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Executives

Barry Hutton - Director, Investor Relations

Don Joos - President and CEO

Mike Healy - Chief Financial Officer

Analysts

Barry McCarver - Stevens Incorporated

George Sutton - Craig Hallum

Dmitry Netis - William Blair

Greg Burns - Sidoti & Company

Mike Lin - Stifel Nicholaus

Mike Latimore - Northland Capital

Rohit Chopra - Wedbush

ShoreTel, Inc. (SHOR) F2Q 2014 Earnings Conference Call January 23, 2014 5:00 PM ET

Operator

Good evening and welcome to the ShoreTel’s Second Quarter Fiscal 2014 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions). After today’s presentation there will be an opportunity to ask questions. (Operator Instructions). Please note this event is being recorded.

I would like to turn the conference over to Barry Hutton, Director of Investor Relations. Please go ahead, sir.

Barry Hutton

Hello and thank you for joining us today, as we report the financial results for our fiscal second quarter of 2014. Joining me on the call today are ShoreTel’s President and Chief Executive Officer, Don Joos; and ShoreTel’s 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 margins, operating expenses and other financial and business related information. The 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, 2013 its 10-Q for the quarter ended September 30, 2013 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 is done in a public forum. Additionally, ShoreTel maintains a presence on Facebook, Twitter and Google Circles, that it uses from time to time to republish company news.

We will be discussing both GAAP and non-GAAP results throughout this call and I ask that you to refer to our press release issued today for the reconciliation between these amounts. Our non-GAAP numbers exclude stock-based compensation charges, amortization on acquisition-related intangibles and other adjustments and their related tax impact. After the prepared remarks, we will host a question and answer session. And we ask that you please keep your questions to the operational and financial results announced today.

And now I’ll turn the call over to Don.

Don Joos

Thanks, Barry. Welcome to our conference call to our fiscal second quarter. Over the past few quarters, we've continued our business momentum by fully integrating the organizational structure, executing the product road map, implementing key sales initiatives and investing in our infrastructure.

Our Q2 financial and operating results clearly reflect this momentum from the team's ongoing work. Our strong Q2 performance was reflected in our solid revenue, earnings and cash flow results. Our total revenue was $84.5 million represents 13% year-over-year growth. Again, we achieved meaningful growth in all three revenue lines, highlighted by the expansion of our cloud business, which was up 27% year-over-year.

Our annualized run rate of our recurring revenue, which is a combination of hosted recurring revenue and support revenue is now $126 million. 20% higher than it was last year. This predictable revenue stream continues to become a larger part of our business model and now represents 37% of our total revenues. We anticipate recurring revenue will be 40% of our total revenue base by the end of the calendar year.

In total, the solid results across the company drove a non-GAAP net income of $3.2 million or $0.05 per share. During the quarter we also generated substantial cash and paid down $9 million of our credit facilities. We now have a net cash position of $48 million which is up a 117% since the start of our fiscal year in July.

As I look forward to the next 6, 12 and 18 months I am increasingly excited about the significant market opportunities that lie in front of us. Recent economic reports indicate that our target customers, small and medium-sized businesses continue to grow and increase employment. Meanwhile the changes in the unified communications industry are driven by both technology advances and new (inaudible) trends. The overall conditions of this environment are driving tremendous growth in the cloud communication segment and we are definitely grabbing our share of the opportunity.

However we believe the total communications industry has three primary components; premise, cloud and hybrid. The assets we have in place to address each component can be leveraged to target the others. In particular we have a large premise install base that provides cloud cross-selling opportunities. We also have a mature channel partner network and an established sales force which is now more aggressively target cloud opportunities.

However despite the tremendous growth in the cloud segment the transition to cloud will not be completed over the next two to three years. Today the premise market segment account for approximately 90% of global UC revenues and analysts expect by 2017, the split will be roughly two thirds premise and one third cloud. Financially, we are able to leverage premise’s high gross margins to help fund initiatives in our cloud business.

These initiatives whether in the form of growth or infrastructure will benefit our cloud business for years to come. It’s clear that the cloud segment presents a large long term and rapid growth opportunity for us. We are committed to becoming the leader in the unified communications as a service base. Today, we are the number two player in the segment, and we continue to make investments in our sales and marketing efforts.

Some of these actions are already underway, so let me provide an update on our growth initiatives. Our first growth catalyst is enhancements to our channel partner program which was launched in early January and involved the collaborator data program with our existing channel partners. These program enhancements along with sales organizational changes represent a major growth investment. By leveraging our existing premise channel partners; we immediately obtained a highly productive network with existing customer relationships in key geographic markets.

Our experience has shown the channel partners routinely attract larger customers, which will advance our business model with the potential for larger average revenue per customer and lower churn. In addition, our partners will be opt to offer our new hybrid solution ShoreTel Connect to up sell their existing premise install base.

In cloud part, the channel program operates in three categories. Most participating partners have completed a certain level of product education, sales training, and agreed to a contemplation plan relating to one of the three following program categories. First, our total partners identify customers interested in the cloud solution and refer the opportunity to ShoreTel’s direct sales team. These referral partners do not have a specific volume commitment.

Second, our approved partners have completed training on the ShoreTel Sky product and they will identify and initiate the sales discovery process, before the ShoreTel sales team is engaged to close the deal. Our approved partners make annual volume commitments representing a given level of monthly recurring revenue or MRR. And third, we initially have six partners participating in the enabled category including a number of larger partners, some of which are passed supple excellence layers. Our enabled partners have received expensive training on ShoreTel Sky products covering both technical and sales components. Our enabled partners own the entire sales process start to close.

The enabled partners also make annual volume commitments to generating monthly recurring revenue. I am very pleased with our partners’ initial enthusiasm for the overall program enhancements. Each quarter we expect to grow the number of participants in the program by signing up more of our existing premise partners and also attracting net new partners.

In addition overtime, we anticipate that some of the partners will migrate to different categories within the program. Our second catalyst for growth is the integration of our premise in cloud sales teams. This also was implemented in early January and now all sales and channel efforts are under the leadership of David Petts, Senior Vice President of Worldwide Sales.

In conjunction with the integration a select move of our premise sales team received training on the ShoreTel Sky products and started to carry a cloud quarter which is incremental to their existing premise quarter. And finally the third catalyst is the availability of a 400 series phones for cloud customers. I am pleased to see this product now available for our sales team and applicable partners. Although the sales cycle will most likely not produce bookings until later this quarter, it is an important milestone for growth and demonstrates our continued focus on execution. So, I am pleased that the sale process has started.

In December, we hired Mark Roberts to be our Chief Marketing Officer. Mark brings 20 years of experience, largely tied to the unified communications industry. As such, his background is extremely complementary to our strategy direction and our growth initiatives and he will play an instrumental role in executing our plans.

I previously stated that the company’s focus on predictable execution, both financial and operational is a priority for me and the employees of ShoreTel have been doing an excellent job to make this a reality. The combination of a 400 series phones, the implementation of the channel program enhancements and the sales team integration are important execution milestones and key catalysts for our growth in cloud.

These initiatives enable us to leverage the strength of our mature channel network which we have built over many years and take advantage of one of the major synergies that was identified as part of our cloud acquisition. This is a distinct advantage as it cannot be easily or quickly replicated.

During the October 2013 conference call, I also committed to deliver several significant milestones on our operational roadmap. The team has remained focused and I am pleased that we are meeting these commitments.

In November, we made the 400 Series SIP phones available to all premise customers. These phones have advance functionality and diagnostics and intuitive interface and several ergonomic advantages. Although it is still early in the lifecycle, we have seen good adoptions of the phone so far.

In December, we launched our enterprise contact center 9.0 with enhancements designed for our larger contact center customers. Specifically, it improves the handling of multi-channel and mobile device interactions, so that call center agents can service customers through separate channels, including integrated chat, web, voice and email or agents can communicate simultaneously through multiple channels. This enhanced solution gives us an opportunity to upgrade our offering to both the new and existing customers.

We also achieved a critical milestone related to our most significant infrastructure investment, our data center migration into our new co-location facility in Dallas, Texas which will support our rapidly growing cloud business.

In December, we provisioned our first new cloud customer at this data center. In January, we started the migration process of our cloud installed base from the New York data centers into the new facility. We continue to expect to be substantially complete with all migration work by the end of the June quarter and we'll maintain our backup facility in Chicago to ensure service availability.

As a reminder, the June quarter will begin to reflect the benefits from the new cloud data center facility, including a 10x improvement in capacity, enabling cost effective growth, the 67% reduction in energy cost; improved reliability as Texas has the highest rated power gird for reliability in the United States; a key security investment in firewall and intrusion protection services ensuring a highly secured experience for our customers.

In early February, the next software version of our ShoreTel solution will become generally available and deliver virtualization to our customers. Given the improved infrastructure and market understanding, the time is now to improve call control, conferencing and collaboration in our virtualized solution.

We remain on track with our commitment to launch the first element of ShoreTel Connect in the June quarter. ShoreTel Connect enabled our premise customers to purchase specific applications on a subscription basis. ShoreTel Connect matches our vision that the UC industry will see a multiyear transition. It represents an important cross-sell opportunity aimed at our growing premise installed base of over 30,000 customers, representing over 3 million end-users.

Let me provide a simple example of the potential of this opportunity. If we were to cross-sell applications worth $10 of monthly ARPU and we achieve an application attach rate of just 5% of the 3 million plus end-users, we have the potential to generate approximately $20 million of annual recurring revenue just from this example. This is a market opportunity that is uniquely available to ShoreTel.

Before I ask Mike to detail our financial results, I want to reiterate my excitement about the market opportunity that lies in front of us.

During Q2, our Cloud business again added over 200 new client logos to our installed base, bringing our total to over 3,000 cloud customers. We now have a 135,000 seats deployed which is a 40% increase over Q2 of last year. Meanwhile our premise business also continued its momentum by adding over 1,100 new customers to our installed base. The North America sales team maintained its annualized productivity rate of 1.6 million per sales rep. Our ability to continuously outpace the market reflects our dedication to providing the best possible customer experience.

ShoreTel’s analytics show that ShoreTel customers who feel they receive the best customer experience will want to spend at twice the level as other customers. So for us, customer experience is not simply a marketing tagline but a core element of the company’s culture and a key business measurement that drives our product development, our sales processes and our overall customer support.

For the first half of fiscal 2014, we once again earned a net promoter score above the world class benchmark. Our focus on the customer’s primary needs was also recognized by Frost and Sullivan, which named ShoreTel as North America’s Company of the Year for Unified Communications and Collaboration. Frost and Sullivan stated that our ability to consistently help customers improve productivity and accelerate business processes have positioned ShoreTel for long term and sustainable growth.

We will continue to move forward with our aggressive road map. And I am confident that we will continue to hit our key milestones on time and on schedule.

Now, I’ll ask Mike to provide the financial details and then we will open the call for your questions.

Mike Healy

Thanks Don. Good afternoon everybody. As Don mentioned, during Q2, we continued to execute on our key business initiatives and we fulfilled one of our major goals this quarter, which was to get our new data center up and running. We showed excellent revenue growth in all three revenue lines in the second quarter and delivered total revenue of $84.5 million which was up 13% year-over-year, driven primarily by our growth in our cloud revenue.

It’s important to recognize that our business model is driving increased predictability of our revenue stream and our recurring revenues continue to decline. Total company non-GAAP gross margins in the second quarter was 60.7% which is down from 61.8% a year ago, reflecting the grown portion of our cloud business.

The company’s revenue growth was led by our cloud business which had $21.7 million in revenue in Q2, a 27% increase over the prior year. In general, our channel partners refer roughly 60% of our quarterly cloud bookings with the balance coming from our direct sales and marketing efforts. In Q2, we booked over 200 new cloud customers for the fifth consecutive quarter.

Now let’s talk about some of our key metrics for our cloud business. Our average member of seats per customer of 44, in Q2 grew slightly as our installed base added more seats across the organization.

The ARPU of $45 is down from last quarter as fewer new customers are buying network circuits applied by ShoreTel Sky as part of our offering. In fact that rate at which new customer locations are choosing to obtain network circuits from us has reduced by 50% over the last year.

In addition, some of our installed base of customers continues to grow by adding seats or upgrading their service, which may result in pricing adjustment upon renewal, which can also put down more pressure on ARPU. The average revenue per customer is a metric that we've included in our press release table this quarter, and it is simply ARPU multiplied by our average number of seats per customer.

In Q2, average revenue per customer was $1,982 per month. The trend in this metric shows that the decline in ARPU is partially offset by the increasing size of our customers, which ultimately drives more profitability as we get more economies of scale from larger customers.

And finally, the revenue trend in the cloud business remains steady at best of breed levels of only 0.3% per month or slightly under 4% annualized. The cloud non-GAAP gross margins in Q2 were 39.8%. The year-over-year and sequential decline primarily relates to increased telecom regulatory fees as well as the start of datacenter cost associated with opening our new facility in Texas, while we maintain the New York City locations.

Beginning in the June quarter, we expect to start seeing cloud gross margin expansion as most of our customers will have migrated to the new data center and we’d be getting to wind down our data center cost in New York City.

I also want to remind you about some components of our cloud gross margins. As part of our commitment to our customers to provide a complete cloud UC offering, we offer private network circuits to our customers. This offering has lower gross margins for us and generally has 10 to 12 point negative impact on our overall cloud gross margins.

The trend of fewer new customers [approaching] network circuits will provide a gradual benefit to our gross margins, while given the size of our installed base it will take sometime for this positive impact to become evident.

In addition, our lower margin non-recurring revenue such as regulatory fees and installation charges also negatively impacts our cloud gross margins by roughly 10 to 12 points each quarter. As such, when we evaluate our cloud business we consider that our base UC service without private network circuits and non-recurring charges has gross margins in the mid to high 60% range.

Now moving on to our premise business, which continued to show very solid results? Our recent industry analyst forecasted IP telephony market indicates that premise sector will grow a mid single-digit percentages over the next four years. In past years we have consistently outperform the broader market usually by a wide margin.

During the second quarter our premise business maintained its strong momentum with revenues of $62.8 million representing 9% growth over the year ago period. The growth in Q2 came mostly from our larger U.S. based channel partners and our service providers who grew 17% and 14% respectively year-over-year.

Our larger service providers AT&T and CenturyLink both showed strong growth in that category. Our international revenue grew nicely and was $8.3 million or 7% higher than a year ago period and grew to 13% of our total premise revenue in Q2. Canada showed the best growth year-over-year of all of our international locations at 19%.

Product revenues of $46.6 million were up 6% year-over-year, which is an acceleration over the last quarter. Sequentially, our product revenue decline is 2% as we've leveled out some of our quarterly seasonality between the September and December quarters. We sold approximately a 136,000 licenses in our premise business in Q2.

The global support and service organization continues to be a bright spot in the company. Q2 support and service revenue is $16.2 million is up 18% year-over-year and 2% sequentially. Support bookings exceeded expectations and helped to grow our deferred revenue on the balance sheet.

New premise customers support agreement attach rates continue to be in the high 90% range and our existing customers renew their support contracts in the high 80% range. This high margin business is a valuable part of our recurring revenue base and contributes stability to our gross margins and generates significant cash flow.

Our Q2 non-GAAP gross margins of premise business were 67.9%, an improvement of 60 basis points from Q2 of last year. The product non-GAAP gross margins were 65.5%, which was a 70% basis point below Q2 last year. Product gross margins in Q2 were negatively impacted by an increase in cost of sales caused by standard cost change for one new product. As this inventories fell through in future periods, we will see the offsetting benefit to that Q2 impact overtime.

Now the non-GAAP gross margins in our service and support business remained very high at 74.8%, which is an improvement of 410 basis points over last year and up slightly from the prior quarter as we continue to offer additional services and applications that our customer clearly value, while keeping our cost relatively constant.

Last quarter and today you heard Don speak to our successful actions integrate and streamline the company. These actions continue to deliver benefits in our operating expense levels. In particular, our Q2 expenses received a four quarters benefit from the reductions made in August. As such, our non-GAAP operating expenses of $47.4 million or the decrease of 2% year-over-year and nearly $500,000 lower than last quarter. The growing revenue and streamline and expense space plus to a non-GAAP op expense as a percentage of revenue level of 56% compared to 65% a year ago.

In the second quarter, we earned non-GAAP operating profit of 4.6% or $3.9 million and non-GAAP net income of $3.2 million or $0.05 per share. This represents the third consecutive quarter of sustained non-GAAP profitability and leaves no doubt we will have non-GAAP profits for all of fiscal year 2014.

Our financials also improved on a GAAP accounting basis year-over-year with our growth profit dollars increasing by 14%, while op expense declined 6% as we had some large tele contract adjustments in the December 2012 quarter and our stock compensation expense has come down by $1.4 million year-over-year, which is a 45% reduction in that one area.

We ended the quarter with a GAAP operating loss of only $175,000 and our GAAP net loss was $940,000 or just $0.02 per share compared to a net loss of $10.4 million or $0.18 per share last year.

At this point, let’s shift the discussion on the balance sheet and cash flow. As of December 31st, we had cash and short-term investments of $57.3 million. We generated $13.5 million in operating cash flows reflecting the improved bottom-line and another stellar quarter of improvements in working capital. In addition, depreciation and amortization was approximately $4.5 million in the quarter, of which $2 million was associated with acquisition-related intangibles.

As expected, in Q2, we had $6.2 million in capital expenditures which was mainly due to our data center migration that Don discussed earlier. As a result, our free cash flow was $7.3 million. Looking forward to Q3 and Q4, we anticipate our capital expenditures to be substantially lower than Q2 levels as most of our initial data center investments have been completed and we have no other major capital projects planned for the rest of the fiscal year.

During the quarter, we voluntarily reduced our line of credit by $9 million, which brought our outstanding debt balance down to $9 million. At quarter end, we had net cash of $48.3 million, which is a 117% higher than it was just two quarters ago.

For Q2, days sales outstanding were 32, as accounts receivable and total revenue were both flat. Our inventory went up $1.7 million in Q2 largely related to the build-up of some of our new products. The rapid growth of our support and service business led to the increase in deferred revenue of $3.3 million in the quarter and on a year-over-year basis has grown 17% to a balance of $61 million as of December 31st. And finally, we ended the quarter with 925 employees, a decrease of [70] from Q1.

Those comments summarize our financial results for Q2. Now I want to provide some insights for the business outlook for Q3 that we've included in our press release this afternoon. In relation to our expectations for the full 2014 fiscal year, we are maintaining our cloud revenue guidance of year-over-year growth in the mid 20% range over fiscal 2013 levels, which was $70.2 million.

For the third quarter, we expect total revenue to be between $80 million and $85 million. As you know our cloud and support businesses both produce recurring revenue and we expect both lines will continue to show steady revenue growth for the foreseeable future. The fluctuations in our total revenue are typically driven by our premise product revenue which has some seasonality.

For example in Q3 of fiscal 2012, we saw a decline of $3.8 million from December to March quarters in this revenue line. In contrast, last year’s March quarter increased by $1.7 million from December as we had an unusual amount of deals push-out from the December quarter into the March 2013 quarter.

As we consider this year’s Q3 guidance, we have based our estimates on the fact that we did not see a meaningful level of push-outs this past December. Thus we have based our Q3 guidance this year with the anticipation of a sequential decline in the premise product revenues for the March quarter.

For the third quarter, we expect non-GAAP gross margins to be in the range of 61% to 62% with GAAP gross margins of approximately 59% to 60% due to an inclusion of approximately $1.4 million in amortization of acquisition-related intangibles and stock-based compensation charges. Our expectation for non-GAAP operating expenses is in the range of $48 million to $49 million and we expect GAAP operating expenses to be in the range of $50.5 million to $51.5 million including approximately $2.5 million in stock-based compensation expenses, intangible amortization and other costs.

We expect operating expenses to increase over Q2 levels mostly due to some key hires to support our growth and an increase in payroll taxes as the new calendar year starts. It was another stellar quarter for ShoreTel marked by excellent revenue growth, profits and cash flow generation.

With that I will turn it over to operator for some questions and answers.

Question-and-Answer Session

Operator

At this time we will begin the question-and-answer session. (Operator Instructions). And our first question is from Barry McCarver of Stevens Incorporated.

Barry McCarver - Stevens Incorporated

Hey good afternoon, guys. Can you hear me?

Don Joos

Yeah Barry. How are you doing?

Barry McCarver - Stevens Incorporated

Good, good quarter. So I guess a couple of questions. First off can you talk a little bit more about the salesforce? And you mentioned portion of the salesforce now is carrying a quota for cloud, could you just help what that percentage is and how you expect that to change over the course of the next year?

Don Joos

Hey Barry it’s Don here. So our approach in there is a phased approach similar to how we are working with our partners we are doing the same with our sales, we are phasing them in. And so each quarter we will be gradually adding more and more as they go through the training and so we’ll continue to open that up right now. We haven’t provided the exact number though as it relates to a percentage but we are taking a phased approach to that. So each quarter you'll see more.

Barry McCarver - Stevens Incorporated

Okay. And then you mentioned the channel partners. On those level three partners, the enabled partners. I believe you said you'd start off with three, but there was potential for growth. How important, I am sorry, you said six and that should grow. How important is it, so that's fixed to grow pretty quickly and what should we think about over the next couple of quarters. Can that go from 6 to 12 or is more like 6 to 7?

Don Joos

Yeah. I think, I would not say it's 6 to 7. Again we're going to take a step function to make sure that everything is operating on all [cylinders] because it's not the more the matter here, this is about getting the value to us. The partners’ enthusiasm is high, because they see the opportunities that they are facing in the marketplace. So, they do want to get in. We need to make sure that we are very focused on how we on-board them, how we train them to make sure that we get the full success out of this. So you are right, we have 6 right now and then we'll keep rolling from there, but it won't be a [lengthy choosy] approach.

Mike Healy

Barry, as Don said interest level is high and earlier indications are a lot of our (inaudible) zones and our top partners on the premise side, our Edge has started selling cloud services and there is a few of them, 6, we've already signed more in the pipeline. So that's an excellent sign that it's our largest partners are signing up to be an enabled partner to sell cloud services quickly.

Barry McCarver - Stevens Incorporated

Okay. And then just lastly I guess thinking about the broader market that was some interesting analytical data you shared on the on-premise market for growth. It seems like that's a bit of a revision upward from what we were thinking on the total on-premise market would look like last year. I think that was probably a little bit better. Is that right? I mean are we feeling better about on premise, because that I think at one point the industry guys were thinking it, would be in decline?

Don Joos

Yeah. I mean what Mike has shared I think in there is just the recent market data that we had available to us. My view Barry is that whether the premise was flat or was increasing or declining. My view is that we will continue to outpace the market and I feel very confident about that right now. But yeah, the market data of recent that Mike shared has shown I think over the last couple of years some single-digit growth there.

Mike Healy

Yeah. That’s over a four year period Barry. So I mean we are thinking about this, the industry analysts are modeling a flattish growth on premise, what we do internally and how we manage the business we will certainly been conservative around that assumption.

Don Joos

Yeah. We’ve taken down our cost model that’s what I’ve said previously is that we have taken a conservative assumption with our cost model to make sure our cost is aligned and if we do better on that revenue line then we create leverage for the business.

Operator

And our next question comes from George Sutton of Craig Hallum.

George Sutton - Craig Hallum

Thank you. Don you provided I thought good clarity around the partner program I wondered if you could give us a sense of whether those breakdowns for what you’re anticipating them to be in other words the number of referral partners versus approved versus enabled or are you managing those numbers more than we might realize?

Don Joos

I think the program one was as I’ve mentioned was we worked very closely with the existing channel partners, that was very collaborative, both in the operations as well as the economics of it. There are these existing partners within our cloud business that roll under these enhancements. So there is an existing base of partners that we have. As I mentioned the enabled category is a new part to the program and that is where we are taking as I said a controlled approach, a phased approach in its early stages to make sure we have everything correct, and then we’ll continue to keep adding from there.

George Sutton - Craig Hallum

You defined ShoreTel Connect for most of your partners as an up-sell program; obviously they are working primarily with premise based customers. Is there the potential? I would assume those partners are also seeing just inbound interest from a pure cloud basis, and that do you expect to see some of that from those partners as well?

Don Joos

Absolutely, absolutely, and so that’s why we have the overall ShoreTel program. We have these enhancements from a referred and approved and an enabled because we do see a lot of premise partners having this opportunity. And so they want to come over and be a part of these categories also, whether it’s in the form of Connect; whether it’s in the form of net new business and so forth. So whether it is the ShoreTel Connect attracts them, whether it’s the ability to have the 400 series phones to cloud customers, yes, I do see partners wanting to come over to that. And like I said, there is definitely enthusiasm within the partner base right now because they have the opportunities in front of them.

George Sutton - Craig Hallum

Got you. Lastly for me, I thought it was interesting you provided a sense of what the cross-selling initiative might generate in terms of an ARPU impact and using attachment rate assumptions, but can you give us a sense of kind of the range of what would make you happy over a period of time relative to those cross-sell efforts?

Don Joos

I don’t know if I have a specific number that would, as you said, make me happy. What I see is the potential. And anytime a partner has the ability to go back and bring value added services to their installed based is a wonderful thing. Like I said, there is 3 million customers out, there 3 million plus customers out there. So, I was using the math as illustrative for the art if possible. I think the other point is that how important our installed base is as a part of our growth strategy because we talk a lot about our premise and installed. The premise and installed base has a lot of growth potential not just from premise sales that we’re doing very well with, but that cross-sell opportunity just opened it up. So for us, it’s wonderful; I think for our partners it’s also wonderful; and I think it’s great for our customers too because this gives them options of flexibility of how they want to purchase their applications.

Mike Healy

Yeah, what I would add George is there is some applications that are probably better served via cloud or usage model than a premise model for instance like mobility. And so that's where we think there is mobility conferencing if you like that works. It’s a more variable cost structure for the customer. And so I think the adoption rate will be a lot higher than it is on the premise side. So that's why; and we’ve got many of those apps that can come in and sell to our premise customers over time as part of our cloud service.

Operator

And next we have a question from Dmitry Netis of William Blair.

Dmitry Netis - William Blair

Great quarter, guys.

Don Joos

Thanks Dmitry.

Dmitry Netis - William Blair

A couple of questions, I wanted to touch again on the guidance, a little bit lower than where the street is. And sort of I’m trying to gauge the level of conservatism if there is any in here. Certainly linearity seem to have been pretty good in the December quarter, you had this huge ramp in deferred revenue. And by the way, if you could walk us through what goes in that deferred and what sort of the timeframe of that moving into the P&L, that would be great as well? But just on the guidance for March quarter, if you could sort of give again, puts and takes and how conservative you think you are?

Don Joos

Sure Dmitry; it’s Don. Let me take the first part and then I’ll let Mike make some comments and also touch on the deferred part. Yeah, so as we look at the guidance, as Mike has highlighted in there, breaking it down into the three areas, we reconfirmed our commitment as it related to the host of other cloud revenue being in the mid 20s. Our support revenue which is also high margin, Mike highlighted we are going to continue with that sustainable growth; if you look back over the last couple of quarters that’s been growing pretty steadily our overall service and support of about 17%, 18%. The seasonality component would be on the premise product revenue. We did smooth some things out from a Q1, Q2 perspective and Q4 as we have changed in the September that’s when our partner year ends versus ShoreTel’s fiscal year ends in June. And that did help smooth some things out. You have some natural activity that occurs as a part of a calendar year when a lot of companies are on a budget cycle there.

So as we looked at a variety, data points, one data point we did look at which is just some of our historical of what happens between the December and the March quarter. And so we used -- that was one data point we used to guide us in there. And that’s why specifically for the product, premise product that’s why we were kind of guiding in that range because trends have indicated that. I think last year we had some pushes which kind of skewed some data points, so we didn’t want necessarily just leverage last year as kind of a reference point for us. But again, I think our cloud revenue and our service and support revenue is substantial there. And then as I said, we are taking that approach from a premise product revenue.

Mike, maybe you comment on the deferred revenue.

Mike Healy

Yeah. So on -- just a reminder on deferred revenue, where that comes from is all from our premise support maintenance contracts which customers sign up for one, three or five years, the majority are one year contracts. So we bill and collect those upfront. Most of that business goes through our partner base who then sells to the end customer. And so that $60 million in revenue, a large chunk of that is revenue coming over the next 12 months as most of the contracts are one year support contracts. And so, why it's been increasing, it’s just been doing a very good job on bookings in the support business. And our business is tending to get a little bit higher percentage of support billings than it has in the past in terms of the overall split between product and support. So, that's a huge asset. You can count on; most of that $60 million come into the P&L in terms of revenue over the next 12 months.

Dmitry Netis - William Blair

That's helpful. And is there a seasonality or specifically seasonality of quarters where whether kind of take up of that deferred into the P&L is greater?

Mike Healy

No, I mean…

Dmitry Netis - William Blair

Evenly spread out over the next 12 months?

Mike Healy

Yeah, evenly spread out, the majority. And there is a little bit of seasonality in the service piece of the service and support business which is training, installation and professional services. That kind of follows the product line to some extent. So that maybe a little lumpy quarter-over-quarter but no seasonality on support.

Don Joos

This quarter is fairly consistent just by increasing from an attach rate, increasing renewal rates as well. Customers who were not under support i.e. time [interval] actually taking support contracts. And that's just been -- those three primary levers have been steadily picking up.

Operator

And next we have a question from Greg Burns of Sidoti & Company.

Greg Burns - Sidoti & Company

Good afternoon.

Don Joos

Hey Greg.

Greg Burns - Sidoti & Company

A question on the cloud business, one competitor out there in particular making a big international push with the implication being to better serve multinational mid market customers. What are your thoughts about international expansion, future?

Don Joos

Sure. Yeah, let me grab that one. Yeah, so from international, international is an important part of the growth strategy. We have our priorities set and we are executing against them and that's what getting us our momentum right now. And I’ve highlighted a lot of our priorities as it relates to our catalyst for growth in those specific growth initiatives. And so what we need to do is we’re staying focused on our priorities which right now that has a lot been on the infrastructure and in the data center as well as on the U.S. market. We’re going to our strategic planning process of which international used a component of that strategic planning and we see that a part -- has a part of our FY15 plan. So, it’s absolutely important or just -- and how we’re prioritizing it, that’s where it’s going to fit.

Greg Burns - Sidoti & Company

Okay. And then just on the premise side of the business, could you just give us any kind of qualitative color on what the pipeline looks like, sales cycle, deal sizes, just any color on what the market looks like?

Don Joos

Yeah. Just I mean from a general perspective kind of in the areas that you’re indicating, I don’t know if I would say our pipe and our sales funnel in its various stages continues to -- I feel continues to be strong in supporting the numbers that we have whether it’s deal size or competitive nature of those things, not really material change from a quarter-over-quarter perspective, so not much more than that.

Greg Burns - Sidoti & Company

Okay. Thank you.

Barry Hutton

Thanks Greg.

Operator

And our next question will come from Mike Lin of Stifel Nicholaus.

Mike Lin - Stifel Nicholaus

Hi. I just had a question about the hosted gross margin, the cloud business gross margin. It seems like it dropped quite a bit quarter-over-quarter and you mentioned some of the reasons for that because of the move in the data center which should be complete about June. So after the June quarter, and what do you expect the cloud margins to sort of rebound back up to? We will be seeing a rebound back up to the high of around 47% in the September 2013 quarter, should it be exceeding that as I think you mentioned on previous calls that has the $90 million annual run rate, the cloud business should be covers cost completely and should be extremely possible?

Mike Healy

Yeah, so in terms of cloud gross margin, yeah this quarter was impacted by ramping up data center in Texas and then we had kind of a one-time tax side and then hidden cost of sale too. Going forward, as said, constantly keep the gross margins in the cloud in the low 40s until we get to the June quarter and then start ramping it up, we haven’t been any more specific than that.

But in the June quarter that’s when we can start bringing down some of those costs for the New York data centers which we have three of them as we have got most of customers moved out of New York into Texas, so we’ll start seeing some reductions in polo costs and connectivity at that point in time. And then it should still continue to ramp up from there, but we haven’t given a specific goal on size of those margins into fiscal year 15.

Mike Lin - Stifel Nicholaus

And just a follow up on the hosted gross margins, you mentioned that as you move away from selling the private lines, private circuits, the impact of the margins on that side could up substantially by 10 points. Do you have sort of a concerted plan to sort of reduce the amount of private lines that are sold? And if so, sort of what’s the timing around that where you could see the uplift in margins when you saw less of those private lines.

Don Joos

Mike it’s Don, so the -- my view in there is right now that as Mike had indicated in this quarter, we saw less circuits taken by customers, and that’s just the natural -- that’s a customer choice. We are still offering that. We have been offering that service because it’s a value add service to our customers, they get benefit from it and we think it is key in managing the overall customer experience. And they have found that and so we believe in that. So we have seen it as important.

In regards to our longer term plans, right now we see a key to our -- to the experience. But at the same time, if there are opportunities for us to look at the different way we handle our operations and still deliver the level of customer experience that we want, we will look at those opportunities right now. But in the short-term we see that as a cost of business that is important. And we see how that manifest itself in regards to our really low churn rate.

Mike Lin - Stifel Nicholaus

Okay, great. Thank you.

Don Joos

Thanks Mike.

Operator

And the next question is from Mike Latimore of Northland Capital.

Mike Latimore - Northland Capital

Hi thanks. (Inaudible) and with the new phones out, I’m getting your broader channel are more likely to promote the (inaudible), but I guess you have a sense of and with the fully enabled partners generate the most bookings over the broader channel, any of you?

Don Joos

It’s a little bit of a hard one right now, because we've launched the program this month, so we’re going to have to see. I think your point, Mike is that the 400 series was definitely linked in regards to our product road map to our go-to-market activities, which is also linked with our data center move, all three are tie-in together. So yes, I do expect that we’ll start to see more amounts of 400 series as available.

How much will the mix change, I think it’s probably a little bit too early to call. I think as we get a little bit further down the road and get some good well approved points, I think we’ll be able to talk more about that.

Mike Latimore - Northland Capital

Okay. And then the -- you mentioned that the deal size for the channel might be a little bigger, do you have a sense of how much bigger it will and also what's the sales cycle looks like there versus an average deal?

Don Joos

The sales cycle pretty much probably in all business is lot of it has to do with the complexity of the deal, the size of the deal. The smaller deals we’re finding are probably in a 30, 60 day cycle, a larger deal may take a couple of months to work through that process. So that’s probably the impact from a sales cycle perspective.

We have some data points in regards to premise partners for several months now, has been providing leads or referrals to our cloud direct sales team, those have been a bit larger. So that has given us a good indicator and kind of validates our thesis that they will be providing. I will be very hesitant or I’m actually not willing right now to put specific numbers out there, I actually would like to have the proof points as they are actually closing deals to use that versus just some other early proxy assumptions. So, probably as we get a little bit further along that will be some of the points of interest that we’ll be able to share.

Mike Latimore - Northland Capital

Okay. And then just I guess the last one, you mentioned kind of as an example a $10 ARPU that could be sold into the current customer base. Is that kind of a rough estimate of what it might look like with the applications that will be available in the June quarter is that when kind of sort of full application [split] out?

Don Joos

It’s going to vary from to application to application, certain applications as you think about, I am just putting some out there, there is a pretty big difference I would say from a mobility versus a contact center as an example. So it was more from an illustrative perspective both on the attach and the price point, but we were kind of using things that are kind of in logical ranges to just illustrate the value that the premise install base has to our longer term growth as it relates to our MRR. They will vary from an application to application.

Mike Healy

But a $10 ARPU is not a stretch for -- it’s a one application frankly.

Don Joos

No, you’re correct there.

Mike Latimore - Northland Capital

Okay, great. Thank you.

Mike Healy

Thanks Mike.

Operator

And the next question is from Rohit Chopra of Wedbush.

Rohit Chopra - Wedbush

Thanks very much. Guys I just wanted to ask you a little bit about the competitive dynamics. Can you talk about discounting in the quarter? What you saw with direct competitors such as Mitel, Ring, Cisco, Microsoft this quarter?

Mike Healy

Yeah. Well, on the premise side we actually did better on discounting, our discounting drops in all geographies. So, let's say the pricing pressure was a little less than in previous quarters. And our sales team continues to do a great job of selling the value to ShoreTel Solutions. So, on a premise side that's been pretty good and good reduction this quarter.

And then on the cloud side, I think we're seeing pricing pressure. We see some of it when customers renew, but nothing ordinary in terms of anyone being overly aggressive that we worry about. Certainly there were smaller guys that come into the markets; they were trying to be aggressive. But we don't try to be the low cost leader in terms of pricing, we're pitching that we're adding a value at a service. And you're going to stay with us for years and years as a customer, an average seven years.

So, in terms of what we go after we'll get competitive, but we won't go after the bottom-end of the prices on -- our customer just wants Voice over IP and it's 23 customers, we don’t always go chase all those.

Rohit Chopra - Wedbush

Sure. And then I just want to get a sense, has there been a response to your channel program. Have you seen anybody else adjust their channel program as I understand that you have, have new discount for some of the channel partners that they register deals and there is a little bit more in there. But have you seen a competitive response in the channel from competitors who are trying to compete with you and your new pricing structure out there?

Don Joos

You’re talking about the premise changes, right?

Rohit Chopra - Wedbush

Yeah. And there were some premise changes instituted starting January 1st.

Don Joos

January we made a variety of enhancements to our overall program, some of them I highlighted during my comments, Mike had highlighted that there were some other elements like opportunity registration and so forth. The answer to your question, no we’ve not seen it, I think it’s probably early right now we rolled that out at the beginning of the January timeframe so it’s also been a couple of weeks. But at this point, no I have not seen any changes or responses to that.

Rohit Chopra - Wedbush

Okay. Last one from me is, the gross margin in premise was down, you now have the new 400 series phone, should we start to see that gross margin tick-up as you sell more of these phones, I know it’s only been out for a short time for everybody, but should we see that go up over the next several quarters, Mike?

Mike Healy

Yeah. So the gross margins on the new 400 series phones as they replace the other lines are either equal to or slightly better from a gross margin perspective in the current line. So the time -- everything else remain equal, you would see a tickle up for that as a higher waiting of the 400 series as a percentage of the total. We’re kind of estimating kind of a year along transition cycle between the current line of phones and the 400 series when the phone certainly hits the majority, 80% something a year from now. So it should have a gradual positive impact, yes.

Rohit Chopra - Wedbush

Thank you.

Mike Healy

Thanks Rohit.

Operator

And this concludes our question-and-answer session. I would like to turn the conference, I apologize. I would like to turn the conference back over to Mr. Joos for closing remarks.

Don Joos

Great, thank you. I just want to thank everyone for joining our call today. Obviously, we are very excited as it relates to the momentum that we have in our quarter-over-quarter performance in here. The execution of all the initiatives we have more importantly not just the execution of them, but the execution of them on time and on schedule. And we are very excited about a lot of growth initiatives that we have. And we are looking forward to continuing to move forward with those and brining those into the market and executing on those. So thanks everyone. I appreciate it.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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