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Executives

Tonya Chin – Director, IR

John Combs – Chairman, President and CEO

Michael Healy – CFO

Analysts

Steve O’Brien – JP Morgan

Ryan Hutchinson – Lazard Capital Markets

Sanjiv Wadhwani – Stifel Nicolaus

Troy Jensen – Piper Jaffray

Samuel Wilson – JMP Securities

Lynn Um – Barclays Capital

Rohit Chopra – Wedbush Securities

ShoreTel, Inc. (SHOR) F2Q10 (Qtr End 12/31/09) Earnings Call Transcript January 27, 2010 5:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome everyone to the ShoreTel second quarter fiscal year 2010 results conference call. (Operator instructions) Thank you. I would now like to turn the conference over to Tonya Chin, Director of Investor Relations. You may being your conference.

Tonya Chin

Hello and thanks to all of you for joining us today as we report our fiscal Q2 financial results. Joining me on today’s call 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 the 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; its Form 10-Q for the quarter ended September 30, 2009, and the current report on Form 8-K furnished today.

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

One final note, we’ll be discussing both GAAP and non-GAAP results throughout this call, and I ask that you refer to our press release for a reconciliation between these amounts. Our non-GAAP numbers, exclude stock-based compensation charges, the adjustments, and the related tax impact. We believe that excluding these items give management and investors a better indication of our true operating results.

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. On today's call, I am going to review our solid Q2 financial results, update you on our strategic initiatives, and discuss some of the highlights of the quarter, including the momentum we're building in the marketplace.

First, let us talk about our financial results from the second quarter. Revenues of $35.5 million were above our guided range of $31 million to $35 million and represented a 5% sequential increase from last quarter.

We delivered our best ever gross margin performance with non-GAAP gross margins at 65.3%, up nearly a full point from last quarter. Despite an increase in our operating expenses, as we invest in key areas of our business, we were able to deliver a positive non-GAAP net income of $340,000 or $0.01 per diluted share, significantly better than our expectations.

We generated over $3 million in operating cash flow in the quarter, increasing our cash and short-term investments to the highest level ever at $115 million. Key areas of revenue growth included business from our national partners, which was up 12% sequentially, double-digit growth in our Asia-Pacific region, and a record highs sales in our contact center business.

These results validate the timing of our strategic initiatives we outlined on last quarter’s call. Since early 2009, we have been developing a strategic plan designed to enable us to accelerate our growth out of the recession. As a reminder, on our last call we highlighted several factors that ultimately drove us to the conclusion that it was time to accelerate our investments in our business.

These factors included more stability in the overall economy, our new and improving relationship with several key national carriers, disruption in our competitive marketplace highlighted by the Nortel bankruptcy, the growing demand for unified communications functionality, and especially our over 50% competitive win rate.

Our strategic investments designed to drive future market share gains in revenue are concentrated in three key areas of our business, sales, product development and branding. Candidly, when we launched our strategic plan, I reviewed its timing to be one of the biggest risks. While we knew that the disruption among our competition, and the increasing demand for UC functionality created an excellent opportunity for us.

The real question was when our market would resume growth. In hindsight, the timing of our accelerated investments turned out to be ideal. It has given us a head start over our competition, as we began investing almost six months ago. With the IP telephony market expected to grow between 7% and 18% in calendar 2010, we are well positioned to accelerate our market share gains, and drive revenue growth as the full benefit of our strategic investments begin to take hold.

As we look forward to the coming year, I'm bullish about ShoreTel’s position in the market and the momentum we're building. Let me take a few minutes to review some of the most exciting developments over the past quarter. Last week, I attended the IBM Lotusphere event, where we together with IBM highlighted our new combined solutions, aimed at small and medium-sized businesses as well as branch locations of larger organizations.

These businesses do not have dedicated IT resources on-site, making local operational support of IT systems very challenging. IBM Foundations is a full suite of remotely managed IT applications, including firewall, VPN, backup, Web and mail server, presence awareness, instant messaging, e-mailing, calendaring and office applications in a single business.

The ShoreTel and IBM solution is a unique unified communications and collaboration offering the tightly integrates the foundation’s IT environment with IP telephony, unified messaging, audio conferencing, mobility and other ShoreTel UC applications in a highly reliable, easy to manage and affordable out of the box solution.

At Lotusphere, IBM demonstrated the ShoreTel IBM solution in their well attended presentation, which was enthusiastically received by the partners and end-user customers in the audience. We are very excited that we can provide a critical and missing component for IBM in this solution that is vital in their battle against Microsoft.

Impressively, IBM Foundation team has already signed over a thousand Microsoft distribution partners to carry the foundation’s products. Separately, we also recently completed interoperability testing with IBM's Sametime Unified Telephony, which targets larger customers, who chose IBM Sametime as their unified communications supplier. Now those businesses can select ShoreTel as their IP telephony product that inter-operates with the Sametime UC deployment.

Next, I'm going to review our announcement last week on our ShoreTel 360 Legacy Migration Program. Not surprisingly, we are seeing a growing number of prospects, customers, especially those with large Nortel bases, interested in preserving their existing PBX investment, while strategically planning their transition to dot [ph] UC software solutions on an all IP platform.

The ShoreTel 360 Legacy Migration Program allows companies with existing PBX systems to reap the benefit of a complete ShoreTel UC system across the entire enterprise, even in locations where they are not already – not ready to displace their existing platforms, protecting earlier PBX investments.

We have already successfully implemented this solution with many customers. I want to stress that our 360 Legacy Migration Program is available for customers today versus Avaya’s recently announced plan to integrate with the Nortel product set in the future. Many customers want an alternative to the migration plan that Avaya has laid out, and we are pleased to be able to introduce prospective customers to existing customers, who are delighted with our ShoreTel 360 Legacy Migration.

We also recently introduced version 10 of our UC software. New and existing ShoreTel customers will benefit from new capabilities that boost user productivity and administrators will benefit from functionality to make the system easier to manage, especially when upgrading large systems.

ShoreTel 10 is aimed at larger enterprise customers, and those customers that have a large number of geographic locations. As always, existing customers that are on a maintenance agreement with us are able to get the upgrade to version 10 at no additional charge, one of ShoreTel’s many competitive advantages.

Last quarter, we shared with you our strong belief that there is a direct correlation between areas we have invested in over the past quarter, and the corresponding growth we have seen in those areas over time. I would like to highlight two key examples. First, over a year ago, we started to make a concentrated effort to grow our government and educational sales team with the goal of significantly expanding our participation in this important vertical.

Over the past year, we have augmented our internal government sales team significantly, and they have been very successful at growing our government business by 18% year-over-year. In addition, we increased the number of government purchasing vehicles from 2 to 16. During the last two quarters, we have won our largest to date Federal customer, a division of the US Bankruptcy Court, and we were awarded a significant state purchasing contract by the Department of Information Resources in the state of Texas.

We are also encouraged by our success in partnering with our government teams within our national distribution partners, where we expect to see increased sales in this key vertical. Another great example is in our Asia-Pacific region, where we added numerous sales resources, including a new managing director about a year ago.

During that same time, we began ramping our relationship with Telstra, a key national partner in Australia. As a result, Asia-Pacific revenues have increased nearly threefold in the past year. These two examples provide us with confidence that our strategic investments will deliver results over time.

I am also encouraged by the early indicators pointing to the effectiveness of our branding effort. During the quarter, we invested in both general and vertical specific campaigns. These campaigns are aimed at change agents, which are ShoreTel targeted customers, someone who is independent thinking and looks for the best in class products.

Our new branding campaign is the result of listening to our existing customer. We asked them what they felt were the most significant differentiators delivered by the ShoreTel system. Resoundingly, our customers repeatedly highlighted the simplicity of our robust and innovative solution. The current campaign revolves around untangling system complexity with ShoreTel’s brilliant simplicity.

We're finding that focusing on the simplicity of our solution really resonates with both existing and potential customers. The buzz around ShoreTel at executive forums and industry events targeting senior decision-makers has never been louder. We are seeing more prospective customers aware of ShoreTel, our products and a reputation for world-class customer satisfaction.

In addition, our distribution partners are capitalizing on a brand-new campaign with local radio spots, print ads, billboards, flyers, to generate leads for their respective markets. And finally, we are extremely gratified to be awarded the Best Overall UC Provider for the sixth year in a row by Nemertes Research, an independent research advisory firm in their annual customer satisfaction survey.

This survey is unique in our industry, and its results are entirely driven by surveys of end-users. This year ShoreTel was rated higher in every one of the six categories, including value, customer service, technology, and ease of installation against every one of the competitive vendors.

Our internal customer satisfaction reporting, which receives feedback from over 60% of our new customers has reminded at world-class levels for over four years in a row. Delighting customers is part of the ShoreTel ethos, and one of the most significant drivers of our strong momentum.

With that, let me turn it over to Mike for a review of our financial performance in the quarter, and then I will return with some closing comments. Mike?

Michael Healy

Thanks, John. As John mentioned, we are very pleased to once again see revenue rise sequentially in Q2 to $35.5 million, which is up 5% from the first quarter. In our vertical markets, we saw increases in our professional services, technology, retail and manufacturing segments.

At national partners continue to perform well with business from that group up approximately 12% sequentially. As a group, our national partners represented 17% of our total business during the quarter with the strongest growth coming from Quest. As a group, these five partners, AT&T, CDW, Black Box, Qwest and Verizon exceeded 6 million in total business this quarter.

International revenues were $3.3 million, which was flat with last quarter and represents about 9% of total revenues in Q2. We saw strong growth in the Asia-Pacific region, primarily due to continued strength of business from Telstra. Service and support revenue totaled $7.6 million, growing over 9% sequentially. Service and support revenues were 21% of total revenues in the second quarter, and included about $1.7 million in services revenue from installation, training and professional services activities.

We sold approximately 85,000 end user licenses in the quarter, up 7% from 80,000 in the prior quarter. Our number of new customers increased 9% in the quarter to over 800 added in Q2. Another positive key metric was revenue from new customers, which increased to 47% in the second quarter, up from 45% in Q1.

Now let us turn to the good news on gross margins. We delivered record GAAP gross margins of 64.5%, as well as our best ever non-GAAP gross margins, which was 65.3%, up 80 basis points from 64.5% in the prior quarter. Non-GAAP product gross margins were 65.1%, and non-GAAP support and service gross margins were 66%, both of which were increases over Q1.

The two most significant drivers of the improvement in our gross margins were a decrease in the cost of our switches and the continued increase of our service and support revenues, while support expenses increased only modestly. Our phones and switches showed growth in both unit volume and ASPs as well.

Non-GAAP operating expenses of $22.9 million were up 1 million sequentially due to increased sales in R&D hiring, investments in our distribution channel, and increase branding activities. The increase in operating expenses was slightly lower than we expected, as we did not add as many new employees in the quarter as we had projected.

We are hiring as fast as we can in order to meet our objectives, while keeping our hiring standards very high to ensure we add only the very best of the best candidates. Overall, we hired 27 employees during the quarter with the majority of those in engineering, global support and sales. We ended the quarter with 413 employees.

We returned to non-GAAP net income in the quarter with our bottom line profitability of $340,000 or $0.01 per share. Our GAAP net loss of $2.5 million includes stock-based compensation charges of $2.8 million and the related tax adjustments.

Our tax expense was a small charge and reflects minimum tax amounts we need to pay in certain states and in foreign jurisdictions, regardless of the net profit or loss we generate.

Next, let me review some of the highlights of our improving balance sheet and cash flow. We ended the quarter with $115 million in cash and short-term investments, and generated over $3 million in positive cash flow from operations, despite making incremental investments in our business.

Accounts receivable shrank slightly to $18.8 million on larger revenue, due to improved days sales outstanding, which declined again to 43 days. Inventory increased $1.4 million to $14.5 million as we continue to ramp up our phone inventory to support our projected growth in demand.

I will like to point out that we have a $1.7 million deferred tax asset included in other assets on the balance sheet. As we update our outlook for growth over the coming quarters and consider other factors, we will need to continue to review the valuation allowance on this asset, and may need to adjust the valuation accordingly.

Deferred revenue increased by $1 million, primarily due to increase in support billing [ph]. Capital expenditures were $400,000, purchases of IP telephony and licenses were another $600,000, and depreciation and amortization was approximately $700,000.

Next, let me give you some updates on our investment activity. Our spending in Q2 was at the lower end of our expectations, and that savings was almost entirely in labor costs as a result of being under our internal hiring projections. We are still planning to add 3 million of incremental operating expenses, both in Q3 and in Q4 as we are planning to continue our investments in sales, headcount, product development, and branding given that most of leading revenue metrics are headed in the right direction.

In terms of our sales hiring, we were slightly under our plan as of Q2, but we do expect to increase our sales team by over 40% year-over-year by the end of June. The good news is another important metric, revenue per US sales executive climbed slightly in Q2. I did go in and update our revenue model with the current hiring ramp, and using our earlier more conservative revenue per sales executive metric, I'm still comfortable that the addition of these sales executives during fiscal year 2010 will generate approximately 40 million to 50 million incremental revenue in our fiscal year 2011.

Let me summarize how we are progressing on some of our leading revenue growth indicators that I mentioned on last quarter's call. Proposal pipeline, national partner revenue, revenue from new customers, revenue from new partners, and sales executive revenue productivity measurements, all showed positive increases over Q1 amounts, which gives us confidence that our business is headed in the right direction.

On the product development site, the products on our accelerated roadmap are coming on nicely, and we plan to unveil many of them to our reseller partners at our upcoming partner conference in July. In terms of marketing spending on our brand initiative, we have invested in online banner ads in places like the Wall Street Journal and BusinessWeek, in both print and online ads in CIO magazine and Network World.

We are on track with our investment in this area, and expect to spend approximately $1 million in both Q3 and Q4 on branding activities. We are continuing to spend on other demand generation marketing activities such as lead generation and trade shows.

Next, let me discuss our outlook for the March 2010 quarter. We are encouraged by signs of improvement in the IP telephony market, but still remain cautious, particularly as we go into the March quarter, which dropped off significantly in product revenue last year. Given these factors, we expect revenue to be in the range of $33 million to $36 million.

We expect non-GAAP gross margins to be in the range of 63.5% to 64.5%. GAAP gross margins are expected to be one percentage point lower due to the inclusion of $300,000 in stock-based compensation charges. We expect to continue to ramp our operating expenses in the March quarter, and therefore expect our Q3 non-GAAP operating expenses to be in the range of $25.5 million to $26.5 million.

We expect GAAP operating expenses to be in the range of $28 million to $29 million, including approximately $2.5 million in stock-based compensation expenses. I was very pleased that we delivered such a strong quarter, exceeding our guidance on revenue and gross margins, while managing expenses to the low-end of the range, all of which resulted in a significant beat on EPS.

In terms of our critical metrics, we saw broad-based improvements in Q2, a very encouraging sign. I am confident that ShoreTel is poised for a very strong calendar 2010. With that let me turn it back to John for some closing remarks.

John Combs

Thanks, Mike. I'm very encouraged by our positive results in Q2, which largely do not yet reflect the recent investments in our business. From my perspective, I feel as though the stars are lining up for ShoreTel to really break out. Today, we have the best products in the market that even our competitors acknowledge is highly differentiated.

Our growing base of (inaudible) customers and expanding group of skill distribution partners, and a really terrific team of passionate employees dedicated to high-performance and world-class customer satisfaction. We have a disproportionately high win rate, when we are considered by a prospective customer. Our challenge today is that we are only involved somewhere between 10% and 20% of the opportunities in our target market segment.

Prospects typically evaluate three suppliers, and historically they had been considering our three largest competitors. With Nortel’s bankruptcy, there is now an open seat at the table. Nothing is more frustrating to me than thinking of all of the customers that have purchased an inferior solution without even considering ShoreTel. The primary objective of our strategic investments is to increase our consideration rate, because when we're invited to compete, we will earn the customer's business.

Thanks again for joining us today. Let me turn the call over to (Paula) to begin the Q&A session of our call. Thank you.

Question-and-Answer Session

Operator

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

Steve O’Brien – JP Morgan

Hi, thanks for taking my question. First of all, could I ask about sort of linearity through Q2. Is there anything unusual in terms of order patterns or revenues booked and you know, then if you could just help us understand what Q3 typically looks like, is it, you know, is it something where you know, enterprises don't spend much or they figure out their budgets and then ramp stronger through the quarter versus other quarters in the year or you tell me, thanks.

Michael Healy

Okay, Steve, good question. Mike here. So, in terms of linearity in Q2. It was a pretty typical quarter, which, you know, typically is we get 50% in the first two months and 50% in the last month. It was a little heavier than that last month and that was primarily due to the kind of year-end budget flush. We did experience some budget flush in some of our regions from corporations using up their capital dollars, and that was probably a little bit due to there was an incentive tax, incentive in place for companies to get accelerated depreciation to take advantage of that.

So, we just feel like we got some of that and so it was little heavier in December. Looking forward to Q3, January is typically a pretty weak quarter because of that budget flush, you are right guys get their budget established for calendar year, maybe not right away, and so we typically see a little bit higher ratio to the back half in the March quarter as well.

Steve O’Brien – JP Morgan

Okay. On the gross margins side, very strong again this quarter and obviously guidance is strong as well. There had been some discussion on promotional activity. I think you started to see at the end of last quarter. Was there anything unusual in terms of you know, product mix this quarter and then secondly not to complain about high margins, but have you thought that you know, maybe you could grab some more revenue share by chance, if you got a little more aggressive on price?

John Combs

Steve, it is not necessary for us to get aggressive on price. We have the best and most complete total cost of ownership tool available to our partners and distribution. So, while the capital cost of the ShoreTel system are comparable to the competitors, the overall expense over the life of the product to the customer is substantially less with a ShoreTel solution. So, if properly sold, we will win on the cost value to the customer almost every time. So, from that perspective, I think that the – it's not necessary to discount. Mike, you may want to comment further.

Michael Healy

Yes. On gross margins, Steve, the primary drivers for the record growth margin this quarter were we got some cost, some more cost out of the cost of our switches and we're looking to do more and more of that obviously. So that was a piece of it, and then the other piece was service support revenue going up and all the expenses increasing modestly. So in terms of promotions, we ran promotions this quarter just like we do every quarter. There wasn't any big change (inaudible) delta.

I think what we are seeing in is we are able to hold the line on discounting that the true cost of our products come out, and so we don't have to discount to win the business and I think that's what you're seeing. So, we are excited about where our growth margins are. We obviously want them to get higher. In terms of future promotions, we would evaluate every 3 to 6 months what promotions will work in any one quarter, and we may get more or less aggressive, but right now I think we've got a good balance between discounting and margin achievements.

Steve O’Brien – JP Morgan

Great. Thank you.

John Combs

Thanks, Steve.

Michael Healy

Thank you, Steve.

Operator

Your next question comes from the line of Ryan Hutchinson of Lazard Capital Markets.

Ryan Hutchinson – Lazard Capital Markets

Good afternoon guys. I have a few questions. First –

John Combs

Hi, Ryan. Hold on. Before you – before you ask your questions, we wanted to thank you for your initiation of coverage today.

Ryan Hutchinson – Lazard Capital Markets

Oh, thank you. Thank you. First off, on the gross margins following up on that question, if I have this correct, I mean last quarter I think you guided us to have the services down, see some slight degradation and it looks like they obviously came in above expectations, but as we think about the guidance for the March quarter, maybe just provide some color around the split between the product and the services and what the expectations are.

John Combs

Yes, it's kind of the same story as last quarter. Last quarter, I did expect the service and support margins to go down, and that was implied in the guidance and that was because we expected the ramp up hiring there, and we did do some hiring but just not as much as we expected and so, you know, a big piece of it would drive the service and support margins is just how many people we have there. So, it's a similar story this quarter in that we are planning to do more hiring in the support organization, which will have an impact on the overall gross margins. So, I am modeling the service and support margins down slightly, and therefore there is an impact on the overall company gross margin. Again that's mostly hiring than anything else.

Ryan Hutchinson – Lazard Capital Markets

And the same goes I guess for product gross margins to get you to the guidance range you provided?

John Combs

Yes. Product gross margins downsizing or forecasting down just a little bit. You know, we maybe a little bit more aggressive on promotion things like that.

Ryan Hutchinson – Lazard Capital Markets

Okay, all right, and then on the services revenue, the jump there up over 9%. If I look at the professional service fees of 1.7, if I have that number correct and then around little over 1.1 last quarter, the difference is about 600 K, which is really the difference between the services revenue from September to December. So, in essence if the math is correct, services piece was flat sequentially. So, the first question is it the math right and second question on that is the 1.7% a sustainable rate moving forward?

John Combs

So, yes let me give you a little bit more insight to there. So I have – our services revenue did have increased quarter-over-quarter of about 300 K and that's again professional services, implementation services and training, okay. And the biggest increase we saw was in implementation services. We do that work for guys like AT&T and Quest, and so that rate going forward, maybe a little lumpy as we move forward, because some of our larger national partners are going to start taking over and doing their own installs, which we think is very positive. So, there could be a little lumpiness on that and on the support revenue we'll just continue to climb as we get renewals on the support business and so that has just a steady methodical increase on its way out.

Ryan Hutchinson – Lazard Capital Markets

Okay, great. And then finally on the guidance range, 33 to 36 just – you talked a little bit about seasonality, but that puts and takes that get you to the low-end, the high-end and above and is it really driven by the fact that you got some successes here with these partners being Qwest that you highlighted that you know, may or may not show up. So, you're being taken somewhat of a cautious approach or you know, just some color on that would be helpful.

John Combs

John Combs, let me respond to that. The approach we used to organize our guidance is the same. Mike works with the sales team et cetera to pull in the forecast. We'll look at the proposal backlog. We look at the size of the distribution pipe in terms of the number of partners added et cetera, and we do a number of different calculations. It's all we do, basically it is math.

As we look at the high-end and the low-end and then we come up with our guidance number. Now, we do know that the last quarter we had a significant dip…

Michael Healy

Last year.

John Combs

Last year, yes, excuse me. Last year we had a significant dip just because [ph] we were middle of a recession. So hopefully that won't recur again but that's what provides us a little bit of caution. We also know that January is the month that is seasonally slow because of the December budget flush. So those are the primary drivers of what brings us to the revenue number.

Ryan Hutchinson – Lazard Capital Markets

Okay, great. Thanks guys.

John Combs

Just one comment to Ryan. Just a follow-on on your question about the margins in the global support and services area. One of the things, just to highlight, is we don't charge anymore, as a matter-of-fact we charge significantly less for maintenance contracts than our competition. What really drives the high margins, we certainly have an exceptional global support team that really drives those high margins and the support section is that we use solid-state switching and our product is just highly reliable. So that really is a key driver of that service functionality. So, over the long term, you're going to continue to see gross margins, I think in the services area they are in the 60 plus.

Michael Healy

As well as you know, the high customer satisfaction we have, specifically when your customers are satisfied, they renew their support contract, right, and that's the key driving that support line up. So –

John Combs

The only problem we have is that the system is so reliable. They don't have to use the support agreement. They say, why do we need to renew it.

Michael Healy

True.

John Combs

Thanks, Ryan.

Operator

Your next question comes from the line of Sanjiv Wadhwani of Stifel Nicolaus.

Sanjiv Wadhwani – Stifel Nicolaus

Thanks so much. Couple of questions, Mike I know you gave the total number of hires for the quarter. Can you talk about how many were in sales?

Michael Healy

Yes, sales, we are a little bit behind our hiring plan as I mentioned. So, the increase in sales was 6 and I think we had planned for about 10.

Sanjiv Wadhwani – Stifel Nicolaus

Okay.

Michael Healy

But we are, you know, we are trying to ramp up and some of those hires, it was a matter of December or January. We pushed out some hiring, because we didn’t want people start last week in December or last two weeks in December. So, I'm expecting that the sales organization will catch up to our plan of hiring here pretty quickly and continue to ramp up to the 40% number year-over-year what we are expecting.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. And this – just on the partnership front last quarter, I think the regional partners were down, can you just talk about what happened to them this quarter, and then also one partner was between 5% to 10% of revenues last quarter. Can you sort of talk about where that partner came in this quarter?

Michael Healy

Sure. So from a regional basis, excluding what we call our national partners, regional guys were up slightly. So that was obviously a good sign of productivities getting better, and then in terms of top customers – so we have one partner, one national partner that is between 5% and 10% of revenue. No one is greater than 10%, and no other partner or no other customer greater than 5% of revenue.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. Just, I don't know if you are willing to share this matter, but Quest, Verizon, AT&T, did all three of them grow sequentially. Any sort of color over there?

Michael Healy

Yes, the biggest driver – increase was Quest, and CDW and Black Box all had good growth.

Sanjiv Wadhwani – Stifel Nicolaus

Okay, got it. And then one quick question for John. I know you attended the IBM event. Is IBM – is the (inaudible) still going to start this quarter with potential revenues in June, any updates over there?

John Combs

No. That's still unscheduled. That's the plan. We had the earlier version to demonstrate to the partners and customers, who attended the IBM Lotusphere event, which is you know, has got thousands and thousands of people show up to it, and so it is a very big event, and we are still on track. We should go into beta, and have our first revenue between now and the end of fiscal year. Although this revenue number initially will be pretty small, right. It will be – not a significant number, but it's the beginning of something that hopefully will be pretty exiting over time.

Sanjiv Wadhwani – Stifel Nicolaus

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

John Combs

Thank you.

Michael Healy

Thanks, Sanjiv.

Operator

Your next question comes from the line of Troy Jensen of Piper Jaffray.

Troy Jensen – Piper Jaffray

Hi, congrats on the nice quarter, gentlemen.

Michael Healy

Thank you, Troy.

John Combs

Thanks, Troy. You're often clear on your phone.

Troy Jensen – Piper Jaffray

It is the ShoreTel phone.

John Combs

Oh, I didn't know that.

Troy Jensen – Piper Jaffray

I guess, you did. Quickly on the national partners, how many of them sell, you know, Cisco, Avaya, and Nortel you know, maybe even more kind of exclusively partnering more with you guys. Is there any opportunities for – with the Nortel, Avaya merging where they may start pushing you guys more now that there is you know, one less player?

Michael Healy

Well, there is certainly an opportunity across the board you know, worldwide and Nortel held like 11%, 12% of the North American market and 10% internationally. So, there's a big market void there for us to fill. Most of the carriers carry the Nortel, the Cisco product lines and the Telstra, AT&T, Verizon, Qwest, all carry ShoreTel as well. So, there is an opportunity for us to step up and, you know, with the announcements that Avaya made last week with the BCM product, which is a smaller Nortel product, that basically looks like it's going away, and a lot of the sale is through the Bell Company, former Bell Company. We're in a small end market on Nortel and that's a great opportunity for us.

Troy Jensen – Piper Jaffray

Hi John, I'm curious on the government vertical, are there any certifications needed or pending that could help you accelerate traction in that space?

John Combs

Definitely is. A lot of – all of our business today in the federal government. So, first of all, Troy if you work from the county, city, state, and federal, we are stronger in county and city. We are growing our momentum and state, and we are beginning to penetrate federal. So in those areas, particularly the county and state, the contracts, the government contracts, quantities and contract purchasing vehicles is something that's very important to get in place that opens up a significant market force. We've also been doing well in the federal area, but the certifications required to really get into the three digit agencies, all the defense, et cetera is the JD [ph], and we are right now evaluating what it would take to modify the product to be JD [ph] compliant, but that would be something that's reasonably long development cycle to get in place.

Troy Jensen – Piper Jaffray

Got it, and then just one for Michael here. Sales expansions supposed to add, you know, $40 million to $50 million incrementally. Can you give us any color what you think the kind of the core, the existing sales teams that kind of grow the revenues next year?

Michael Healy

That's a good question. The core sales team could grow revenues, but – you know, it's over 100 (inaudible) people today right. We assume – right now their average is supposed to be about $1.4 million a year all right. And that 111 was 80 something a year ago. So, let us say, 30 incremental heads on $1.4 million out of that number is 45 or something. You know, if you just do straight math now. Theoretically, if you get more sales people, the productivity is not going to all go up at the same rate, but that's how we look at it. I haven’t penciled that out, but that's a good question.

Troy Jensen – Piper Jaffray

And keep up the good work guys.

John Combs

Thank you, Troy.

Michael Healy

Thanks Troy.

Operator

The next question comes from the line of Samuel Wilson of JMP Securities.

Samuel Wilson – JMP Securities

Good afternoon. Just two really small questions here at the end. First, it sounds like there was no real pricing pressure from Cisco and Avaya or others in the quarter. Is that true?

John Combs

There is always, always pricing pressure.

Samuel Wilson – JMP Securities

Yes, did you have an abnormal pricing pressure?

John Combs

No abnormal pricing pressure, and the real difference for us is at our sales kick up meeting we updated the newer version of TCO tool, which is just an outstanding job the team has done or put that together, and the smart salespeople, the skilled sales people, the mature salespeople, not just in ShoreTel, but in our partners who are selling against the competition use that total cost of ownership analysis as a way to deflect that so that it can really stand. The Cisco system, almost every application they can give the hardware up front and the software up front and all the capital investment away for free, and still cost the customer more money over the life of the product. So –

Samuel Wilson – JMP Securities

Got it, and then second based on your comments and Mike's comments, it sounds like you're little bit behind in hiring, a little bit behind in spending on some of the new initiatives, yet there was still revenue upside for the quarter. So, could you tell us kind of what went better than expected, you know, away from sort of the new initiatives?

John Combs

It is the Asia-Pac group grew to a new record for them, which was very exciting to see. The growth on our national partners was up nicely over the quarter, twice the others. Those will be real significant, and overall the productivity of the sales team went up higher than what we had forecasted the existing team, and I want to emphasize that the revenue gains we saw during this last quarter, but really not a reflection at all of the investments we are making today to grow the business in the future.

Samuel Wilson – JMP Securities

So, is it fair to say your guys did better or was end market demand maybe a tad bit stronger than you thought?

John Combs

It could be a combination of both, but I think overall our guys did better.

Samuel Wilson – JMP Securities

Got it. Thank you so much.

John Combs

Thanks, Sam.

Operator

The next question comes from Lynn Um of Barclays Capital.

Lynn Um – Barclays Capital

Hi, thanks for taking my question.

John Combs

Hi, Lynn. How are you?

Lynn Um – Barclays Capital

Good. Just going back to the guidance question, it looks like the range has been tightening a bit, can you maybe just talk about how that may be reflective of perhaps visibility improvements or other factors to think about there?

Michael Healy

Yes, I mean the range of $3 million versus our typical $4 million last quarter, you know, is a little bit symptomatic of a little bit more confidence, and like John mentioned when we wrote the sales forecast, you know, we ask for a best case and worst case, and we use their range to help us guide, and did have a bigger range on their different elements by distribution channel. So that trend is reflected in our guidance.

Lynn Um – Barclays Capital

Okay. And then back on to the sales hiring plans, I think you mentioned up to about 40% year-over-year by June. I think last quarter you said up to 50% could be just – interpret that as being maybe just applying to another plans rather than (inaudible). How can we think about that?

John Combs

Yes, the change is really not a change in a player at all. It's a change in our ability to execute. We have a – one of the investments for making, one of the things that would be very easy to do would be as we begin to add a substantial number of new team members, is to compromise the hiring standards, and I can tell you that we haven't done that in the case of our organization.

We've maintained our high standards and sometimes to the frustration of the members of the team, because everybody in management and everybody in the sales organization that joins – I'm part of the interviewing process. So, we've done I think an exceptional job of getting, as Mike mentioned, the best available in the marketplace, and I am very encouraged by the way with the quality of people we have attracted to our organization.

Lynn Um – Barclays Capital

Okay, great. Congratulations and good luck.

John Combs

Thank you, Lynn.

Operator

Your next question comes from Rohit Chopra of Wedbush Securities.

Rohit Chopra – Wedbush Securities

Hi guys. I have four questions for you guys. I just wanted to see, is there a change in sales cycles that you could point to?

Michael Healy

Short answer is no.

John Combs

I guess, maybe what I would say is that the sales cycles, the people coming into the funnel are actually coming out rather than get stuck in. So, really from that sense there would be a shortening of the sales cycle, but there is an improvement in the customers who are delaying, it is not as many as there were in the past year, for example.

Rohit Chopra – Wedbush Securities

Okay. It's a good way to look at it, and then I want to come back to the national partners. When you guys signed up Verizon and Qwest, I think, you guys were pretty excited and I know you still are, but can you tell us are they tracking ahead of where AT&T was at this time after you signed AT&T. Is there a way to look at that?

Michael Healy

It's too early on I think to really tell. Right now, if you were to track, Verizon is about on par with AT&T and Qwest is ahead, the net-net of that. But they are both so early on in their cycles, and in all three of them, we, you know, barely penetrated the opportunity and as well as Telstra in Australia in the marketplace. So, we are pretty excited with the way they are penetrating. I'd say that Verizon was on course, Qwest is above as fast as AT&T and this point, and hopefully we can maintain the growth in those areas.

Rohit Chopra – Wedbush Securities

Okay, a couple of other questions more related to competition. So, is there any way to quantify the impact on the low-end of the market from (inaudible)?

Michael Healy

I'll tell you, well I – they are down there? I can't find them.

Rohit Chopra – Wedbush Securities

Okay.

Michael Healy

And I don’t mean to be quip or funny or whatever, but it is very, very, very rare that I hear anything about these (inaudible) product line. I mean, we hear about Microsoft as a new competitor and a bunch of other folks, but they just don't show up and may be that those customers are going because the free software, the downloading it and doing it, and just simply not coming out to bid but when the customer, when we discover a customer in general that's not one of the competitors they bring up.

Rohit Chopra – Wedbush Securities

Okay, and then I had one other question related to competition, and as you said, I think Avaya and Nortel, or Avaya, let's just say Avaya rolled out their product roadmap, I think last week or the week before, Mytel [ph] had something the other day. I think maybe it was last week, but they are all rolling out some type of video in their suite of UC products, whether they are partnering or not partnering, I guess that doesn't matter and in the analyst day you said that video was not part of your product roadmap, and I'm just wondering is it necessary given the competitive threat from Mytel. I don't know how they're doing it. They're building their own, and of course, Polycom is partnering with Avaya to help them along, but are you going to be pushed into supplying a broader suite of products for UC.

John Combs

Well, here is what I'd say. First of all, I didn't see anything on the Mytel deal, and maybe just didn’t catch it, but the – on video today, we add video in our system, it's currently available today, and it's the desktop to desktop video. It's an area that we can add lot of value in because we can drive it from our personal call manager, et cetera, but we are not planning to go into the telepresence conference room video system business.

Our job is to integrate with them. So, we'll continue to integrate with the (inaudible) of Polycom's and other suppliers in that market area, but do not plan to actually go out and build the product. So, I can only speak for myself, but I think it would be silly to go build a video conferencing system. The world doesn’t need another one of those, right. They've got a whole bunch of them, and that's not our area of expertise.

Michael Healy

But we are planning to continually increase our suite of UC offerings outside of conference room video. So, you'll continue to see more and more UC products from us in that area.

Rohit Chopra – Wedbush Securities

Thanks guys.

John Combs

Okay, Rohit, thanks.

Michael Healy

Thank you, sir.

Operator

(Operator instructions) At this time, there are no further questions. I'll turn the call back over to John for closing remarks.

John Combs

Okay. Thank you very much for joining us today. Our main drive in our business is to improve our consideration rate because when we're at the table, we win. I'm extraordinarily excited about how the timing of the investments we're making. We've got a head start, because the market has turned in conjunction with our investment. You know, looking back into 2009, the wind was on our face from the overall marketplace.

I would say today, we got a breeze at our backs that is slightly positive. You know, our team has fired up both our partners and our employees on the acceleration of our business and our growth plan, and we are very excited for the prospects for our business for 2010. Thanks again for joining us. Have a great week, great month, and great year.

Operator

Thank you. This concludes your conference. You may now disconnect.

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Source: ShoreTel, Inc. F2Q10 (Qtr End 12/31/09) Earnings Call Transcript
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