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ShoreTel, Inc. (NASDAQ:SHOR)

F3Q 2014 Earnings Conference Call

April 24, 2014 5:00 PM ET

Executives

Barry Hutton – Director, IR

Don Joos – President and CEO

Mike Healy – CFO

Analysts

Sanjiv Wadhwani – Stifel, Nicolaus & Company

George Sutton – Craig Hallum

Barry McCarver – Stevens Incorporated

Dmitry Netis – William Blair

Mike Latimore – Northland Capital

Operator

Good afternoon and welcome to the ShoreTel’s Third Quarter Fiscal 2014 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 now 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 third 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. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Additional information concerning the risk factors that could cause actual results to differ materially from those in the forward-looking statements can be found in the company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2013 its 10-Q for the quarter ended December 31, 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. We ask that you please keep your questions to the operational and financial results announced today.

Now I’ll turn the call over to Don.

Don Joos

Thanks, Barry. Throughout the past year, we focused our efforts on integrating our cloud and premise businesses, launching new products and growth initiatives and making significant infrastructure enhancements. Simultaneous with these efforts we have reduced our operating costs and built out our new co-lo datacenter to support our cloud operations.

In our fiscal third quarter, we placed an increased focus on growth momentum as we built the foundation for our future, I am very pleased that we have continued to achieve strong financial results each quarter. Our ability to grow the company, while executing critical initiatives indicates the intense focus of our employees, quality of our customer relationships and the productivity of our channel partner network.

Our total revenue in Q3 was $82.4 million, up 5% year-over-year led by the 24% growth in our cloud business. Recurring revenue was 40% of our total revenue compared to 35% last year. Over the past year, we have made adjustments to our business model to provide greater flexibility to handle the potential quarterly variations and seasonality of our premise business while still generating a non-GAAP profit.

Although we had expected seasonality with our product revenue in Q3, our non-GAAP operating expenses decreased by 4% year-over-year resulting in a non-GAAP net income of $2.6 million or $0.04 per share. This represents four consecutive quarters of non-GAAP net income.

Q3 was an important quarter for the company as we launched a number of strategic growth initiatives. These initiatives included, enhancements made to our channel program, integration of our cloud and premise sales force, the availability of the 400 series phones for our cloud deployments and the start of customer provisioning and the migration of our cloud install base into our new datacenter.

These are important interconnected events as each supports the expansion of our channel program leading to growth in our hosted bookings and revenues. The enhanced cloud channel program has partners operating at the enabled, approved and referral levels.

I will remind you that our enabled and approved partners complete the technical training for the ShoreTel cloud solution, manage large portions of, for all of the sales process and also make volume commitments to generate recurring revenue each year.

These partners are now actively selling into their customer base as well as finding new opportunities. The number of enabled partners has grown to 19 as of quarter end up from the six enrolled at the time of our January call and we also have approximately 100 premise partners at the approved level. This is incremental to our existing cloud partners.

Clearly, the growing number of partners is indicative of the excitement in both our partner networks and our customer base. But I will emphasize that we are focused on total bookings generated by all three partner levels plus the direct sales and marketing efforts.

Furthermore, the bookings are evaluated in conjunction with our installation cycle times and our continued ability to manage the industry’s lowest churn. That said, it’s noteworthy that our Q3 bookings represented the largest amount of cloud booking through any single quarter in the company’s history.

This includes our largest ever single cloud deal representing roughly 4000 seats from one customer. The monthly recurring revenue for this order will start to ramp in our fiscal Q4 and will continue to ramp over the next three to four quarters as the installation process completes.

It is even more encouraging to recognize that the strength of the bookings was very broad. Even with the large deal excluded, the Q3 bookings showed quarter-over-quarter growth.

Furthermore, the majority of the activity came from our direct sales team and the existing cloud partners including the quarter’s largest deal which was sourced from one of our longstanding cloud partners.

Meanwhile, the premise partners that recently joined the cloud channel program at the enabled and approved levels started to build a pipeline of opportunities. As expected, they closed deals during the quarter, but we are still in the early stages of deployment of the program. We view Q3 as a very positive indication that all aspects of our sales and go to market strategy is starting to pay off.

In addition to launching growth initiatives, we continue to achieve multiple milestones on the company roadmap. I will not provide some key highlights from our fiscal third quarter. The architectural build out of our new co-lo datacenter is complete. And at this point, we have migrated well over half of our cloud install base into the new facility in Texas.

We remain on schedule to our commitment to substantially complete the migration by the end of June. We began to ship of 400 series sip base phones to cloud customers. And this was a catalyst for many of our premise partners to start selling cloud services to our channel program.

One key value of our communications platform is the ability to integrate with and help customers leverage their key business applications. We announced a significant upgrade to our sales force integration for both cloud and premise customers. This integration helps a company improve their sales force productivity and customer service response.

We delivered virtualization to our premise customers with the latest software version of our ShoreTel solution thereby providing a virtualized environment that includes call control, conferencing, and collaboration capabilities. This expands our offering in a market that places an increased priority and improved infrastructure costs.

As I look forward to upcoming product introductions in our fiscal fourth quarter, we remain on schedule to launch ShoreTel connect or hybrid offering. This application delivery model provides us a distinct advantage as it directly addresses the ongoing premise and cloud convergence we see in the industry.

Also in the June quarter, we will release the next major version of our mobility offering. This introduces support for video communications enabling employees to collaborate from anywhere using their phones and tablets, optimize for low bandwidth cellular and wireless networks, organizations can now leverage their investments into a room-based video systems by expanding their reach to remote and field employees without sacrificing quality of experience.

Even though our cloud growth initiatives are in the early stages, we continue to see an increase in the number of new cloud customers signed in the quarter. We now have roughly 3200 cloud customers representing a 142,000 seats deployed. As I mentioned earlier, in Q3, we generated the largest amount of cloud bookings in the company’s history.

In addition, we added over 900 new premise deployed customers to our installed base. Throughout the process of launching numerous initiatives within our go to market model, I continue to be pleased with our sales productivity rate.

As I have mentioned in the past, everyone in ShoreTel is focused on providing the best customer experience. Over 4000 customers have provided us formal feedback this fiscal year on their ShoreTel experience. And once again, we achieve the rating above the world-class service threshold.

Our ability to consistently operate at the world-class level provides us advantages with both new and existing customers. In particular, our research shows that customers who store their experience at the highest level churn less and spend almost twice as much as other customers.

In summary, Q3 was another very successful quarter for the company. We continue to build momentum by executing against our corporate objectives, become increasingly more predictable as we grow our recurring revenue and consistently generate non-GAAP profitability.

At this point, I will turn the call over to Mike for his review of the financial results.

Mike Healy

Thanks Don. Good afternoon everybody. I am really pleased that in the past year we’ve improved our operational discipline and continue on to innovative solutions into the marketplace. We’ve made great progress against each of the company milestones that we’ve communicated in the last few quarters.

During this time of investment and innovation, we’ve continued to produce positive financial results each quarter and strengthen our balance sheet. In our third fiscal quarter, we continue to grow the company by generating total revenue of $82.4 million, which is a 5% year-over-year increase led by growth in our hosted revenues.

Our recurring revenue which combines our monthly recurring revenue – hosted revenue and support revenue continued to grow rapidly, up 20% year-over-year.

In Q3, our recurring revenue had an annualized run rate of $130 million and accounted for 40% of total revenues thereby making our business model increasingly more predictable. In Q3, our hosted revenue grew 24% over the prior year to $22.6 million. Compared to Q2, we saw a good increase in the number of new customers booked and a record level of cloud bookings.

I want to echo Don’s earlier comments that the premise partners who recently joined the cloud partner program are just beginning to contribute to our cloud bookings. However, these new partners are getting trained, beginning their sales activities and doubling their pipelines to generate future bookings which will subsequently turn into monthly recurring revenue over time.

We closely track a number of cloud business metrics which were outlined in our earnings press release today. Our average number of seats per installed customer of 44 shows a slight increase year-over-year and remains steady sequentially. In Q3 ARPU or Average Revenue Per Seat was $45, flat quarter-over-quarter.

Average revenue per customer was $1978 per month, essentially unchanged from last quarter. Naturally the large customer deal that Don mentioned will provide significant economies of scale and most likely impact some of our metrics going forward as that customer’s 4000 seats gets fully installed over the next three or four quarters.

It will probably decrease our overall ARPU but increase our average number of seats and average monthly revenue per customer.

We continue to have very low churn in the cloud business in Q3 which was 0.4% per months or roughly 5% annualized. Product revenues were about $43.4 million represented a year-over-year and a sequential decline of 5% and 7% respectively. This revenues decline was consistent with our expectations and guidance for Q3 which reflected the seasonality in the premise business.

We expect our product revenues to rebound in Q4 as it’s typical in the June quarter. We sold approximately 124,000 licenses in the premise business in the quarter. In Q3, our regional U.S. based channel partners grew 3% year-over-year.

However the business from our service providers was down significantly in Q3 to $7 million which was a 16% decline year-over-year and down $1 million sequentially. In the March quarter, we had a few large service provider deals push out into Q4, some of which we expect to close by the end of April.

As I have noted previously, our server provider business can be inconsistent from quarter-to-quarter. In contrast, the recurring nature of our global support service business continue to drive double-digit expansion in Q3. Support and service revenue up $16.4 million represented growth of 12% year-over-year.

The attach rate on new premise customer support agreements continues to be in the high 90% range and our existing customer renewal rates on support contracts remains in the high 80% range. This high margin business is a vital part of our recurring revenue base and contribute stability to our gross margins and generates significant cash flow.

Our international revenue increased by 4% year-over-year to reach $7.5 million in Q3. This represents 12% of the total premise revenues.

Now turning to gross margins. Total non-GAAP gross margins in the third quarter were 60.1% which is down from 62.1% a year ago and down slightly from last quarter.

The two main reasons for the decline are an increase in the inventory reserves and a mix shift as our hosted revenues which carries out lower gross margin continued to climb upwards as a percentage of our total revenues. For Q3, our hosted revenue grew to 27% of total revenues.

The hosted non-GAAP gross margins in Q3 were 41.1%, up slightly from the previous quarters due to the increase in revenues which was partially offset by the anticipated higher COGS associated with startup of our new co-lo datacenter.

With most of the incremental cost being depreciation expense. Since the 400 series phones began shipping to cloud customers late in the quarter, there was minimal positive impact on the Q3 hosted margins.

The product non-GAAP gross margin was 64.2%, which is 260 basis points below Q3 last year. The product gross margin in Q3 was negatively impacted by increased inventory reserves of approximately $1 million on two select products. Without this reserve increase, our product gross margins would have been approximately 66.5% similar to last year in a 100 basis points above last quarter.

The non-GAAP gross margins in our server and support business remain very strong at 75.4% which is an improvement of 230 basis points over last year and up slightly from the prior quarter.

Overall, I was pleased that we are able to manage our operating expenses and keep them at 57% of revenues on a non-GAAP basis. Non-GAAP operating expenses of $46.7 million were down slightly from last quarter and down 4% from last year, even with the $4 million increase in revenues.

Operating expenses were lower than our guidance due to savings and labor-related spending, lower travel expenses and we deferred a few spending projects out to Q4. We ended the quarter with an employee headcount of 930 which was up five from the last quarter. We are planning to continue to hire in key areas.

In total, our Q3 non-GAAP operating profit was $2.8 million or 3.4% of revenue which led to a non-GAAP net income of $2.6 million or $0.04 per share. Our fourth consecutive quarter of net income while we continue to make strategic investments for growth.

On a GAAP basis, we had year-over-year improvements in both gross margin dollars and operating expense dollars of 1.4% and 5.6% respectively. As a result our GAAP net loss was $1.2 million or $0.02 per share which was a vast improvement over last year’s loss of $5 million.

I also will highlight a few cash and balance sheet items. Our cash and short-term investment balance ended the quarter at $53.9 million. As of the end of March, the outstanding balance on our line of credit have been reduced to $4.1 million. As of March, our net cash position was $49.9 million, up 125% for the fiscal year.

Furthermore, I am happy to report that in April, we have paid down the remaining outstanding amount of our debt. So as of today, we are debt free. We generated approximately $100,000 in cash flow from operations which is down significantly from the two previous quarters due to the inventory buildup and the timing and the amount of products shipped in the quarter.

Year-to-date our cash flow from operations is close to $28 million, which allowed us to make strategic investments while also pay off our line of credit. In Q3, we generated approximately $7.5 million in cash from employee stock option sales.

In Q3, our capital expenditures were $1.7 million, down significantly from Q2 ass our datacenter build out was substantially completed in December. Our total depreciation and amortization in the quarter was $4.8 million. During the quarter, our accounts receivable grew slightly to $32 million due to the timing of product billings within the quarter.

Our days sales outstanding grew slightly from 32 days to 33 days. Inventory rose by $4.7 million to $24 million as inventory levels for both switches and phones increased due to a combination of factors including a buildup of our new 400 series phones to supply both our cloud and premise customers and a slight increase in distributors’ inventory.

Deferred revenue grew to $62 million and primarily represents billings for our support maintenance contracts but we recognized revenue over the support contract term. You’ll also notice on our balance sheet that we made our second and final payment of the $3.7 million for our earn out liability related to our M5 acquisition which closed in March 2012.

Now I want to provide some insight for the business outlook for Q4 that we included in our press release this afternoon. Given our results year-to-date and expectations for Q4, we are reiterating our guidance for growth in hosted revenue for fiscal year 2014 in the mid 20% range over fiscal 2013 levels of $70.2 million.

For the fourth quarter, we expect total revenue to be between $83 and $89 million. We expect non-GAAP gross margin to be in the range of 60.5% to 61.5%, with GAAP gross margins of approximately 59% to 60% due to the inclusion of approximately 1.4 million in amortization of acquisition related intangibles and stock-based compensation charges.

Our expectation for Q4 non-GAAP operating expenses is in the range of $47.5 million to $48.5 million and we expect GAAP operating expenses to be in the range of $50 million to $51 million including approximately $2.5 million in stock-based compensation expenses intangible amortization and other costs.

We expect operating expenses to increase over Q3 levels as we move forward with our hiring plans and internal projects that we deferred into Q4.

Finally, I want to wish our customers the Brooklyn Nets, the Golden State Warriors, The Buffalo Sabers, The St. Louis Blues and the Chicago Black Hawks, good luck in their respective NBA and NHL play-offs. With that I’ll turn it over to the operator for questions and answers.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Sanjiv Wadhwani at Stifel.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

Thanks. Mike, I think you are going to have a team in the play-offs and every season looks like sometime down the road. Couple questions, first one, just as it relates to the inventory issue that you had on the gross margin side.

Can you just walk us through what products they are related to and then the large customer win that you had, I had sort of two questions on that, was that an existing premise customer and competitively sort of how did that pan out, who did you see and could you just walk us through the mechanics of that deal? Thanks.

Mike Healy

Okay, so I’ll take the inventory one, then Don can talk about the exciting new win from the customers. So the inventory adjustment was on two products for $1 million. We are not going to disclose the actual products for competitive reasons.

But it was simply – we took a look at our supply of those products which we ordered a while back versus the expected demand, made a reserve for the excess supply, we don’t think we are going to sell in the foreseeable future. So that’s what happened on the inventory as a reflect back on that, I think, this is the first time in over seven years I can remember that we have had any amount of significant inventory reserves.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

Got it,

Don Joos

Yes, Sanjiv, it’s Don. I think I am relating to that that large deal that was not a migration from a premise to a cloud.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

Got it. And comparatively could you just – any details if you could give us as to how that whole thing panned out on the competitive side?

Don Joos

We are displeasing a premise competitor in this process here and bringing them their total environment to a cloud-only environment.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

And I am guessing on the hosted side, you probably had the usual suspects competing for the deal or?

Don Joos

Yes, I mean, there is lots of players obviously in the marketplace right now. As we have gotten into the mechanics, it’s we were working very closely with this customer here. So I think we probably saw a less of competitive nature in this particular deal than I would say in other deals.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

Okay, and any color on the industry Don?

Don Joos

Yes, from a vertical perspective, it’s – the customer in the media and communications vertical, we still have the permission right now to providing it.

Sanjiv Wadhwani – Stifel, Nicolaus & Company

Got it, all right perfect. Thanks so much.

Don Joos

Thanks, Sanjiv.

Operator

The next question comes from George Sutton with Craig Hallum.

George Sutton – Craig Hallum

Thank you. I wondered if you could discuss, you mentioned you are in the early stages of the new cloud program with your resellers. Can you give us a sense over the next few quarters, how significant the impact you would expect to come from the furthering of that situation?

Don Joos

Yes, so – I mean, correct, we are in the early stages with the premise partners now part of the cloud program. I would say, we had a couple things happening simultaneously, George. I’ll go overall then I will come back to them specifically.

These early stages is really one of many components from a growth perspective as Mark Roberts joining in the December timeframe as our CMO. He has been doing a lot of work with the sales team as it relates to the marketing efforts, how we are using our marketing dollars for campaigns where we are targeting things.

So, that is an overall contribution that a lot of the existing channel is leveraging and creating some of the growth. What excites us is that the premise partners, their excitement is what excites us, again they are in the early stages, so we have seen some deals, but they are still starting to ramp right now.

We are expecting them as time progresses over the next couple of quarters and they start to ramp up both from the training as they start to ramp up from the pipeline is that they are going to be and continue to be more and more of a material part of our bookings growth as we look out into the horizon.

And then naturally the bookings and time translates into a revenue perspective. So, our expectation is as they are ramping in the FY 2015, they are starting to make a significant contribution as we think about our FY 2016 revenues.

George Sutton – Craig Hallum

So as a follow-up, that isn’t really a follow-up relative to the 4000 seat deal that’s obviously a massive size cloud only deal and I am curious from a broader perspective, are you seeing more customers willing to do those kinds of deals on a cloud-only basis or are we still seeing the largest customers go predominantly premise with some interested migrating over time to the cloud?.

Don Joos

It is a large deal and obviously that's what we are very excited about it. I think it is indicative of the broader trend. What we have seen as we look at our pipeline right now is an increase in the size of the deals that are going into our funnel, when I say pipeline, we are referring to our funnel, our opportunities are getting are larger and larger there.

I think that’s a broader industry trend right now. If I look six months ago, I think we talk about lot of deals being smaller. As I look at it now, I would say, every six months, I would expect to see every six months that we start to see a larger and larger adoption and our pipeline or funnel opportunities to reflect that.

And so far, as I looked at Q3 and we start to looking to our Q4 right now, we are starting to see that there. So, yes, I am starting to see a market trend happening right now, yes.

George Sutton – Craig Hallum

Super, thank you.

Don Joos

Thanks, George.

Operator

The next question comes from Barry McCarver of Stevens Inc.

Barry McCarver – Stevens Inc.

Yes, thanks guys for taking my questions. I guess, first off, on the enabled channel partners, of the 19 that you’ve announced, can you first off walk through the math of the enabled partner, I am pretty sure if – they have a quota to meet every quarter and how many of those 19 contributed to some sales in 3Q?

Don Joos

Yes, so, it’s both the – of the three categories that we have which is the referral the approved and the enabled, the approved and the enabled, both of those categories partners are signing up for a specific volume commit as it relates to recurring revenue on an annualized basis.

The approved are committing to a little bit smaller and they are doing a little bit the selling process. The enabled are committing to a larger number and they own the entire sales and sales process in there. So, the 19, in each of these categories, there are – I would say, sub-levels based upon the compensation model that they choose.

Of the 19, again they are in the early stages. We have seen a small amount of deals so far coming from the enabled partners. We have been really more focused with them on the training and watching their pipeline of opportunities building.

So at this point, in regards to our Q3 results, they were not a material contributor yet and I think, and I – so that is why I think we are so excited. We have such a good result and they have not yet begun to contribute yet, but our expectation is in the near future they will be.

Barry McCarver – Stevens Inc.

Very good.

Mike Healy

And Barry, I would just add, when they sign up for us, they sign up for an annual MRR number. So we don’t have a quarter-to-quarter per se on an annual number to get them into the different enabled versus approved sections until they have to hit those numbers in the next 12 months.

Barry McCarver – Stevens Inc.

Oh, okay. I understand. Okay, great. And then, you didn’t mentioned in your prepared remarks but it’s in the press release, you announced a new vertical sales program for the finance industry, can you give us a little more color on what you are doing there? If you talked about it, I am sorry, I missed it.

Don Joos

No, in our prepared remarks we didn’t, but you are correct, it is in our press release right now. I mean, the financial service sector for us is an important area from our installed base if we have about 1000 customers there and so as we start to look at a lot of customers in that size, we start to look at how we market and bundle our solutions into there.

We thought it was appropriate at this time to have a sales force vertical focused on that space selling into that space and so that’s what we are really highlighting is that this is an important area and we are putting resources and energy against that, because we see it as how much it has grown and how much if so could grow.

Mike Healy

And then we would have our innovation network solutions, our third-parties that help develop apps for us, they would make some specific applications for that industry whether it’s a credit union or labor and so. They are focused on that as well.

Barry McCarver – Stevens Inc.

Okay and then just one follow-up on margins, if you are 50% through with the datacenter conversions, what do you expect hosted gross margins to look like in the next couple of quarters, are we going to see that continue to kind of rebound back to the margin, pre this project?

Don Joos

Yes, so on margins, the message is the same as last quarter on the hosted margin that is – then that, as we get through the datacenter conversion in this quarter, June quarter, then we can start de-commissioning some co-lo costs and connectivity. So I do expect our hosted gross margins to start trickling up in Q4, everything else remaining constant and then ramp up from there into our fiscal year 2015 which starts in July.

Barry McCarver – Stevens Inc.

Very good, thanks guys.

Don Joos

Thanks, Barry.

Operator

The next question comes from Dmitry Netis at William Blair & Company.

Dmitry Netis – William Blair

Thank you very much. On that topic, on the margin topic guys, could you quantify what’s the upside on the hosted margin in the June quarter and what potentially we could expect in the September quarter? So, I think you have mentioned a five point upside, I was wondering if that’s still the case in the June quarter?

Don Joos

I don’t remember a five point upside. I think what I have said is, June quarter is – they start to move up and so that’s what we expect, we haven’t quantified into the number. Certainly implied in our overall guidance of non-GAAP gross margins of 60.5 to 61.5 that we will have some upward trend on the hosted gross margin number and then ramp from there, there is still some investment we are trying to make in support organization cost of sales.

So, even though our revenue will certainly ramp up, we do expect our cost to increase. We are not holding our cost down on the hosted or referred side, because there is some investments we are still making. So that will reflect in the gross margins a little bit, but it should continue to move up and just they don’t have an exact – pay it on the timing of when we are out of the datacenters and when we can stop paying co-lo rent for instance, think about that.

Dmitry Netis – William Blair

Okay, that's fair, when you fully transition, what would be the contribution roughly to the margin line?

Don Joos

When we are fully transitioned, I think what we said is our mid-term margins on the hosted business should ramp towards the 50% model, mid-term is not necessarily one year in less than five years but beyond one year.

So, we do think we can get that and that margin, that 50% includes no big change in our connectivity or our customer circuit business which as you know is kind of a pass through environment, but puts us about 10 to 12 points on the gross margin number. And just to give an update there, our new bookings on that business continue to be pretty low, our installed base…

Mike Healy

Connectivity continues.

Don Joos

Connectivity continues to be low as a percentage of total business. So that’s the good news. And then our revenue from our connectivity business declined a little bit this quarter, it’s about 18% of our total cloud business. So, all those trends are going in the right way to help gross margins after that's a very low gross margin barrier for us.

Dmitry Netis – William Blair

Okay, but are you still roughly in the built out when you expect that ramp to occur, right, that it’s not saying that ramp in the margin, I realize the mid-term target that you put out, but maybe – it could be possibly on the year, but, this is either prior quarter’s expectations, are you still sort of tracking in line with those expectations or at that line?

Don Joos

I’d say lines moved a little bit and because we are right in the middle of our planning for the next year what we are going to do from a international cloud perspective and a few items like that.

So we are kind of evaluating the impact so things are going to have on our hosted gross margin. And so, I wouldn’t say, we are going to for instance, I don’t think we are going to be at 50% in the next few quarters or anything like that on the hosted line. So I think we will ramp up.

Mike Healy

It will be ramping towards us, but…

Dmitry Netis – William Blair

Understand. Okay, thank you. I appreciate the color. And then, just speaking to the margin line, the inventories that are seen in this quarter, I think there was comment that the product gross margins should ramp back to the – kind of December quarter levels, is that, did I get that correctly? Just wanted to clarify that piece and I think were at 65.5 then, so, is that what we should be expecting for the June quarter?

Don Joos

Yes, I mean, I don’t guide by product line, but certainly implicit in our – on our margin guidance to the mid-point of 61 which is up from the 60 we just did. So, we think as reserves adequately managed our inventory for our exposures there and we don’t anticipate in the future so, that 1 million should not replicate itself in the June quarter.

Operator

The next question comes from Mike Latimore at Northland Capital.

Mike Latimore – Northland Capital

Hey, great, thanks a lot. Nice quarter there.

Don Joos

Hi, Mike.

Mike Latimore – Northland Capital

I just want to get the number, did you say there was a 100 approved partners, developed partners for cloud?

Don Joos

When I said, there is a 100 premise partners now in the approved category. The total approved category is actually larger when you factor in the existing cloud partners.

Mike Latimore – Northland Capital

Got it, okay. And then, maybe any color on the incentives you are giving to your own sales people, I mean, you talked about adding quotas. Can you talk a little bit about are there more sales people with quotas? What has changed at all? How you are thinking about that?

Don Joos

Yes, I mean, we are right now in this fiscal year 2014 specifically the second half, so that's the January through the June. The premise or a part of the premise organization started to carry a cloud quota incremental to their existing premise quota, it is not all of the premise quota carrying. I’d probably say wrong numbers roughly about half of them are starting to carry that. So, that’s the change from the compensation side that occurred in conjunction with our announcements back in January.

Mike Latimore – Northland Capital

Got it, okay. And then, as you look at the pipeline for fully enabled and the approved partners, generally what are you thinking of in terms of sales cycles, how long will they be for the product sector targeting and what kind of deployment timeline and timeframes would you expect as well?

Don Joos

Yes, so, as I look at that right now, I would say it is going to vary based on our business segmentation, size-wise segmentation and I think we have approved points right now, based upon if it’s on the smaller side versus actually a mid versus, as example this quarter with 4000 seat, and those takes several quarters to implement.

So we are kind of using that right now as kind of a guide as we start to model out the future. Again, because we are in the early stages, we will probably make some cost corrections as we go.

Our expectation is that as the partners start to ramp up and get more comfortable, they are going to be getting finding larger opportunities. So, I said, as a whole, I would think that the premise partner community that’s joining in is probably going to have a slightly larger or longer cycle time.

As a rule of thumb, simply because they are going to have to targeting some larger customers. And thus by booking to revenue then may take a little bit longer than normal, because it may take an incremental quarter or two because of the size of the deal.

Mike Latimore – Northland Capital

Right, right. Yes, and then just generally, Don, obviously new bookings with future revenue growth, how do you think about the contribution of sort of current customer buying more applications or having more seats. How much growth would come from them, I guess?

Don Joos

I would say, would I expect growth from it? The answer would be, yes. If I quantify it exactly what that would look like, I haven’t yet, I think with the connect program, just we are launching in this fiscal quarter here in June, we will probably start to get some early indicators right now.

Also as we think about the install base, there are actions that we are going to be taking to migrate some install base customers at the appropriate time into a cloud solution. So, I would – that’s how I think the premise as such a strategic asset for the business right now which creates that. But probably early stages for us right now to specifically follow the applications.

Mike Healy

Yes, the other thing I would add, Mike is, when we do get a fair share of new bookings every quarter from our existing install base, we were upsizing their sizes, seat sizes and adding applications and things like that. So, I mean, it’s not one done, certainly even though smaller customers. So there is a good chunk of those every quarter’s bookings, it does come from the installed base just increasing seats or apps or anything like that.

Mike Latimore – Northland Capital

Great, thank you.

Mike Healy

Thanks, Mike.

Operator

This concludes our question and answer session. I would now like to turn the conference back to management for closing remarks.

Don Joos

All right, thank you Amy. Just some quick comments at the end here. As I reflect back over in the last eight months in the CEO role, I am extremely pleased with how far the company has come in such a short period of time and that perspective that gives me confidence and excitement as we continue to execute and see our growth initiatives mature. So I want to thank everyone for joining the call today and have a great day. Thanks.

Operator

The conference is now concluded. Thank you for attending this presentation. You may now disconnect.

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