Mitel Networks Management Discusses Q1 2014 Results - Earnings Call Transcript

Aug.29.13 | About: Mitel Networks (MITL)

Mitel Networks (NASDAQ:MITL)

Q1 2014 Earnings Call

August 29, 2013 5:00 pm ET

Executives

Cynthia Hiponia - Managing Director

Richard D. McBee - Chief Executive Officer, President, Chief Operating Officer and Director

Steven E. Spooner - Chief Financial Officer and Principal Accounting Officer

Analysts

Kiera Kilkowski - BofA Merrill Lynch, Research Division

Ron Shuttleworth - M Partners Inc., Research Division

Paul Treiber - RBC Capital Markets, LLC, Research Division

Prabh Gowrisankaran

Todd Coupland - CIBC World Markets Inc., Research Division

Operator

Good day and welcome to the Mitel Networks First Quarter Fiscal 2014 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to Ms. Cynthia Hiponia, Investor Relations. Please go ahead, Ms. Cynthia Hiponia.

Cynthia Hiponia

Thank you, Sam. This is Cynthia Hiponia, Mitel Investor Relations, and I'm pleased to welcome you to Mitel Networks' First Quarter Fiscal Year 2014 Earnings Results Conference Call. At 4:05 Eastern time, Mitel published its earnings release through GlobeNewswire. The release is also available on Mitel's Investor Relations website at mitel.com. A replay of the conference call will be available through Monday, September 2, 2013. To access the replay, please dial (888) 203-1112 and enter passcode 3811976. Callers outside the U.S. and Canada should dial (647) 436-0148 and enter passcode 3811976. The webcast will also be archived on Mitel's Investor Relations website for 3 months.

Some of the statements made in this presentation, including the information regarding our financial performance targets for the second quarter fiscal 2014 will be forward-looking statements within the meaning of applicable U.S. and Canadian securities laws. This presentation includes forward-looking statements pertaining to, among other matters, our future economic performance, profitability and financial condition, general global economic conditions, our business strategy, plans and objectives for future operations, our industry and growth in the markets in which we compete, the cost of operating as a public company and our ability to implement and achieve our business strategies successfully. These forward-looking statements reflect currently available information or our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. In making these statements, we have made assumptions regarding, among other things, no unforeseen changes occurring in the competitive landscape that would affect our industry generally or Mitel in particular, a stable or recovering economic environment, no significant event occurring outside the ordinary course of our business, and stable foreign exchange and interest rate. Actual events for Mitel's results performance, financial position or achievements could differ materially from those contemplated, expressed or implied by such forward-looking statements as a result of the various risk factors and uncertainties, including the risk factors described under the headings Risk Factors in Mitel's annual report on Form 10-K which has been filed with the U.S. Securities and Exchange Commission on June 24, 2013, and filed with Canadian securities authorities. Except as required by law, Mitel is under no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

Let me now turn the call over to Mitel's President and CEO, Richard McBee.

Richard D. McBee

Thank you, Cynthia. With me this afternoon is Steve Spooner, Mitel's Chief Financial Officer. With first quarter revenue of $141.6 million and gross margins of 56.6%, Mitel posted solid results with both year-over-year revenue growth and record gross margins. We demonstrated growth in our core IP telephony and UC business and saw continued strong momentum in cloud, with public and private cloud users up 71% year-over-year, to approximately 300,000 users.

We are pleased to achieve these metrics in what is typically a seasonally slow quarter for Mitel and in a quarter which we have been rebuilding our new sales leadership in the Americas. We view this as evidence of both the competitive advantage and solutions and continued execution by the company. In our last call, I outlined our strategy to focus on delivering profitable growth by leveraging the strength of our traditional software-based solutions with its large and growing installed base, while also focusing on growth in the cloud market and the rapid expansion in the contact center space.

Let me update you on the progress in each of these since the last call. In July quarter, for Mitel's core IP telephony and UC products, we posted year-over-year revenue growth based on an improved execution in North America and Latin America. As I detailed on the last earnings call, we hired new sales leadership in the Americas and have begun to see the benefits of the organizational changes we've made. In addition to the new sales leadership in Q1, we also implemented a series of changes to streamline and simplify our overall sales process and align our compensation programs to recognize the growing value of cloud opportunities. We continue to see good progress in our focused channel approach. It's worth noting that revenues from our top 6 channel partners in the first quarter grew a combined 23% year-over-year.

I'd like to take a moment to congratulate Sandy Hill who we appointed last quarter as Vice President of Channel and Distribution Management in the Americas and being recognized by CRN Magazine as a Leading Woman of the Channel. On the customer front, we announced that the Rock and Roll Hall of Fame selected Mitel's flagship MiVoice and MiCollab platforms to deliver our cost effective cutting-edge communications and collaboration solutions throughout the museum. With the strong support of our local Cincinnati-based partner, Warrick Communications, Mitel won this highly competitive opportunity against Avaya, ShoreTel, AT&T and others. It's a great example of when we get a chance to compete head-to-head, we have great success.

Let me now update you on our accomplishments in maximizing our growth in the cloud. In the first quarter, we had approximately 300,000 private and public cloud users. This was up 12% sequentially and 71% year-over-year. Our leadership and virtualization continues to offer compelling differentiation to our customers. In the first quarter, 27% of our MCD shipments were virtualized and 54% of our UC applications were virtualized. This is a significant milestone, with now over half our UC application sales being virtualized. During the July quarter, we announced a partnership with Vidyo, to bring video to the cloud by delivering integrated HD video across Mitel's entire line of UCC products. The joint solution tightly integrates video into Mitel's platform, with the joint solution being software-based, it's ideal for public, private and hybrid cloud deployment.

On the channel front, we acknowledge the addition of RackForce Networks. In Canada, another strong addition to our Powered by Mitel ecosystem, delivering cloud services. RackForce, the largest VMware Service Provider Partner in Canada, selected the Mitel MiCollab and MiVoice for business platforms to fully leverage the virtualization advantages for our cloud solutions. RackForce will offer a white label cloud solution to resellers and service providers and brand it as their own.

Similarly, we are also pleased to expand our relationship with Black Box, another new Powered by Mitel partner who will begin offering their cloud communication service nationwide for customers in the U.S., based on our MiCloud suite of solutions that will deliver a set of communications, collaboration and customer care services. Both of these are great examples of cloud providers deciding to choose our underlying product, cloud technology platform, which we have brandied Powered by Mitel as their solution. This is a reflection of the increased demand from service providers selecting Mitel to enable their own cloud service offering.

Another customer deployment in the first quarter of cloud -- of MiCloud, our retail cloud offering, was Indiana's Portage township schools. They replaced their legacy Avaya Lucent system with a MiCloud-hosted UC solution. The solution includes more than 1,000 MiVoice seats deployed across 17 locations and our MiVoice video multimedia collaboration tool. Internationally, The Stern Group, the largest automotive conglomerate in the Netherlands, with over 100 Ford, Mercedes and Volvo car dealerships, announced they will deploy a MiCloud solution with over 2,500 seats beginning in September.

Finally, as we've previously discussed, our strategic move into the contact center market, which is an estimated to be over $3 billion annually market. During the July quarter, we completed the acquisition of prairieFyre, and have already seen margin improvement with a fully integrated solution. Steve will discuss the accretive benefits we are seeing from this acquisition in more detail.

Another example of a customer deploying our contact center solution in the quarter is Philadelphia Zoo deployed both the MiContact Center and MiCollab solutions to upgrade its voice contact center infrastructure. The simplified IT administration and cost savings has allowed the zoo to expand its contact center operation from 5 to 7 days a week, and the staff efficiency is also improved through the collaboration features.

Internationally, we were pleased that the Immigration and Naturalisation Services in the Netherlands selected MiContactCenter as a part of the Dutch government's ongoing OT2010 project.

In summary, in the July quarter, we made solid progress against all 3 strategic areas. Our progress is evidence of the strength of our business model which serves as a strong foundation for us to grow our market share in the IP telephony cloud and contact center space.

Now let me turn the call over to Steve to detail the financial results of the first quarter and provide our outlook for the second quarter of 2014.

Steven E. Spooner

Thank you, Rich. Good afternoon, everyone. Before I begin, please note that I will be discussing the financial results on a U.S. GAAP basis, unless otherwise indicated. A reconciliation of non-GAAP to GAAP measures was included in our earnings release, which can also be found in the Investor Relations section of mitel.com.

We are pleased with our results for the first quarter. We delivered revenues in line with our guidance and had record gross margin in the quarter of 56.6%, which was largely attributable to the higher margins associated with our Contact Center business following our acquisition of prairieFyre. As Rich mentioned, we've been very pleased with integration of prairieFyre. Within only the first quarter, the acquisition was accretive, contributing to our EBITDA growth of $8 million year-over-year. We remain confident that this acquisition will continue to enhance our channel sales by addressing the growing demand for contact center solutions and create strong pull-through opportunities for associated sales of Mitel's core IP telephony and UC solutions.

Let me now turn to our results for the first quarter ended July 31, 2013.

Total revenues were $141.6 million, up 2.2% compared to Q1 of last year and down 6.2% sequentially. Mitel Communications Solutions, or MCS revenues, were $117.9 million, up 3% compared to Q1 last year and down 6.4% sequentially. The year-over-year increase was a result of improved execution in the Americas, the sequential decrease was a result of the typical seasonality in our business, with Q1 normally being down versus our fourth quarter. Mitel NetSolutions revenues were $21.7 million, up 4.8% compared to Q1 of last year and 0.5% sequentially. The increase in our NetSolutions revenue was driven primarily by growth in our MiCloud retail offering.

Looking now at our first quarter revenues on a geographic basis. In the U.S., our total revenue of $90.5 million was up $2.2 million over the prior year quarter and down $5.7 million sequentially. Europe, Middle East and Africa revenue of $34.9 million was down $0.5 million over the prior year quarter and down $4 million sequentially. The slight year-over-year decrease was a result of unfavorable foreign exchange movements. Without the negative impact of these foreign exchange movements, EMEA revenue would have been up marginally year-over-year. Canada and Caribbean and Latin America revenue of $11.1 million was up $1.3 million over the prior year quarter and down $1 million sequentially. Revenue in Asia Pacific of $5.1 million was flat versus the prior year quarter and up $1.4 million sequentially.

Our gross margin for the first quarter was 56.6%, an absolute increase of 220 basis points from Q1 of last year and a 50-basis-point improvement over Q4. The improvement in gross margin, as I mentioned earlier, was primarily a result of higher margins associated with our Contact Center business following our acquisition of prairieFyre, as well as continued product cost reductions across the entire product portfolio.

GAAP operating expenses for the first quarter of fiscal 2014 were $75.3 million. Non-GAAP operating expenses for the first quarter of fiscal 2014 were $62.9 million or 44.4% of revenue. As a percentage of revenue, non-GAAP operating expenses had a 300-basis-point improvement for first quarter of fiscal 2013 and were up 270 basis points for Q4.

R&D for the quarter represented 9.7% of revenues, down from 10.5% in the prior year and up from 8.9% in the fourth quarter. In absolute dollars, we saw a decrease in R&D, year-over-year, as a result of the restructuring actions taken in fiscal Q2 of 2013, partially offset by higher R&D spending resulting from the prairieFyre acquisition. Sequentially, R&D spend was essentially flat.

Non-GAAP SG&A as a percentage of revenue was 34.7%, down from 37% in Q1 last year and up from 32.8% in the prior quarter. In absolute dollars, we saw a decrease year-over-year, in non-GAAP SG&A expenses driven primarily by previous restructuring actions taken. Sequentially, non-GAAP SG&A was essentially flat.

Stock-based compensation expense for the first quarter was $1.1 million, consistent with the prior year, and up from $0.9 million in the prior quarter. We recorded special charges and restructuring cost of $5.3 million in the quarter, primarily as a result of headcount reductions related to the restructuring of our U.S. sales organization and workforce synergies driven by our acquisition of prairieFyre. Included in depreciation and amortization expense for the quarter was $6 million associated with the amortization of acquired intangible assets, up approximately $0.5 million from the prior year and prior quarter, as a result of the recent prairieFyre acquisition.

Interest expense for Q1 was $6.5 million, up from $4.7 million in the prior year and $5.8 million in the prior quarter. The higher interest expense reflects the interest rate on the new credit facility implemented in the fourth quarter of fiscal 2013. For the July quarter, we recorded a tax expense of $1.4 million compared to a tax recovery of 2.6 million in Q1 of last year and a tax recovery of $2.7 million last quarter.

Mitel reported non-GAAP net income for the first quarter of $9.3 million or $0.17 per share compared with non-GAAP net income of $4.1 million or $0.07 per share in the first quarter of last year and non-GAAP net income of $13.9 million or $0.25 per share in Q4. The year-over-year increase was due to improved gross margins and higher operating income. The sequential decreases was a result of lower operating income driven by lower revenue in the first quarter due to normal seasonality.

Our GAAP-based net loss for the first quarter fiscal 2014 was $3.8 million or $0.07 per diluted share. This compares with a net loss of $2.1 million or $0.04 per diluted share in the first quarter of last year and net income of $8.1 million or $0.14 per diluted share in Q4.

Adjusted EBITDA for the quarter was $20.6 million compared to $12.4 million for Q1 of last year and $25.3 million in the prior quarter. Our adjusted EBITDA margin for the quarter was 14.5%, up from 9% in Q1 of last year and down from 16.8% in the prior quarter. These increases, year-over-year, were driven by an overall improvement in operating income, which I described earlier.

Let me now discuss quarterly metrics for each of our business units.

Revenue from MCS consists of hardware and software sales and service. For the first quarter of fiscal year 2014, software comprised 81% of our MCS enterprise platforms and applications revenue, up from 79% in the fourth quarter of fiscal year 2013. Virtualized MCD solutions represented 27% of total MCD software shipments in Q1, up from 18% in the prior year and 25% in the prior quarter. On the applications front of our UC applications licensed in the first quarter, 54% were virtualized, up from 36% in the prior year and 46% in Q4.

In our Mitel NetSolutions unit, we ended the quarter with approximately 8,800 customers. In the first quarter, our monthly recurring revenue represented approximately 74% of our total NetSolutions revenue for the quarter. For our total business, lumpy recurring revenue comprised 26.7% of revenue.

Moving now to the balance sheet.

We ended the quarter with $55 million in cash and cash equivalents compared to $69 million in the prior quarter. Our cash position is supplemented by an available undrawn $40 million line of credit, providing us with $95 million of total liquidity. The reduction in cash during the quarter was a result of our $20 million prairieFyre acquisition, which was partially offset by our cash flow from operations. We generated $13.2 million in cash flow from operations, an increase from $3.4 million generated in Q1 of last year and $6.6 million last quarter, reflecting strong operating performance as well as favorable changes in noncash working capital balances.

Under our new credit facilities which we announced in February, for the quarter ended July 31, 2013, our leverage ratio was 2.8, which compares favorably to a maximum leverage ratio of 4.0 permitted by the covenant in our first lien credit agreement. We've included the covenant in our actual leverage ratios for the last 2 quarters in our 10-Q which was filed today.

Our DSO for Q1 was 72 days, down from 74 days in the prior year and in the prior quarter. Inventory turns were 9 for Q1, in line with the prior year and quarter. We ended the quarter with total headcount of 1,745, down from 1,899 in the prior year and up from 1,652 in the prior quarter. The sequential increase in headcount was primarily a result of personnel we gained from our prairieFyre acquisition, partially offset by headcount reductions related to the restructuring of our U.S. sales organization.

Turning now to our business outlook. Please note that statements regarding our future financial performance targets are forward-looking statements. I refer back to the forward-looking information caution we provided to you earlier on this call. We are providing the following financial outlook for the second quarter of fiscal 2014.

We currently expect revenues to be in the range of $142 million to $148 million. Gross margin percentage to be 57% to 58%. Non-GAAP operating expenses as a percentage of revenue to be 44.5% to 45.5%. This excludes estimated amortization of $6.4 million for the amortization of acquisition-related intangible assets and estimated stock-based compensation expense of $1.1 million.

So to recap, we are excited by the progress we've made in our acquisition of prairieFyre, which has proven to be accretive within the first quarter and provides a strong foundation to further capitalize on market demand for contact center solutions. We are pleased that we delivered top line growth and continued gross margin expansion. Our strong EBITDA performance allows us to invest in our cloud and contact center solutions to drive revenue growth.

With that, Rich and I will now take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes in from Kiera Kilkowski from Bank of America.

Kiera Kilkowski - BofA Merrill Lynch, Research Division

I just have a few quick ones. First, I missed the recurring revenue percentage.

Steven E. Spooner

Yes. So, for the total business, Kiera, the recurring revenue was 26.7%, and for Mitel NetSolutions, it was 74%.

Kiera Kilkowski - BofA Merrill Lynch, Research Division

74%. Okay. And then maybe if you could just talk a little bit more about what you're seeing, obviously, you had some nice competitive wins this quarter, what you're seeing in the environment overall, just on the macro side. And then if maybe you could talk about some of the puts and takes to get you to the high-end and low end of your guidance ranges that you've provided.

Steven E. Spooner

Okay. Yes, I think that we continue to see really strong cloud demand out there. The funnels, both in Europe and in the North American markets, continue to be solid. They're very strong, they're actually growing, so we feel good about that. Our solution is being well-received, both by people that are offering the cloud and in cloud ourselves. And those that are converting, I think our platform, as a single software stream, is really resonating very well in the marketplace. So we feel good about that. I'll make a little bit of color about the guidance and maybe Steve can add into that. I think that when we look at the guidance, and we see 2 of the biggest players in our segment are reported both down in the market, being Cisco and Avaya. We're taking a cautious note on that. So, we look at our business, we're executing to our model, our plans are good, our growth initiatives are all growing very well and we feel very strong about that. We are seeing a little bit of legacy business, like service and maintenance, that might be slightly declining at a rate a little bit faster than we thought. So we're keeping an eye on that, but the core elements of our strategy are sound and we continue to execute. So what we've done is we try to take into account the plusses that we see in the marketplace and how we're driving that, and then also make sure that we're cognizant of, okay, a couple of the big players sawed things down a little bit, and so we're trying to put that in our guidance as well. Steve, would you?

Steven E. Spooner

Yes, I think those are the points, Rich. The only thing I'd add is -- as we're seeing the traction that we're getting, particularly with some of the service providers on our Powered by Mitel cloud offerings. It's early days and it's tough for us to predict how many of them will work with us upon a monthly recurring model as opposed to a capital sale. So that definitely will impact the timing and then the rate of revenue growth. I think we're excited about contact center. We think there's some -- so, on the positive, it's cloud and contact center, and just the continued improvements we're seeing in the quality of the team, and the process and everything that we're putting in place in the North American sales organization. And I think Rich touched on some of the risks in terms of, we're battling the legacy maintenance decline that is an industry-wide phenomenon, but on the other hand enjoying good take at software assurance revenues. So there's lots of moving parts and I think it's -- and our guidance reflects the kind of blend of all of those moving parts.

Operator

And our next question comes from Ron Shuttleworth from M Partners.

Ron Shuttleworth - M Partners Inc., Research Division

Just a couple of questions on the makeup of revenue for this quarter. Did I catch that correctly? You said that prairieFyre -- how much revenue did prairieFyre represent this quarter? I missed that.

Steven E. Spooner

Yes, we don't disclose that level of detail, Ron. But I think the key point to note, on prairieFyre, as we've highlighted when we announced the acquisition is that Mitel represented roughly 95% of prairieFyre's revenue because we have been OEM -- we were their primary channel to market. So prairieFyre was not expected to make a near-term impact on our top line. Where we saw the benefit was some enhancement to our gross margins, offset in part by picking up the R&D expense and the SG&A expense of their organization, which is now part of Mitel. But, net-net, it was marginally accretive, it drove a bit of profit in the quarter, which was favorable to our original expectations.

Richard D. McBee

Yes. And I think that -- so, in the short term, I think Steve's right, but over the long term, we see that it's going to be a real good catalyst for growth. The funnels are building very well, nicely. We're seeing a lot of opportunity for that and it's one of the segments that we've staked out as a good growth segment, and candidly, it pulls a lot of the other organizations' products along with it. So it's a software-oriented business, which is really good. It pulls software assurance, it pulls professional services along with it. So we're really kind of gearing up for growth in that segment.

Steven E. Spooner

And I think the other point I'd make is that contact center sales opportunities tend to be prioritized higher by customers, than your typical IP telephony sale because they're typically customer-facing and often revenue-generating for the customer. So they tend to be a more resilient sales opportunity, even in a challenging macro environment.

Ron Shuttleworth - M Partners Inc., Research Division

And in terms of the prairieFyre or I guess the contact center solutions, are they sold as a perpetual license or are you beginning to see some term licensing from that? Perpetual versus recurring.

Richard D. McBee

Yes. So, historically, Ron, the majority of them would have been on a license sale -- enough for a license sale. I think, particularly as we are seeing cloud contact center offerings or opportunities, we're going to see more and more of that be bundled into an MRR model.

Ron Shuttleworth - M Partners Inc., Research Division

Okay, just last question. As you've made changes to your sales team, did you detect any additional sort of draining of a swamp this year as compared to last year? I know that last year, it was a big issue and I know you tend to address it. Did you detect any of that stuff happening?

Richard D. McBee

Well, I don't think the last year was as much a drain of a swamp, as it was timing of orders. But I think going between the fourth quarter and the first quarter, the swamp wasn't drained the year before, it was -- we changed sales leadership and we're able to maintain the book of business and grow it year-over-year in this environment. So we feel really good about it. And I think that, as the sales leadership -- and we've brought on some really strong people underneath Joe Vitalone in the Americas. We looked at just getting stronger and our metrics, to see how that's happening, what's happening in the funnels. Are the funnels growing, is the quality of the funnel good and improving, and all those things are moving in the right direction.

Ron Shuttleworth - M Partners Inc., Research Division

And that's happening in Europe too, right?

Richard D. McBee

Yes, it is, actually.

Ron Shuttleworth - M Partners Inc., Research Division

Better than last quarter? Because I'm assuming that you're starting to see the uptick in the economies of those countries, right?

Richard D. McBee

Well, you're generally seeing that. But, from a quarter-over-quarter comparison, we're coming off the summer holiday in Europe. And I would maybe say that, this summer, they took more holiday.

Steven E. Spooner

I think the other thing I'd add is we had FX headwinds in terms of currency rates this year versus last year. So when you do the year-on-year compare in U.S. dollars, our European business was certainly impacted by that.

Operator

And our next question comes from Paul Treiber from RBC Capital markets.

Paul Treiber - RBC Capital Markets, LLC, Research Division

I just wanted to touch on the decline that you saw in the legacy business. What could you attribute the greater than expected decline in that business to? Is it related to the macro environment or does it reflect the shift to the cloud or maybe the competitive environment?

Richard D. McBee

No, I think it's a shift to the cloud. What you have is an old capital kind of related model that's shifting to a recurring revenue model, and so we saw some customers do that. And then one of the big areas which everybody in our industry is really kind of suffering through is -- there used to be large -- on these large capital sales, there would be a large maintenance and service contract with them, and candidly, some of these systems are getting pretty old and they're fairly stable with the old services they provide and they're just looking at -- is that a way to save money. I will note as a transition forward into the more modern systems, what we're seeing is a tremendous uptake of our Software Assurance business, and our platforms are really not hardware-oriented anymore, they're very much software-oriented. So it's more of a softer buy with the service assurance as kind of a given, where buying a maintenance contract today is a pretty tough sell out there in the marketplace.

Paul Treiber - RBC Capital Markets, LLC, Research Division

And then when you think about -- I mean, I guess there's 2 sides to that coin, one is there could be an upgrade opportunity to the cloud. Do you look at those as opportunities and do you look at your win rate? And how do you think you're doing in terms of up-selling your legacy customer base?

Richard D. McBee

I think were going pretty good. Some of them are upgrading to our software solutions. And one of the big things that we see in the customer base is that they're not going to cloud, they're certainly considering it. And our single software stream allows them to move from kind of a hardware-oriented solution to software-oriented solution to cloud all in the same software stream. So it's something that -- it's very big and important for them. Some customers still want what would be termed as premise-based solution but it's really software sitting on a server. But they want the ability to go to cloud and we provide that all in the same software, so that's with same sets, the same user interface, all those kind of things. So that's very important to them. But as they move to that and they move to a recurring model versus a capital purchase, you're going to see -- if a capital purchase was $10, a recurring revenue stream would be $0.75 a month. I think one of the things that we're going to do in our upcoming analyst conference is kind of talk about the book of orders that we have around the cloud and give people, really, kind of a better feel for all the things that are associated in our cloud business and how it's made up.

Paul Treiber - RBC Capital Markets, LLC, Research Division

Yes, I think that would definitely be helpful. Moving on, could you elaborate on the restructuring charge this quarter and the headcount reduction in the U.S. workforce?

Steven E. Spooner

Sure. So the restructuring charge was largely due to 2 things. With the changes that we made in the U.S. organization, there was a number of terminations, there was also some costs, we saw some synergies. One of the things that we obtained with the acquisition of prairieFyre was that we brought on board some tremendous software expertise and application development expertise. So that enabled some acquisition-related synergies. And we've also had facility closures in the U.S., as we continue to kind of get the footprint of our facilities in line with our channel-based go-to-market model in the U.S.

Paul Treiber - RBC Capital Markets, LLC, Research Division

Okay. And then just lastly, it looks like the tax rate for this quarter, went -- you're using 15% for the adjusted tax rate. I think it's up from 12% previously. Should we use 15% going forward?

Steven E. Spooner

Yes, that would be our best guidance to use 15% as the non-GAAP effective tax rate.

Operator

And our next question comes from Prabh Gowrisankaran from Canaccord.

Prabh Gowrisankaran

Quick question on the margins I know it's been steadily marching up. I know you guided to, with the prairieFyre, that you'll see a benefit. Where do you see it going as the software mix improves? Can it expand from the 57.5 midpoint that you guided to or what do you expect the long term targets to be?

Richard D. McBee

Well, I think, Prabh, we'll update the long term targets at our Analyst Day. We typically update our long-term model once a year at the Analyst Day. I will say to you, directionally, that clearly we've been able to drive gross margin expansion beyond what we had indicated last year, and we do continue to see some upside versus near-term guidance and we'll paint that picture at the Analyst Day.

Prabh Gowrisankaran

Okay, great. And the other question I had was on the software sales, you're beyond the 80% level. Do you expect, at some point, passing the 90% mark, like divesting off your Hardware business or how do you view the combination of your hardware versus software mix in the MCS?

Richard D. McBee

Well, the stat that we quote is 81% of our MCS enterprise platforms and applications revenue. So there are still some low-end products that are essentially hardware-based offerings, and frankly, there are a number of customers that still, particularly in the small business environment, like an appliance-based solution. So we don't think that, that's going away. What we certainly have seen, though, is that in our enterprise offerings, it's becoming very much a software-based solution. If you looked at our engineering team, we have very few hardware engineers on board, it's all about software now and the ability to virtualize that, to be able to spread it on-prem or host it in private or public cloud, so that's all what we've been focused on. So I think there's -- they'll be continued -- probably some opportunity to see that percentage of software creep up a little bit, but I don't think there's -- I don't see it going to 90-plus in the near term.

Richard D. McBee

Yes, and I think that, from the development perspective, I mean, the hardware development is basically done. I mean, there's not a lot of money in it, it's cost-optimized, so we treat it more as a variable cost. It's not really -- there's not engineering going into it. So it's all software today.

Operator

And our next question comes from Todd Coupland from CIBC.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. I have a few macro questions, if I could, and then I have a balance sheet question. So, firstly in Europe, I'm kind of getting mixed messages. I mean you see pretty good economics stats coming out of the U.K, and France not as good, but I think the majority of your business is in the U.K. And you see the ugly Cisco guide, but then you see manufacturing in car sales and just the overall economy seems like it's doing better there. So maybe just talk about what's going on in your business. I know it was flat, but what does the funnel look like and might we start to see that turn?

Richard D. McBee

Yes, I think our funnels are very good. You have to think about -- the majority of our business in Europe, U.K., is enterprise-class business. So the sales cycle is approximately 6 to 9 months with a thing like that. So you'd want to see a little bit of sustained goodness in the economy before you'd really start seeing any kind of marked pickup in our kind of products or services. So we've got great market share in the U.K., we're doing good from a business perspective, we feel good there, we're constantly watching Europe. I think everybody's watching Europe to see, okay, there's starting to be a few points of good news out there, when is this going to be a trend. But nobody's calling it yet. So we're still very focused on the markets. Our funnels and opportunities are good. It's really kind of the conversion to, okay, when are you going to actually buy. So there is a lot of pent-up demand out there. But the question's when it's going to get high enough on the CIO and the CFOs list to actually spend money on it. I think it's still a little bit away before you're going to see any big massive change out there.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. And so that's fair enough, so 6 to 9 months, so maybe later in your fiscal year, if it actually were at the beginning and maybe longer, if not.

Richard D. McBee

Yes.

Steven E. Spooner

That feels good.

Todd Coupland - CIBC World Markets Inc., Research Division

So then the question is, in between now and then, are you concerned that we might see another 2012 summer style slip or do have your arms around business that you can close so that's less likely?

Richard D. McBee

Yes, you never say never, but we feel pretty comfortable with the funnels that we've got, the business that we've got. A lot of business we have are with very large institutions or large retail customers. For example, they're rolling things out, we don't see them stopping rolling them out. So a lot of the ongoing business, even the OT2010, that's a 120,000 port, we continue to add stuff to that. That's going to roll on. So those things have been done to get us through this timeframe, and we continue to see new opportunities come up, and a lot of the governmental or local governmental agencies are actually buying mission-critical equipment. So there's enough business out there to sustain where we're at.

Todd Coupland - CIBC World Markets Inc., Research Division

And then when you think about the U.S., should we mirror this commentary to the U.S. as well?

Richard D. McBee

I think the U.S. is a little bit ahead. It can move a lot faster, up or down. So, I mean, you have that. And the other piece is that, in the U.S., the cloud adoption rate has been much, much faster in the U.S., and that's what I think is driving the lower end of the market. At the upper end, you've got private cloud, at the lower end, you've really got commodity cloud, for a lack of a better term, and there is a lot of people that are looking at good ways to save money and they'll move their whole capability to cloud and we're seeing that with the growth in our own cloud -- triple-digit growth in our own Cloud business. So we're seeing good growth in the cloud at the bottom end of the market. And I would say, at the top end of the market, it's still pretty cautious, but it's worked up, and a lot of the businesses is getting much higher on the mission-critical. And the main driver for that is -- the average life of a telephone system is 8 years. Y2K, everybody updated their systems. 2008, just when they were getting ready to update their systems, we had the big recession. So a lot of these systems out there are getting really long in the tooth, and the older systems just aren't really good at leveraging the mobility and a lot of the features of the new systems. So that's actually why our hybrid cloud offering is doing very well, where people might have a PBX-oriented system that they had, now cloud the UC aspect of it. So there's a little difference, there's still a macro -- I wouldn't say things are up everywhere, but the dynamics of each market, what we're offering each market, is slightly different.

Steven E. Spooner

The only thing that I would add is, I think, as we've talked before, there is upside in the U.S., we think, just from better execution. Not so much that the market is getting stronger, but that we have felt that, in recent years, we haven't been getting our fair share of the business and we had opportunities to do better. And we're really excited about the team that we've put in place there, the changes that we've made, the investments in systems and tools and training. And we feel that we've got a very, very solid team, many of whom are new and came on in the quarter. So we're feeling good about kind of the second half of the year, as these folks are getting up to speed.

Richard D. McBee

Yes, I think I would add to what Steven said. I mean, the Rock and Roll Hall of Fame is a great example of that. It's one of those deals where every competitor was in it. We were in it with all the guys that are the big competitors, and we won head-to-head, And so one of the things that we've really been working on, and with the new sales leadership and our new marketing leadership, is getting more kinds of that. Because we really think we've got a very solid solution, we've seen it time and time again, when we win. So we think that there's more land and more places that can be selling, so the team's working pretty aggressively at expanding that.

Todd Coupland - CIBC World Markets Inc., Research Division

I was actually going to ask you about that win. So, when you look at who you had to tune up against to win, who would have been the strongest in that competitive situation and who had the clunkiest offering?

Richard D. McBee

I'm not going to say high to low. I think a video that we do with the investors, it's on there. I think everybody pitched what their solution was in the best light, and when they did that, Mitel came out on top.

Todd Coupland - CIBC World Markets Inc., Research Division

And it wasn't on price?

Richard D. McBee

No, that wasn't a price deal.

Todd Coupland - CIBC World Markets Inc., Research Division

Yes, yes. Okay, fair enough. And just lastly, on the balance sheet. So you obviously had some cash drawn down this quarter because of acquisition, even though you had good EBITDA performance. What's the thinking on the rhythm of debt repayment over the course of this fiscal year? Just talk about your thoughts on that and how much debt you would hope to repay in fiscal 2014.

Steven E. Spooner

Sure. Well, I think, Todd, our messaging has been that, from a -- there's a level of cash that we need to run the business. It's not a very large number, we don't have a lot of trapped cash in our business internationally. We have said that, what kind of feels right to us is cash reserves in that kind of 50 to 75 range, just kind of feels right. We've also indicated that as we generate excess cash, if there are attractive kind of tuck-in acquisition opportunities ala the prairieFyre, that would be one way that we would look to put our cash to good use. But in the absence of those opportunities, we'd look to pay down the debt. So I will caveat that in the absence of other acquisition opportunities, we would hope $30 million to $40 million is not out of the realm of possibility this year for debt pay down, just based on the cash flow generating capabilities of the business.

Operator

And our next question comes in from Ron Shuttleworth from M Partners.

Ron Shuttleworth - M Partners Inc., Research Division

It's, again, regarding, I guess, the old switch maintenance revenue. You were mentioning that there's a decay in the revenue stream. I'm just wondering if you can give us a little bit of a hint on maybe the size of that, the scope of that revenue and maybe what you're thinking the decay rate is going to be. I'm assuming this is all going to go away as everyone moves to the cloud. But what's the pace of that?

Richard D. McBee

Well, I think the first thing I'd say, Ron, is that the decay in the legacy hardware maintenance revenues, a, is industry-wide; and, b, it's not new this quarter. I think that Rich's comment was really that, as we looked at -- certainly in Q1, it was a little higher than we had expected, it's too early to see whether that's a trend, but certainly that business is declining. Rough rule of thumb maybe kind of 10% kind of annually. So that's the kind of rate. In terms of overall, we don't disclose that level of information. But it would be kind of sub-20% of our revenues. So, in that 10% to 20% range.

Ron Shuttleworth - M Partners Inc., Research Division

Okay, that's good enough. What I want to know is -- what I was really making sure that it's not bigger than a bread box, that as you build your business forward and you start closing your pipeline, that this is not going to come out and bite you in the butt.

Steven E. Spooner

No, and I think the key thing -- I mean, it's -- frankly, our industry, companies have had to manage a lot of transitions, analog going to digital, digital going to IP, the product revenue streams, one, declining, the new ones ramping up. Same thing with the services. So, as Rich commented earlier, while the legacy hardware maintenance is dropping off for all of the folks in the industry, we are enjoying very rapid growth in our Software Assurance revenues, which is typically a higher-margin revenue stream than the legacy hardware revenues. So from that perspective, helps the operating model, and we're seeing that -- again, I think as Rich highlighted, it's an easier sell to sell software assurance. People are accustomed to buying it, they want the latest upgrade, they want the bug fixes, they just think it's good hygiene to buy it. So we see a good take rate with that and expect continued growth there.

Operator

There are no further questions. Please continue.

Richard D. McBee

Okay. Well, thank you, again, for joining us this afternoon, in what was a seasonally slow quarter for Mitel and a quarter which several of our key competitors reported revenue decline, we were pleased to achieve year-over-year revenue growth -- to post record gross margins. The competitive advantage of our product platform, offering a single software platform which addresses both traditional cloud-based needs, is resonating extremely well, both at the channel and our customers. Our new sales leadership and structure in the Americas has begun to gain traction and we are seeing early results from the changes. But the overall macroeconomic environment remains relatively unchanged. Our own funnel of opportunities remain strong and we remain sharply focused on driving profitable growth and increasing shareholder value. As a reminder, we are hosting our Analyst Day, September 19, in New York City. At this event, we will provide a deeper dive into our investments in the cloud and the contact center space, and our strategies to drive growth. I hope to see you there and I thank you for joining our call today.

Operator

Ladies and gentlemen, this does conclude your conference call for today. We thank you for your participation. You may now disconnect your line and have a great day.

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