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Executives

Tonya Chin - Director, Investor Relations

John Combs - President and Chief Executive Officer

Michael Healy – Chief Financial Officer

Analysts

Troy Jensen - Piper Jaffray

Sam Wilson - JMP Securities

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Steve O’Brien - JPMorgan

Lynn Um - Barclays Capital

Rohit Chopra - Wedbush Morgan

Samuel Wilson - JMP Securities

Jeff Kvall - Barclays Capital

Mike Lattimore – Northland Security

ShoreTel, Inc. (SHOR) F1Q10 Earnings Call Transcript October 28, 2009 5:30 PM ET

Operator

Good afternoon. My name is Maggie and I will be your conference operator today. At this time, I would like to welcome everyone to the ShoreTel first quarter fiscal year 2010 earnings conference call. (Operator Instructions) I will now turn the call over to Ms. Tonya Chin. Ms. Chin, go ahead.

Tonya Chin

Hello, and thanks for joining us today as we report our fiscal Q1 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 will make forward-looking statements within the meaning of the safe harbor provision of federal securities laws regarding the company’s anticipated future revenue, gross margin, operating expenses, and other financial and business-related information.

These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Additional information concerning the risk factors that could cause actual results to differ materially from those in the forward-looking statements can be found in the company’s annual report on Form 10-K for the fiscal year ended June 30, 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 public disclosure forum.

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

John Combs

Thank you, Tonya, and thanks to all of you for joining us today. First, I’ll review the financial highlights of the quarter.

Revenues of $33.8 million for the first quarter were within our guided range of $30 to $35 million. Revenues were up by 4% sequentially from our fourth quarter performance.

We saw solid improvement in our non-GAAP gross margins. We’re up a half a point at 64.5%. Our non-GAAP net loss for the quarter was a little better than expected and came in near the break even with a loss of $91,000.

I’m particularly pleased that we were able to generate operating cash flow in excess of $5 million in the quarter.

During the quarter, we passed a significant milestone in our customer satisfaction performance. For 16 consecutive quarters or four years in a row, we have delivered world-class customer satisfaction to our end users.

Customer satisfaction has been a powerful differentiator over our competitors as a key driver of the momentum that we have generated in the market.

There’s nothing more powerful than having an existing customer provide a raving testimonial to a perspective customer.

Next I’d like to discuss some of the dominant trends in the IP and business communication space. There continues to be a transition from what is viewed as the old traditional TDM tele providers to the emerging IP players in the industry like ShoreTel and we expect this transition and ShoreTel’s growth to continue.

Throughout this transition, we have consistently gained market share growing 40% in U.S. IP space over the past four quarters to 7.7% share in the June 2009 quarter.

Overwhelmingly, we found that companies are no longer willing to tolerate Legacy systems and solutions that aren’t nimble, intuitive, or cost effective. Those enlightened companies are turning to ShoreTel to replace their old phones and old thinking.

The evolution includes a downfall of a major competitor Nortel and we believe that they will not be the last to fall. There are others in the industry that have aging TDM bases with very significant debt loads coupled with low cash generation to service that debt. This is a dangerous combination.

Another major trend is the growing importance of unified communications for phone system buyers. The UC market is estimated to be $5 billion in calendar 2010 growing to $8 billion in 2012. Significantly extending our current addressable telephony market.

ShoreTel has been the leader in unified communications since before the term UC became popular. The heartbeat of unified communications as the end user client used to manage and control your communication options such as voice, unified messaging, collaboration, IM, and video.

Our personal call manager was an integral part of the first system we shipped in 1998. Today, our personal communications manager, the navigation of all of our UC functionality is ranked number one worldwide in the SMB market with nearly 20% market share.

Our PCM shows as senior integration of all of the UC functionality distinguishing us from several of our competitors that have called with our UC offerings acquisitions.

Today we are the leader in delivering a full range of UC capabilities beyond office to any location in the world. From airport, the hotel room, or home, ShoreTel’s UC solution is there to serve the end user.

We are particularly encouraged about our opportunity, the growing stabilization in the market we serve. According to Synergy Research, the IP telephony market in the U.S. appears to have stabilized, declining only 1% in the June 2009 quarter after two quarters of dramatic decline.

Stability combined with our own recent experiences in the marketplace leads us to believe that the economic climate is beginning to warm up. Synergy is forecasting that the worldwide IP telephony market will be down about 27% year-over-year for calendar 2009 and then return back to a growth mode in calendar 2010 with an estimated 12% year-over-year growth.

One of the brightest spots for ShoreTel during the quarter was the outstanding growth we saw from our national partners. As a group, we saw orders from our national partners increase by nearly 40% sequentially from the June quarter. We’re very excited to report that Verizon, Quest, and Telstra in Australia, which are early in their ramp up with us, all outpaced the expectations during the quarter.

As we mentioned during our prior quarterly calls, we invest in our national partners during last year and it’s very encouraging to see that investment beginning to pay off.

For the growing number of positive indicators, we determine that now is the time to be aggressive and invest for our future growth. Our substantial cash balance together with a solid cash flow for the past two years has put us in the enviable position of having resources to invest in ourselves.

While we do expect our plans to result in any significant cash burn over the next year, it is nice to have the luxury of liquidity to make strategic investments that will drive ShoreTel’s future growth.

The transition of voice over IP is far from over, but the future leaders are going to be determined by what actions companies take now. The window of opportunity to grow market share and become one of the top few suppliers in this market will not be open forever.

Looking back over my long tenure in the telephony market, I’ve never been presented with such an ideal time and set of circumstances as the ones open to ShoreTel at this moment.

The race has begun and we plan to take our rightful place in the winner’s circle. We are seeing our competitors look over their shoulders to see how fast we’re gaining on them. As a veteran of many races, I can tell you that this is a fantastic sign as it drives us to run even faster.

We view the investments we’ll be making over the coming quarters as stepping stones to ShoreTel’s growth of rapidly becoming one of the top market share providers in the IP telephony and UC markets.

Our planned investments will take advantage of the momentum we have built in the market and compliment our current strength. With these incremental investments, we expect to grow ShoreTel’s market share in our sweet spot and expect to become the leader in this segment of the market over the next few years.

We’ll expand our major accounts team to driver growth with larger customer. We also plan to further invest in the under one hundred size market beginning with a new relationship with IBM that is focused on delivering a complete office application and communicate suite for the small enterprise with the integration of IBM foundations with ShoreTel’s unified communications.

The increased investments will be concentrated in the following three areas. Our first area of investment will be in ShoreTel’s sales team, which we expect to grow headcount by up to 50% during the fiscal 2010.

Our indirect sales team is expected to increase our penetration and market share going forward.

Second, we will accelerate our very exciting product road map. We expect this demand a third of our incremental investments in R&D. These actions will result in over 25% of the projects on our product road map being accelerated by six months as well as the addition of new features and products to serve our expansion into adjacent markets.

Finally, we will continue to invest in our branding initiative. Early feedback on our ongoing campaign has been encouraging. We plan to ramp up our activities in this area and will measure its effectiveness after the campaign has run for three more quarters.

This is a key element of our strategy, because our biggest competitor is not being considered in an opportunity. When (?) to compete, we win over 50% of the time.

With that, I’ll turn the call over to Mike to review our financial performance. Mike?

Michael Healy

Thanks, John. I’ll be discussing both GAAP and non-GAAP results throughout this call and I ask that you refer to your press release for the reconciliation between these amounts.

Our non-GAAP numbers excluded stock-based compensation charges, restructuring items, and the related tax impact. We believe excluding these items gives management and investors of our true operating results.

As John mentioned, revenues were up 4% sequentially from the fourth quarter at $33.8 million. In our vertical market, once again we saw a growth in the government vertical. In fact, our largest deal this quarter was a California state agency. We have invested in our team that sells to the federal government in the last few quarters, but we don’t expect that to pay off significantly until next year.

We also saw growth in healthcare in the professional services segment. These increases were partially offset by declines in the manufacturing and education verticals.

As John highlighted, business from our national partners was up approximately 40% sequentially with an excellent ramp up from Quest and Verizon. The increase was also bolstered by AT&T closing on three large deals in the quarter. These three deals totaled close to $1 million in total business. As a group, our national partners represented 16% of our total business during the quarter.

International revenues were another bright spot, up over $1 million or 45% from last quarter to $3.3 million for the quarter. We strong revenue growth in Australia, primarily due to strength of our business through Telstra.

We’re also gaining traction in Canada where we added a dedicated sales resource a year ago. John recently visited Canada this quarter and was very impressed with the quality and enthusiasm of the partners we recruited in this important market.

Service and support revenue totaled $6.9 million, also growing 4% quarter-over-quarter and an impressive 18% year-over-year. Our service and support revenues were 20% of our total revenue this quarter.

Offsetting the increases discussed earlier was a drop off in revenues from our U.S. regional partner base, mostly due to a decline in revenues from our U.S. central region.

We sold 80,000 end user licenses in the quarter, up 5% from $76,000 in our June quarter.

Our number of new customers increased 11% to750 customer signed in Q1. Our business from new customers was pretty consistent with last quarter and was 45% of our total volume.

Non-GAAP gross margins improved to 64.5% up from 64% in the prior quarter. The biggest driver of the improvement in gross margin was a decline in discounting in the quarter.

Product margins increased one point while service and support margins decreased by two points, due to increased labor expenses in our global support business.

Non-GAAP operating expenses of $29.9 million were up $2.5 million as expected due to increased sales hiring, investments in our distribution channel, and increased branding activities.

Overall we hired 11 employees during the quarter with the majority of those being (?) and sales people.

Our GAAP net loss was $91,000, or break even in terms of EPS. Our GAAP net loss of $2.1 million includes stock base compensation charges and related tax adjustments.

Our tax expense was minimal and reflects minimum tax amounts we need to pay in certain states and in foreign jurisdiction regardless of the net profit or loss we generate.

Next let me review some of the highlights of our balance sheet and cash flow. We ended the quarter with $111.5 million in cash and short-term investments and generated over $5 million in positive cash flow from operations.

Days sales outstanding improved another two days in the quarter to 46 days, once again marking our lowest DSOs since being public. DSO continues to decline as a direct result of our high levels of customer satisfaction, since satisfied customers tend to pay their bills on time.

Inventory increased $1.3 million to $13.1 million as we ramped up our phone inventory.

Deferred revenue increased by $1.1 million, primarily due to an increase in support billing.

Capital expenditures were $1.3 million and depreciation and amortization was approximately $644,000.

We ended the year with 386 employees.

Now we’ll discuss our 8-K filing from last week. We recently discovered that equity edge, the well known software program we use to calculate our stock base compensation charges have….software we were using related to the calculation of forfeiture rates. This has effected a growing number of other public companies in a similar manner.

When we applied the patch that was recently issued suddenly our stock base compensation charges from 2007, 2008, and 2009 were understated. It’s important to note that the overall cost of stock base compensation is not increasing, just the timing of when it is reported.

This problem only affects our GAAP numbers and will change our GAAP loss per share from $0.27 to $0.29 in FY09 and will reduce our FY08 GAAP EPS from $0.06 to $0.05.

Adjustments to our 2007 results are not material.

Since our non-GAAP results exclude stock base compensation charges, none of our non-GAAP results including revenue, gross margin, operating margin, EPS, or cash balances will change. I expect this problem will have little effect on analysis models, since almost all the analysis I know about use only non-GAAP amounts for evaluation purposes.

We plan to file a revised 10-KA in early November and expect to keep current with our SEC filings.

Next, I’d like to discuss some of the investments we plan to make in our business in a little bit more detail. John shared with you our decision to invest in our business over the coming several quarters, which we expect to result in non-GAAP operating losses until these investments can have a meaningful impact on revenue.

To give you a little insight into future quarters, we could add up to $3 million of incremental expenses of each Q3 and Q4. Using our current hiring plan and expected revenue ramp, this extent increase would result in quarterly non-GAAP offering losses throghtout[Author ID1: at Wed Oct 28 20:31:00 2009

]throughout[Author ID1: at Wed Oct 28 20:31:00 2009

] FY10.

For us to continue this kind of aggressive expense ramp, our leading indicators will need to be moving in a very positive direction in the second half of the year.

The additional $3 million spending per quarter in Q3 and Q4 is planned to be an incremental sales headcount, acceleration of product development, and continuing branding activity.

We plan to carefully monitor our leading revenue growth indicators, some of which are proposal pipeline signs, national partner revenue and penetration, revenue from new customers, revenue from new partners, discounting trends, market share, and sales headcount for activity measurements to ensure we are on track with our revenue growth expectations.

If these metrics tell us to adjust our plans in spending, we will do so accordingly. We recognize that the actions we are taking will take time to have a significant impact on revenue, especially product development. Several areas we’ve invested in over the past year resulted in positive results, including gtowth[Author ID1: at Wed Oct 28 20:31:00 2009

]growth[Author ID1: at Wed Oct 28 20:31:00 2009

] in revenue from major account sales, the government vertical, national partners, as well as revenue from Canada and Australia.

Let me share some further details on our investment activities that are underway. First, as John mentioned, we’re planning to grow our sales force by up to 50% over the coming fiscal year. While we can’t perfectly predict the future success, we have modeled the potential risk revenue impact of this hiring using our normal productivity and ramp statistics.[Author ID1: at Wed Oct 28 20:33:00 2009

] We expect that these additional sales people should generate additional revenue in the range of $40 to $50 million dollars in FY11.

Secondly, we’ve made a conscious effort to accelerate our product development road map. This will require increased engineering resources, investments in property, and other engineering product development costs.

The products being developed from these investments are very exciting and will continue to position ShoreTel as the undisputed leader in unified communication.

Finally, the last major item is the sustained branding campaign, which we expect will raise ShoreTel’s awareness level up significantly with the corporate IT buyer. This campaign is ramping up and is expected to cost about $2 million dollars over the next three quarters.

Next, I’ll discuss our outlook for the December 2009 quarter. Right now our business to date is on a similar pace to last quarter and therefore we expect revenue to be in the range of $31 to $35 million.

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 50 basis points due to inclusion of $200,000 in stock base compensation charges.

As discussed earlier, we expect non-GAAP operating expenses to grow in the December quarter as we increase our investments in sales, product development, channel development, and branding and therefore expect our Q2 non-GAAP operating expenses to be in the range of $23 to $24 million.

We expect GAAP operating expenses to be in the range of $25 to $26 million, including approximately $2 million in stock base compensation expenses.

Overall, I’m happy with our performance in Q1. I’m encouraged by the positive indicators and many opportunities in front of us and I’m looking forward to getting our growth engine reinvigorated over the coming quarters.

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

John W. Combs

Thanks, Mike. It’s understandable that investors will be anxious to see the results of our investment as soon as possible, but there’s an inevitable delay between each investment and when we expect it to deliver meaningful results.

Ramping sales personnel, training new partners, engineering design cycles, and end user purchase cycles all take time to drive revenue growth.

Despite this, I feel very confident of the choices we are making. With a fantastic track record of execution and a number of compelling opportunities in front of us, we are convinced that now is the time to push the accelerator to the floor.

As we review the competitive landscape in our market, we can’t help but feel bullish about ShoreTel’s future. There are only four competitors with more market share North America than ShoreTel. Three are ladened with huge debt. One of these has already declared bankruptcy and the final one has a strong brand, but has a complex product.

The opportunity for ShoreTel has never looked better. If you look back at the annual growth rate prior to the economic slowdown, we have been able to double our revenue every two or three years. I’m hopeful with the investments we’re making, we’ll be able to return to that historical benchmark.

With that, let me turn the call back over to Maggie for question-and-answers.

Question-and-Answer Session

Operator

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

Steve O’Brien – JP Morgan

I’d like to drill down a little bit on the incremental sales you expect in 2011 from this ramp in your sales and R&D and marketing efforts.

If I understand it correctly, in the operating expense growth, $3 million in the third and fourth quarter, that would mean OpEx run rate is $6 million a quarter higher going into 2011 and we’re talking about $10 to $12 million of incremental revenue from these efforts. I just want to understand that right and my numbers are right.

Michael Healy

On expenses, if everything is looking good, the revenue metrics are on their way up, leading indicators, and we’re hitting our revenue goals, then our current plan calls for a $3 million increase in incremental spending each quarter, if we’re hitting those plans, and that’s just further hiring, more branding activities, channel development, and product development activity.

So that’s on the expenses side. Then from the revenue side, using our normal productivity measurements, our sales take four to five quarters to ramp up to full productivity, right? So hiring, you’re at 30 to 40 sales guides, it will have a meaningful impact on FY11. Some impact on 2010, but most on 2011. When I pencil out that hiring, I get to $40 to $50 million in incremental revenue from that hiring of people.

The reason we’re not seeing a big run up right now, last year when we were dealing with recession, we ended up hiring about five net sales people for all of FY09. So we’re feeling a little bit of the impact on that now in that we didn’t have that many new sales people added during last fiscal year.

Steve O’Brien – JP Morgan

So would OpEx be run rate $6 million a quarter higher going into 2011?

Michael Healy

It could be if we’re hitting our certain measurement productivity.

Steve O’Brien – JP Morgan

If we apply sort of a normal 63-64% gross margin to the incremental revenue in 2011 and layer in the additional OpEx, I guess what I’m not seeing is the additional profitability there.

Additional growth from the core business?

Michael Healy

What you’re not seeing is international revenue, we expect to grow. A flavor of what the US sales would add. National partners could grow a lot faster than that. International could grow a lot faster. Those are the two things outside of that.

Steve O’Brien – JP Morgan

What did you see? Was it something this quarter? Last quarter, it sounded like the tone of the business had improved, but was there something that marked the turning point this quarter?

John Combs

This is not something we planned during the last quarter. If you go back in time, the first indication we saw of the entering the economic recession was December of 2007 and during the early part of 2008, we assessed where we were in the marketplace. We put together tactical plans, which was lay the foundation with our national partners and solidify our relationship with our regional partners and continue to build our business on an international front, including a significant major accounts program, and after we got that plan in place, we had a slight headcount reduction to normalize our expenses. We began the planning process to figure out when the right time is to grow.

So we’ve been spending nine months to a year working on this project to figure out when the right time is to accelerate.

We’re blessed with a significant balance sheet that does not have debt, but has a lot of cash on it and that we believe now is a time to invest in ourselves and the reasons we’re seeing to make this investment are one, the stability in the market, while it’s only been a quarter or two now. We don’t see it continuing to accelerate on a rapid rate, but at least stabilizing.

We see major disruptions in our market. We’ve been talking about it for a long time, the transition from TDM to IP and now we’re beginning to see the biggest TDM supplier in the work just went bankrupt. Other folks have very similar balance sheet configurations as they did and see more disruption in the industry.

We’ve improved our distribution. We now have got distribution with every one of the Bell system companies, pre-divestiture in ‘84 plus GTE are carrying the ShoreTel product, making very good progress. You combine that with unified communications for which we are a leader and then you combine that with our extraordinary win rate. We’ve got an opportunity right now in this business to accelerate and take ShoreTel to the next level.

Operator

Next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

The national partners are up 40% quarter-on-quarter, but you mentioned the partners, particularly central region partners were down.

Can you give us a sense of what’s going on there? Is it a matter of a different customer or a specific region or something else?

John Combs

Central region down the most, but most of the regional partners, they’re have been down slightly for us through the entire recession and we balance that by the growth we’ve enjoyed in the national partner growth.

Samuel Wilson - JMP Securities

John, is there a chance here that your national partners are cannibalizing sales from your regional partners?

John Combs

There’s certainly conflicts in certain situations, but for the most part, Sam, it’s been incremental.

Don’t look at the distribution, but look at the customers.

Samuel Wilson - JMP Securities

You mentioned if your leading indicators, is it the type of thing where we should start to expect to see a change in the directory of the business in two quarters, in four quarters, in six quarters? What’s your sense when we should start to see a teak in the line.

John Combs

It’s really difficult to figure the inflection point, Sam, but definitely obviously we wouldn’t make these investments if we didn’t have a lot of confidence or see the revenue moving up.

The things that I’m looking at from a business perspective is the size of the pipeline, market share growth in the business. We track carefully to see the growth in revenues from our existing partners and our new partners. Obviously keep an eye on the pulse of the win rate. It was particularly encouraging in last quarter that our win rate was maintained a very significant position and we also reduced our discounting.

We won a lot of deals last quarter where the capital cost of the customer was higher than the competition, because the overall cost of ownership of the ShoreTel product are significantly advantaged to the competition. So we didn’t have to discount as much in the marketplace and I expect to see improvement happening over the next two or three quarters.

Samuel Wilson - JMP Securities

Mike, are there any customers, national customers, that are starting to get above the 5% barrier and inch toward the 10% of revenue barrier at all.

Michael Healy

We had one partner this quarter that was between 5 and 10% but no end customer above 5%. So one customer between 5 and 10%.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan.

Rohit Chopra - Wedbush Morgan

How many sales people do you have?

John Combs

We have about 90 in total ending the quarter.

Rohit Chopra - Wedbush Morgan

When you talked about the expenses, have you modeled any gross margin impact?

John Combs

Most of those expenses will come down in operating expenses and not necessarily in cost of sales. The cost of sales impact would be from the support people we need to hire.

To clarify, Ro, U.S. sales headcount, 85 at the end of September and then we have about 20 in total international.

Rohit Chopra - Wedbush Morgan

This is mostly US initiative that you’re trying to push?

Michael Healy

International as well as selective countries, but the majority of the effort is in N.A., U.S. and Canada for sure, and also Mexico.

Rohit Chopra - Wedbush Morgan

Can you talk about the training efforts at Verizon and Quest? How many deals?

Michael Healy

I don’t have number of deals. I have the billings from each of them, which in both cases for this quarter, September was better than our plan and better than expectation.

John Combs

In Verizon and Quest, in the last quarter, we trained hundreds but not thousands of sales people and the degree of training varies by their role. So some have been 2-3 hours of ShoreTel to give an overview of the product and company and attributes and benefits and get them excited.

In both Verizon and AT&T, we’re also launching the training of their technical teams to do their own installations of the ShoreTel product.

I would say the customer satisfaction in Verizon and AT&T, in particular, we haven’t got a lot of feedback yet from Quest. We got our first score back from Quest, which was a perfect score by the way, but all three have been very good in terms of their customer staff performance as well.

All three have been very good.

Michael Healy

We’re early on in terms of penetration in Quest and Verizon in terms of getting throughout those companies and moving up into their main lines of business. So we have a little bit ways to go. That’s part of the investment we’re making, right? There’s training, that’s just one small piece of the sales cost.

Rohit Chopra - Wedbush Morgan

Can you talk a little bit about progress on maybe snagging some more Nortel resellers or customers?

John Combs

We have nice growth in both areas. We ran a promotion for Nortel customers. We saw a nice popup in our conversation rate to the end user customers during the quarter and required almost ten significant Nortel partners during the quarter. We’re finding that the Nortel partners, we’ve got some folks that have been selling with us for a long time. We do find that some of the Nortel partners have really been building their business the last few years of serving and supporting their base, not necessarily focusing on new sales.

Michael Healy

Feedback I would add, Nortel pretty loyal sales customer base and partner base and from what I’m hearing is they’re holding on hope until the bitter end until it became very clear that Nortel was going to liquidate and sell into bankruptcy (?)

We’re looking at that as an incremental opportunity that’s come about with the sale of the assets that took place last month.

Rohit Chopra - Wedbush Morgan

Do you have the necessary certification to sell into the federal government or is that part of the R&D effort.

John Combs

We have enough to do a good job in the federal government. We built that up last year in the non-department of defense categories. So there’s some special requirements there that we have not yet attacked, but on the commercial side of the federal government, we’re in pretty good shape to begin to explore that. We probably have 50 cities in N.A. that are being served by the ShoreTel system.

Operator

Your next question comes from Jeff Kvall - Barclays Capital.

Jeff Kvall - Barclays Capital

On the timing of the decision to accelerate market share gains, in some measures it’s been pretty clear for a number of quarters that Nortel was going to head down the trajectory of liquidations, so I’m wondering what it was that you’ve seen in the last quarter that made you feel like now is the time versus six months ago or a few months in the future?

John Combs

The June quarter was pretty stable and so was the September quarter. Not necessarily the fact that Nortel went into bankruptcy, but now the realization that they’re really going to go out of business and that’s not a unique potential for Nortel. It’s something that could happen to the other folks as well that are carrying TDM products.

The fact that we see our tier one distribution coming on as strong as they are and we see a healthy demand for unified communications and in the last six months, for example, the study came out showing we had a 20% market share leader in UC desktop and the fact that the win rate has continued to be very strong and particularly this last quarter we saw that the discounting required to earn business had lessened for us. Those were the elements that really said now is the time to move forward aggressively. We’ve been studying, discussing.

Jeff Kvall - Barclays Capital

The December guidance is kind of flattish relative to September. If the market is getting better, wouldn’t we expect to see a bit of improvement in December quarter?

John Combs

We’ve seen good growth in the pipeline. Certainly the national partners is positive. We need to see a kick up in our regional partners for us to go forward there.

December quarter 2008 was one of our best quarters. December in 2007 was a down quarter for us. So it’s been kind of a mixed bag for us. We’re off to a good start in October versus July, but we’re not really seeing the ramp in revenue

Jeff Kvall - Barclays Capital

Do you have a sense of why that might be?

John Combs

I just think it takes time. It’s back to the situation of investments take time to come to fruition, right? So the investments we’re making to grow our business and branding and sales and design take quarters, sometimes years in the case of the engineering stuff to come to fruition.

So we’re making the investments now knowing we’ve got a great track record, having these investments deliver returns to the company, and we think now is the time to do it, because we want to take, over time, we want to take a significant step up in the revenue growth.

Michael Healy

We expect the market to increase, but I wouldn’t say we’re expecting a dramatic upward trend in the marketplace. I think it’ll be up minimal but not up huge.

Operator

Your next question comes from Sanjiv Wadhwani - Stifel Nicholaus.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

This is Chris in for Sanjiv. Can you tell us when you started your branding campaign?

John Combs

Basically it started at the beginning of the September quarter.

Michael Healy

We started off initially with focusing on vertical market campaigns to kind of test the concepts and we’ve gone a little bit harder into some other…we’re brought it to more horizontal approach during this quarter and the December quarter we’ll go pretty hard in November and early December and then back off and in January, February, and March continue in advertising.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Where do you see it having the biggest impact?

John Combs

The vertical programs, if you think about the customer at the decision process, ideally you like to catch them right before they’re ready to buy, right? That’s where we have focused.

We do about a half a million dollars in lead generation activities in today’s environment and we try to get the customers right when they are looking, when they’re searching around for activities.

This is more to get the IT decision makers and business decision makers further down the funnel when they may be considering thinking about wanting to learn more about as opposed they’re ready to buy.

And so, the advertising will take about 80%, will be in online ads in things like Network World, Wall Street Journal, New York Times, things like that.

We’ve done some radio advertising and sports activities, particularly with the San Francisco Giants. We’ve done both verticals in the government and right now the team is on the road show with both customers introducing the next release. We’ve also focused on customer testimonials.

So the whole reason to do this is to get the awareness up to where the customers say oh I’ve heard of ShoreTel.

And it didn’t make sense three or four years ago when we were early in the ramp process, but now we got to a point where we can build product and ship product and really delight customer in significant volume. So we believe now is the time to accelerate the branding activity.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Based on the three and a half or four months the branding activity has taken place, any noticeable improvement in terms of getting more invites…compete for business?

John Combs

No. That period of time, you’ve got all the sales cycles to work through. We do have a pretty good lead tracking mechanism. We’re looking to make it even better to provide a close loop system to track these kind of activities. It really does take 12 months to a year.

Now what we did is before we began this process, we did in-depth study of 400+ CIOs, plus we had the focus groups, large and small customers in different geographies, both ShoreTel customers and non-ShoreTel customers to determine what our market awareness and brand awareness was and another benchmark study the same point in time in the November, December, January, and February period of time to measure the progress made so far and another study probably in the middle of the year to once again measure the progress.

Michael Healy

Chris, this is probably the first time we’re really done any meaningful branding campaign from a marketing perspective. This is a little shift in philosophy. It took a while to get the money out of John’s pocket to do this, but we’re very excited and we think it’ll have huge payoffs, but we have the metric in place and we’ll measure the results and they certainly have to be positive for us to continue.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Sales force of roughly 90 heads right now, does that include national accounts such as Quest, Verizon and AT&T.

John Combs

Yes.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

And what percent of those are supporting those accounts?

John Combs

I don’t want to get into specific numbers by account, but we have a pretty good team supporting the national account, pretty good team and we’re looking to expand that significantly with the hiring we talked about. We’re not done going after national accounts. There’s more to go get, both here and abroad.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

So of those 40 to 45 heads that you could add to the sales force over the next year, do you think half of those could be supporting the national accounts?

Michael Healy

It’ll be maybe a third.

John Combs

We’re still making investments, international folks, for example, sales engineers. We’ll take our regional distribution partner sales force and support group and add additional territories into that. So it’s pretty much across the board, but we made good size investments in national over the past year and a half and even though net gain in the number of sales people is only five, the amount we have shifted to move into national accounts over the past 12 - 18 months has been more than that.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Speaking of national accounts, is Blackbox a significant contributor to that group? There was commentary yesterday that they’re in discussions with Avaya.

Michael Healy

I’m not aware of the discussions. I mean I think it’s public knowledge that there was a lawsuit between Avaya and Blackbox at some point in time. I know that Blackbox has a very large base of Nortel, so I would think that that would make sense.

To answer your question, Blackbox is part of our national partner or revenue base and they have significant revenue in Q1 just like they’ve had in the prior quarters.

Chris in for Sanjiv Wadhwani - Stifel Nicholaus

Expectations for ramp of IBM?

Michael Healy

Right now, we plan to go into the beta in the January-March quarter and testing integrations. I’m pretty excited about it. Assuming beta goes well and the customers are excited about the product, we’ll begin to see revenue before the end of our fiscal year.

Operator

Next we’ll take a question from Mike Lattimore – Northland Security

Mike Lattimore – Northland Security

John, I think you mentioned something about not expecting significant cash burn. Can you elaborate?

John Combs

When I say not significant, I mean I would expect us at $111 million now that we’re going to work really hard to keep it above $100 million. But that growth, if we see things really taking off, I could actually see where we would accelerate even more. Right now, I would expect this not to have significant cash burn and keep it well in excess of $100 million.

Mike Lattimore – Northland Security

In the quarter, how was pricing, the AST in the quarter here?

John Combs

From an AST perspective on both switches and phones, it was pretty consistent, nothing big movement, plus or minus a few percentage points here and there.

Mike Lattimore – Northland Security

Linearity about the same?

John Combs

Actually linearity was a little bit better this quarter than in the past. The model is typically 50% the first two months and 50% the last month and that’s what we hit this quarter, actually 49% in the last month this quarter and that was much better than the previous quarters. We felt better about linearity and we’re hoping to have the same this quarter, but you never know.

Mike Lattimore – Northland Security

It sounds like you did less discounting this quarter versus last. What prompted that? Why did you back off on some of the discounting?

John Combs

Because we didn’t need it to win. What we’ll do is when the partner comes to us with an opportunity that we need to participate and cooperate with them as a partner to earn the business, we’ll do that. We placed a lot more emphasis on our total cost of ownership tool and when we do that and the customer looks at objectively, most times we can win without having to do significant discounting. So we’ve been able to work with our partners to become more sophisticated and we want all sales force to do the same to manage our business more effectively.

Michael Healy

The other thing I would add is I personally approve and when large discounting against one of our competitors, I’m pushing back and saying have you looked at the financial statements of this vendor that you want to buy from and we shouldn’t be losing to those vendors given their vicarious financial position. That’s I think helping a little bit to push back and keep our pricing up too. So we’re using our financial position as a major advantage against some of our competitors.

Mike Lattimore – Northland Security

You’re accelerating the product road map. Can you talk about which products you think you’ll accelerate?

John Combs

Two primary categories. One, we’re making investments in the IBM relationship to integrate our products to serve the smaller end market.

Certainly in the mobile area. ShoreTel’s mobile call manager is a great product. We plan to enhance the product significantly in addition to adding it on to more cellular instruments. Then unified communications, we’ve got some very exciting things happening in that arena and our engineering team has just been on fire there in driving that and also making improvements in some of the collaboration capabilities we have.

Mike Lattimore – Northland Security

You mentioned in the December quarter, you’re seeing similar trends to the last quarter. So is that the national and international are growing sequentially and kind of your traditional base is declining sequentially?

John Combs

A little early to make any assessments on international versus regional specific assessments, because it’s still very early in the quarter.

John Combs

I want to go back, I think it was Sam that asked the question about the sales through Verizon and Quest. We’ve got about a hundred new customers that came from Quest and Verizon and Verizon went from zero in our fourth quarter, substantial increase in Q1, and then Quest tripled in the Q1 period.

Operator

There are no further questions or comments at this time.

John Combs

Thank everybody. We appreciate your participation on our call today. We’re very excited about the new campaign we’re on in terms of really accelerating our business. This is something we’ve been anxious to do. I’ll tell you it’s not just an executive excitement either, it’s the entire team, our sales team, the engineering team, our operations team, our customer support team is very excited to see us move forward with this.

We have begun the hiring ramp in our organization. I interview everybody who goes into our sales organization and most of the senior engineering folks and the quality of talent we’ve been able to attract to the company is outstanding. So we think we’ve got the time right to really lay the foundation to accelerate our growth. And we thank all of you for joining us today. Take care.

Michael Healy

One final comment. We will be on the road for a number of conferences, but we do have an analysis day scheduled on December 9 in San Francisco that we welcome all of you to come and hear more about the company and there’ll be a few presentations from a few of the management team besides John and myself. Thanks again and we’ll see you on the road. Thanks.

Operator

Thank you for joining today’s conference call. You may now disconnect.

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Source: ShoreTel, Inc. F1Q10 (Qtr End 09/30/09) Earnings Call Transcript
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