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ShoreTel, Inc. (NASDAQ:SHOR)

F4Q10 (Qtr End 06/30/10) Earnings Call Transcript

August 12, 2010 5:00 pm ET

Executives

Tonya Chin – Director, IR

John Combs – Chairman, President and CEO

Mike Healy – CFO

Analysts

Ryan Hutchinson – Lazard Capital Markets

Steven O’Brien – JP Morgan

Lynn Um – Barclays Capital

Rohit Chopra – Wedbush Securities

Mike Latimore – Northland Capital

Christopher King – Stifel Nicolaus

Greg Burns – Sidoti & Co.

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the ShoreTel fourth quarter and fiscal 2010 earnings 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. I would now like to turn the conference over to Ms. Tonya Chin, Director of Investor Relations. You may begin.

Tonya Chin

Hello, and thanks for joining us today as we report our fourth quarter and fiscal year 2010 financial results. Joining me on the call today are ShoreTel’s 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 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 10-Q for the quarter ended March 31st, 2010, 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 forum.

We will be discussing in both GAAP and non-GAAP results throughout this call, and I ask that you refer to our press release issued today for the reconciliation between these amounts. Our non-GAAP numbers exclude stock-based compensation charges, other adjustments, and the related tax impact. During today’s call, we will be discussing both our fourth quarter and fiscal year 2010 results.

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

John Combs

Thank you, Tonya, and thanks to all of you for joining us today. I will review the highlights of our outstanding fourth-quarter financial performance.

Revenues of $42.2 million in the fourth quarter were well above the high end of our guided range of $35 million and $38 million, and slightly higher than our July 14 preannounced range of $41 million to $42 million. We were very pleased to see our fourth quarter’s revenue increase by 14% sequentially over the previous quarter, and a strong 30% over the fourth quarter of fiscal 2009.

Product revenues grew 16% sequentially, while service and support revenue grew 8% sequentially. Non-GAAP gross margins were another record at 66.8% and our non-GAAP net loss came in better than expected at $954,000 or a loss of $0.02 per share.

Fiscal 2010 revenues were $148.5 million, up 10% over last year’s revenue of $134.8 million. Non-GAAP gross margins for the fiscal year were 65.6%, up from 64.2% in fiscal 2009. Non-GAAP net loss was $2.5 million or $0.05 per share reflecting our increased spending associated with our strategic objectives we announced in October of 2009.

Before I get into the details of the quarter, I’d like to take a minute to reflect what we have accomplished in the past year. In October of last year, we announced a three-part strategic plan aimed at growing and increasing our consideration rate. Looking back, we took a calculated risk regarding the timing of these investments, which have clearly paid off. The investments we made in our business has driven our Q4 revenues to the highest level in company history by a wide margin.

I’m very pleased that we were able to continue to grow our market share and during the March quarter moved into the top three suppliers in IP telephony in the United States according to Synergy Research. As we all know, we have been operating at a down-market for over two years. Using the most recent data published by Synergy Research, the market for IP telephony in the United States declined 21% between March 2008 and March 2010, and the worldwide market declined 24%. In that same period, ShoreTel was able to show revenue growth of 15%, and as a result we continue to capture market share.

During the March 2010 quarter, our US IP telephony market share grew to 5.2%, moving us into the number three position in the United States in the enterprise IP telephony market behind Cisco and Avaya. And in the pure IP market, which excludes hybrid systems our market share is even higher at 7.5%. We increased our worldwide (inaudible) sales team by over 40% from Q4 2009 to Q4 2010. These new members in the team have ramped quickly as evidenced by our sales productivity metrics, which improved by 6% in Q4, despite the fact that approximately one third of our sales team have been with us less than a year.

We recently introduced ShoreTel 11 and Contact Center 6 further enhancing our product’s competitive advantage, and I’m very encouraged by the fact that we have seen an improvement in our brand awareness, which had increased our consideration rate over the past year. As we close our fourth quarter, we analyzed the primary drivers for our strong growth we saw during Q4. We confirmed our competitive win rate continues to be exceptional, well north of 50%.

What we do see changing is our ability to get a seat at the table for new opportunities. While it is hard to quantify it is clear that through our branding efforts more potential customers have heard of ShoreTel and have a favorable impression of us. Our sales team also clearly benefited from the growing contribution of our new team members, allowing us to follow up on more leads and chase down more opportunities. And finally our international business has ramped very nicely, now representing over 10% of our revenues for the fiscal year. All of this combined to deliver a fantastic end to our fiscal 2010.

Now let me get into some of the details about the fourth quarter. One of the highlights of the fourth quarter was the strength we saw from our US regional partner base, which represents over 70% of total revenues. As a group, our US regional partners grew 22% sequentially showing solid growth across the United States. Our regional partner revenue had not grown strongly as we liked it during the first few quarters of fiscal 2010. So, it was very good to see the engine begin to hum again, as many of these business owners’ record ShoreTel revenues during the quarter.

Businesses from national partners represented 16% of our revenue during the quarter, and was down slightly from the prior quarter. This was understandable, because this group as a whole has seen explosive growth during fiscal 2010, growing 78% from Q4 2009 to Q4 2010. Additionally, we saw a significant number of orders from our national partners in the first few days of July, suggesting the decline was driven by customer timing versus decline in demand. We are still in the early stages of penetration into the distribution category, so looking forward we expect strong growth out of this group of partners in fiscal 2011.

We’re also very pleased with our progress in our international front during the fourth quarter. International revenues represented 12% of total revenues in the fourth quarter, and were up 44% sequentially from the third quarter. We saw across-the-board growth internationally with strong improvements in EMEA, Asia-Pacific and Canada. In EMEA, highlights for the quarter included ShoreTel being selected for our contact centre capabilities by a customer with over 1000 agents, reinforcing our focus beyond IP telephony in key growth areas of contact center and unified communications. Plus our team delivered over 70 new customers and we experienced strong incremental demand from the Benelux region and Italy.

Our increase in the number of EMEA channel partners, which is up 50% in the second half of fiscal 2010, had a very positive impact on our fourth quarter and is expected to continue to drive growth into fiscal 2011. In the Asia-Pacific region, highlights included a record quarter with Telstra, significant growth in our major account sales in the region, and a very bullish outlook for fiscal 2011.

In July, we hosted our 2010 Champion Partner Conference in San Diego, California. It was a huge success with over 500 distribution partners attending our four-day conference, of which over 90 partners were from outside the United States. It was very exciting to see the energy and enthusiasm the group showed towards ShoreTel, and hear them talk about the successes they have been having delighting customers with our brilliantly simple solution that sets ShoreTel apart from other competitor’s more complex and costly systems.

We presented our plans for accelerating our growth, including significant increase in channel support staffing, as well as increased funding for brand building and lead generation programs. As the previous partner conferences the highlight we shared with our partners is our exciting product roadmap, the partners were very happy to see that ShoreTel has continued to innovate across the areas of unified communications, contact centre solutions and other corporate communications applications.

We are very encouraged by the positive reaction and great feedback we received both from the partners and the 21 industry analysts that attended the Partner Conference for the first time.

At our Partner Conference, we also made two exciting new product announcements. We introduced ShoreTel 11, which is the newest version of our award winning UC software. There are many enhancements to ShoreTel 11, but I will mention three highlights. First, one of the key drivers of our world-class customer satisfaction has been the ShoreTel communicator. Our client allows every user quick access to all of the unified communication tools, such as voice presence, [ph] instant messaging, and desktop video.

With ShoreTel 11, we enhanced the end-user experience by introducing two new versions of the ShoreTel communicator client. One is a Web-based version that can be accessed on any computer from any browser using a simple username and password login. The other version of the communicator is especially designed for the iPhone, and is available as a free download from Apple. We also have mobile communicators for the Blackberry, Nokia, Windows Mobile, and now the iPhone platform.

The second major enhancement delivered in ShoreTel 11 focuses on system administrators. With this new release, we added enhanced distribution database capabilities for improved system performance, especially in the increasing number of ShoreTel large enterprise customers in the 1000 and 10,000 user category.

The third major enhancement in ShoreTel 11 extends our integration capabilities with legacy PBXs. As we moved up market and became increasingly successful in tracking midsize and larger customers, we found that many of them want to migrate to ShoreTel – to an all IP ShoreTel based system for unified communications capabilities over time.

Our second major product announcement was the latest version of our Contact Center software, Contact Center 6. Our Contact Center is not a clumsy bolt-on to our UC solution like many of our competitors. Instead, it is integrated into the core offering, enabling simpler management and administration, as well as system consistent end-user experiences for employees across the entire organization.

The newest enhancements delivered in Contact Center 6 include a major step forward in opening our interfaces. We now offer a new real-time event feed that generates group, queue, and agent information through an open API, allowing customers to create custom applications and more easily integrate with existing business applications.

The second is our ability to support larger contact centers by increasing the number of concurrent agents supported from 600 to 1000 with a maximum of 2000 configured agents. The third major enhancement is the new ShoreTel Contact Center Agent Dashboard, a web-based application that allows supervisors to publish customized dashboards for their agents. The dashboards can also be deployed on mobile devices mobile devices such as an iPad, allowing supervisors to work with their teams without being tethered such as an such as anto their desks.

In June, we officially launched our ShoreTel for IBM Foundations UC solution for the SMB market. Our out of the box solution is a perfect choice for customers looking for a complete unified communication system, and a full suite of office applications, all driven from a single hardware appliance. ShoreTel for IBM Foundations is the first solution of this kind to service market, and is recently honored within an innovation award from Technology Marketing Corporation, TMC, in its unified communications publications. We have signed a group of initial partners to sell this solution and are quickly ramping up additional channel partners to sell and service this unique offering.

I’m very excited about all of these new products, which have received strong interest from new and existing customers, who continue to aggressively invest in product development to enable us to continue to deliver a differentiated and brilliantly simple solution.

Now I would like to take a few minutes to discuss the highlights of our 2010 fiscal year. I’m very pleased with our accomplishments this year, including growing both our US and worldwide enterprise market share by over 30% in the last two years, and moving into the top three US IP telephony suppliers, introducing two new versions of our UC software, ShoreTel 10 and ShoreTel 11, adding significant functionality and extending our lead competitively. By being the only UC vendor to receive a strong positive in Gartner’s market scope for unified communication solutions in the 20 to 500 line market, strengthening our position in the Gartner Magic Quadrant for corporate telephony along both axes, completeness of vision and ability to execute.

Shipping our 1 millionth phone continued to add to our distribution network, growing our total number of partners and distributors by approximately 17% during the year, adding approximately 3000 new customers bringing the total of over 14,000 unique customers, serving 1.4 million end users. We entered the quarter with $116 million in cash and short-term investments. For the year that equates to over $11 million of cash flow generated from business operations, and finally delivering world-class customer satisfaction every quarter for five years in a row.

This is a critical period in the company’s life cycle and ShoreTel is positioned very well for its next significant growth phase. Our three part strategic plan has clearly started to pay off during the fourth quarter as the company has made some impressive accomplishments like growing revenue in the United States and internationally to achieve the highest revenues in company’s history by a wide margin, and consistently delivering a level of customer satisfaction that significantly differentiates ShoreTel from our competitors.

We are making our mark in the industry as a prime challenger in the status quo of overly complex and expensive systems. Our brilliantly simple message is resonating with customers, resellers and especially prospects alike as evidenced by our most recent results. Organizations are increasingly willing to break with old habits, laying off the systems that are well exceeded (inaudible) and they are choosing ShoreTel as the best solution with the lowest total cost of ownership, and highest customer satisfaction in the industry.

I firmly believe that ShoreTel is on a positive course for the future and that we will look back in 2010 as the year we laid the foundation for ShoreTel’s next phase of accelerated growth. With that I will turn the call over to Mike. Mike?

Mike Healy

Thanks, John. I’m very pleased that ShoreTel delivered 14% sequential revenue growth to $42.2 million, and achieved record non-GAAP gross margin performance of 66.8%. We continued our investments in our strategic objectives, and a ramped non-GAAP operating expenses by $3 million to a total of $29 million.

Therefore, we had a non-GAAP net loss of $954,000 or $0.02 per share. Now let me review some of the important metrics for the quarter. Product revenues grew 16% sequentially and 30% year-over-year to $33.5 million, which we believe will point to market share gains for ShoreTel when the June quarter data is released later this month.

We sold 96,000 end-user licenses in the quarter compared to 85,000 in the March quarter, an improvement of nearly 13%. Within our vertical markets, we saw excellent sequential growth in the professional services, government, and education verticals. Business from our major accounts program was very strong with a sequential increase of 55% during the quarter, which included numerous large add-on orders from some of our largest customers, including Robert Half International and Ashford University.

We added 800 new customers during the quarter bringing our total customer count to over 14,000. Volume from our US regional partners was up 22% from the third quarter. In general, we are seeing more confidence from these partners. International revenues were 5.1 million for the quarter, up 44% from the third quarter and representing 12% of our overall business. International revenue, driven by excellent growth in EMEA and Asia Pac grew over 129% compared to the same quarter last year.

Service and support revenue continued its steady upward climb and grew 8% to $8.8 million, mostly on the strength of a 16% increase in support renewals. Our national partner revenue was down slightly this quarter to just over $7 million or 16% of total business. In addition to what John mentioned, another factor influencing the revenue from these partners is that our service providers have been moving towards performing their own installation services and providing customer support. This is a positive development in that it makes the ShoreTel product more strategic inside of each provider, which will ultimately drive more volume.

However, in the short term the transition is having a small negative impact on services and support billings. Our revenue concentration continues to be well distributed with only one partner between 5% and 10% of revenue for both the quarter and the fiscal year. In addition, no end customer was greater than 5% of revenue for the quarter or the year.

As you would expect, our improved revenue had a favorable impact on gross margins. Our non-GAAP product gross margins were an all-time record high of 66.9%, up 120 basis points from Q3. Our service and support gross margins at 66.1%, down slightly from last quarter as we made a few incremental hires to support our growing customer base.

Non-GAAP operating expenses increased $3 million or 11% from the third quarter to $29 million and was slightly higher than our expectation due to variable incentive compensation associated with the increase in revenue. We also continued our hiring in the sales area by adding nine quarter (inaudible) in the quarter, bringing our total for the fiscal year to 132 sales people, which represents a 42% increase for the year.

Our non-GAAP net loss of $954,000 included approximately $113,000 of interest income in Q4, foreign exchange losses in the euro and British pound currencies totaled $197,000, and therefore drove an 84,000 loss in the other income and expense line on the P&L.

Our GAAP net loss of $3.7 million, or $0.08 per share, included $2.9 million of stock compensation and related tax adjustments. When we have low levels of earnings or losses, we will have fluctuations in our tax rate due to stock compensation and timing differences, the tax treatment, legislation and other factors that may have a material impact on both our GAAP and non-GAAP tax rate.

Speaking of taxes let me give you an update on our 382 NOL recovery project. As you may recall, during last quarter’s call I indicated our recovery of NOLs could be in excess of $20 million. While we have a little bit more work to do in this complex area, I can tell you that it looks like our NOL recovery amount will be at least $25 million, and could reach $35 million or more. We expect to get cash refunds of cash prior taxes paid of $2.2 million, most of which we expect to receive in the current quarter. Going forward the remaining NOLs will be used to offset future GAAP taxable income. We will keep you updated as we finalize the NOL recovery amount on the next earnings call.

Now, let me review some of the balance sheet highlights for Q4. Days Sales Outstanding, improved one day to another ShoreTel record at 36 days, which represents a 12 day or 25% improvement in DSO over a one-year time span. Inventory decreased by $2.3 million to $10 million, as we have a solid increase in our inventory turns due to the large increase in shipments. I expect inventory levels to grow in the upcoming quarters as we build a plan for significant future revenue growth.

Deferred revenue increased 8% to $28.7 million driven by an increase in support renewals that we typically see in our fiscal fourth quarter. Capital expenditures were approximately $1.1 million, and depreciation and amortization was approximately $760,000. Also, we generated $1 million in cash flow from operations, and we ended the year with 479 employees, which represents a 28% increase in headcount for the year.

In terms of revenue specifics for fiscal year 2010, our strongest growth areas included our national partners, which are AT&T, Qwest, Verizon, Black Box, and CDW showed a solid 77% growth in volume year-over-year, driven by large percentage gains from AT&T, Qwest, and Verizon. Our major accounts program in government areas also showed year-over-year growth of over 30% each.

Service and support revenue grew 24% to $31 million on the strength of a growing and very satisfied customer base. For the year, service and support revenue was 21% of total revenue. International revenue for the year was $15 million, or just over 10% of our total business, and showed year over year growth of 60%. We are now able to sell into 35 countries outside the US with the UK, Australia and Canada being our strongest international locations.

For the year, we saw a 29% increase in customer accounts, and business from new customers represented 44% of total business. Before I move to the outlook for Q1, I would like to cover one other accounting item. First, as most of you know, ShoreTel will [ph] be impacted by the new revenue recognition rules EITF 09-03 and 08-01 beginning in Q1 of fiscal 2011. On a test basis, we calculated the impact on these rules on our Q4 revenues in order to give you an estimated impact on Q1. Based on our preliminary review, product revenues in Q4 would have increased by approximately $150,000 and support revenue would have decreased by the same amount. So, clearly we don’t expect a real impact to our revenue lines when we report our Q1 results.

Next, I will discuss our outlook for the September 2010 quarter. Based on our backlog and business booked to date, we expect revenue to be in the range of $41 million to $45 million. Based on the data we are seeing from our leading indicators, we plan to continue aggressively ramp the sale and distribution activities of the company. We’re off to a good start with 15 sales employees already started on having accepted offers to start this quarter.

For the September 2010 quarter, we expect non-GAAP gross margins to be in the range of 65% to 66%, and GAAP gross margins are expected to be approximately 75 to 100 basis points lower due to the inclusion of $300,000 in stock based compensation charges. We expect non-GAAP operating expenses to grow in the September quarter as we continue to invest in our strategic activity, as well as increased expenses related to our year-end audit, SOX, tax activities and our partner conference, which cost us in excess of $1 million. Therefore we expect our Q1 non-GAAP operating expenses to be in the range of $30 million to $31 million.

We expect GAAP operating expenses to be in the range of $33 million to $34 million, including approximately $3 million in stock based compensation expenses. We realized many of you are wondering when to model a return to profitability. The exact timing of that includes several factors, including getting our new CEO up to speed on our investment strategy. We’re comfortable saying that despite the continued investments towards our strategic objectives, we expect to return to profitability before the end of fiscal year 2011.

I would like to take a minute to discuss John’s departure as CEO, which is slated for September 30. John has done a tremendous job of leading the company over the past six years. Some of the highlights include growing revenue from $19 million in 2004 to $148.5 million this last year, and moving us into the number three position in the United States IP telephony market, improving GAAP gross margins from 50% in 2004 to 65% in 2010, leaning [ph] on a successful IPO in July of 2007, expanding our regional partner network from under 400 to over 800 that deliver 80% of the company’s revenue.

John oversaw the expansion of our Tier 1 distribution partners to include all three major telecom carriers in the US, AT&T, Verizon, and Qwest plus Telstra in Australia. We also grew our cash and short-term investments from $738,000 in June 2004 to $116 million today. And most importantly John built the culture of delighting the customer and delivering world-class customer satisfaction every quarter for five years in a row.

I as well as the whole ShoreTel family will miss you John. You work over the last six years have positioned ShoreTel extremely well for success going forward. We were really lucky to have you. We appreciate all your hard work, and wish you the best of luck in your next venture.

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

John Combs

Thanks for the kind words, Mike. It has truly been my pleasure to work alongside such a talented team here at ShoreTel and with our partners and end user customers worldwide. A CEO search is under way and I’m supporting the board in this search in order to ensure that we track the very best talent available to ShoreTel.

Frankly, there has never been a better time to attract a new leader. The board and the executive management team are all committed to executing our strategic plan, which is designed to deliver accelerated revenue growth. ShoreTel’s new CEO has a solid strategic plan in place that will enable them to hit the ground running.

Special thanks to all of you that have believed in the ShoreTel team during the past six years, and with that let me turn it back to Paula to open it up for questions and answers.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Ryan Hutchinson of Lazard Capital Markets.

Ryan Hutchinson – Lazard Capital Markets

Good afternoon, and congrats on the quarter.

John Combs

Thanks.

Ryan Hutchinson – Lazard Capital Markets

I guess, the obvious question is John is just why you’re leaving now as it appears to be you know are hitting on all strides here?

John Combs

That is the first time I heard that question Ryan.

Ryan Hutchinson – Lazard Capital Markets

Yes, now I’m asking in an open forum though right?

John Combs

Right, everybody does. So, here is the company’s situation. First of all, you want to leave it or [ph]. So, I wasn’t planning to leave the organization until we broke through the $40 million range. And now that things are really hitting on all cylinders, and we had a major partner conference coming up, we thought the timing would be good to make the announcement of a transition.

So that is basically the short answer to the question. The strategy is working. The company is on a roll. It is like changing race car drivers in the middle of the race. The car is still moving, you want to do it on a straightway and when things are going well. So that is basically what we are doing.

Ryan Hutchinson – Lazard Capital Markets

Okay, fair enough. And then if you just look at the upside in the quarter, and kind of analyze it, how much do you think was driven by the new hires versus perhaps share gains from some of your competitors like Mytel and the woes there – the recent woes there and then maybe the Nortel and Avaya opportunity.

John Combs

Well, I definitely think we gained. So adding the sale executives has certainly helped to have our folks in the field not be quite pressed so thin. But it is true that we have benefited from the Nortel and Avaya situation, particularly based on Synergy Research they lost 6 points of market share last quarter, and when I say last quarter, the March quarter that is the latest numbers we have. And Mytel’s market share has been declining over – actually since the time that they acquired the Inter-tel group.

So, we have definitely benefited from that, and as I mentioned in the call Ryan, I’m very pleased that the competitive win rate, which is extraordinary for us continues to be at that level.

Ryan Hutchinson – Lazard Capital Markets

Okay, fair enough. And then just finally on gross margins, the guidance, can you kind of break that out between product and service, I mean, specifically what I’m trying to drive at is why wouldn’t the product gross margins continue here at the level seen last quarter, and that’s it from me. Thanks.

Mike Healy

Yes, so it is Mike. So, the gross margin guidance 65% to 66% has been obviously down from what we did last quarter and there is really two reasons. Both support gross margins and product gross margins obviously influence that. So on the support gross margin side, we do expect to ramp up hiring in the customer support organization so that we will always have a little bit of impact on the margins. And then also on modeling, we are having a little bit of component costs go up on our phones, and so I expect our margins on the phones to drop a little bit, and so that is the reason I have been modeling product gross margins down a little bit.

Ryan Hutchinson – Lazard Capital Markets

Is that supply constraints that you are seeing.

Mike Healy

No, no supply constraints. It is just some components from our phone manufacturer going up a little bit.

Ryan Hutchinson – Lazard Capital Markets

Okay, fair enough. Thanks guys.

John Combs

Thank you, Ryan.

Operator

Your next question comes from Steven O’Brien from JP Morgan.

Steven O’Brien – JP Morgan

Hi, thanks for taking my question. Could you please comment on the sort of the tone of business through the quarter, and then has it kind of continued in July, or anything noticeable about the pace of demand, any drop-off either in the EMEA region or in general towards the back end of the quarter, you know, the economic outlook started to look more gloomy?

John Combs

You know Steve, I know that Cisco has put forth a pretty negative forecast, and we know that a new entrant to the publicly traded market in our business has preannounced a shortfall. But frankly, we are not seeing it. So for our first two months as we went into the quarter, we were above plan and we had a spectacular close in June. And that continued, and when we look at our business today, we are actually ahead of where we were last quarter in terms of our sales in the July in the early part of August period. And this has traditionally been a tough quarter for us because people are onto the market with (inaudible) et cetera.

So, we’re not seeing it. Our pipeline is strong. Our sales forecast is strong. The enthusiasm with our partner network has never been better; customer satisfaction is at world-class levels. So, right now, knock on wood, we are not seeing a slow down, and based on the revenue outlook that Mike gave you, you can see we’re pretty bullish on things moving forward, both in terms of returning to profitability and continuing to grow the revenue line.

Steven O’Brien – JP Morgan

Thanks for that. On the September quarter, I guess there are some challenges from exiting your fiscal year, partner conference, seasonally slower time for vacations et cetera, but my model goes back to 2006, and I think ShoreTel has always posted a strong sequential September. I guess my question here is what is the uptake from government and education? Is that typically stronger here in September, and if you could remind us what – how large those verticals are as a contributor.

John Combs

Yes, in the government area, we have got a very strong presence in the education side of the government. We have got a very strong presence in state and local government. We are not as strong in the Federal area, which in the fiscal year I believe closes in August. So that is not a big pop up for us like it is with Cisco, for example, maybe in Avaya. But I think Mike can go over the numbers in the government area. In the last quarter, we had some spectacular growth in our government business, government and education.

Mike Healy

Yes. So just in terms of the vertical concentration, our biggest vertical last quarter, Q4, professional services and that has been our biggest. That has driven some of our major accounts like Robert Half International. And the other ones, the big one there education and government as you mentioned, and they are typically between 10% and 20% of the total volume with professional services being the largest.

Steven O’Brien – JP Morgan

Okay.

Mike Healy

Does that answer your question, Steve?

Steven O’Brien – JP Morgan

Yes, more or less. I think the only other question I have in the – just wondering, John if you can kind of comment on your 10b5 share sale plan. I guess the 144 filing came out today, you know, I missed the previous disclosure on the

10b5, but what is the sort of pace of the future share plan sales here going forward.

John Combs

Yes, I haven’t made any changes in my 10b5 plan at all. I think what has happened is as the volume of shares for ShoreTel has increased substantially in terms of average days trading, they are required to file a form that highlights the fact that the maximum number of shares I could sell would be higher just because the daily volume went up. That was strictly a procedural issue, no change in my 10b5 plan at all.

Steven O’Brien – JP Morgan

I appreciate that clarification, thanks.

John Combs

Thanks Steve.

Operator

The next question comes from Lynn Um of Barclays Capital.

Lynn Um – Barclays Capital

Hi. Thanks for taking the questions.

John Combs

Hi, Lynn.

Lynn Um – Barclays Capital

Hi. I guess I just wanted to go a little bit deeper into the guidance, it sounds like on a sequential basis it can go anywhere from down a few points to up 7%, and for the prior question, historically I think it has been in the mid-single digit range, maybe just comment on what some of the factors may be that could drive that towards perhaps the lower end versus the higher end of the guidance range?

John Combs

Lynn, we do the forecast and the guidance the same way every quarter. It is pretty routine, and we get – our estimates from our sales both highs and lows, and their best guess. And so, I’m not going to get into the details of what could go up or down. You know, we are certainly cautious in listening to what some of our other competitors are saying about the marketplace in IT spending, but we are feeling very good about where we and our guidance, and we have hired a lot of sales people recently, and we have been spending a lot of money on branding.

And so we expect revenue to keep going up, right. That is the reason we did all this investment. So in terms of high or low, we want to put a range out there that we certainly believe is achievable every single quarter.

Mike Healy

But also Lynn, I think too as you know very well, we have to book and ship the majority of our revenue each and every quarter during the quarter. And so a lot of that comes in the last month. So that is why you are going to be – always have a downside that is conservative.

Lynn Um – Barclays Capital

Okay, okay. And then going back to the gross margins, I may have missed this, but what was behind the product margin strength in particular this quarter, and also on the designs [ph] could you maybe just comment on the pricing environment, anything abnormal or was it what you would have normally expected?

John Combs

Yes, so product margins obviously we are very thrilled at 77% almost on the product side, and that is really just a function of the revenue increase more than anything in that there is some level of fixed cost in our product margin, some of the operations group of things like that. So that number doesn’t go up or down. So that is one part of it. The second part is in Q3, we had a little bit of higher transition cost when we moved our OEM manufacturer and so, Q3 had a little burden of product margins that didn’t repeat itself in Q4. So, those are the two reasons why they have had better achievement.

Really the revenue upside can you see really flows down to the gross margin, all the way down to the bottom line pretty quickly.

Mike Healy

And Lynn, as much as I like to say we have 77% product gross margins, it is really 67%.

John Combs

Sorry.

Mike Healy

It does make a really good internal goal.

Lynn Um – Barclays Capital

Okay. And then on the pricing environment?

John Combs

Pricing, there was a very, very slight uptick in the discounting in the quarter that we saw, but not material at all. And as you are very well aware, our team, we put a lot of time and a lot of investment and a lot of effort, and one of the biggest things at the partner conference was the total cost of ownership tool for ShoreTel, where we have a total cost of ownership guarantee.

If we are not at the lowest total cost of ownership in the market place of any major supplier, we will lower our prices until we are. And we have got that all mechanized competitors, it is on our public Web site. So, we really are putting a strong drive forward

to not get hooked into the discounting game to book business, but have the customer step back and look at what their hard dollar costs are going to be over 3 years, 5 years, 7 years, 10 years, and they will see a significant saving. So it is really not necessary for distribution partners to discount in the vast majority of cases, and by the way, we have had our total cost of ownership guarantee in the marketplace out now for about four or five months, and we have yet to have a claim that we couldn’t – where we had a discount to match some of our competitors.

Mike Healy

And then Lynn, I would add from a competitive standpoint, nothing too unusual in the market place from our competitors, other than one of our competitors was pretty aggressive is what we heard from our sales force, giving away support and things like that. But as John said, we don’t feel like we have to go down and match that aggressive pricing as evidenced by our gross margin and discounting, which shouldn’t change very much. We didn’t and we still are able to achieve very good revenue growth.

Lynn Um – Barclays Capital

Thanks, that is very helpful. I think that is all from me. Congratulations.

John Combs

Thank you, Lynn.

Mike Healy

Okay, thanks, Lynn.

Operator

Your next question comes from Rohit Chopra of Wedbush Securities.

Rohit Chopra – Wedbush Securities

Thank you. A few questions here, average deal size in the quarter, was that up and down, maybe you can also talk about sales cycles, if they are shortening, and if that also helped in that quarter. And I had a couple of follow-ups I wanted to ask you.

Mike Healy

So, I will take average deal size. I will let John talk about sales cycle. So that was up, almost about 10% Rohit in terms of size. So, we did have a number of large bigger orders, but nothing huge. It really would have popped revenue uncharacteristically, but we are getting larger and larger deals, $500,000 deal in the quarter is not uncommon for us now.

John Combs

And Rohit, on the sales cycles, intuitively, I think we saw a little bit of an improvement. Some of our proposals that came through during the fourth quarter were ones that have been around for a year or 18 months. So, those sales cycles are longer than we have had in the past, but they are beginning to close. So, in terms of the absolute days in the sale cycle, I’m not sure if I can comment on that being shorter, but we did get a lot of business from customers that have been around for a long time and finally moved forward.

Rohit Chopra – Wedbush Securities

Okay. And then, I just wanted to get a sense on here when you see OpEx leveling off and where do we start to look at that. I know you commented on profitability, but I thought maybe we could look at it from a different angle, where do we sort of slow down the investment, take your foot off the accelerator?

John Combs

But it is – in a few weeks, it is not going to be my call anymore, so I can respond to your question, but I think in terms of moving forward Rohit, our major strategic initiative is to grow the business. And what we see is that as we are gaining momentum, it is not necessary to over invest. But I do believe it is going to be very prudent for ShoreTel to continue to increase its investments in growing the distribution, improving brand awareness. Because right today, our biggest challenge is to have somebody makes a communication system decision without ShoreTel being present. And to the extent to which we can fix that problem has huge benefits for the revenue production, and the shareholder value of the company.

So, we’re going to see you come back to a more normal state, I believe, but we will continue to favor revenue growth over expense, being conservative on our expenses.

Mike Healy

So, Rohit, it is just a little difficult to give absolute guidance too business we will get a new CEO in here, and if you want to look at the plan and see where we are investing, but right now it is still all guns blazing on sales and distribution. We have cut back branding a little bit to help with the Partner Conference funding in Q1, and then we’re going to start ramping that up in September. So, you should see a new campaign from us coming out after that, which I think you will enjoy, and continue to push on product development at the same time.

So, I’m not trying to be ambiguous, but we got to really kind of set the groundwork, and a lot of it is depending on how fast the revenue grows.

Rohit Chopra – Wedbush Securities

No, I understand. And then last question here, just on renewals, you mentioned that support was up due to some renewals at the end of the year. Is there a way to quantify the amount of renewals from just the normal cycle? Just want to get a sense of the magnitude of that?

John Combs

Yes, it was better growth than we have each quarter. Typically, a lot of our customers 80% something are on one year renewals and so, when we had the big June in the previous year, those renewal contracts come for renewal again in the following June. So, typically in June we have a pretty big increase in the support renewals and that doesn’t affect revenue too much as you know, then we amortize it over time.

But in terms of quantifying the impact, it is always bigger in June, at least has been in the last couple of years that way.

Rohit Chopra – Wedbush Securities

All right. Good quarter, thank you.

John Combs

Take care.

Operator

Your next question comes from Mike Latimore of Northland Capital.

Mike Latimore – Northland Capital

Hi, good evening. Great quarter.

John Combs

Thanks, Mike.

Mike Latimore – Northland Capital

On the national partners, did you say that you are starting to see some of their orders pick up in the kind of the July August timeframe here?

John Combs

Yes, what we had is I think it is more of a timing issue than anything Mike that we saw. There was a slight decrease of $200,000 or $300,000 in the absolute dollars we received from the national partners in the fourth quarter or the third quarter. And we had a nice healthy set of bookings that showed up in the first few days of July. So basically, compensating for that.

Mike Latimore – Northland Capital

All right. And can you just go a little bit more in depth around the US channels, you know, are really strong in the fourth quarter there. I mean, what do you think really grow that, was it your marketing brand awareness, more sales people, overall environment, just a little more detail around that will be interesting?

John Combs

From my perspective, it is not just one single factor. I think that the customer set piece is resonating well; the total cost of ownership is very strong. The product itself is very capable and rock solid. So, we have got a strong group of references. I think we have had a long significant pipeline build up over time, and we are seeing that come to fruition. We did have a close to our fiscal year, which our partners get up on stage and we always bring 10 people up, 10 customer set, 10 volumes and 10 circle of excellence winners, and circle of excellence in the group sort of combined with customer set and revenue. And those are pre-coveted position, and so they were fighting very hard to get on stage, and it was quite a battle. I mean, the top 15 to the top 10, there was very little difference in the revenue. So there was significant enthusiasm from some of our largest partners in that area.

And the international piece was picking up very nicely as well. You have seen that has been a long hard slug for us, and 12% of revenue in revenue that we had a significant increase in overall company revenue, that was also a spark. We have great leaders in our EMEA market and our Asia Pac market, who are doing a very good job of driving business going forward.

Mike Healy

The only other thing I would add Mike, just one other comment to add is, you know, we don’t have any data, but we don’t believe there was an appreciable increase in the market size in June, and of course we will find that out in a little while. So that what led to our comments about I do believe we gained significant amount of market share in the June quarter, because I think when the market data comes out, it may be flat to up a little bit would be my guess for the June quarter.

Mike Latimore – Northland Capital

And it sounds like so far in July things are tracking well, and I guess for me discounting in sale cycle in the July August timeframe, can you provide any sort of comments on that, and do you see much change there?

John Combs

No, no. the gross margins were up, the discounting was up ever so slightly. But just a very, very small increase. The TCO is a total cost of ownership advantage we hold is significant. And we now have the tools in place Mike that anybody, you can go on our website and compare ShoreTel to all of our major competitors and see what the differences are, and we have a simple, brief, quick version of the TCO tool and we have the very in-depth customized for specific partners, specific end-users, and if we’re not the lowest total cost of ownership we will make it so. So it changes the rules of the game in terms of how to engage with the partner because we’re not talking about increases as a result of better productivity in the organization, or some of the soft benefit, we are talking about hard dollar savings.

Mike Latimore – Northland Capital

Last question, did you, as you say you have already added 15 sales people this quarter?

John Combs

We started some and offers outstanding that we will have at least 15 adds by the end of the quarter.

Mike Healy

Okay.

John Combs

The offer is out, and not everybody is started yet Mike, but they have accepted and they have a start date this quarter.

Mike Healy

Which is well in excess of the nine last quarter, so like I said we are going to continue to invest pretty heavily in sales.

John Combs

And the reason why the nine was we want to be really – it is so easy when got a lot of personal requisitions to get sloppy and screen in Bs and Cs in terms of their capability. We really try hard to ensure that we continue to attract the very best people to the organization.

Mike Latimore – Northland Capital

Okay, great. Thank you.

John Combs

Thank you, Mike.

Mike Healy

Thanks, Mike.

Operator

Next question comes from Sanjiv Wadhwani of Stifel Nicolaus.

Christopher King - Stifel Nicolaus

Hi there, this is actually Chris in for Sanjiv.

John Combs

Hi, Chris.

Christopher King - Stifel Nicolaus

Hi, just a couple of questions up here, going back to the regional partner base, it sounds like the growth that you saw this last quarter, would you characterize that to a fairly wide base, or were there just a handful of vendors that came back, and I know it was kind of lagging to the recession, and there was one thing you were looking to kind of pick up back, where there any new vendors I guess (inaudible)?

John Combs

There are some new – we added thirty something distribution partners during the quarter in North America, and probably double that combined internationally, and throughout the world. So, basically 30 and 30. But that was not the primary driver. The primary driver is that the existing distribution partners have really stepped up. And remember, our focus is not so much in the quantity of distribution partners, but the quality of distribution partners we have out in the market place.

So we’re looking to not necessarily focus on adding in terms of quantity, because we do also let a lot go. The key is to maintain the quality. So we’re looking to expand our distribution, but basically by moving up market, not down market.

Christopher King - Stifel Nicolaus

And that step up, was it primarily, you guys started at the beginning of the quarter in your perspective or…

John Combs

It is all across the board.

Christopher King - Stifel Nicolaus

Across the board. Well, but I guess looking back, what did you see when those partners dropped off during the downturn, what were some of the leading indicators than and I guess, we should be looking out for if you like over the next 6 to 12 months?

John Combs

The biggest thing is that the pipeline held steady, but nothing came out of the pipeline, basically that was it. If you look at leading indicator, it is just a…

Mike Healy

A conversion of that pipeline last year was down significantly from what we did this year. So that is one of the big indicators right, and we were lucky, we didn’t have too many partners go out of business or stick us with bad debt or anything like that. So a lot of them hang in there. But it does take a while for a partner to get ramped up and launched and trained. So, you don’t usually see an impact for a couple of quarters until a partner starts ramping up.

Christopher King - Stifel Nicolaus

Okay, great. And one last question is just maybe you can provide a little bit more color, or your feel on now that you have the product with IBM out there in the market, what is your expectation for that looking forward?

John Combs

The IBM Foundation product is very exciting. So what I was watching is the reaction of our distribution partners in the room to the demonstrations and the presentation we did on IBM Foundations was very positive. But Chris, we don’t have a really – we don’t have a good model to follow in this area. This is kind of a new frontier from us because this is not just communication, this is a communications plus office application, and so we don’t really have a good pattern to say that we have done this in the past.

So this is all new to us. And we’re adding distribution partners aggressively; the enthusiasm seems to be very high. And we will continue to measure and monitor, we of course, are beta sites for it, and those were successful installations. So, we’re going to continue to monitor carefully. But right now, we’re not giving an individual forecast on this until we get some more run-time with end-user customers.

Christopher King - Stifel Nicolaus

And does go across the same channels of your current partner base just (inaudible) incremental partners that you will be adding?

John Combs

Yes, it will be both.

Mike Healy

To sell the foundation thought you have to be qualified and this is a different sign up process. So, our partner base today just can’t start selling. They have to go through the qualification process and get approved to sell it.

John Combs

Right, and we have got a lot of people signed up and many have already completed the training.

Christopher King - Stifel Nicolaus

Okay. Thanks for your time.

John Combs

Thanks, Chris.

Mike Healy

Thanks.

Operator

(Operator instructions) Your next question comes from Greg Burns of Sidoti & Co.

Greg Burns – Sidoti & Co.

Hi, thanks for taking the call. And just a follow up on the 15 sales hires this quarter, is that coming off the 40% or so you were planning on adding last year, or is that in addition, I guess, and if so is that just based on what you are seeing in the market?

John Combs

Yes, that is in addition, Greg. So, the 40% we talked about increasing sales quarter carrying headcount that is from fiscal year ’09 through the end of fiscal year ’10 June. And then in addition, we have already got 15 kind of signed up for Q1. Obviously, we will hire probably a little bit more than that. And the reason for that is we saw the momentum, all the metrics go in the right place. So, we have always said to all of you, as long as the metrics are going in the right place, the leading indicators and revenue are going to keep ramping this up.

Greg Burns – Sidoti & Co.

Okay, and I saw the newer hires that have been around long, could you just give us an idea of how they are tracking, are they on schedule or ahead of schedule for what you expected them to be producing, and may be an update on the guidance you had given for the incremental revenue? Do you expect the new sales guys to add this year and maybe next year?

Mike Healy

Yes, so the productivity of the sales force both US and worldwide had a pretty big increase quarter-over-quarter even with hiring a good amount, as you would expect with the good revenue in bookings we had. So that is all part of it, and we expect the productivity to hopefully continue to grow, but it will go up-and-down as you hire a number of people.

So in terms of the incremental impact to fiscal year ’11, so if you take all the sales guys we hired in the US and we were quoting those US numbers, times their average productivity, which at Q4 was about $1.5 million, you get into that range of 40 to 50. that is the bottom end of that range because we were a little bit behind in our hiring in fiscal year ’10, but if you take guys we hired – the people we hired times their average Q4 productivity, you get to that incremental revenue. And that is US and on top of that will be international and new business like Foundations and things like that.

Greg Burns – Sidoti & Co.

Okay. Thank you.

Mike Healy

Thanks, Greg.

John Combs

All right. Let us wrap it up. Thanks to everybody for joining us today. I will say from a personal perspective the last six years have been a great adventure for me and one that I have thoroughly enjoyed. I’m looking forward to watching ShoreTel continue to grow. I believe that we are really on the right path forward, and it is going to be another very exciting six years for the company.

Take care and thanks for joining us today.

Operator

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

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Source: ShoreTel, Inc. F4Q10 (Qtr End 06/30/10) Earnings Call Transcript
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