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Mitel Networks (NASDAQ:MITL)

Q2 2014 Earnings Call

December 05, 2013 5:00 pm ET

Executives

Michael W. McCarthy - Vice President of Investor Relations

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

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

Analysts

Todd Coupland - CIBC World Markets Inc., Research Division

Kiera Kilkowski - BofA Merrill Lynch, Research Division

Richard Tse - Cormark Securities Inc., Research Division

Paul Treiber - RBC Capital Markets, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to Mitel Networks Second Quarter 2014 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to hand the conference over to Mr. Michael McCarthy, Vice President of Investor Relations. Sir, you may begin.

Michael W. McCarthy

Thank you, Sayeed, and good evening, everyone. I'm Michael McCarthy, Vice President of Investor Relations, and it's my pleasure to welcome you to Mitel's discussion of our fiscal 2014 second quarter results. Shortly after the market closed, the company issued a press release and filed its report 10-Q with the SEC. A copy of both of these documents are available on our website at mitel.com.

The replay of this conference call will be available through the close of business on Monday, December 9 at 5 p.m. Eastern Time. To access the replay, all callers can dial (404) 537-3406 and enter passcode 18304820. The webcast will also be archived on Mitel's Investor Relations website until the company reports its next quarter results.

On the call this evening is Rich McBee, Mitel's President and Chief Executive Officer and Steve Spooner, our CFO.

Before turning the call to Rich, I'd like to remind listeners of the live call and subsequent rebroadcasts that some of the statements made during this conference call are forward-looking statements or may contain forward-looking information within the meaning of applicable U.S. and Canadian securities laws. These include statements using the words target, outlook, may, will, should, could, estimate, continue, expect, intend, plan, predict, potential, project and anticipate and similar statements, which do not describe the present or provide information about the past. There's no guarantee that the expected events or expected results will actually occur. Such statements reflect the current views of management of Mitel and are subject to a number of risks and uncertainties. These statements are based on many assumptions and factors, including general economic and market conditions, industry conditions, corporate approvals, regulatory approvals, operational factors and other factors. Any changes in such assumptions or factors could cause actual results to differ materially from current expectations. All forward-looking statements attributed to Mitel or persons acting on its behalf are expressly qualified in their entirety by the cautionary statements set forth in this notice I am providing in advance of this evening's discussion. Undue reliance should not be placed on such statements.

In addition, material risks that could result -- could cause results of operations to differ include the merged companies' ability to achieve or sustain profitability in the future, fluctuations in the quarterly and annual revenues and operating results, fluctuations in foreign exchange rates, current and ongoing global economic instability, intense competition, reliance on channel partners for a significant component of sales, dependence upon a small number of outside contract manufacturers to manufacture products, the ability to successfully integrate the acquisition and realize certain synergies and our ability to implement and achieve our business strategies successfully. Additional risks are described under the heading Risk Factors in Mitel's annual report on Form 10-K and in Mitel's 10-Q for the 6-month period ended October 31, 2013, and filed with the SEC on December 5, 2013. Forward-looking statements speak only as of the date they are made. Except as required by law, we do not have any intention or obligation to update or publicly announce the results of any revisions to any of the forward-looking statements to reflect actual results, future events, developments, changes in assumptions or changes in other factors affecting the forward-looking statements. I would now like to turn the call over to Mitel's President and CEO, Rich McBee.

Richard D. McBee

Thanks, Mike, good afternoon, everyone. This is the most exciting time in my tenure as the CEO of Mitel. Consistent with our long-term strategy to drive profitable growth by leveraging our core strengths and rapidly expanding in the cloud and contact center space, in our Q2, our financial results, we continued to show solid business progress. The strategic investments we are making in growth areas, including cloud and contact center, are building momentum. We are adding depth and breadth to our management team and employee base in those areas to drive growth. Operationally, we are consistently delivering strong results, including in Q2, another excellent financial performance, with revenues of $144.9 million, record gross margins of 58.2%, sequential improvement in our EBITDA margins to just over 17% and cash generation that enabled us to pay down $20 million of our long-term debt early in November.

On this strong foundation, we have layered our ambitious and successful merger and acquisition strategy. The prairieFyre acquisition which we completed last June has quickly proven to be a key asset and a growth driver for us in the contact center space. More recently, with the announcement in November of our intention to merge with Aastra, we are poised to significantly expand our technology portfolio and geographic presence, giving Mitel a massive new market scale, one of the industry's largest customer bases, $100 million cloud business, including both direct retail offerings in the U.S. and global wholesale offerings through which we will enable cloud and a new global employee talent base. I'll discuss the status of the merger later in my comments.

These strategic business developments are designed to proactively and aggressively drive growth and profitability for our customers, partners, employees and ultimately, shareholders. Our experience and ability to successfully integrate and secure successive mergers and acquisitions while at the same time delivering solid quarter -- delivering a solid quarter, is a testament to the caliber of my leadership team and all of the Mitel employees. I want to take this moment to express my sincere thanks to them for their relentless driving of our business, the dedication, professionalism, talent and raw effort are the keys to our success, both in the past and more importantly, in the future.

Back in mid-September, we hosted an analyst meeting in New York where we provided more detail and perspective around our plans for delivering profitable growth. We outlined our market opportunities and our strategic plan to capture them. We raised the bar in the target model that we drive our business to daily. In the results we reported earlier this evening, we are pleased to see strong improvements in gross margin, cash flow generation and net earnings resulting from sequential growth we realized in our top line. Traction in our key growth areas, cloud and contact center, enabled us to shake off most of the headwinds thrown off in the final month of our quarter, which was also the timeframe that the U.S. Government experienced their shutdown. We are especially pleased that we were able to exceed expectations for earnings per share. This success and success in the quarters to come will further strengthen our leveraged business model.

The total number of Mitel cloud end-users increased 70% year-over-year to approximately 337,000 during the October quarter. In the subsegment we refer to as our retail cloud, we experienced extraordinary revenue growth of more than 200%. As we head into the holiday season, I want to take a moment to acknowledge the great work being done by the Mitel retail cloud customer, Operation Smile. They're an international medical charity providing cleft surgery to children around the world. Operation Smile had outgrown their capability and capacity of their digital phone system. Our MiCloud retail solution was a perfect fit for their 140 seats and a new contact center now enables their staff to reach out globally to prospective financial donors all from their headquarters in Virginia.

Also driving our cloud growth is the continued focus and business expansion from key partners like CallHosted, one of our European service provider customers that is leveraging MiCloud, powered by Mitel solution, to deliver solutions to their customers. CallHosted recently introduced Mitel's Orya provisioning platform, which allows customers to manage their own cloud communication environments directly without having to rely on external sources. CallHosted is one of the first partners globally to build a service on the Mitel or MiCloud platform and is now the first partner in the Netherlands to be Mitel Orya certified.

Our Contact Center strategy and focus continues to deliver outstanding results. The seamless and swift integration of prairieFyre into the Mitel organization has placed us in a great position to identify and close on many new opportunities. Year-over-year, our Contact Center seat count growth is up 52%. We are well positioned to grow faster than the overall market growth rate. Remember, this is a $5 billion global market. Our ability to surround customers with Microsoft Lync deployments with the Mitel Contact Center Solutions in a way that optimizes their overall business value and effectiveness is increasingly becoming an attractive and competitive differentiator for us, too.

I want to take this opportunity to congratulate European-based Mitel Contact Center customer TUI Services on being awarded the European Call Center Award for Innovative Travel and Hospitality Customer Care Solution. TUI uses Mitel's Contact Center to provide guest services with knowledgeable agent support via phone, email, SMS, text messaging. It's a winning solution that has provided customers in Germany, Austria, Switzerland, Poland and among others. TUI's technology partner was Belarus Vygon [ph].

Another growth area I want to bring your attention to is our services business. Historically, this part of the business has revolved around the repair and replacement of equipment in the field. As Mitel has evolved into a software-based company, so has the services segment. During the October quarter, these new services, primarily our software insurance programs, have grown to a level where they are now beginning to meaningfully contribute to the new services revenue. Our software insurance offering, which is a healthy margin business, grew to a rate that exceeded 20% year-over-year in which we expect will continue to grow as our products reach farther and deeper into the regional and vertical markets being served by Mitel. Our channel-centric go-to-market model continues to help Mitel's products and solutions expand into new regions with new customers. While we are continuously and selectively adding new high-performance channel partners, we are also aggressively managing our existing channel. In the second quarter, we continue to see impressive growth from our largest partners in the U.S. with the top 6 partners growing their collective Mitel revenue by approximately 40% on a year-over-year basis. In addition, we are seeing the early results of our strategic investments in our U.S. channel development team announced earlier this spring with the team driving a double-digit number of new channel partners signed in the last quarter and a significant increase in channel cloud demand in the last 6 months.

We continue to add senior sales leadership to expand our market presence and to position Mitel for market share gains. In Q2, we added Steve Kelly as Vice President of Global Cloud Sales based in the United Kingdom. Steve brings more than 25 years experience in the telecommunications industry. And his deep expertise in wholesale enterprise and mobile solutions will help us further drive MiCloud sales worldwide.

Similarly, as we position for growth and expansion in the Contact Center market, we also added Jeff Kroeger [ph] as Vice President for U.S. Contact Center Sales to focus and expand our traction in this key strategic growth area for us. I'd like to take this opportunity to welcome both Steve and Jeff to the team.

Finally, with respect to our proposed merger with Aastra, the updates I can provide you are fairly limited. But as announced earlier this week, Mitel has received approval from the majority of the company shareholders to proceed with the merger. The Aastra team is preparing for their special shareholders meeting, and we expect the date will be announced and proxy materials distributed over the next couple of weeks. We have also begun the regulatory review process for filing in Canada and France. In short, things are moving along consistent with the timetables we set out in our announcement on November 11. To the extent we can prepare for the integration, I can assure you we are. We have a tight and very capable team tasked with that job, but the majority of our management employees will remain focused on executing our strategy in our core business.

Before I hand the call over to Steve for his review of the financials, I want to emphasize for you what my personal priorities are for the weeks and months ahead. First, I'm relentlessly focused on ensuring that we continue to tightly manage Mitel, to further improve our overall financial performance and to deliver on the business commitments and targets we announced today. Second, in anticipation of the merger closing, I'll be working closely with the small and focused integration team to ensure that we are ready to hit the ground running day 1 and to quickly capitalize on the financial synergies and the massive market expansion opportunities we outlined for the combined company. And finally, I'm passionate about ensuring we bring the same management intensity, focus, discipline and rigor to the combined organization that has enabled Mitel to deliver the outstanding operating performance and the superior shareholder value that we enjoy today.

I will now turn the call over to Steve, who will review the financials. After that, we'll be happy to take your questions.

Steven E. Spooner

Thank you, Rich. Good afternoon, everyone. Before I start my review of the quarter, I would like to add my appreciation of the team as well for the outstanding work they did on delivering a solid quarter, as well as pushing through the Aastra due diligence and deal review process. Please note that I will be discussing our financial results on a U.S. GAAP basis, unless otherwise indicated. A reconciliation of non-GAAP to GAAP measures was included in our earnings release, which can also be found in the Investor Relations section of mitel.com.

The results for our second quarter were strong. We delivered revenues at the midpoint of our guidance, posted record gross margins of 58.2% and recorded a 20% sequential increase in our adjusted EBITDA. Our leverage business model continues to produce solid results in a challenging environment, thanks to expansion of our gross margins and ongoing focus on our operating spend. For the second quarter ended October 31, 2013, total revenues were $144.9 million, roughly flat with last year's second quarter and up 2.3%, sequentially. Mitel Communications Solutions, or MCS, revenues were $118.8 million, down 2.6% compared to Q2 last year and up about 1%, sequentially. The year-over-year decrease was a result of lower volumes in the U.S. in our direct premises base business, which was partially offset by strong cloud sales, as well as increased volumes in Canada and Latin America. The modest sequential increase was primarily a result of higher volumes in these regions.

Mitel NetSolutions revenues were $22.1 million, up 5.7% compared to Q2 of last year and up 1.8%, sequentially. As was the case last quarter, the increase in our NetSolutions revenue was driven primarily by growth in sales of our retail cloud services in the U.S.

On a geographic basis, revenues in the U.S. were $91.7 million, down $3.2 million over the prior year quarter and up $1.2 million, sequentially. As Rich spoke to earlier, the U.S. Government shutdown hit during the final month of our quarter and had a modest impact on our business, yet, we were able to deliver revenues at the midpoint of our guidance, which speaks to growing funnels and improved U.S. execution.

Europe, Middle East and Africa revenue of $35.5 million was down $2.2 million over the prior year quarter and up $0.6 million, sequentially. The year-over-year decrease was primarily a result of the lower business volumes in both the U.K. and Europe.

Canada and Caribbean and Latin America revenue of $12.8 million was up $4.3 million over the prior year quarter and up $1.7 million, sequentially, driven by very strong performance by both our Canadian and Latin American channels.

Revenue in Asia-Pacific of $4.9 million was up $0.5 million versus the prior year quarter and down $0.2 million, sequentially. Our gross margin for the second quarter was a company record 58.2%, an increase of 200 basis points from Q2 of last year and a 160 basis point improvement over our first quarter performance. The improvement in gross margin was primarily a result of higher margins associated with our Contact Center offerings, driven by our acquisition of prairieFyre, as well as improving service margins, given our growing services assurance mix and continued product cost reductions across the majority of our product portfolio.

GAAP operating expenses for the second quarter of fiscal 2014 were $75.6 million. Non-GAAP operating expenses for the second quarter of fiscal 2014 were $63 million or 43.5% of revenue. As a percentage of revenue, non-GAAP operating expenses were up 120 basis points from the second quarter of fiscal 2013, due primarily to the prairieFyre acquisition and the related increase in both R&D and SG&A spend. In comparison to the prior quarter, non-GAAP operating expenses were 90 basis points lower as expenses stayed practically flat while revenue grew by 2.3%.

R&D for the quarter represented 10.2% of revenues, up from 9.6% in the prior year and up from 9.7% in the first quarter. In absolute dollars, we increased our investment in R&D by $0.9 million year-over-year, primarily as a result of higher R&D spending associated with the prairieFyre acquisition. Sequentially, R&D spend was up $1 million.

Non-GAAP SG&A as a percentage of revenue was 33.3%, up compared to 32.8% in Q2 last year and down versus 34.7%, sequentially. In absolute dollars, we saw an increase year-over-year in non-GAAP SG&A expenses, driven primarily by the prairieFyre acquisition. Sequentially, non-GAAP SG&A was down about 2%. Stock-based compensation expense for the second quarter was $1.2 million, roughly flat with the $1.1 million recorded in both the prior year quarter and the first quarter of fiscal 2014. We recorded special charges and restructuring costs of $4.9 million in the quarter. The charges consisted of $3.2 million of restructuring-related expenses associated with previously announced restructuring actions, as well as $1.7 million of merger acquisition and integration activity, including diligence costs relating to the planned merger with Aastra.

Included in depreciation and amortization expense for the quarter was $6.5 million associated with the amortization of acquired intangible assets, up approximately $0.9 million from the prior year and $0.5 million in the first quarter as a result of the recent prairieFyre acquisition.

Interest expense for the second quarter was $6.5 million, up from $4.6 million in the prior year and flat versus the first quarter of fiscal 2014. The higher interest expense year-over-year reflects the interest rate on the new credit facility implemented in the fourth quarter of fiscal 2013. For the October quarter, we recorded a tax recovery of $2.6 million compared to a tax expense of $1.4 million in Q2 of last year and a tax expense of $1.4 million last quarter.

Mitel reported non-GAAP net income for the second quarter of $12.7 million or $0.22 per share compared with non-GAAP net income of $13.8 million or $0.24 per share in the second quarter of last year and non-GAAP net income of $9.3 million or $0.17 per share in Q1. The year-over-year decrease was due primarily to higher interest expense being incurred in the second quarter of fiscal 2014. The sequential increase in profit was a result of a combination of higher revenue levels and gross margin expansion.

Our GAAP base net income for the second quarter of fiscal 2014 was $5.4 million or $0.10 per diluted share. This compares with a net loss of $1.9 million or $0.04 per diluted share in the second quarter of last year and a net loss of $3.8 million or $0.07 per diluted share in Q1.

Adjusted EBITDA for the quarter was $24.8 million compared to $23.6 million for Q2 of last year and $20.6 million in the prior quarter. Our adjusted EBITDA margin for the quarter was 17.1%, up from 16.2% in Q2 of last year and up from 14.5% in the prior quarter and represents the second best quarter of EBITDA margin performance in our company's recent history. These increases were driven by an overall improvement in operating income, which I described earlier.

Let me now discuss quarterly metrics for each of our business units. Revenue from MCS consist of hardware and software sales and service. For the second quarter of fiscal year 2014, software comprised 82% of our MCS enterprise platforms and applications revenue, up from 81% in the first quarter of fiscal year 2014. Virtualized MCD solutions represented 34% of total MCD shipments in Q2, up from 20% in the prior year and 27% in the prior quarter. On the applications front, of our UC applications licensed in the second quarter, approximately 50% were virtualized, up from just under 40% from the prior year, however, down from 54% in Q1.

In our Mitel NetSolutions unit, we ended the quarter with approximately 8,800 customers. In the second quarter, our monthly recurring revenue represented approximately 72% of our total NetSolutions revenue. For our total business, monthly recurring revenue comprised 27% of revenue.

Moving now to balance sheet. We ended the quarter with $70.5 million in cash and cash equivalents compared to $55.3 million in the prior quarter. Our cash position is supplemented by an available and undrawn $40 million line of credit, providing us with $110.5 million of total liquidity. Shortly after the quarter was closed, we announced that we used $20 million of our cash balances to prepay long-term debt. This decision is consistent with the goals we have set out and most recently affirmed during our analyst meeting in New York this past September that being to use excess cash reserves to aggressively pay down debt. It is a signal that our business model is generating cash and more importantly, of the confidence we have in our business looking forward.

We generated $16 million in cash flow from operations, down slightly from the $16.7 million generated in Q2 of last year and an increase from $13.2 million last quarter with the sequential increase in cash flow driven primarily by the higher operating income.

Under our new credit facilities, which we announced in February, for the quarter ended October 31, 2013, our leverage ratio was 2.8, which compares favorably to a maximum leverage ratio of 4.0 permitted by the covenant in our first lien credit agreement. We've included our actual leverage ratios in the last 3 quarters in our 10-Q, which was filed today.

Our DSO for Q2 was 73.5 days, essentially flat versus the prior year and up slightly versus the 72.2 days in the prior quarter. Inventory turns were 9.7 for Q2, improved from 8.5 in the prior year and 9.2 in the first quarter.

We ended the quarter with total headcount of 1,727 personnel, up from 1,702 in the prior year and down from 1,745 in the prior quarter. The year-over-year increase in headcount was primarily a result of personnel we gained from our prairieFyre acquisition. The sequential decline was driven primarily by headcount reductions in North America related to previously announced restructuring actions.

Turning now to our business outlook. Please note the statements regarding our future financial performance targets are forward-looking statements.

I refer back to the forward-looking information caution we provided to you earlier on this call. We are providing the following financial outlook for the third quarter of fiscal 2014.

We currently expect revenues for our third fiscal quarter ending January 31, 2014, to be in the range of $145 million to $150 million. Gross margin percentage to be 57.5% to 58.5%. Non-GAAP operating expenses as a percentage of revenue to be 44.5% to 45.5%. This excludes estimated amortization of $6.5 million for the amortization of acquisition-related intangible assets and estimated stock-based compensation expense of $1.2 million.

So to summarize my review of the quarter, Mitel's execution of its growth initiatives and cost improvement programs continue to remain on track. We are decisively managing our business to add new capability and geographic presence to direct organic investment, as well as through a disciplined M&A strategy. We can move forward along this path as our balance sheet continues to strengthen and we demonstrate our ability to deliver results in a challenging environment.

Before I turn the call back over to Rich, I wanted to remind participants in the call this afternoon that we are continuing to move forward with our proposed merger with Aastra. As Rich mentioned, we are moving along the time line set out on our November 11 call. A key structural element to the proposed merger, which is intended to streamline all future reporting processes and improve our Investor Relations flexibility will have Mitel shifting its fiscal year from the end of April to a standard calendar year end and quarterly reporting cycle. Accordingly, Mitel will make the required calendar year filings in both Canada and the U.S. for the fiscal year ending December 31, 2013. In anticipation of an early calendar 2014 close and our deal with Aastra, the first quarter to be reported as a combined company will be for the period ending March 31, 2014. The 2014 March quarterly filings will be made by the required dates in mid-May. We will also provide to the investment community calendar quarter 2013 comparatives for their modeling use.

Once all shareholder and regulatory approvals have been received, we will be moving swiftly to integrate the 2 companies, generate the attractive synergies we have laid out for the combined company, leverage our global scale and combined portfolio strength to bring compelling solutions to current and prospective partners and customers. It is an exciting time at Mitel. With that, we will open up the call to your questions. Operator, if you could review the process for asking questions and open up the lines, please.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Todd Coupland from CIBC.

Todd Coupland - CIBC World Markets Inc., Research Division

I just wanted to ask a couple of housekeeping items and then I'll talk about the business. So, Steve, so I get Q1 is the first combined quarter. Will we see a 2-month Mitel quarter then publicly, or will the next report will be the combined Q1?

Steven E. Spooner

The next report will be the combined Q1. We will be filing a December Mitel-only set of financial statements, which essentially will be from May 1 to December. And that will be our transition then to a calendar reporting cycle.

Todd Coupland - CIBC World Markets Inc., Research Division

I see. When you file that, will you hold a conference call or will you -- that will just be filed?

Steven E. Spooner

I think we will likely just file it.

Todd Coupland - CIBC World Markets Inc., Research Division

I see. Okay. But the guidance is for the full 3 months, the typical third quarter -- fiscal quarter?

Richard D. McBee

Yes, it is. And as we thought about what was appropriate at this time, we continue to remain as separate companies and operate as separate companies. And frankly, the proposed deal has not yet been approved by the Aastra shareholders, so it's business as usual from our perspective from an Investor Relations perspective.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. Rich, I wanted to talk about channel execution. You made -- you threw a couple of statistics out there, wanted to go back to the 40% growth in your top 6 accounts and then adding channel partners double digits, so at least 10% in the quarter. How should we be reading into this in terms of share gains and the quality of the channel and things like that in the U.S. market?

Richard D. McBee

Yes, I think that share gains are -- will come with the fact that our biggest channels are very high quality channels. We're really aligning ourselves around strength in the marketplace. We're being a little bit more selective than we have been in the past in adding channel partners. So the gates that we take them through are a lot more significant than they might have been in the past. So we're really seeing in this marketplace that large partners have a lot of strength. The small partners provide us geographic reach. There's no question about that. But the very large partners can put a lot of time, resources, marketing dollars and that kind of stuff in it. So we're really making sure that we're getting the leverage through those. And I think eventually, it will start showing through in the aggregate set of numbers. I think that the channel partners that we're adding, as I said, we had double-digit add this quarter, and I don't have a target for -- I want to add double-digit partners every quarter. My target is adding high-quality partners in vertical segments that we don't have coverage. So we're not trying to create channel conflict here. What we're trying to do is selectively add partners that we really truly believe that we can get incremental reach and share gain from. And we have excellent streamline process now to on-board partners. And it -- we expect -- before, we were saying it would probably take 9 months to a year for a channel partner to get up and running. And with our new process that we have in place and the hug we put on them, we expect and we've seen channel partners, they start hitting stride in 6 months. So about 6 months is when we expect them to be up and running and self-sufficient.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. And that's just started now. So we should start to see second half of '14 some benefit from these gains and partners that you are talking about?

Richard D. McBee

Yes. We added a few last quarter, obviously. And we had the program to onboard them in the first phases, and that -- and we just keep building momentum. We brought some outside talent in to lead our on-boarding process with the channel partners, and it's really making a market difference. And I've heard back from channel partners that they're very excited about the quality and the attention that they're getting to bring them up to speed.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. And then I just wanted to ask a software question, if I could. So I'm not sure what to do with all the percentages that you give us on the MCS side of the business. Just in terms of total revenue, do you disclose how much of that is software content?

Richard D. McBee

We don't typically. I would say that, anecdotally, we've made comments that in a typical quarter overall software mix is kind of 40% to 50% being a combination of the software platforms and the software applications, but we don't routinely disclose it on a quarter basis.

Todd Coupland - CIBC World Markets Inc., Research Division

Okay. And that's been obviously trending up with the sub-stats that you're providing?

Richard D. McBee

It has.

Steven E. Spooner

Absolutely.

Operator

And our next question comes from Kiera Kilkowski from Bank of America.

Kiera Kilkowski - BofA Merrill Lynch, Research Division

I just had a few quick ones for you tonight. First of all, I wanted to talk about maybe some of the verticals where you saw some strength this quarter. I know you said government was obviously weak in the last month of the quarter, but could you maybe talk about if you're seeing some of those deals pull in, in this upcoming quarter? And then maybe if you could talk about what you're seeing in Europe? And then I just have one follow-up.

Richard D. McBee

Okay. I'll take the first part and then, Steve, if you want to add in. Some of the verticals that continue to be strong for us are the Education space, nonfederal government obviously. And the health care space and hospitality we're seeing really good growth in those sectors. In Europe, we're seeing -- our business in Europe is primarily large enterprise and it's predominantly in the U.K. and the Netherlands is the biggest piece of that for us. So we're seeing strong adoption in health care in the Netherlands. And then just kind of a broad-based set of business across the U.K. We're not seeing it wildly up but we're not seeing it wildly down. We've got a low-end product in the U.K. that's been gaining traction, but it's still a relatively small amount of the number. Steve, I don't know if there's any other color there?

Steven E. Spooner

Yes, and I think there were certainly a couple of opportunities we had in the Netherlands that we were hoping to get into the quarter but it slipped into the past quarter but we're looking very well positioned. But I think that was our...

Richard D. McBee

Yes. And I think the federal -- I mean, they're more like there's deals we've won. They're going to roll into the next quarter, we've just got to get them executed and know when it works, that's it. So it is stretched out.

Kiera Kilkowski - BofA Merrill Lynch, Research Division

Got it, understand. And then the second thing I wanted to ask about is cloud and Contact Center seem like they're doing really well. Can you maybe talk about the difference in the competitive landscape that you're seeing now that you're ramping up with those products and maybe why you think Mitel is winning.

Steven E. Spooner

Yes. So we have a very unique approach, I think, to the market, which is we view the cloud market as commodity cloud, business cloud and enterprise cloud. So if you think about very small- to medium-size business to large enterprise. And it's also one of the things we're very excited about Aastra coming onboard together because they have a very large enterprise, a great cloud solution, but what we're seeing in our Mitel AnyWare capability, and that's the retail cloud, is really focused down in the top end of the commodity cloud and the business cloud. So like the RingCentrals and those guys are predominantly down in the commodity cloud space. There's good growth down there, but the margins are obviously smaller. Where we actually play, we think is a very good place, because of the single software stream we have where we can not only provide a retail solution or provide cloud services, but we can also enable them. And so on the same software stream, the same products that we've developed, we can offer a retail cloud offering but we can also enable another third-party or a service provider to provide cloud services. So when we look at our cloud business we've got some really good, what I call, first multipliers in the large bars, black boxes, one of those that we talked about using our cloud service enabled by Mitel. At the same time, we're providing Mitel AnyWare. So our cloud strategy on a single software stream is really to be in it as a provider and an enabler. And I think over time, what you'll see is the enabler business will become significantly larger very fast because we continue to add bars and we continue to add service providers to our enabled by Mitel, or Powered by Mitel as we put in the marketplace. So eventually, those are going to come up and you got one Mitel selling Mitel AnyWare in the retail services but you have a lot of bars and a lot of service providers also providing that capability. And predominantly, overseas, we go with the Powered by Mitel, enable other people. So it's only really in the U.S. where we have a branded Mitel retail solution.

Steven E. Spooner

The other thing that I'd add, Kiera, is that as we go to the market with customers, we're not leading and saying, here is a cloud solution or here, we have a premise solution. We have the ability to offer both that allow the customers to make a choice, the choice of one or the other or a hybrid of the 2 and kind of migrate to the cloud at the pace that makes sense for them with, again, the same sets, the same applications, the common user experience and that's quite a differentiated approach versus some of the folks that are kind of pure cloud vendors.

Richard D. McBee

And we also see a good growth in public cloud but also see good growth in private cloud where a company is hosting its own cloud. So we can play them both on the same product basically.

Operator

And our next question comes from Richard Tse from Cormark Securities.

Richard Tse - Cormark Securities Inc., Research Division

What do you guys figure the impact of the U.S. Government pullback was on the quarter? I don't know if you can sort of frame a number on it but...

Richard D. McBee

Yes. We -- there's a lot of orders that are moving around but we think it's about $1.5 million to $2 million.

Richard Tse - Cormark Securities Inc., Research Division

Okay, okay. And then I know you talked about service assurance on the call. I guess, the first question is should I sort of view that as -- I think you talked about the recurring components. What was the percentage there again?

Richard D. McBee

Well, we grew 20% in the quarter, and this is going to be part of our long-term business model and gross margin improvement candidly. As our products are more software-oriented, they come with Software Assurance. The virtualized solutions that we prided in the marketplace we actually require Software Assurance. Every time we saw that, we get Software Assurance and that's the natural mix that you see in our company where traditionally, we were hardware-oriented, now we're software-oriented. And then, as we make that transition, the Software Assurance continues to be a larger part of the business, and Software Assurance has extremely good margins.

Steven E. Spooner

And regarding to your question, Richard, on the recurring revenue. The Software Assurance is certainly a component of the various recurring revenue streams that we have. We quoted 72% of our NetSolutions, the M&S revenues were recurring and for the total Mitel business, recurring revenues run about 27%.

Richard Tse - Cormark Securities Inc., Research Division

What would that number have been last year?

Steven E. Spooner

It's similar, actually. I think what's really happening in the mix of those recurring revenues is that we're seeing legacy hardware maintenance revenues, which are lower margin kind of the break/fix, dispatch a technician and a truck. Those revenues are declining and we're seeing a really nice growth rate in the Software Assurance revenues which are much higher margins, and that's helping contribute to the overall gross margin expansion that we're seeing in the business.

Richard Tse - Cormark Securities Inc., Research Division

And would you say that from your analysis of Aastra, they sort of have a similar profile or is it different?

Steven E. Spooner

No, I think that -- and they would certainly agree that we're further ahead in terms of traction with Software Assurance. It's a relatively new offering for them in the market, which we view as an opportunity, frankly. And I think we have a higher mix of IP-based products, which are -- it's more typical to see the Software Assurance attached to those. So -- but again, we look at that as the base moves forward and migrate towards an IP, whether premise or cloud-based solution, we'll have the opportunity to be selling the merits of Software Assurance as the base transitions forward.

Richard D. McBee

Yes. And I think that that's one of the things that we're excited about in this merger is the countries where Aastra is very strong in Europe, they're not at the same pace that the United States is in this transformation. So as they're transforming to IP and from hardware to software, it's at a little bit later stage and they're -- as they've already started in North America. So we're very excited by the opportunity to ride that wave as Europe starts to move heavily to software, too.

Richard Tse - Cormark Securities Inc., Research Division

Okay. And just a couple of quick housekeeping items. In regards to regulatory reviews that are still outstanding, could you maybe go through some of the major ones?

Richard D. McBee

Sure. There's really 2. One is an industry Canada or investment Canada review. And it's a surprise to most people but technically, given the fact that many of our shareholders are outside of Canada, were subject to an investment Canada review process, and that process typically takes kind of 45 to 75 days, and we're optimistic we'll be getting feedback likely early in the new year with respect to our application. And the other is the French government, and that really is driven more by the fact that there are significant customers in France, significant government customers in France, that trigger that review. We're -- obviously, we don't want to be presumptuous but we're cautiously optimistic that both of those approvals will -- we can look forward to those over the next month or 2.

Steven E. Spooner

Yes. And I think that majority of the French ones are more of -- they have contracted obligations to the government agencies, and they want to make sure that they will be continue to be serviced and supported, but clearly, we said they would be.

Richard Tse - Cormark Securities Inc., Research Division

And then just one final question, following up on Todd's question earlier. So am I correct in saying that the next conference call you guys would have would be, let's call it, April?

Richard D. McBee

April-May timeframe, where we do the first quarter results. Again, presuming the transaction moves forward, then that would be the first quarter that we would report as a combined company would be March and we'll likely be out in kind of the early May timeframe to discuss those results.

Operator

[Operator Instructions] And our next question comes from Paul Treiber from RBC Capital Markets.

Paul Treiber - RBC Capital Markets, LLC, Research Division

In regards to Q3, what do you expect to be the linearity over the quarter, and will the U.S. federal government shutdown that happened in October, will somehow flow back earlier in the quarter or spread throughout the quarter?

Steven E. Spooner

Well, our typical linearity is kind of, I would say, the last month of the quarter is kind of high 40s, mid-40s, depends on the quarter. And it -- we don't anticipate a significant change in the SKU in the third quarter. As Rich mentioned, it was a relatively small amount of business that was -- that we attribute was impacted by the government shutdown. Now with Christmas, we would expect that, that takes a week to 2 out of kind of typical customer buying in the month of December. So we might see more of a skew to the month of January than would be in a typical quarter.

Paul Treiber - RBC Capital Markets, LLC, Research Division

That's helpful. And then in regards to Aastra, I mean, I understand you're limited in what you can say, but your own business, have you seen any customers delaying or holding back deployments pending better visibility to the acquisition close?

Richard D. McBee

No, not really. And I talked with a lot of customers and obviously, I monitor with the senior management at Aastra, what their customers are saying. And what we've heard today is it's positive. So customers just want to make sure that one of the key things that happens to them is they're not going to get stranded and that they're going to have a path forward and we've been very adamant that that's -- we understand that. I mean, a lot of companies that have merged with European companies haven't done a good job of that. And we've learned from their mistakes. So we have a very definite and methodical process that we're using to make sure that we don't strand customers. Because really what we want to do is we want to take that large customer base that we got and we want to migrate them at their pace to the new products and services available provided by both companies. And that's that hardware to software, that TDM to IP transition that improves margins. So we're pretty excited about it, and the customer base really candidly hasn't seen anything as a negative.

Paul Treiber - RBC Capital Markets, LLC, Research Division

And then moving on to the cloud, your install base in the cloud is just over 300,000. That's, I think, about 3% of your 10 million total users. What's your sense of how many of your cloud users are upgrades from the install base versus new users? And then where do you think -- do you think big picture, long term, does your install base eventually move entirely to the cloud or do you think there will still be a chunk on them that will be on-premise?

Richard D. McBee

It's kind of interesting. It's a slow transition. When you look at a specific market like the U.S., it moves pretty fast but when you look at the global, I mean, I think that it's still 52% or 54% of the world is still TDM. So it's a big planet and these systems take a long time to transition. You've got to think about last year 98% or 96% or 94% of the market bought TDM systems -- I mean, IP systems that may be premise-based, they're going to have that system probably for 8 to 10 years. What we think is pretty unique about the capabilities we bring to the market is the fact that they can buy a premise-based system today, and we can move them -- the software is the same. We can just pull the server out. We can move them straight to the cloud through either ourselves or one of the enabled partners. And this is a big differentiator that we're trying to get people to understand is that they can move at their own pace and their time. So for a customer, it's right to move to the cloud, at 2 years where the traditional system is 8, they can do that without having to basically replace -- rip and replace everything they have. So the reality in this market is the systems that they use have a very long tail. They make a decision and they usually keep it for 8 years. If they want to refresh earlier, we're extremely well positioned to handle that. Cloud's going to grow -- continue to grow, I think, very fast in North America. And if you think about the 3 segments that I talked about: Commodity cloud, business cloud and enterprise cloud, very easy to change in the commodity cloud space. It gets more difficult as you go up the curve. You just don't switch that. Having said that, Marks & Spencer, as we've talked about in the past, is a great example of a premise-based system that moved to hybrid and moved to cloud with us. It's a 20,000-plus European retail chain. And so we were able to move them from premise to cloud and the whole group in 2 years. So if they want to go, they're ready to go. But most companies, it's going to be a long time as they make this transition.

Paul Treiber - RBC Capital Markets, LLC, Research Division

Okay. And then just one last one for me. On the cloud. On the economics of the accounting behind it, and I think most of you understand that the software revenue is recognized over 36 months. But on the handset revenue, is that recognized also over 36 months or is it recognized upfront and then does the cash flow match that recognition?

Steven E. Spooner

I mean, typically we find that the sets are sold upfront and then a monthly recurring fee for the service portion. So we would recognize the revenue upfront for the set and build that for collection on our normal credit terms. So there are exceptions, there are situations where folks will look for a kind of a combined offering, but the vast majority today we've been doing on a -- recognizing the sets up front.

Operator

I'm showing no further questions at this time. I would like to hand the conference back over for closing remarks.

Richard D. McBee

Okay. Thank you for joining us this afternoon. As Steve said, this is an extremely exciting time for Mitel. We're executing on our strategy to expand the core cloud and Contact Center, and we're seeing solid market traction and reaction as a result. Our strong financial performance and ongoing focus on our leverage business model continue to deliver balance sheet strength. We are looking forward to completing our planned merger with Aastra early in the new year and to working with them to further position Mitel for global market expansion and ongoing profitable growth. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect and have a wonderful day.

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Source: Mitel Networks Management Discusses Q2 2014 Results - Earnings Call Transcript

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