would expect service revenues to be down? How should we think about that?

Mike Healy

At the $29 million low end of the guidance range I would expect service revenues to be kind of flattish with last quarter.

Sanjiv Wadhwani - Stifel Nicholaus

Got it. All right.

Mike Healy

Remember, the base is big and growing, we added another 600 or so customers this quarter. So that support revenue number will continue to grow. The only variation is how much installation revenue and training gets done in the quarter, really moves that number up and down significantly

Sanjiv Wadhwani - Stifel Nicholaus

Right, just mathematically it should continue to grow with product revenues rising.

Mike Healy

Yes.

Sanjiv Wadhwani - Stifel Nicholaus

Right. If your attach rate on services fairly high or can you talk about a number? Is it like 95% or renewal rate, any metrics over there?

John Combs

We don’t release the renewal rate, but it is very high and global support team has got a campaign underway to work with those folks who run time and materials to convert them to contracts. And that has been very successful last quarter; we are redoing it again this quarter. It’s particularly good because now the customer gets both the service contract as well as the upgrades to Release 9 as part of that package included in the price. So it really substantially reduces our costs overall.

Sanjiv Wadhwani - Stifel Nicholaus

Got it, all right, sounds good. Thanks so much guys.

Mike Healy

Thanks, Sanjiv.

Operator

And the next question is from Steven O’Brien from JPMorgan. Your line is open.

Steve O’Brien - JPMorgan

Hi, thanks for taking my questions. Can I ask again about the pipeline up 5% heading into the next quarter versus for sequential revenue guidance flattish? Is the revenue guidance just reflecting an element of conservatism or is the aforementioned aggressive pricing environment the difference here between the pipeline growth and the revenue outlook?

John Combs

No, Steve it’s all in the conversion rate. So we’re not losing anymore business than we have in the past, it’s that the customers in the pipeline are not following through on the decision purchases. The new business is down is basically what the answer is.

Steve O’Brien - JPMorgan

Okay.

John Combs

It’s delaying, it’s not being lost.

Steve O’Brien - JPMorgan

All right, okay, understood. Can I ask about AT&T or just in general carrier sales channel in the quarter and the outlook going forward? Was there any disruption from potential work stoppages during the just reported quarter or is this just something you’re keeping your eye on? In general, just could you talk about AT&T and other carrier business we’ve seen versus previous quarters?

John Combs

I’m very pleased with our progress in AT&T, CDW and Black Box, but specifically with AT&T. There was no disruption in the business other than the organization had taken a lot of their sales force and administrative support people that work with us and put them to training classes in the event of a labor shortage. So those people could move into those roles. So there were some impact. I don’t think it was material in the quarter. But going forward, if they did have a labor shortage, and we have no idea and wouldn’t want to comment on what the probability of that was, then it would impact our revenue significantly, but not more than 10%. So it’s not like it’s a huge revenue impact to us, but it would be material.

Steve O’Brien - JPMorgan

That’s 10% of the AT&T business right?

John Combs

No 10% overall

Steve O’Brien - JPMorgan

Overall?

John Combs

Yeah.

Steve O’Brien - JPMorgan

I see. So what would AT&T or aggregate carrier contribute in the given quarter?

Mike Healy

We don’t disclose out the amount of revenue from each carrier because it is confidential. Like John said AT&T would be less than 10% of our total revenue and the other two Black Box and CDW are well below that for this quarter. I can give you a range but that’s about the best that I can do.

Steve O’Brien - JPMorgan

Okay. If I can ask a more mechanical question on the legal settlement. You said that the 4.1 million, correct me if I am wrong here, includes all these future fixed payments over the next four years. Am I right in understanding that? And then I guess we won’t see it on the P&L but it seems like we’ll see the cash payments in the cash flow statement going forward?

Mike Healy

Yes, exactly correct. So we have the full amount recorded in the financials this quarter and then all you’ll see is the cash go out over the next four years.

Steve O’Brien - JPMorgan

Got you. So if they are in a model 4.1 million divided by 16 quarters going forward in the cash flow statement?

Mike Healy

Yeah, the terms of the agreement are confidential. I guess what I could tell you is it’s a once a year payment and it’s not that even, it’s a little weighted heavily towards first payment and lighter in the last payment.

Steve O’Brien - JPMorgan

And I don’t think there was but is there any payment in this just reported quarter?

Mike Healy

No.

Steve O’Brien - JPMorgan

Okay.

Mike Healy

The first payment starts this quarter. And again the reason we did this settlement, it’s all economics, right? We just looked at the cost to take this thing to trial and IP attorneys, if you’ve ever contracted one are very expensive and the cost to taking that to trial at IP litigation plus our trade liable case in Canada was well in excess of the negotiated settled amount. So for us it was purely an economic decision to settle this.

Steve O’Brien - JPMorgan

So the 800,000 of legal expense this quarter which was not taken out as a one-time or called out as a one-time item should pretty much go away in subsequent quarters, correct?

Mike Healy

Yes, that’s part of the 1.5 to $2 million reduction.

Steve O’Brien - JPMorgan

Right.

Mike Healy

I just gave you that number to give you an indication of how much we were spending per quarter on this Mitel litigation matter.

Steve O’Brien - JPMorgan

Okay, understood. I appreciate the opportunity, thanks.

Mike Healy

Okay, thanks, Steve.

John Combs

Thanks Steve, take care.

Operator

And our next question is from Lynn Um from Barclays Capital. Your line is open.

Lynn Um - Barclays Capital

Hi, this is Lynn calling on behalf of Jeff.

John Combs

Hi, Lynn.

John Combs

Hi there.

Lynn Um - Barclays Capital

Hi. Actually I think most of my questions have been answered, but I guess, if you could maybe just start talk a little bit more about the international scene. It looks like the mix shifted again towards international, sounded like China was in there. Were there any other particular areas that were particularly strong or maybe not as strong during the quarter?

John Combs

No, pretty consistent. The European market was down slightly and the Australia-Asian market was flat over the quarter, well, basically flat. What drove the increase of the percentage was the North American sales decline as a higher percentage of the total revenue.

Lynn Um - Barclays Capital

Got it, okay. And if I could just go back to the services margin, obviously it continues to grow, lot of it being driven by the growth in revenue as mentioned. Just from a modeling perspective, how do you see the trajectory start pulling out at a certain point or how we can think about that?

Mike Healy

Well, obviously our goal is to continue to drive that up as much as we can. And it’s a balancing act between maximizing the margins and maximizing customer satisfaction. So long as we continue to have great customer satisfaction, I would suspect we can drive more margins in the service business higher. I will say we have to probably catch up a little bit in hiring, but there isn’t a limit we are putting on the gross margin right now long as we continue to have these other support and services continue to trend up.

John Combs

But Lynn, as soon as we saw any of the metrics in the technical support group or training support group or end user customer satisfaction go in a negative directions, our first priority of our global support team is do an exceptional job in supporting our customers and that will always take precedence.

Lynn Um - Barclays Capital

Got you. Okay, that makes sense. Thanks very much.

Mike Healy

Okay, thanks Lynn.

John Combs

Thanks Lynn.

Operator

And the next question is from Rohit Chopra from Wedbush Morgan. Your line is open.

Rohit Chopra - Wedbush Morgan

Hey, guys. How are you?

Mike Healy

Great, Rohit. How are you?

Rohit Chopra - Wedbush Morgan

Good, I just wanted to follow up on Sam’s question on pricing real quick here. Were you guys trying to match pricing during the quarter? I know you had promotions but were you trying to match aggressive pricing at the same time?

John Combs

The key for us Rohit is that when we get the customer to look at a total cost of ownership, a lot of our major competitors can almost give their product away and would still be more cost effective over a five-year period for example. So that’s the key sales for us. And we work hard not to discount the capital investment upfront, because overall we’re giving the customer very good value, because the backend expenses to manage and care and upgrade a ShoreTel system are so much less than they are with a competitive product. So that’s where we really focus our attention in competing against them.

But that the larger competitors and particularly Cisco when they want to deal, will be, I would consider to be erratic in their pricing. They’ll sell to the customer, propose the customer at a 100% list price and later on at the end of the battle they’ll give them 50% off, and some customers think that that’s good. I think most customers look at it as they would have sold it to me for list price.

Rohit Chopra - Wedbush Morgan

The aggressive pricing by competitors continues, so there is no change?

John Combs

There is no change. Maybe this quarter we saw a little bit more because I think all of us were struggling with pretty pathetic January and February sales. So I think that it might be up a little bit this quarter. But it wasn’t up materially to the point where it affected our gross margin.

Rohit Chopra - Wedbush Morgan

Okay, a question on financing. Is that helping you guys? I know you have a partner who helps you with the finance side of things. Has that been a driver at least?

Mike Healy

Yeah, so we have ShoreTel Financial Solutions where we through a leasing company offer very competitive leasing rates and a technology upgrade program. We don’t carry the paper or anything, so it’s more just branding. The volume was down though in the March quarter over December quarter as credit just got tighter for everyone. But it was just launched a couple of quarters ago so it has been a very good benefit for us, for our end customers, to enable us to help close business. We’re looking to continue to expand that relationship in programs so it gets much bigger.

Rohit Chopra - Wedbush Morgan

And I had two other questions. One was head count. I don’t know if I missed that or you said that.

Mike Healy

So head count at the end of March was 396 full-time employees, up three from December, and then the RIF action after that with some hiring here and there, we’re at about 370 heads today. So kind of back to June last-year numbers.

Rohit Chopra - Wedbush Morgan

Okay, and then one last question; maybe John can take this one. Is there, have you seen any increased threat from hosted solutions?

John Combs

Any increased threat?

Rohit Chopra - Wedbush Morgan

Yeah, has anything changed on the hosted side?

John Combs

No. No, I think most major carriers will lead with a hosted solution, IP solution. It’s not very prevalent in the marketplace in terms of the success rate. There is a lot of challenges associated with hosting environment. In the old Centrex days, Ro, used to have a huge capital investment that you put into a location, you had to have very technically qualified people to manage it and you had a pair of copper wires that if it didn’t get underwater would run down the street to the desk phone. So you had a reliable communication system.

When you go with a IP system, you got a lot of active components between you and your switching equipment. And if they go down, you don’t have any phone service at all except for your cell phone at the location. So a lot of customers who value reliability and availability don’t like that kind of the solution. It’s also difficult to provide the custom configuration and feature customization to a specific customer’s requirements when you are operating it from a standard one-box serves all kind of a hosting solution.

Operator

And the last question is from Samuel Wilson, JMP Securities. Your line is open.

Sam Wilson - JMP Securities

Just one follow-up. In last Nortel Systems conference call from the numbers you could tell that large enterprise did better than SMB. It sounds like from your large deals that you saw a little bit of that same phenomenon where larger companies through the end of the quarter were willing to deploy some capital while SMBs were still pretty cautious. Is that fair?

John Combs

I didn’t see a change in our business overall Sam, because the revenue is down overall. We did see, our average size did go up during the quarter, but I didn’t think it was material. We keep pretty close track on the really big ones that are planning to come in and I was frustrated by the fact, how many have gotten pushed out. So I don’t notice the difference between large and small. Our average size went up slightly but I don’t think that that was really a reflection of the larger size being more effective than the smaller size in this last quarter

Sam Wilson - JMP Securities

Got it.

Mike Healy

I would add Sam, we have closed a lot more major account deals in that we have won them and then just the timing of when they want to take their first install and shipment has been delayed.

John Combs

Or even subsequent it’s slow.

Mike Healy

Yeah.

John Combs

They get two or three sites and they put them on hold. Sorry.

Mike Healy

So we have a pretty good backlog of deals won and the hope is they start chipping in our Q4 and the June quarter but there is no guarantee of that. So that the major account programs continue to progress well. That was certainly down this quarter like the rest of the business but a lot of big orders were not in their same backlog, but ready to go sooner or later.

Sam Wilson - JMP Securities

Right and those big orders are not in deferred revenue backlog, they are just hanging out there waiting to...

John Combs

Right. That’s right. Yeah, they are down at the end of the pipe. Customers give us a verbal; some cases give us POs for certain installations maybe has the rollout on hold for a while.

Sam Wilson - JMP Securities

Got it. Okay, thank you.

John Combs

Take care, Sam. Thank you.

Mike Healy

Thank you, Sam.

Operator

And there are no more questions at this time.

John Combs

All right, I would just like to wrap it up by saying that this certainly is a difficult environment we are operating in right now. But if you step back from today’s current events and look at our industry, there is worldwide an $18 billion market that’s under a huge transition going from older technology digital TDM equipment, IP technology equipment. We’re 30 to 40% of the way through that. So it’s not a matter of, if, there is going to be transition to IP, it’s a matter of when. So that it still represents for our company a long-term future in terms of market opportunity.

I’m very comfortable with the fact we’ve got a foundation that’s based on the best-in-class product combined with world-class customer satisfaction and the growing distribution network. We truly did establish our foundation for the future. I have a very, very high degree of confidence in our ability to scale our organization to ship more equipment, to train more people, to roll out the sales force to selling ShoreTel based on our experience today. We’ve got the model worked out. It’s just a matter of working distribution network and increasing our market share growing as the economy improves.

So thank you very much for attending today. We appreciate it, and I will be available for you to meet us throughout the quarter. Take care.

Operator

This concludes today’s conference call. You may now disconnect.

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