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ShoreTel, Inc. (NASDAQ:SHOR)

F3Q10 (Qtr End 03/31/10) Earnings Call Transcript

April 29, 2010 5:30 pm ET

Executives

Tonya Chin – Director, IR

John Combs – Chairman, President and CEO

Michael Healy – CFO

Analysts

Andrew Nowinski – Piper Jaffray

Steve O’Brien – JP Morgan

Greg Burns – Sidoti and Company

Rohit Chopra – Wedbush Securities

Lynn Um – Barclays Capital

Douglas Ireland – JMP Securities

Operator

Good afternoon, my name is Michelle and I will be your conference operator today. At this time I would like to welcome everyone to the ShoreTel third quarter fiscal 2010 conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session (Operator instructions) Thank you. Ms. Chin, you may begin your conference.

Tonya Chin

Hello and thanks to all of you for joining us today as we report our fiscal third quarter financial results. Joining me on the call today are ShoreTel’s Chairman and CEO, John Combs; and Chief Financial Officer, Mike Healy.

Before we begin, I will remind you that during today’s call management will make forward-looking statements within the meaning of the Safe Harbor provision of the federal securities laws regarding the Company’s anticipated future revenue, gross margin, operating expenses, and other financial and business-related information.

These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Additional information concerning the risk factors that could cause actual results to differ materially from those in the forward-looking statements can be found in the Company’s Annual Report on Form 10-K, as amended, for the fiscal year ended June 30th, 2009; its Form 10-Q for the quarter ended December 31st, 2009, and the current report on Form 8-K furnished today.

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

One final note, we will be discussing both GAAP and non-GAAP results throughout our call, and I ask that you refer to our press release for the reconciliation between these amounts. Our non-GAAP numbers exclude stock-based compensation charges, other adjustments, and the related tax impact.

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

John Combs

Thank you, Tonya, and thanks to everyone for joining us today. On today’s call I am going to review our strong third quarter financial results, provide you with a brief update on the strategic plan initiatives, and discuss some of the highlight from the quarter.

First, I will review the financial results from our third fiscal quarter. Revenues of $37 million were all-time record high for ShoreTel. This performance represent a 19% increase from the same quarter last year, and a 4% sequential increase from last quarter.

For the third quarter in a row we increased our gross margins with non-GAAP gross margins of 65.6%, up from 65.3% in the second quarter. Driven by our ramp-up and investments in our strategy plan, our non-GAAP net loss was $1.7 million, or $0.04 per share. We generated $1.7 million in positive operating cash flow in the quarter and ended the quarter with $114.6 million in cash and short term investments.

In addition, we recently received a positive private letter ruling from the IRS, which will allow us to utilize over $20 million in net operating losses or NOL that were previously limited. Mike will go into further details of this great news later in the call.

Next, let me update you on the key developments in our market. The momentum we are feeling in our business and increased confidence our customers are expressing are confirmed by date provided by Synergy Research, which shows that the U.S. pure IP market grew 3.5% sequentially in the December quarter, which is the most recent quarter data is available. Synergy’s data show that ShoreTel grew market share once again in the December quarter to 7% in the U.S. pure IP market and 4.5% of the IP telephony market.

Gartner recently highlighted ShoreTel and its market scope of Unified Communication Solutions in the 20 to 500 line market report, validating our growing strength in the market. Gartner conducted a comprehensive review that included direct discussions with customers, resellers, and technology partners over several months, and evaluate the 11 suppliers including Avaya, Cisco, Interactive Intelligence, Microsoft, MyTel, and NEC, in their report. In the report, ShoreTel is the highest possible rating of strong thought [ph]. Our positive momentum in the SMB market it allowing us to address a growing number of large customers beyond 500 line that equally benefit from our brilliant simplicity. We encourage you to read the report in its entirety and see how we stacked up against our competition. You can find a link to the report on our website www.shoretel.com

We have seen growth broadly across our business over the past quarters and this quarter is no exception. Here is revenue growth third quarter included. Business from national partners, which was up 19% sequentially and more than double from the third quarter last year. Our EMEA revenues showed sequential revenue growth of close to 40%, driven by positive impact of enterprise partners that we recently recruited are taking now, taking home. The continuous strength in our services business with 7% quarter-over-quarter revenue growth and up 24% from the same quarter a year ago.

And finally, we shipped our one millionth IP phone during the quarter, surpassing a key milestone. We are feeling a growing sense of momentum over the past couple of quarters with revenue and gross margin clearly moving in the right direction. We are optimistic that this will continue to accelerate as strategic plan begins to bear fruit.

Next I will give you a brief update on our strategic plan initiatives, but before I give you the specifics let me say that the sense of excitement among ShoreTel’s customers, partners, and employees is electric. Our mission to our brilliantly simple advantage throughout the industry is getting a lot of attention and we continue to make progress on our strategic goals for growth as shown by all-time high revenue this quarter, which marks our fourth consecutive quarter of growth.

We made good progress on our hiring goals in the sales area during the quarter. We increased our sales ranks by nearly 13% and each of these new hires represent an outstanding addition to our team. I am very pleased with the quality and experience of our new team members we are hiring. Most of these new hires have come from our competitors and represent the best and the best from the industry. We have implemented a quick start off monthly [ph] process to help these newly hired sales executives become productive members of the team as quickly as possible.

Our investments in the engineering area are also proceeding well. We increased our headcount resources and R&D by 11% in the third quarter. As with sales, we have a very thorough and disciplined recruiting process that screens in only the very best engineers. These newly hired resources help keep us on track to deliver exciting and significantly accelerated roadmap plans. We are especially looking forward to our partner conference in July at which we are expecting record attendance. At the conference, the product roadmap traditionally is one of the most highly anticipated presentations and this year we are expecting a really enthusiastic response from our channel partners who will introduce a number of key strategic new products that will enhance our competitive advantage with exciting new capabilities that extend the brilliant simplicity of the ShoreTel solution.

We formally launched our joint product with IBM at VoiceCon, which represents a new market for ShoreTel. We are very pleased to have IBM demonstrate how ShoreTel for IBM Foundations product in their key note address and also have Bruce Morse, Vice President, Unified Communications and Collaborations, top four at IBM join us for the announcement.

This is an exciting product, an all-in-one solution that includes both IBM’s Office applications and ShoreTel’s Unified Communications functionality and is aimed at the SMB market. It has been successfully deployed at several beta customer locations. It has already (inaudible) customers both performance and simplicity. We expect to be generating – we expect it to be generally available to the market in the next few months.

In addition, we continue to make significant progress in our branding initiative during the quarter. Our Brilliantly Simple brand positioning is resonating well with customers, prospects, partners, industry analysts, and the media, who are responding very well to the fact that our product really is simple, which ultimately drives lower costs, greater reliability, unmatched scalability, and significantly higher overall customer satisfaction. We are focusing on crushing complexity in the workplace by helping organizations realize that complexity is costly and unnecessary. We continue to spread the word about our Brilliantly Simple solution and the freedom it brings to an organization.

During the quarter, we continued our investments in vertical marketing campaigns focusing on the healthcare vertical. We showcased our UC solutions for healthcare verticals at the HIMSS Conference in Atlanta, Georgia, one of the world’s largest and most respected healthcare IT exhibitions. The healthcare industry is particularly well-suited for ShoreTel solutions as it is often characterized by multiple locations, mission-critical telephony requirements and tight budgets.

We recently highlighted several successful implementations in the healthcare industry, including the Evangelical Lutheran Good Samaritan Society, the nation’s largest not-for-profit long-term care provider, which is currently deploying ShoreTel’s UC solution to more than 17,000 end points in an installation that includes approximately 5000 mobile devices and 200 locations throughout the United States.

The Good Samaritan Society is a great example of how ShoreTel’s Brilliant Simplicity and lowest Total Cost of Ownership make it the logical choice for both large and small customers.

I am delighted to announce that we recently introduced a lowest Total Cost of Ownership guarantee program. CIOs and business decision makers are increasingly aware of the fact that the upfront purchase price of a new communication system represent only about 25% of the Total Cost of Ownership of that communication system over its useful life. 75% of the total cost follow the initial installation and include ongoing maintenance, upgrade, system management, power consumption, end user training and other costs.

In order to empower our prospects and customers to quantify and analyze ShoreTel’s significant cost advantages, we created a patented TCO tool that utilizes verifiable third-party data in order to accurately compare the Total Cost of Ownership for a prospective customer’s specific planned deployment against comparable deployment against comparable deployments from several of our competitors. We welcome a fair fight, which is why we are comparing ourselves to the competition head on. ShoreTel is making the entire process more transparent to prospective customers, involving them in the TCO analysis, and in fact we encourage them to use their own data so they can see for themselves that ShoreTel is the best solution for their organization.

For example, RehabCare, a leading healthcare services provider performed the analysis and found ShoreTel’s TCO was 25% lower than our competition. RehabCare has realized an 80% reduction in operating cost with ShoreTel compared to their legacy system. Because we are so confident with this lower TCO, we introduced the lowest Total Cost of Ownership guarantee program to increase customers’ focus on this compelling advantage.

I would like to be clear. This is not a price war. It’s the value war. It’s a performance war. We unquestionably deliver the best product that satisfy the customers’ needs and gives them the best value for their money, including the lowest TCO. Period.

The third quarter was also marked with multiple industry accolades and a focus on ShoreTel’s achievement in the customer and partner satisfaction area. Because we are so focused on customer satisfaction, we use the MarketTools organization to track and analyze our customer satisfaction feedback. Only companies really committed to delivering an exceptional customer experience utilize MarketTools’ services.

Therefore, we were very pleased when ShoreTel was awarded seven MarketTools CustomerSat ACE Awards for 2009. We are in six individual awards, more than any other company, as well as the best overall award for the third year in a row. We are very proud to be acknowledged as the best of the best in customer satisfaction, which is such an important part of ShoreTel’s culture and identity.

In addition to our focus on customer satisfaction, we are also very committed to our channel partner satisfaction. We have developed an innovative channel partner program that is enabling our partners to grow faster and generate higher returns than with competitive offerings. Therefore, we are very pleased to e recognized in the 2010 Everything Channel Partner Program Guide as one of North America’s top information technology vendors for our ShoreTel channel program. ShoreTel received the five-star rating in recognition of our exceptional partner program.

In summary, we had a very solid quarter. This is an exciting time for ShoreTel as customers gain more confidence that the market is beginning to expand out of the recession. In hindsight, our timing to invest to accelerate our growth in the third quarter of last year could not have been better.

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

Michael Healy

Thank you, sir. As John mentioned, we are very pleased to deliver our highest ever revenue performance of $37 million. Let me give you some more details on the metrics around our revenue in the quarter.

And our verticals markets remained fairly constant with Q2 other than two to three point increases in both the financial and the government verticals. Professional services continues to be our largest vertical at nearly 20% of the total business. From our national partner group, which includes AT&T, Black Box, CDW, Qwest, and Verizon, now represents about 19% of our total volume during the quarter. For the first time, four out of five of our national partners exceeded $1 million in business during the quarter, and no single partner exceeded 10% of revenue.

International revenues were a record $3.6 million, which is up 9% from Q2, and represents approximately 10% of total revenue in the third quarter. We saw a particularly revenue growth in the EMEA region, which is up 40% sequentially in the third quarter with a few deals over 1000 users driving much of the improvement.

Service and support revenue totaled $8.1 million and represented 22% of our total revenues in the third quarter. Support revenues included approximately $1.8 million and services revenue from installation, training and professional services activities in Q3.

We sold approximately 85,000 end user licenses in the quarter, essentially flat with Q2, and we added approximately 800 new customers in the quarter.

Now, let’s talk about our improving gross margin. Once again, we delivered our best ever non-GAAP gross margin 65.6%. Breaking down that number, product gross margin was 65.4% and support and service gross margin was 66.3%, both of which were improvements over Q2. The improvement was mostly due to slightly lower labor cost combined with incremental revenue increases in both areas.

Non-GAAP operating expenses at $26 million were up $3 million sequentially, as planned, mostly due to increased sales and R&D hiring, investments in our distribution channel, and increased branding activities.

Our G&A expenses were up approximately $500,000 in the quarter, primarily due to a couple of nonrecurring items including the final settlement amount relating to our shareholder lawsuit, which was filed in January, 2008. The securities and derivative litigation have now been settled.

We added 42 employees during the quarter, including 14 in the sales group with the balance added mostly in engineering and global support. We ended the quarter with 455 employees.

As expected, our investments resulted in a non-GAAP net loss for the quarter of $1.7 million, or $0.04 per share. Our GAAP net loss of $4.5 million, or $0.10 per share included stock-based compensation charges of $2.8 million and the related tax adjustments.

Next, let me give you an update on our favorable private letter ruling from the IRS we received last month. Our future tax rate should benefit from this ruling, which will allow us to utilize NOL carryforwards previously limited by Section 382 restriction. This ruling is expected to reduce our tax expense over time, which will be dependent on how much taxable income we generate. In addition we plan to file a minute [ph] return for 2008, which we expect will enable us to recover approximately $1.7 million in cash from the refunds of previously paid taxes by utilizing some of these NOLs. We are evaluating how much NOLs will be available in total, but we expect the final amount will be well north of $20 million. We will provide an update on the final NOLs available after we completed our analysis, which we expect to have wrapped up by the time we report our fiscal year end result.

Next, let me read to you some of the highlights of another strong quarter of balance sheet and cash flow improvement. We generated approximately $1.7 million in positive cash flow from operations and ended the quarter with $114.6 million in cash and short term investments.

Accounts receivable increased $900,000, and DSO, or Days Sales Outstanding, improved to our best performance in Company history at 37 days. Certainly this improved DSO reflects our hard work in our collections group, but more importantly it shows how our high level of customer satisfaction translates into tangible business results as satisfied customers tend to pay their bills on time.

Inventory decreased $2.2 million to $12.3 million on increased demand and as we completed our transition to Flextronics to provide an additional phone manufacturer. Capital expenditures were $1.8 million. Purchases of IP technology and license was another $300,000, and depreciation and amortization was approximately $730,000.

Most of the increase in capital expenditure was due to computer equipment and parts for the 42 new employees we hired and increased manufacturing and tooling costs related to our transition to Flextronics.

We ramped our sales organization in the quarter and ended the quarter with 125 employees in the sales group on a worldwide basis.

In terms of our revenue metrics, most continued the positive trend including national partners revenue growth, international revenue increases, sales hiring, discounting, a small investment in market share and excellent growth in service and support revenue. A few of our metrics that did not move in a positive direction this quarter were sales – U.S. sales rep productivity, which declined about 9% primarily driven by the significant hiring in the third quarter.

Our business from new customers dropped three points to 44% as March is the seasonally weaker quarter for us in terms of new customer business. Last year, we experienced a similar but more pronounced decline of eight points. Overall, I am pleased with our direction on most of these important indicators.

Next, let me discuss our outlook for the June 2010 quarter. We are optimistic about our fourth quarter, but with so much of our business still to be booked during the quarter we do not want to get ahead of ourselves. Given these factors and our volume to date, we expect the revenue to be in the range of $35 million to $38 million.

We anticipate non-GAAP gross margins in the range of 64% to 65% and GAAP gross margins to be one percentage point lower due to the inclusion of $300,000 in stock-based compensation charges. We plan to continue to ramp up our operating expenses in the June quarter, and therefore expect our Q4 non-GAAP operating expenses to be in the range of $27.5 million to $28.5 million and GAAP operating expenses to be in the range of $30 million to $31 million, including approximately $2.5 million in stock-based compensation expenses.

I know some of you are wondering about the impact of the new revenue recognition rules on ShoreTel, specifically the EITF 08-01 and 09-03. These new rules will be effective for ShoreTel in the September 2010 quarter. We have been performing an analysis of the impact of these new revenue recognition rules and the preliminary results indicate there will not be a material impact on our revenue on a quarterly basis.

Depending on the number of variables, including discounting trends and amount, we expect that a small amount of support and service revenue will convert to product revenue on a quarterly basis, which will effectively shorten the time to recognize that revenue for ShoreTel. We will update you on this next quarter as we get closer to adopting these new standards.

I was very pleased that we delivered another strong quarter with record revenue and gross margins, positive operating cash flow, and posting our best ever DSO. Looking into Q4, we are very encouraged about our ability to deliver a solid financial quarter to end our fiscal year 2010.

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

John Combs

Thanks, Mike. ShoreTel is on a mission to deliver Brilliant Simplicity. Customers are learning that they no longer need to tolerate the communications complexity our competitors force upon them. They are learning that there is another answer, a brilliantly simple answer and that is ShoreTel. Thank you for joining us today. I will turn the call back to Michelle to conduct and mange our question-and-answer session.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Andrew Nowinski with Piper Jaffray.

Andrew Nowinski – Piper Jaffray

Hi, good afternoon.

John Combs

Hi, Andrew.

Andrew Nowinski – Piper Jaffray

Thanks for taking my question. Great quarter.

John Combs

Thank you.

Andrew Nowinski – Piper Jaffray

Just want to kind of get some color I guess on the assumptions you are making with regard to your guidance first. You talked about (inaudible) in your business and some of the increased confidence in the customers. Is it – is there I guess – I mean what factor of your guidance is really some conservativism versus some of the maybe linearity that you are – normal linearity you are seeing right now through the (inaudible)?

John Combs

Alright, Andrew, I think that first you need to understand that the – we use the same process, same method each quarter to come up with our guidance. We take a number of different factors. Mike’s got this very fancy algorithm he uses to determine the factors, but it’s important to note that in our business we have to book and ship 80% of the business during the quarter. And 50% to 60% of that comes in, in the last month and 75% to 85% comes in the last two months, right? We haven’t quite met that point at this point in time. Last year June was up about 4%. The guidance range we offered is the highest we ever done in our history and I think it’s important to realize that we are – there is nothing non-seen [ph] on the horizon that you would not be aware of in terms of what’s happening in the marketplace. So, we are trying to be sure we have a full appreciation of what we are seeing out there, and there is a lot of momentum, but it is lot of work that needs to be done in a relatively short period of time.

Andrew Nowinski – Piper Jaffray

Got it, understood. Thank you. And then are you guys seeing any kind of – just talk about the benefits you are seeing with regard to the Nortel, Avaya acquisition from both a channel partner, and customer acquisition perspectives?

Michael Healy

Yes, I will start and then I’ll have John add. So, from that – the trend – Avaya is starting the transaction, right, the transition. And as with most large integration, they got to simulate the product line, so they’ve already announced they are eliminating some of the Nortel products and will provide support for a certain period of time. I think they have made about 4500 lay-offs of personnel right after the merger was complete. So all that I am sure is causing disruption with – inside Avaya trying to swallow that big Nortel base. So from a customer standpoint, our goals is as that disruption is going on is to go capitalize both on the customers of Nortel and the partners to make sure we’re getting as much market share as we can. I would also add we’ve heard from the sales force that Avaya was relatively aggressive this quarter in terms of their pricing and discounting when they were going against ShoreTel. John, anything else you would add?

John Combs

Well, I think that the – it’s not necessarily directly regulated to the Avaya-Nortel, but that’s the – the pricing issues are why we are being so aggressive on the Total Cost of Ownership guarantee because a lot of times the customer gets focused on what the check they have to write to get the product installed and working, and when they do sign, really a majority of the cost are featured [ph] on the back end. So we believe that we have the opportunity to change the rules of play in competition against Avaya, Cisco, all the confederates out there if we are early in the sales cycle and can share with the customer so they can fully understand how those costs are developed and accumulated.

Andrew Nowinski – Piper Jaffray

Sounds good, guys. Keep up the good work.

John Combs

Thanks, Andrew.

Michael Healy

Thanks, Andrew.

John Combs

Take care.

Operator

Your next question comes from the line of Steve O’Brien with JP Morgan.

Steve O’Brien – JP Morgan

Hi, thanks for taking my question. Want to start off asking about one of the other important metrics, average deal size, how did that trend in this past quarter? And then secondly, what were the specific signs of optimism that you think are quantifiable in this past quarter? Now, if – maybe we don’t see it in the guidance here. What underlying trends may be are we not seeing? And then on that same token, is there a strong sales force incentive that would normally make June a seasonally stronger quarter and any like big deals in the third quarter that create a headwind on a sequential basis for that first quarter?

Michael Healy

Okay, so let me take the first and the third and John will take the second one in terms of the optimism. So, average deal size was down still in the range of $20,000 to $25,000, it was down about 3%, if I remember my number correctly for this quarter. And like we said, our new business was down three points to 44% of the total and that seems to happen every March. So there is seasonality in our March quarter in that we usually have a pretty strong December quarter in new customers and then the March quarter is more renewals. Our add-on business is very strong in the March quarter and therefore most of the metrics around new customer business were down, flat to down, and that’s more than the average deal size.

In terms of the sales force incentive to bring in stronger deals or anything like that, most of our large deals even for a 1000-seat deal like the Good Samaritan Society John talked about earlier it starts relatively small. It’s not like we get 1000 seats for $1 million all at once in quarter. If the install takes time I think good Sam [ph] will grow over two years. So every quarter will be a little bit of revenue from that customer. But there is a pretty good backlog of bigger sized deals that we’ve closed on and maybe some shipped a little bit in Q3 and will continue to ship in Q4. So that’s part of the optimism.

The sales force incentive, the only thing driving sales force and our partners is we have our partners' conference in July. Everyone wants to finish their year strong and get up on stage and be that number one person and so that’s part of the incentive and that’s why we typically we have a little bit stronger June quarter than we do March. But then again we certainly don’t want to get ahead of ourselves in terms of our volume coming out and as John said, we still have a long way to go in terms of hitting the numbers for this quarter.

John Combs

Your second question was what are the signs of optimism that might not be clearly visible. The ones that are – we actually we highlighted in the call, particularly that the amount of revenue we’d be able to generate year-over-year and 19% of the national partners was very exciting. It’s nice to see the international team really kicking in as well even though we focus a lot of our comments to North America. It’s nice to see the international team coming in. We are building a lot of momentum both in EMEA and in Australia. And Australia, lot of that’s driven by the success we are seeing with Telstra.

Things you might not see is that I spent a good part of the last month down the field visiting with customers, visiting with partners, traveling to the spot of a sales executive and the intangible here in terms of looking forward is that the sales team on balance both in terms of the sales forecast and in terms of individual conversation are very positive and bullish, which was quite a bit different than what we have been seeing a year ago.

Steve O’Brien – JP Morgan

And if I could one not too steal any thunder from the partner conference, but could you update us on some of the R&D programs, efforts to increase line size capability? I think the 20,000 are from (inaudible) and support for Apple iPhone, and increased call center line support.

John Combs

You got them in. Yes, there you go. There is also the things we are working in the handset as well that we think will be pretty exciting and there is a bunch of other things as well in terms of additional UC functionality we’ll be introducing at the show as well. But it’s a – these kind of developments take 12 to 18 months. And our engineering team has really been – you can see when you go back and talk to them how giddy they are about the new products they are coming up with. And I think it’s going to be a great conference this year in July.

Steve O’Brien – JP Morgan

Okay.

Operator

Your next question comes from the line of Greg Burns with Sidoti and Company.

Greg Burns – Sidoti and Company

Good afternoon, guys.

John Combs

Hi, Greg.

Greg Burns – Sidoti and Company

You mentioned that the as the product review, the salesmen in North America was downsized, but I guess that was due to the new salesmen hired, but the – if you exclude those guys, the existing sales force, how was their productivity trending for the quarter?

John Combs

Their productivity – I don’t have the number, but I think it was flat to up a little bit in terms of the existing base. The real reason the U.S. productivity went down, we added 14 people and any time you add that many quickly unless you really bust [ph] out revenue the productivity number is going to go down. So, we expect that it will average down, get back to more normal rate of we’ve kind of said publicly $1.4 million to $1.6 million annually that our sales guys can produce.

Greg Burns – Sidoti and Company

Okay. And in regards to your partners, you had a nice growth with the national guys. Can you highlight anyone in particular that was particularly strong in the quarter, and also what was going on with the regional partners? And if you could comment on any impact that the Qwest-CenturyTel merger might have on you guys, that will be great?

John Combs

Okay. See if I can get them off. So the national folks, we don’t break them out, Greg, as they we kind of consider that proprietary information we start giving their numbers out, but as Mike mentioned we had of them over a million, which is the first time ever. The – in terms of the regional distribution partners, if you understand this group, these are mostly entrepreneurs, they for the most part been around a long time. When they saw the recession setting in, they kind of battened down the hatches. And as a result – they are usually slower to come out of a recession, because they got to go hire sales people and things like that to rekindle their operations they begin to see the environment around them improving.

In the case of Century’s acquisition of Qwest, Qwest has ramped faster than any of those national carriers we have worked with today. They really came out of the gate and had a lot of cause of momentum. The deal will not close until January of 2011. I don’t expect that they have much impact on us in the near term. As I mentioned, we’ve made very good progress with Qwest, but it’s very – it’s too early to say what the impact is going to be over time. But near term I don’t see any changes.

Greg Burns – Sidoti and Company

Okay, and—

John Combs

Did I miss one?

Greg Burns – Sidoti and Company

Excuse me.

John Combs

Did I miss one?

Greg Burns – Sidoti and Company

No, you got them all.

John Combs

Got them, okay. Okay.

Greg Burns – Sidoti and Company

And as you are hiring in regards to sales men going back on track I guess it was kind of behind pace last quarter. Are you back on pace?

John Combs

Yes, yes, very much so. We didn’t make up for the shortfall we had in the December quarter, but we are right on track for hiring and this – our March quarter. What I would tell you is I had a chance to meet and get to know most of the new people we hired and I think we’ve got a very strong group of folks coming in the door.

Greg Burns – Sidoti and Company

Okay, and then–

Michael Healy

Greg, so overall we are – we still expect to be able to grow the sales force, but by about 40% year-over-year is still the goal. So we got hiring to do this quarter to get to that number.

Greg Burns – Sidoti and Company

Okay. And I guess does that go into the sequential decline in the gross margin guidance?

Michael Healy

No. Sales hiring wouldn’t affect the gross margin. The reason for the gross margin guidance a little bit lower than what we did last quarter is a couple of reasons. One, we do expect international actually to grow pretty healthy next quarter too. And if you remember, it caused us a little bit more points to go through to do distribution internationally, so that could have some impact on gross margins, as well as in the support organization, we are a little bit behind in hiring too. We got to ramp hiring there a little bit in global support. And that does affect the gross margin in the support organization, so the labor cost will go back up there.

And then I factored in a little bit more aggressive discounting in the June quarter. So, those are the reasons for the gross margin guidance, little bit lower than what we saw this quarter.

Greg Burns – Sidoti and Company

Okay, thank you.

Operator

Your next question comes from the line of Rohit Chopra with Wedbush Securities.

Rohit Chopra – Wedbush Securities

Hey, guys. Did you answer Greg’s question on regional partners? I just want to get a sense of the growth over there.

John Combs

Yes, regional partners were about flat quarter-over-quarter, almost all the growth in the business came from international and national partners.

Rohit Chopra – Wedbush Securities

Okay and the reason I wanted to ask you about regional partners is that part of the reason for the branding campaign, which I think you are spending roughly $1 million a year, is to get that brand out there and help the regional, right, you can average at it versus the national guys you can push into existing client bases. I am just wondering is that one of the metrics you are looking at as far as sales with the regional.

John Combs

Yes, there was a partner. The branding campaign is designed to get the IT decision makers and business decision makers to get us included to the invitation. So, it’s really designed to grow from the end user community back into the partner base and to us as we (inaudible) et cetera. And we are spending – the last quarter we spent $1 million on the branding campaign. This quarter we are spending $1 million on the branding campaign in addition to all rest of the branding activities, so it’s not just advertising, it’s – we just completed the Interop trade show. We did the VoiceCon trade show. So there is a lot of different things we are doing to drive the band.

A lot of the activities we have to do lead generation with our regional distribution partners, so I think to forecast the best for us over time is the lunch in Lorentz [ph], the seminars, those kinds of activity, which will work off the distribution partners to drive that activity to schedule on a regular basis and the ShoreTel team comes in the search. So–

Rohit Chopra – Wedbush Securities

Right, okay. And then just want to get a sense on the comment about discounting. Are you doing that in response to anybody because the company is at – they go public recently? Believe it or not they are like the two-for-one special or something like that and they may just add discounts all over the place. So I am just wondering are you trying to respond to them in the market.

John Combs

Not at all. We don’t see them that often, so – but where we do we really focus real on the Total Cost of Ownership that that’s our main drive is to work on that. And they can go two-for-one or three-for-one and at the end of the day, our Total Cost of Ownership will still be below just about anybody in the business.

Rohit Chopra – Wedbush Securities

All right. And then two questions, linearity and how is the sales cycle out there?

Michael Healy

So, linearity for the March quarter was absolutely consistent with Q2 in that about 50% came in the last month. As John mentioned, typically in the June quarter, we even see that more back-end loaded. And I wanted to answer you – one more question on discounting. Just to be clear on discounting, this quarter, Q3, our discounting was a little bit less than the previous quarter. So we haven’t been discounting even though our margins continued to hold up well. And that’s again a lot focused on the product and the quality and customer service, all some of our key traits.

John Combs

And in terms of the sales cycle, Rohit, I – it’s really difficult to measure the sales cycle, but my sense is it’s improving and what we are seeing is a lot of the customers that put their opportunities on hold a year ago are now coming off. So, it’s not necessarily a cycle as much as it is they are saying okay, now is the time to go.

Rohit Chopra – Wedbush Securities

That’s great. Thanks, John, thanks, Mike.

John Combs

Thank you, Rohit.

Michael Healy

Thank you, Rohit.

Operator

Your next question comes from the line of Lynn Um with Barclays Capital.

Lynn Um – Barclays Capital

Hi, thanks for taking my question.

John Combs

Hi, Lynn.

Michael Healy

Hi, Lynn.

Lynn Um – Barclays Capital

Maybe some question back on the gross margins I think last quarter you talked about taking out some costs on the existing components. Is that mostly done or is there more to come?

Michael Healy

Yes, there is – we took out some cost in our switches a couple of quarters ago and got some benefit last quarter. There is a little bit more we can do in terms of our switch in working with our manufacturers to drive cost out, but nothing in the short term horizon. And – but there is potential to drive those costs down a little bit more, but sooner we are there I will let you guys know.

Lynn Um – Barclays Capital

Okay, okay. And then back to the U.S. sales hiring that happened this quarter, typically how long does it take for them to kind of ramp up in productivity I guess for the 14 that were hired this quarter?

John Combs

It’s about a year, so the first quarter, Lynn is basically zero, because they re in training and et cetera, but then it ramps over the next three quarters and then in the fifth quarter is when their full ramp is intact.

Lynn Um – Barclays Capital

Okay. And have you commented on the – I think the 40% sales ramp year-over-year driving incremental may be $40 million or $50 million in fiscal ’11, is that pretty much the same or has that changed at all?

Michael Healy

Yes, so, Lynn, it’s Mike. We thought we updated the analysis and recalc and we still expect to be north of the $40 million number.

Lynn Um – Barclays Capital

Okay, great. Congrats on a nice quarter.

John Combs

Thanks and take care.

Operator

Your next question comes from the line of Douglas Ireland with JMP Securities.

Douglas Ireland – JMP Securities

Thank you. Good afternoon.

John Combs

Hey, Doug, how are you doing?

Douglas Ireland – JMP Securities

Good, glad to hear you building the team there. It’s great to see you guys going into aggressive mode.

John Combs

Thank you.

Douglas Ireland – JMP Securities

Yes. The questions have been covered very well. It seems like everyone got five or six in, so I am a little late – one of things I was really curious about was the tax effect and when we are looking at modeling this out, is there anything that we should do to take a change in tax into account on the EPS line. You don’t guide that far down and I am just wondering how I should take that into consideration.

Michael Healy

Sure. So let me just give you a little bit more detail on the NOL private letter ruling. So, it took a while to get through but we couldn’t be more excited, real tangible results for the company and great cash coming back to the company over time due to our – the change in 3D2 [ph] ownership. So what I would suggest although we are not modeling, we are not giving you guidance for when we are going to have GAAP income, but whenever you model that in you should model approximately 90% of the taxable earnings can be offset by these NOLs going forward and to use up the NOLS appropriately. And we’ll still have some minor cash taxes for our foreign operations in those states that charge for other things other than income tax, those kinds of things. But essentially it was – soon as we can start generating that taxable income, we should be able to offset a majority of that. So it will result in a relatively low tax rate until we can burn through those NOLs. So when I have the final number, then we should be able to kind of hammer that down a little bit better for you in terms of how long that will go and what the rate would be.

Douglas Ireland – JMP Securities

Okay, great. So, at Interop yesterday, one of your partners won Best of Interop for their video solution. I am just wondering how important you think the video capability is and what role that plays in your revenue and in your sales cycle?

John Combs

It’s definitely a key element in the Unified Communications suite, Doug, and as you know we have desktop-to-desktop video that is built in to the ShoreTel Personal Call Manager. And then we also interface with any and all of the industry standard conference room video system. So we are continuing to build our portfolio of those integrations. We don’t plan to go in that business ourselves, hence the reason for the working with our technology partners.

Douglas Ireland – JMP Securities

Recognize revenue on that or is that more of a meat in the channel type of a relationship?

John Combs

The revenue comes to us for the desktop video and the partner purchases from our technology partners directly. That revenue does not flow through ShoreTel.

Michael Healy

Those are just referral arrangements we work with the other companies on. But, we do sell a software license for that desktop-to-desktop video that’s in our numbers.

Douglas Ireland – JMP Securities

Great. Just want to learn about how that works. It seems like a really elegant solution.

John Combs

Right.

Douglas Ireland – JMP Securities

Thank you.

John Combs

All right.

Michael Healy

Douglas, thanks.

Operator

(Operator instructions) And I am sure there are no further questions at this time. I will turn the call back over to Mr. John Combs, CEO.

John Combs

Thank you, Michelle. So just to wrap this up, we are very pleased with the record revenue levels and particularly the growth in the national partners and our international teams. Also of course the gross margin improvements. We feel that the strategic plan is working. We are excited about it. Particularly the hiring in the sales and engineering areas during the quarter was within our target. And the thing I am most excited about right now is the Total Cost of Ownership guarantee we have in the market, because it really provides more than just a way to compete, it changes the rules of engagement because once we get the customer to take a look at their total cost over time, and present value of those costs, it really just really shines a bright light on the advantage that ShoreTel really holds in the marketplace against any of our competitors.

So, thanks again for joining us today. Have a great day and we’ll talk to you again next quarter. All the best.

Operator

And this does conclude today’s conference call. You may now disconnect.

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Source: ShoreTel, Inc. F3Q10 (Qtr End 03/31/10) Earnings Call Transcript
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