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ShoreTel, Inc. (NASDAQ:SHOR)

F4Q09 Earnings Call

August 12, 2009 5:30 pm ET

Executives

Tonya Chin - Director, Investor Relations

John W. Combs - President and Chief Executive Officer

Michael E. Healy – Chief Financial Officer

Analysts

Steve O’Brien – JP Morgan

Samuel Wilson - JMP Securities

Jeff Kvall - Barclays Capital

Rohit Chopra - Wedbush Morgan

Analyst for Sanjiv Wadhwani - Stifel Nicholaus

Operator

At this time, I would like to welcome everyone to the ShoreTel fourth quarter and fiscal year 2009 conference call. (Operator Instructions)

Tonya Chin

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

Before we begin, I will 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 March 31, 2009, and the current report on Form 8-K furnished today. The information in this conference call related to projections or forward-looking statements is based on management’s current expectations. 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 Regulation FD Public Disclosure form.

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

John W. Combs

Thanks to all of you for joining us today. First, I will review the highlights of fourth quarter financial performance.

Revenues of $32.4 million in the fourth quarter were within our guided range of $29.0 million to $34.0 million. We were pleased to have the fourth quarter revenues increase by 4% sequentially over third quarter performance.

Non-GAAP gross margins continued to be strong at 64% and we returned to non-GAAP profitability with a net income of $1.4 million, significantly better than any quarter during the fiscal year.

Fiscal 2009 revenues were $135.0 million, up 5% over last year's revenues of $129.0 million.

Non-GAAP gross margins for the fiscal year were 64.2%, up from 63.6% for fiscal 2008.

Non-GAAP net income was $1.2 million, or $0.03 per share. I am pleased that we were able to finish the year with such a positive note, especially considering the addressable market has declined 24% in the United States and 26% worldwide in the past 12 months.

Perhaps the biggest news of the quarter is that we have added two new U.S. telecommunications carriers, Quest and Verizon, to our distribution network.

Quest sells to 95% of the Fortune 500 and provides network, data, and voice services for small and large businesses, government agencies, and wholesale customers, and employs a sales team of over 1,000 people. We are very pleased how quickly the Quest team has embraced the ShoreTel offering. Important lead generation events have begun and we saw a nice ramp-up in new customer sales during the quarter.

We were also pleased to announce our new relationship with Verizon, a global leader in providing broadband, wireless, and wire line services with over $97.0 billion in annual revenues. We have completed the introductory training with over 400 Verizon sales team and conducted extensive training with over 100 Verizon sales engineers during the quarter, to support the ShoreTel product line. We received our first order from Verizon in August and are excited about the future opportunity of this new relationship.

Verizon and Quest join AT&T, Black Box, CDW, and Telstra as organizations with national reach who are experts in our industry and have decided to move forward with ShoreTel. We were able to sign these major telecommunications organizations as a result of unique benefits that ShoreTel offers to our partners and customers, including: high win rates that ensure the partner can succeed in competitive bid situations; a role best set of unified communications features that are converting more and more end users in the rating fan; the easiest to install manage and use business communication system in the industry, ensuring low maintenance costs; a modular architecture allowing customers to never lose their initial investment and instead just add capacity and scale seamlessly as their business grows; and a business model that delivers superior margins to channel partners.

We also had a significant development in our relationship with AT&T during the quarter. We were awarded their highest level of supplier status, that of a Tier-1 vendor. We are very pleased to have reached this top level of partnership with AT&T and expect it will provide more focus on ShoreTel within the company, which we believe will contribute to higher revenue in future quarters.

Those who follow the history of the Bell system can appreciate the magnitude of having relationships with the top three U.S. telecommunications carriers, AT&T, Verizon, and Quest. These organizations serve the same territory covered by all seven of the former Baby Bells, plus GTE. Clearly a huge opportunity for ShoreTel.

These organizations are large, complex and will take time to ramp up to full speed. Ramping these large organizations is like spinning a giant flywheel, it takes a lot of effort to get it going but once it builds momentum, there is no slowing it down.

As we consider the obvious magnitude of these opportunities, we realize that we must make specific, event-driven investments now in order to grow our market share within these strategic partners.

While the emerging relationships with our national partners represent a milestone for ShoreTel, today most of our sales comes from a strong group of regional distribution partners. One of the best things about our national partners is that they are complementary to our regional partners. In general, the customers who purchase from national partners are different from those served by our regional partners.

In July we announced an agreement with IBM to integrate ShoreTel's Unified Communications System with the new Lotus Foundations Reach product offering. The result will be an out-of-the box solution that combines a full range of IT, email, office productivity, and collaboration applications, such as Lotus Sametime, with ShoreTel's brilliantly simple Unified Communications Solution.

The combined offering will be targeted globally to small- and medium-size businesses as well as branch offices of larger enterprises, where IT resources and skills are often limited.

This partnership offers many benefits to ShoreTel, including harnessing the combined strength of our distribution partners with IBM's powerful distribution channel. We expect the product to begin shipping by the end of the calendar year.

During the June quarter our customer satisfaction level was the highest in company history. We are particularly pleased with this achievement as we also reached the highest gross margins in our history in our services business during the quarter. Providing our customers with world-class support while continuing to grow our services gross margin is a significant accomplishment that is driven by our highly reliable product and our outstanding global services team.

We also made significant progress in growing our market share and worldwide share. According to Synergy Q1 Enterprise Voice Market Share Report the worldwide Enterprise IP telephony market declined 22% and in the United States the market declined 23% sequentially in March 2009 quarter. Despite the significant decline in IP telephony market, ShoreTel was able to post a solid gain in market share both in the U.S. and worldwide.

Based on Synergy's latest data, we estimate that our United States market share in Pure IP is approximately 7.5%, up almost a point from 6.6% in the prior quarter. Additionally, our Pure IP worldwide market share grew to 3.5%.

Next, let me share my thoughts on Avaya's bid for Nortel's Enterprise business and the speculation that Enterprise Network Holding, a joint venture between the private equity firm, Gores Group and Siemens AG, they also bid to acquire Nortel Enterprise business. There have been many articles written about the potential impact on the companies involved, Avaya, Gores, Siemens, Nortel.

However, the key question that everybody seems to be overlooking is what happens to the existing Nortel customers. Customers buy communications systems with expectations that it will last ten years or more and they expect their supplier to continue to offer new enhancements and upgrades during this period.

For Nortel customers who have made a significant investment in a new system, the outlook is uncertain at best. While no one can say for sure, I'm fairly confident that the ultimate acquirer will not enhance the Nortel's systems and technology, but instead work to sell existing Nortel customers on a new platform.

Frankly, this isn’t surprising. After working in this industry for decades, I understand that it's difficult if not impossible to afford to invest in the engineering resources required to maintain two separate product lines to serve the same market.

As a result, I believe a large number of current Nortel customers will be converting to new communications systems over the next few years. The winning bidder will inherent the existing customer relationships, however, I believe that many customers will resist being forced to change, which will provide an opportunity for ShoreTel and others to compete for this business.

Many Nortel customers have already been converted to ShoreTel systems and are experiencing the business of lower total cost of ownership and boosting productivity on a reliable platform designed for the long haul.

In terms of the impact on ShoreTel, we are seeing a growing number of Nortel partners are coming forward with a desire sell ShoreTel and our average size of the Nortel conversions to ShoreTel we had during the quarter were nearly twice our company average.

I would like now to update you on our branding campaign we mentioned in last quarter's call. Our biggest competitor continues t be not being invited to compete. Why are we not considered? Our win rate is over 50%. To improve our consideration rate we launched a branding initiative, which we expect to help increase our awareness and ultimately drive additional revenue.

During our last quarter call we mentioned that we were advertising in AT&T Park during the San Francisco Giants games. The key element of this program is a rotating ShoreTel sign directly behind home plate. I received a lot of calls after our ShoreTel banner was prominently displayed in the Sanchez no-hitter that was broadcast nationally on July 11.

Now I would like to take a few minutes to discuss the highlights of our 2009 fiscal year.

Looking back, few could have forecasted the magnitude of the impact the worldwide recession was going to have on our industry. In light of these challenges, ShoreTel has had a very strong year that includes the following accomplishments:

In a period where many of our competitors were cutting back on their research and development spending, we increased our R&D investment and as a result were able to introduce many new products and services during the year. These include two new versions of our Unified Communications software that extend the availability of our advanced Unified Communications desktop globally, delivers new personalized communications capabilities, and further enhanced our distributor architecture.

We also updated our conference product lines that lets customers eliminate costly third-party conferencing charges from their monthly telecom budget.

ShoreWare Contact Center 5 enhance our Contact Center redundancy options and double their agent capacity.

Several new phones, including our ShorePhone IP 230g, a low-end gigbit Ethernet capable phone, and our integrated VPN phone. With VPN support enterprises can better serve their remote workers by equipping their home office with a high-quality, easy to use and affordable ShoreTel IP phone that is simply connected to the corporate system via the Internet.

And we also enhanced our distribution architecture with the introduction of the new family of ShoreTel V switches, the first to include voice mail both right into the switch using solid-state flash memory. This allows the customers to enjoy reliable distributed voice mail in each location without the need to use a separate server that is costly and less reliable.

The V switch is represented in nearly 10% of our total switching shipments in the fourth quarter only, only two quarters after having launched the product.

During a time when many of our competitors were shrinking, we grew our annual revenues 5%, reaching a record high of $135.0 million in fiscal 2009. We made significant progress in building our partner base, adding over 250 new partners worldwide during the year, bringing our total number of partners to 880. We added 2,900 new customers, bringing the total to almost 11,000 and added our one-millionth end user being served by ShoreTel.

We continue to ramp our new facility in Austin, Texas, which gives us access to a rich talent pool of highly educated employees outside the high-cost California region.

Most notably, as I mentioned earlier, we have significantly extended our national product distribution channel during the year.

Highlights for the year would not be complete without a special thank you to our regional partners. This dedicated group of entrepreneurs has been propelling ShoreTel forward since our very early days. Their ability to sell and delight customers has been a cornerstone of our growth to date. They continue to be the heart of our business and were a significant driver in our ability to grow revenues despite the fact that the IP telephony market was declining materially.

With that, let me turn the call over to Mike.

Michael E. Healy

I will be discussing both GAAP and non-GAAP results throughout this call and I ask that you refer to our press release for the reconciliation between these amounts. Our non-GAAP numbers excluded stock-based compensation charges, restructuring items, and the related tax impacts of these adjustments. We believe excluding these items gives management and investors of our true operating results.

First, I will review our fourth quarter performance, and as John mentioned, the highlights included a 4% sequential increase in revenues, continued solid non-GAAP gross margin performance of 64% and tightly managed operating expenses of $19.4 million that came in slightly below our guided range. And therefore we return to non-GAAP profitability of $1.3 million, or $0.03 per diluted share.

Let me give you some more details on the quarter. We sold 76,000 end user licenses in the quarter compared to 69,000 in our March quarter, an improvement of nearly 10%. Within our vertical markets, we saw excellent growth in the government vertical with new business from federal government and continued strong sales to city governments and education.

Another sign our business is improving was a 24% increase in our order bookings from Q3 to Q4, which include both product and support bookings. Business from our national partners was down 27% sequentially, mostly related to the one-time benefit from deferred product revenue that we recorded in our third quarter.

However, Q4 national partner volume was up when compared to Q2, with CDW showing the largest percentage increase.

International revenues were $2.2 million for the quarter, down 7% from the third quarter. Non-GAAP product gross margins were 64%, down slightly from 65% in Q3. Product margins declined slightly due to promotional pricing we put in place to drive demand. Our service and gross margins hit another all-time high of 66%, a sequential increase of over 5%.

Our 10% decline in operating expenses from Q3 was primarily due to the reduction in workforce we completed in April and a $600,000 decrease in legal expenses that was a direct result of resolving our patent litigation in early April.

Our non-GAAP income of $1.3 million was our highest quarterly income all fiscal year and was helped by an increase in other income of $574,000, which included approximately $163,000 of interest income and $411,000 of positive foreign exchange impact in the quarter.

Our GAAP net loss was $688,000, or $0.02 per share, including an unusually high GAAP tax break for the quarter of $497,000. Our non-GAAP tax expense was $597,000, or 32% of taxable income for the quarter.

As a reminder, when we have low levels of earnings or losses before taxes, we will have fluctuations in our tax rate due to stock compensation, timing differences, book versus tax treatment, legislation, and other factors that may have a material impact on both GAAP and non-GAAP tax rates.

Now let me review some of the metrics related to our strong balance sheet. We ended the quarter with $108,000 million in cash and short-term investments and generated $1.0 million in cash flow from operations.

Days sales outstanding improved 5 days in the quarter to 48 days, which is our lowest DSOs since being public. Inventory increased $2.1 million to $11.8 million. Deferred revenue increased by $1.4 million, driven by an increase in support revenue orders. Capital expenditures were $400,000 and depreciation and amortization was approximately $525,000.

We ended the year with 375 employees, with close to 80% of that total in product development, sales, and global support organization.

Next, let me review some sales and customer highlights from the quarter. Looking back at Q4, the sales environment felt slightly better than Q3. We saw a general improvement in buyers' attitudes toward purchasing unified communications systems. We believe this was driven by companies that are attempting to do more with less and becoming more willing to spend today in order to secure long-term telephony cost reductions and increased employee efficiency.

Secondly, the decline in the overall economy seems to have slowed and there are a growing number of positive signs that indicate the worst part is behind us. As a result, customers are feeling more confident to spend on their critical IT needs of their business.

I am pleased with our revenue performance during the quarter and we are excited to see nearly every business metric move in a positive direction. Orders from major accounts were very strong with a sequential increase of 39% during the quarter, clearly demonstrating that ShoreTel continues to make progress selling to large enterprise customers.

We increased the number of large-size deals we won during the quarter and we were also pleased to see our number of new customers increase 14% from Q3. These improvements were partially offset by a decrease in revenues from our national partner, mostly as a result of our deferred revenue catch up that we discussed on last quarter's call.

We added close to 700 customers in the quarter, bringing our total to nearly 11,000 customers in all. We also passed a milestone of 1.0 million end user licenses using ShoreTel systems to manage their communication.

Some examples of recent customer wins include: Kenwood USA, a leading developer and manufacturer of consumer electronics and communications equipment that has installed ShoreTel in several branch locations and is currently in the process of installing the ShoreTel system in its corporate headquarters; ITC Ltd., Australia's leading environmentally-certified forestry company that has installed ShoreTel in 16 of its sites.

We continue to do very well with national sports teams and recently have installed a system for the St. Louis Rams. The Rams add to our impressive list of professional sports teams, which include the wild-card contending San Francisco Giants, the Verizon Center Home of the Washington Wizards and Capitals, the Buffalo Sabers, the L.A. Lakers, and various minor league baseball teams.

And finally, we recently deployed a ShoreTel system at the Limited stores, a national fashion retailer that offers high-quality, private-label apparel for women. The Limited has installed ShoreTel in a significant number of its stores, as well as its corporate offices.

Many of the Limited sales associates do not have individual office phones and have been set up as mail-box-only users with access to Voice Mail Black. In a retail environment, this allows management to effectively communicate directly with sales associates regardless of where they are located.

Next, let me give you some additional business highlights on our fiscal year 2009 volume as compared to fiscal year 2008.

Some notable growth areas included orders from our major accounts group grew 37% year-over-year, mostly driven by excellent progress in city governments, professional services, and the education verticals.

Business from national partners, which include AT&T, CDW, and Black Box, and now Quest and Verizon, was up more than 40% year-over-year, with AT&T as the most significant driver behind that number.

For the year, our national partners business was nearly $15.0 million, or 11% of total order volume. We expect our national partner business, as a percentage, to grow throughout our fiscal year 2010 as AT&T, Quest, and Verizon continue to ramp up.

Our support and services revenue, which grew 39% year-over-year, exceeded $25.0 million. The increased revenue, along with prudent cost management, allowed our non-GAAP support and services margins to grow from 48% in 2008 to 59% in 2009. This 11 point increase had a positive influence on the overall company gross margins of 200 basis points.

Next, I will discuss our outlook for the September 2009 quarter. The visibility continues to be challenging, given the ongoing variability in our market and the overall economy. Therefore, we expect revenue to be in the range of $30.0 million to $35.0 million.

The September quarter typically has a drop off in order volume from June due to the summer vacations delaying UC purchasing decisions and the fact that our fiscal year just ended in June. For the September 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, approximately 75 basis points to 100 basis points, due to the inclusion of $200,000 in stock-based compensation expenses.

We expect non-GAAP operating expenses to grow in the September quarter, as we increase our investment in sales, channel development, and branding activities. Based on the number of opportunities right in front of us, we are front loading our fiscal year 2010 hiring plan in the U.S. sales group to ensure we can add additional resources to support our growing distribution channel. We expect to hire close to 20 new employees this quarter with half of them being quota-carrying sales people.

Our other spending areas will include trade shows, demo equipment, branding, and training activities. Therefore, we expect our Q1 non-GAAP operating expenses to be in the range of $21.5 million to $22.5 million. We expect GAAP operating expenses to be in the range of $23.5 million to $24.5 million, including approximately $2.0 million in stock-based compensation expenses.

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

John W. Combs

I will wrap up the call. I would like to share a bit more about our plans for the upcoming quarters. While we haven't seen a sustained period of growth in our industry, we believe the decline in the U.S. economy seems to have abated and most indicators in our business have shown some positive improvement over the last 90 days.

Our 24% quarter increase in bookings is the most concrete metric we have to demonstrate this. We believe these improvements, in general, will continue, however it is hard to predict the pace. We have identified opportunities in front of us, but as I've discussed, it is clear that now is the time to invest in our future.

Let me outline some of the factors that have led us to this conclusion. First, despite the significant decline in our addressable market over the past 12 months, we have managed to grow our business, and as a result, grow our market share and are coming into our fiscal 2010 with positive momentum.

Second, having solidified relationships with all three of the top U.S. telecommunications carriers, plus CDW, Black Box, and Telstra in Australia, we will significantly expand our reach and the number of opportunities we are involved in. With specific high-potential opportunities ahead of us, including these new distribution partners, our newly designated Tier-1 status with AT&T, our recently announced partnership with IBM, and our growing opportunity with Telstra, we are confident that these investments we are making during the year will yield strong growth in future quarters.

And finally, Nortel going out of business has caused market disruption that I believe is favorable for ShoreTel. Most enterprise telephone purchases include three potential vendors on a short list. In the past, that's also often been Nortel's fiscal [inaudible]. Now Nortel is liquidating its assets, they've lost their seat at the table and leaving a vacancy that ShoreTel has the opportunity to fill.

It is clear that ShoreTel is at an inflection point with a tremendous opportunity to grow. To fully capitalize on these opportunities, we will front load our planned investments in sales and marketing with a majority of the resources going to ramp up partner channels. This will include increased spending for our brand awareness, a critical component of being considered in an engagement.

We have starved these areas of our business over the past four quarters, when the demand environment was uncertain. We recognize the near-term impact on our income statement may be negative if Q1 revenue were at the low end of our guided range. Despite this, I firmly believe the direction is clear. We must strike now and make these investments in order to fully recognize our true potential for significant, accelerated growth in calendar 2010 and beyond.

Now let me open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steve O’Brien – JP Morgan.

Steve O’Brien – JP Morgan

I just wanted to touch on the top line guidance for next quarter, pipeline was up 24%, deferred revenue up $1.5 million quarter-over-quarter, and looks like accounts receivable and inventory you suggest you're gearing up for stronger demand heading into the next fiscal year. So how much of guidance should we attribute to seasonality and how much to some element of conservatism here?

Michael E. Healy

Typically the September quarter does have a drop-off in orders. We experienced the same last quarter. Because everyone is pushing through the quarter, through the end of the fiscal year, partners and sales guys, to get on the podium for the end of the year. So we do expect a drop-off in orders.

Our guidance, we have taken all our metrics into consideration, including our roll up from the sales organization and look at all our external factors and come up with our guidance and that's what we reflect in the $30.0 million to $35.0 million number we gave you.

I wouldn't say it's any more conservative or aggressive than any other quarter we've given guidance.

Steve O’Brien – JP Morgan

So on that same topic, how did the quarter progress seasonally in the fourth quarter, or between the three months, and then we're almost halfway Q1 here, how does Q1 typically shake out on a month-to-month basis? Is it any different from other quarters, like Q4?

John W. Combs

Let me tell you first about Q4. Usually, in Q4, we get about half our business in the first two months of a quarter and the other 50% in the last half. The June quarter was more back-end loaded than prior quarters in the past. Looking to this quarter, July was a stronger month than was April, which was a pleasant surprise for us. But that's where we sit as we are today.

Michael E. Healy

I think the only thing I forgot to mention is in Europe especially it's very choppy. In July and August everyone is on vacation so you really don't see much progress in Europe until you get back and everyone's back from holiday in September. But typically from that side of the business, most of the orders come in in the month of September.

Steve O’Brien – JP Morgan

Can I just follow-up on the gross margin in product this quarter. It seemed like there was some promotional activities that led to the sequential decline. Do you expect those kind of promotional activities to continue and can you help us understand whether they were key factors that drove the more back-end loaded June that we saw.

Michael E. Healy

In terms of product, those margins that went down about a point quarter-over-quarter is a combination of a couple of things. If you remember, Q3 they had this catch-up in deferred product because of deferred revenue. So that catch-up actually helped grow product margins last quarter in Q3 so we didn't have that one-time event this quarter. So that contributed a little bit of the decline.

Discounting was up a little bit. We are aggressive in going after the Nortel base. The competition was pretty aggressive, with Cisco's year end as well in July, as you guys know. So everything was a tad more aggressive. I don't expect discounting to go up next quarter. I think we should be relatively flat. At least that's our hope.

And we did have a little more spending in some of our departments than we expected and that contributed to the product gross margins declining a little bit, too.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

First, a housekeeping item. I need the percentage of business from existing customers.

Michael E. Healy

The percentage of business from existing customers was 54%. And that's up from 41% last quarter, from the new customers.

Samuel Wilson - JMP Securities

On Quest and Verizon you were very clear to caution us to not be too quick about this. They take a while to ramp. Can you give us some color as to what you would expect the ramp time to be before these become material partners.

John W. Combs

As you know, they have the potential to become material partners in very short order, but if we use the AT&T ramp piece that we've seen, because we've been through that in the last 18 months with AT&T, things start reasonably conservative and you build momentum over time. So we've got off, as I mentioned in the script, to a really quick start with Quest. They've really embraced the product and they've come out of the gate faster than we saw AT&T come out some months ago. Verizon seems to be coming out with a little more aggressive approach as well.

So near term, I don't expect material impact on our revenues during this calendar year, but as we go through quarter to quarter we will keep you posted on the kind of progress we're making and give you a better assessment. But I expect that as we look forward, months and years out, they will be a significant portion of our revenue.

Samuel Wilson - JMP Securities

Telstra was a major win a quarter or two ago. Can you just talk a little bit about how you view right now the international carrier opportunity for ShoreTel?

John W. Combs

Given the significant, prestigious position AT&T holds in that worldwide community, it has served as an introduction to many organizations. And Telstra has taken off to a very fast start. As a matter of fact, I'm leaving tomorrow night to head to Australia to meet with them after they've done their launch, and they came out with a nice quick start as well.

But we are actively working with other major carriers worldwide as a way to leverage and expand our business. Also as I mentioned in the script, it's nice because the customers, by and large, it's not perfect of course, but by and large the customers who buy from the large carriers are a different set of customers than buy from regional partners. So those two groups end up being very complimentary in terms of expanding the real market that we are addressing as opposed to just adding additional partners to cover the geography and fight over the same particular orders.

Samuel Wilson - JMP Securities

You talked about bookings being up 24% but I just want to get some color on your general sense of the June quarter's RFP activity. And the RFP activity even into July and here in the first part of August. Just how often is the company being penned for request for proposals and has that been increasing roughly the same? Just your tone there.

John W. Combs

The RFP activity, surrogate for me would be the proposal activity, was a slight increase during our fourth quarter and remained flat coming into our current quarter. So I haven't seen a gigantic increase in the RFP activity. We have seen a nice step up in the government sales activity. We've got some nice things working, both in the federal government, which has not been strong for us, and state, we've got a number of state contracts now, so we're excited about that, so that's a definite positive move from our company's perspective.

But I haven't seen a gigantic increase in the number of RFPs coming through.

Operator

Your next question comes from Jeff Kvall - Barclays Capital.

Jeff Kvall - Barclays Capital

It does sound as though you are somewhat more optimistic about the outlook for beyond the September quarter than you had been previously.

John W. Combs

Absolutely.

Jeff Kvall - Barclays Capital

I would like to dive in a little bit on that because it seems as though the September quarter isn't where the uptick in revenue comes but it comes beyond that based on other things that you are seeing and yet the September quarter is when the opex is picking up. So I'm wondering if you could talk me through a little bit some of the timing of things and what's driving the longer-term visibility, or longer-term confidence, in revenues.

John W. Combs

First of all, our sales headcount for the last year has been flat, basically. And as we add, layer in, new sales executives, even if you hire a seasoned executive, you have time to acquire them, take them the interview process, you bring them, you get them trained in the equipment, you get them out to meet their partner network, to build relationships, and they go out and find some customers, and build some proposals. That sequence takes a long time before you begin to see the results of that investment. So that's basically what is the delay in the return on the investment.

Jeff Kvall - Barclays Capital

But these are hires in support of the new national distribution opportunities?

John W. Combs

No, it's across the board. It's support in our regional partner activity, it is activity in things like our proposal support group, our inside sales team, certainly our national partner program. So it's not just for the national partners.

Michael E. Healy

And I would add from a branding standpoint, we just kind of kicked off the branding campaign last quarter, ramp up from there, and as you know, it takes a little while to see the impact of that branding campaign. And what we're going to do absolutely is measure the awareness. We have a yard stick we did earlier, and we're going to spend this money and then we're going to go back and measure how our awareness increased, i.e., how effective the branding campaign has been. So it does take a while for that to have some impact, as well.

So it's really that the ramp of the sales guys, and then the branding impact, and then sales tools and training and getting equipment and demo kits out to guys. All that takes a while to have an impact.

Jeff Kvall - Barclays Capital

That makes sense, I guess. My follow-up then would be if RFP activity is relatively steady, where it's been, relatively consistent with the revenue trends you're showing, what is it that gives you the confidence that these new sales folks will come in and find opportunities in the December or March quarters?

John W. Combs

Two things. One, we have pretty good metrics. As we add a sales person into a specific category within our sales organization, what their ramp productivity is and going to be. And also, with the addition of some of the things we talked about in the script, we have a lot of new frontline sales people in our distribution channels that are now out carrying the ShoreTel flag. So we should see the proposal backlog pick up. And you know, before you can get the proposal backlog to pick up you've got to get the sales executive trained, to get them aware of the ShoreTel system, its benefits, make them feel comfortable that they will translate those benefits to prospective customers.

Sometimes we go out on sales calls with the prospective sales people to help them the first few times through, so that process is what takes a while to ramp the proposal backlog.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan.

Rohit Chopra - Wedbush Morgan

The average deal size, I think last quarter you talked about it being up. I just wanted to get a sense of where that was this quarter.

Michael E. Healy

It's still in the $20,000 to $25,000 range. It was up 12%, so it did grow a little but that's the average new deal size for the first order from a new customer so it moved up about 12% quarter-over-quarter.

Rohit Chopra - Wedbush Morgan

And you're using the same comparables when you talked about it being up 24% last quarter?

Michael E. Healy

No. What was up 24% last quarter was the bookings. So the total order input for all product services from existing customers, service contract renewals, and from new business from Q3 to Q4 went up 24%.

Rohit Chopra - Wedbush Morgan

I got that part, I was just going back to last quarter and I think there was a comment by Mike indicating that deal size was up 24% in the quarter. But let's move on to the next question.

Can we come back to the gross margins? I just want to get a sense of the sustainability of margins, where they are, for product and support and service.

Michael E. Healy

Long term expect gross margins to be in the low- to mid-60s. The support margins obviously continue to amaze us, given the high level customer satisfaction we continue to have, and at 66% this quarter. I am modeling them down ever so slightly next quarter because we are going to do a little bit of hiring in the support organization.

And then product, it comes up with mix and we are trying to get some more cost out of the product that will have a positive impact going forward. But our guidance is to be relatively consistent with the last quarter, 63 to 64, non-GAAP gross margin is the guidance for the September quarter.

Rohit Chopra - Wedbush Morgan

And I wanted to come back to the Telstra ramp. I just wanted to get a sense, out of the $2.2 million in international revenue, how much is Telstra actually contributing. I'm just trying to get a sense of the ramp over there because they've been a partner. I just want to get an idea of how that's growing. And then the rest of the international, what is the rest of the international?

John W. Combs

Telstra is a small part of the $2.2 million at this point in time. But basically they've only had two months after their launch of selling ShoreTel. So it's a small piece now but we've got a lot of confidence it's going to build over time.

Michael E. Healy

The bulk of the international revenue is really U.K. is typically the biggest country, then followed up by Canada, then Australia. They're kind of the top three.

Rohit Chopra - Wedbush Morgan

The other question I had was, I know you talked about IBM and that relationship ramping towards the end of the year. You said that you're going to ship a new product. I just wanted to get a sense, what is the gross margin profile on the new products? I assume that includes some type of hardware component as well and what are your expectations for that? There's a lot of people have partnerships with IBM and it's always been somewhat of a disappointment, especially on the UC side. So I just wanted to get a sense of your confidence that that can ramp.

John W. Combs

I'm pretty confident in it. Now, we don't have any experience in this area, nor does IBM. But if you step back and you look at small- and medium-size enterprises, the idea of having a single product that provides them with all the office applications, maybe even their local-area network, and take the Unified Communications on top of that, that's something that we believe there's a strong, strong demand for, if you can get it right, and make it easy to deploy, easy to install, and easy to manage for the end users in that particular market.

And as you know, that's kind of our claim to fame on the communications side. We believe that IBM has done it right in terms of really focusing on their foundation's product which is designed specifically for the small end and our expectations are pretty high.

And as far as gross margins, it depends. We may end up having to have a systems integrator involved in the middle of this to pull these products together, which might impact the gross margin piece a little bit but I don't it's going to be material.

Rohit Chopra - Wedbush Morgan

Maybe you could bring me up to speed on the timing of everything. It looks like you took out 20 people roughly. I don't have the exact number. I'm sure you did some stuff in the middle of the quarter. But you took out some people with the restructuring and then you're adding back approximately 20 people. So when you decided to cut staff did you have no visibility in the national partner program, which was beginning to ramp? I'm just trying to figure out why cut all those people and then add back?

Michael E. Healy

Let me give you some details on the number and then John can give a little more enlightenment on the positioning.

So at the end of Q3 we had 396 employees and after we did the RIF we were down to 370, so almost 30 reductions, 9%. So in essence we hired 5 people back this quarter. We ended the year at 375. And then we're going to add from that.

So in terms of why we did that, we didn't see—in April we didn’t know where the bottom was going to be. We knew kind of where our revenue was going to be, so we really wanted to kind of right-size the organization and re-deploy people—we're certainly in the middle of trying to get customized and signed up and we knew that was coming but the plan all along was kind of re-deploy people into the right places, whether it was sales or other areas.

So I'll let John give you a little more color on that, but that essentially was the plan.

John W. Combs

I think it was at that point in time it just made good sense for us to ensure that we had our expenses at a level where we needed them to be. And as we go forward, we'll make the same kind of adjustments going forward. If we see that this thing is opening up as hope it will, we will continue to accelerate the headcount growth and likewise, if we see things slowing down, we will pull back on the lever, and slowdown on the headcount growth.

Operator

Your next question comes from Analyst for Sanjiv Wadhwani - Stifel Nicholaus.

Analyst for Sanjiv Wadhwani - Stifel Nicholaus

You mentioned that the pipeline had increased about 24% and I think in the last quarter you had also discussed that one of the challenges why revenue wasn't kind of tracking in line, they were having, following that growth rate, was that the conversion was low. Can you talk about your conversion rate over this last quarter and what you see going forward?

Michael E. Healy

Let me just clarify. The pipeline is not up 24%. The bookings, which is orders in-house, were up 24% quarter-over-quarter and that includes product and support combined. So that doesn't always equate to saying revenue because the support booking you bill and take over time into revenue.

Our pipeline, our gross pipeline, that we measure things against, was up just a little bit from Q4 into Q1, when we started Q1. So the pipeline is up a little bit. But the good news is the conversion of that pipeline did increase from Q3 to Q4 and that helped us obviously get into the revenue range. The Q3 pipeline conversion rate was the lowest we've had in years. So that's one of the positive metrics we saw is the conversion of that pipeline in Q4 going up.

And we're kind of modeling for Q1 for that to be relatively consistent with Q4.

Analyst for Sanjiv Wadhwani - Stifel Nicholaus

The other question I had was just in terms of the activity with picking up potential Nortel customers, can you quantify any pick up or expected pick up in your business related to Nortel over the last three months and kind of for the end of the year, and talk to you about any specific actions you might have to aggressively secure wins in those type of accounts.

John W. Combs

I think everybody in the market now sees the vulnerability of the Nortel network and we certainly are going after those as aggressively as anybody else. So we focus our distribution partners on opportunities there. And it ends up building a compelling and pending event for the customer. While it's not as immediate as moving to a new location or something like that, the customers are concluding quickly that their long-term support is going to be going away.

And some customers early on in the process were very reluctant to even speak with anybody because they were pretty comfortable where they're at, but as the bankruptcy and the liquidation of Nortel has continued, people have a higher degree of angst and they're all waiting to see who's going to pick up the responsibility to manage the base.

So there definitely is an opportunity there for ShoreTel and we're also doing a good job, I believe, of picking up distribution partners. That's particularly, I think for long term, that's a better opportunity for us than near term, just chasing down the customers. The people who currently have the Nortel base that are managing it, we have got a number of those in our distribution network now. Both in terms of national players as well as regional players, that are looking to take care of their Nortel base, be responsible, but also want to be the person in charge when the customer decides to move on.

Operator

There are no further questions in the queue.

John W. Combs

Thank everybody for investing the time to listen to the ShoreTel results in the quarter. I would say that we are feeling very confident in the progress we're making, even coming out of a very, very difficult marketplace. I think the company is positioned for some significant growth over time. It's going to take a while to make the investment and get the return, but we're becoming more and more bullish now and we're confident that it's time to strike now in terms of making investments to come up roaring out of this recession as opposed to waiting to tire chase somebody who's got a head start on us.

So thanks again for attending and we'll talk to you again next quarter.

Operator

This concludes today’s conference call.

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Source: ShoreTel, Inc. F4Q09 (Qtr End 06/30/09) Earnings Call Transcript
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