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ShoreTel, Inc. (NASDAQ:SHOR)

Q4 2014 Results Earnings Conference Call

August 7, 2014, 05:00 PM ET

Executives

Barry Hutton – Director, IR

Don Joos – President and CEO

Mike Healy – CFO

Analysts

Barry McCarver – Stevens Incorporated

George Sutton – Craig Hallum

Dmitry Netis – William Blair

Inder Singh – SunTrust Bank

Greg Burns – Sidoti & Company

Mike Lin – Stifel

Mike Latimore – Northland Capital

Spencer Mitchell – Odeon Capital Group

Operator

Good day, and welcome to the ShoreTel Fourth Quarter Fiscal 2014 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded and our company uses a ShoreTel system.

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

Barry Hutton

Hello, and thanks for joining us today as we report the financial results for our fiscal fourth quarter and fiscal year for 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 federal securities laws regarding the company's anticipated future revenue, growth 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 March 31, 2014, 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 you that 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, other adjustments and their related tax impact. We ask that you please keep your questions to the operational and financial results announced today.

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

Don Joos

Thanks, Barry. Today's announcement marks the end of a transformative, productive and record fiscal 2014 for the company and we ended our fiscal Q4 on a high note.

Before I comment on the many milestones that we achieved during the year, I want to share some key financial highlights, which include our highest ever revenue and non-GAAP profits for Q4.

Our Q4 results reflect the actions we took earlier in the fiscal year, to create a business model that positioned us for the growing demand for cloud-based solutions and has the operating leverage to generate ongoing profitability.

Our total revenue in Q4 was 88.6 million, up 4% year-over-year, led by our hosted revenues up 24.1 million, which increased 25% year-over-year.

In Q4 we produced a non-GAAP operating margin of 6.3% and a record level of non-GAAP net income of 4.9 million or $0.8 per share. We also achieved a GAAP profit of 2.12 million with an EPS of $0.03. This GAAP profitability is a key milestone for us. Our full-year results also show significant financial progress for the company. Our total revenue was 340 million, up 8%, driven by the year-over-year increase of 27% in our hosted revenue.

The non-GAAP operating income for the year was 5%, leading to a non-GAAP EPS of $0.23, a significant improvement over the loss of $0.03 a year ago. As we move into fiscal 2015, we will had keep a laser focus on achieving our strategic goals to drive our business forward, to do so profitably and to have a leadership position in unified communications, as measured by our solutions, technology, and financial position.

Our strategic goals are the following. First, drive growth. Our success will be measured in terms of our total revenue and accelerated bookings growth in our cloud business. Second, expand our technology in infrastructure capacity. Our technology and infrastructure provides the ability to deliver high-quality solutions to our customers and channel partners, while building capacity to rapidly scale our cloud customer base.

And third, to continue to earn a world-class reputation for customer satisfaction. Our strong reputation tied to the user experience provides competitive advantages with our customers and channel partners. Everyone at ShoreTel, the executive team and employees, are all held accountable for each of these objectives. And we are firmly committed to keeping a balance between growth and continued non-GAAP profitability.

It has been one year since I stepped into the CEO role, in which I committed to transform the business. This transformation has three distinct phases. The first phase is foundation, laying the foundation for change and improvements. The second phase is migration. Migrating our business to capture the growth in cloud-based solutions, while remaining competitive in the premise market. The third phase is acceleration. Accelerating the hosted revenue growth as we reap the benefits of our prior investments and strategic actions.

Today I am very pleased that we have predominantly completed the first phase as we laid the foundation for change in fiscal 2014. Last October, I outlined an aggressive company roadmap and throughout the year we consistently delivered on each of those commitments. We focused on our operational and financial model, by completing our integration and restructuring our cost model, to create greater financial flexibility.

As a result, we are positioned to execute our strategic plan, while producing consistent profitability and positive cash flows. We executed numerous infrastructure initiatives, most significant was the new data center, followed by the six-month migration of our entire cloud customer install base, which we completed in June. This investment provides our cloud customers with improved reliability and network performance.

We implemented numerous growth initiatives. In January, we modified our sales compensation plan and expanded our channel partner program to encourage our existing premise partners and recruit new partners to sell our cloud offering. As a result, we have greatly expanded the sales capacity to generate bookings for our cloud business and have started to realize early success.

During the year, we executed an aggressive product introduction schedule by launching our new SIP-based phones and enhanced salesforce.com integration for both cloud and premise customers, along with virtualization and enterprise contact center enhancements for our premise's cost solution.

ShoreTel Connect is now available to our customers and includes fax and scribe applications. We also introduced Mobility 8, which is virtualized with video collaboration, so that mobile workers can use single-touch calling for multi-party collaboration, using iOS and android smartphones or tablets. With this new mobile release, we're extending the Beta program length for the Connect Mobility application, and also expanding the Beta participants.

As we executed our business plan, we remained committed to generating a non-GAAP profit. During the first half of fiscal 2014, we made a conscious business decision to temporarily limit our investments in specific areas, including sales and marketing. This allowed us to fund key foundational infrastructure investments while still generating a non-GAAP profit and positive cash flow.

As we anticipated, that decision impacted our cloud bookings during the first half of fiscal 2014. And our bookings growth rate was in the low single-digits year-over-year. As we redirected our investments back into sales and marketing, in the second half of fiscal 2014, we grew our cloud bookings nearly 40% over the second half of last year.

We're very pleased to see the quick correlation between our second half investments in sales and marketing and the second half growth bookings. In January, we launched new go-to-market efforts targeting the growing opportunity for cloud-based solutions.

And as of June 30th, we have 34 new enabled leveled partners, plus, 129 new approved level partners. Again those numbers are incremental to the roughly 100 approved cloud-only partners we have.

In addition, Mark Roberts, our Chief Marketing Officer, who joined us in December, has also redirected various lead-generation campaigns. Although the initiatives are still fairly new, the sales momentum is matching our expectations and the partners are building their sales pipeline and contributing to our bookings volume.

In Q4, we booked almost 300 new cloud customers, by far the highest number of the fiscal year. It's also evident that larger customers are increasingly adopting cloud solutions. Today, the average customer in our install base has 45 seats, and represents nearly 2,000 in monthly recurring revenue.

As I discussed last quarter, a 4,000-seat customer was reflected in our Q3 bookings. And in the June quarter, we once again closed additional large deals. The first customer is a travel agency, with 1,900 seats. And the second is a construction firm with 1,000 seats.

Bolstered by the two large wins, we had a strong end to the year, as cloud bookings achieved another record quarter in Q4, which was 59% higher than the year ago period, and also 23% higher than fiscal Q3.

Clearly, we're excited by this progress. However, I want to remind you that our bookings results have the potential for variability from quarter-to-quarter, given the normal flow of sales cycles and the timing to close large deals.

ShoreTel is at the forefront of an industry that is in transition. And we believe it will be compromised of three models, cloud, premise, and hybrid. Furthermore, it is our belief that hybrid is becoming a critical piece of the industry transition.

We're now entering the migration phase, and we're aggressively migrating our business model to capture the growth in cloud-based solutions, while continuing to remain competitive in the premise market.

The final step of our integration effort is to complete the development of a cloud purpose, multi-tenanted common platform, which combines two separate call controls into one. This common platform will enable a single ShoreTel solution, which includes common applications such as contract center and in-conferencing, as well as common end points to be consumed in a cloud premises or hybrid environment.

We expect the common platform to be available in less than one year, which will fulfill our vision of providing customers with a single solution that can be consumed in the environment that best fits their business needs.

Over time a common platform will enable our premise installed base customers to make seamless premise to cloud migration at their natural pace. At the same time, ShoreTel will gain significant operational leverage, as we can develop our solutions once, but deliver in multiple deployment models.

We will enter the acceleration phase, as our common platform becomes available and our growth initiatives continue to mature. At that time, we will see a meaningful acceleration in our hosted revenue growth.

The sales and marketing, product development, and infrastructure initiatives we have been and continue to execute today will open up new routes to market, including expanding our international presentation. And we will have the competitive position, operational leverage, and financial flexibility to realize ongoing growth.

Clearly, fiscal 2014 was a very rewarding year for ShoreTel, as we delivered upon a wide range of commitments, including operational and financial improvements, product launches, and new growth initiatives.

With the dedication of the entire employee base and our channel partners, we created a more predictable and profitable business with much greater operational discipline. And we delivered the best financial results we've reported in many years.

There is a tremendous opportunity to change the way communications are delivered to small and medium businesses and ShoreTel is uniquely and ideally positioned to be the catalyst for that change. As I reflect on our past years' successes, it provides me confidences in our ability to execute both near and long-term.

Now, I'll ask Mike to give the details of our financial results.

Mike Healy

All right. Thanks, Don. Fiscal 2014 was a tremendous year for ShoreTel, both operational and financially with all kinds of records set in terms of cloud bookings, revenue, unit shipments and profitability.

Don's comments highlighted the extensive progress we made, including the integration of our cloud and premise operations, many product introductions, enhancements to our infrastructure and a launch of a number of growth initiatives.

During this time, we also achieved very strong financial results, by most measures the best in ShoreTel's history. I'll provide some detail on the fourth quarter results then highlight some of the full-year 2014 achievements. And then conclude by discussing our business outlook for 2015.

During our fiscal fourth quarter, we achieved total revenues of 88.6 million, which is a 4% increase from a year ago, as the company growth continues to be driven by our recurring revenues, which combines our monthly recurring hosted revenue, plus our support revenue.

The stream of highly predictable revenues grew 19% year-over-year to reach an annualized run rate of 136 million and represented 38% of the total company revenue. Q4 hosted revenue continued to grow well and reach 24.1 million, an increase of 25% over last year, and up 6% sequentially.

The accelerated growth rate in Q4 resulted from a higher amount of non-recurring revenues, plus a good increase in customer installations early in the quarter, which drove higher monthly recurring revenue.

The success of our recent go-to-market actions is evident in our cloud metrics, including the growth of our installed base to roughly 3400 customers and 151,000 seats, which is a 30% increase over last year.

Our average number of seats per installed customer grew slightly to 45, while ARPU ended at $44 per user. The average monthly recurring revenue per cloud customer was $1,974 in Q4 while our revenue churn was again below 5% annualized.

Our cloud sales efforts were very successful in Q4 as we reached our highest bookings quarter ever with a 59% year-over-year growth rate. We continue to track large customers in Q4 was no exception, with two new large customers booked, totaling 2900 seats, which will start installing over the next few quarters.

We now have 163 of our premise channel partners committed to selling our cloud solutions. Although we expect the overall bookings trend in 2015 will continue to grow, we also expect that our bookings will fluctuate quarter-to-quarter due to sales, cycles, the timing of large deals and the seasonality of purchased decisions between quarters.

Our product revenue in Q4 was 47.3 million, a decline of 7% year-over-year, but up 9% sequentially, as the June quarter is traditionally, seasonally strong. We shipped over 150,000 licenses in the quarter, which brought us close do 550,000 licenses shipped for the entire fiscal year, which was also a record amount.

In Q4, our support and service revenue continued its steady climb and was 17.2 million, up 13% from Q4 of last year. The new customer attach rates and customer renewals continue at high rates, and the strong results were also helped by a great quarter from our professional services group, that saw a 42% increase in revenue year-over-year.

Service providers had a particularly strong quarter, showing a 14% increase over last year, with 8.3 million in billings, including over 1 million worth of deals that shifted out of Q3.

Meanwhile, the international revenue up 7.7 million was a 4% year-over-year growth in Q4, and remained at 12% of our combined product plus support and service revenues. Europe continued to be strong and in July, we now move to a new European office to further support our customers and channel partners in the region.

Now, let's move on to discuss some gross margins and expenses, where I will mostly quote non-GAAP numbers unless otherwise noted. Our total gross margins in Q4 were 61.1%, down 30 basis points from last year, reflecting our continued revenue mix shift towards hosted revenue, which was 27% of total revenue in Q4. Gross margins increased 100 basis points sequentially as we had higher gross margin in all three lines, hosted, product and support and services.

Hosted gross margins showed good improvement to 43.7%, as we saw leverage from our revenue growth, plus declines in our provisioning the customer services costs resulting from our ongoing initiatives. Our product gross margins in Q4 of 64.6% was down 130 basis points from a year ago, reflecting the smaller revenue base and promotional pricing on certain bundled offerings sequentially, product gross margins improved by 40 basis points.

Meanwhile, the support and service gross margins continued its trend of expanding each quarter and reached a record high 75.9%, benefiting from the steady rise in support revenue, coupled with a great quarter we had in the professional services group I mentioned earlier. As I move down the income statement, operating expenses reflect the financial model that we created through our integration and resource realignment actions.

This operating leverage on the seasonally high revenue led to op expense dropping to 55% of total revenue, compared to 57% in Q3 in last year's Q4. Op expense dollars were essentially flat year-over-year, while total revenue grew 4%. Q4 operating expenses had a 2 million sequential increase, primarily due to increased hirings for infrastructure in IT projects, most notably our common platform, along with higher sales commissions, linked to stronger premise revenue and cloud bookings growth. We ended June with 954 employees, with the 24-person increase mainly related to adding engineering resources in low cost regions.

Finally, our operating profit for Q4 was 5.5 million or 6.3% of total revenue, resulting in our highest non-GAAP net income ever of 4.9 million or $0.08 per share. The financial improvements are also reflected in our year-over-year GAAP numbers, as gross margin dollars increased, while the GAAP operating expenses decreased by 2.4 million, resulting from our integration efforts and lower stock compensation expense.

In Q4, we achieved a GAAP net income of $2.1 million, or $0.03 per share, which is a significant financial milestone for our company. Our progress during the year enabled us to strengthen our balance sheet as well. We ended the year with 56.1 million in cash, and during Q4 we fully repaid our line of credit. As a result, our net cash position has increased by over 150% from the last 12 months.

We generated $8.3 million of cash flow from operations in the quarter, representing improvement above Q3 levels, due to the higher profitability and better working capital utilization.

For the full year, we generated cash flow from operations of close to $36 million, which allowed us to fund various growth actions, pay off our debt, and invest 11.7 million on capital expenditures.

Our depreciation and amortization in Q4 was 4.7 million, which includes 1.9 million of acquisition related intangibles. Our accounts receivable increased slightly to 33.8 million, while day sales outstanding was 33 days, a level consistent with last quarter. Inventory levels increased to 26.5 million, as we accelerated our purchasing schedule to take advantage of the availability of certain hardware products.

On the liability side of the balance sheet, our deferred revenue is 64.5 million, reflecting an increase of 2.5 million in Q4, and 9.5 million increase compared to last year. It's, noteworthy, that over 70% of this deferred revenue will be recognized within the next 12 months.

Now very briefly, I'll mention a few specifics about the full year 2014. Our fiscal year total revenue was $340 million, representing an 8% increase from last year. The growth was led by our hosted revenue increases of 27%, which reached 89.1 million.

Our product revenue of 185 million was essentially flat versus fiscal 2013, while our support and services revenues of 65.7 million were up 15% year-over-year. While the June market data is not yet available, we feel confident that we outpaced the premise market in our fiscal year 2014. The gross margins for fiscal 2014 were 61.1%, down 90 basis points from a year ago, because of the ongoing revenue mix shift towards lower margin hosted revenues.

The operating expenses declined by nearly $4 million in fiscal 2014, as we integrated and lined our business function around key objectives and created financial flexibility in our model. For the year operating expenses were 56% of revenue versus 62% a year ago. Thus, generating a big increase in operating profit for ShoreTel in fiscal year 2014.

In 2014, we had a strong operating profit of 16.9 million, or 5% of revenue. The net income of 14.7 million resulted in EPS of $0.23 per share, which is a vast improvement over the net loss of 1.6 million in fiscal 2013.

As I provide our business outlook, I want to tie a link between our various initiatives to our financial expectations for fiscal year 2015. In the first half of fiscal 2014, we placed a priority on investing in our infrastructure initiatives, knowing that would temporarily limit our cloud bookings growth, as Don articulated earlier.

Given those past booking levels, the time delay between current bookings and customer installations and ultimately the startup customer billings, we currently expect our fiscal 2015 hosted revenues to grow in the low 20% range over fiscal year 2014.

In order to help you measure the progress of our recent gross initiatives, we will be providing our cloud bookings growth rate each quarter through our fiscal 2015, which should assist you in your estimates of future revenue growth.

The business environment for premise solutions continues to be difficult to predict mid and long-term. As such, we will continue with our current practice of providing guidance for total company revenue, total gross margins, and operating expenses one quarter at a time. However, we are also firmly committed to non-GAAP profitability for fiscal year 2015, while we target specific opportunities for growth.

In fiscal 2015, we expect to spend a similar amount on capital expenditures as we spent in fiscal year 2014, which was just under $12 million. We expect that our non-GAAP cash tax rate for the year will be roughly 10%, reflecting the availability – available net operating losses of over $90 million that we can apply against future earnings.

With that background for 2015, let me give you the financial outlook for the first quarter of fiscal 2015. We expect total revenues to be between $84 million and $89 million. We expect non-GAAP gross margins to be in the range of 60% to 61%. Our expectation for Q1 non-GAAP operating expenses is in the range of $49 million to $50 million, a slight increase over Q4 due to expected hiring, an increase in sales and marketing initiatives, along with increased spending on our common platform.

In summary, it was a great way to end the year with such a stellar quarter. And, by the way, I thought you'd be happy to hear that we added two more professional sports teams as ShoreTel customers, specifically the Cleveland Indians and the Buffalo Bills.

At this point, I would like to open up the call for questions and answers.

Question-and-Answer Session

Operator

We will now being the question-and-answer session. [Operator Instructions] The first question comes from Barry McCarver of Stephens, Inc. Please go ahead.

Barry McCarver – Stevens Incorporated

Hi. Good afternoon, guys. Good quarter. I know it was a year of hard work. So congratulations on that.

Don Joos

Thanks, Barry.

Mike Healy

Thanks, Barry.

Barry McCarver – Stevens Incorporated

So, I guess, first off on the completion of the data center migration in the quarter, do you know – can you give us – share with us the timing of when the leases on the old data centers will run off? Are they going to be done by the end of September?

Mike Healy

Yeah. I mean, Barry, as you know, we were in three different data centers, I don't know the exact dates, but we're getting out of them as quickly as we can, decommissioning some equipment, moving some equipment. So I'd say over the – the majority of them would expire in September.

There might be a little fall over into the December quarter. So we will start to see the benefits of lower Colo costs and connectivity costs by getting out of data center, starting in Q1. We saw just a little bit impact in Q4.

Barry McCarver – Stevens Incorporated

Okay. And then I guess secondly, you always provide a lot of good guidance for gross margin. But on EBITDA margin, kind of what are your thoughts throughout the year as the hosted segment becomes a bigger piece of the revenue pie. I would assume it's going to be, you know, some pressure as we move through that cycle?

Mike Healy

Well, I mean, for us EBITDA follows operating margins, other then our depreciation and a few other things. No interest expense to speak of, right, because our debt is paid down.

So, you know, being we're not guiding to a full-year operating margin, it's hard for me to give you full-year EBITDA direction. But, you know, we're pleased with the EBITDA we generated this year. I think if you add it up, it's over $27 million on kind of a non-GAAP basis.

Barry McCarver – Stevens Incorporated

Okay. Thanks a lot, guys.

Mike Healy

Thanks, Barry.

Operator

The next question comes from George Sutton of Craig Hallum. Please go ahead.

George Sutton – Craig Hallum

Thank you. Nice results, guys. So, Don, you had mentioned in your prepared remarks the sales capacity improvements that you've made. And I wondered if you could sort of lay out for us in a quantitative way what kind of capacity do you think you have going into this year relative to what you had going into last year and even over the last couple of quarters?

Don Joos

Let me – I'll put that into a couple different ways. One was, you know, as I shared over the course of the fiscal 2014, we talked about the sales productivity with a lot of effort that was going on both from a process perspective, from a structural perspective and just from an overall cost model.

We were seeing each quarter steady improvement in our sales productivity numbers, which started to stabilize, about 1.6 million on an annualized basis per quarter carrying rep.

When we made the changes in the January timeframe, when we started to introduce a cloud quota, that was incremental to the premise quota, that productivity metric, you can't carry the same way. But I would say from a capacity perspective, we delivered a very strong Q4, while the team was carrying this incremental cloud quota. So right there you get the capacity.

As we head into FY 2015, we have also continued to refine and align the sales compensation plan for our sales teams to the market opportunities. So it's balancing both of the cloud opportunity that exists, as well as the premise opportunity that is still there.

So that's how I see capacity is how we're balancing that quota. You know, investment-wise we're going to continue to invest in our sales and marketing efforts. That's both in campaigns as well as people. We'll continue to get capacity from that perspective also.

George Sutton – Craig Hallum

Okay. My follow-up question is unrelated. But relative to Mobility 8, you mentioned extending the beta period and expanding the beta customer list. What am I suppose to read into that?

Don Joos

Nothing fancy or tricky about that. What we have is we have the timing of a new mobile release in conjunction with the timing of the connect. So with this great capability to come with Mobility 8, which is both virtualization, as well as from a video perspective, what we want to be very mindful of is the user experience.

We have – you know, we have earned a great reputation for having great customer satisfaction. We have a strong net promoter score. And so all we want to do was we want to make sure that connect was out and available, with the facts, scribe, but for the mobility piece we want to make sure that this is a great experience and great introduction. And so we decided to actually extend and expand it to make sure we stay focused on that. And that's about as simple as it gets.

George Sutton – Craig Hallum

Okay. Thanks, guys.

Don Joos

Thanks, George.

Operator

The next question comes from Dmitry Netis of Blair. Please go ahead.

Dmitry Netis – William Blair

Thank you. So let me add my congratulations on the good results. Nice outlook and nice work on the cloud gross margin front.

Don Joos

Thanks, Dmitry.

Dmitry Netis – William Blair

Speaking of that, I'd like to pick your brain Mike, where the clouds gross margins can throughout to 2015. We saw the bump this quarter. How should we think about that as we go through the…

Mike Healy

Okay. Yeah. Let me give you a little bit more color on the cloud gross margins. So like I said earlier, you know, they went up because we got a little bit more leverage in some costs, some people costs actually went down quarter-over-quarter in some of our support groups.

So that helped gross margin and just a little bit of impact from the data center moves out of New York into Texas. So we'll start seeing more of that impact next quarter. But that will be offset by some costs we're incurring and starting to ramp up around supporting the common platform and network system group and things like that.

So those two are kind of going to offset each other for a little while, and could be a little lumpy, depending on when the CapEx comes in for that common platform. So net, net, we expect gross margin to be relatively consistent for a little while, and we're going to handle it one quarter at a time, in terms of overall guidance for gross margins at the company level.

Dmitry Netis – William Blair

Okay. So do they go down actually or do they stay in the 44% range, is what you're implying here?

Mike Healy

I mean, if you look at next quarter, I think you'd say they're going to be pretty close to Q4's number.

Dmitry Netis – William Blair

Okay.

Mike Healy

Implied in the guidance.

Dmitry Netis – William Blair

Okay. And then when do we start to get into the 50s? Is that a year away, two years away. I mean, can you give us a sense of that, Mike?

Mike Healy

No. I think we're going to take it one quarter at a time, Dmitry. Just because there's a lot of different moving parts going into the common platform and when things will come in and what kind of increase we're going to get.

So we're not going to give out a number for when we're going to get to 50% or 60% for that matter until we solidify some of these other initiatives we're working on.

Operator

The next question comes from Inder Singh of SunTrust Bank. Please go ahead.

Inder Singh - SunTrust Bank

Yes. Hi. Thanks for taking the questions. So a very solid set of financials for sure across the board. And I think that it's surprising to see the strength that you have on the cloud business, in particular. And that obviously is the growth [ph] part of your business.

Can you just give us some color on, you know, on how you see bookings turning into revenue. How you see the investments cycle relative to that, the cost of provisioning, et cetera.

And, then how do you see that playing out, now that you're seeing such solid volumes there. Are you feeling like you're having to make some investments here that we should be taking into account? And I have follow-up.

Don Joos

I think from an investment wise, I think, with any SaaS model, you always have costs in front of the revenue. So I think that's a component that's into our business right now. We are seeing, as we highlighted, in our numbers both install bases as well as just these larger, we are getting good traction in larger customers, which is a great thing. The piece that comes with these larger customers is the provisioning cycle, in that they don't all get implemented all at once.

They typically take a couple of quarters. And so from the translation into the revenue, to get the full value and the compounded value, that may take three to four quarters for us to be fully realized when you're dealing with thousands of customers have a migration plan, because these aren’t net new customers we're displacing, most likely a competitive premise solution there.

So for us this is moving at the pace with the customers, as they're moving or changing the solutions in their office. But that’s probably the big thing right now is just -- it's that cycle time on those large deals from when they book and until we get actually get a provisioned and implemented is typically a couple of quarters.

Mike Healy

And then in terms of customer acquisition costs, Inder, that's an area we're certainly working on, especially around provisioning side and along sales and marketing side to bring down that CAC for us over time. A lot of initiatives on the sports side in terms of going to lower cost regions and for support and things like that.

And then sales and marketing, as Don mentioned, right, we've added an abundance of new sales resources to the cloud solution just by giving quotas to our premise sales reps. And so, that helped in Q4, but certainly the expectation is that we will ramp beyond the Q4 levels. Don?

Don Joos

Yeah. Coupled with, that I think these ties back to George's question earlier and I forgot to add one point when we talked about the sales capacity. Leveraging the channel and now the channel selling whether it's an enabled partner or an approved partner is a key part of our sales capacity, because it's not just adding sales reps, it's the investment we're making into our channel, which we have already made investments in leveraging the channel. That is the way for us.

So we believe that, yes, it is partly adding heads, as Mike had said, which have a cost, but it's also making the investments with the channel, where we already have made a lot of investments with them. And that's a cost-effective way for us to get leverage in our sales capacity.

Inder Singh – SunTrust Bank

And you started thinking about sort of the customer lifetime value of hosted customer versus a traditional customer? And I'm assuming the hosted model has a higher customer value over time, more stickiness, less churn, if you get the churn below 5%, for example. Have you thought about that at all? And how does the two compare in your mind?

Don Joos

We do, obviously look at areas like that. As you said, we're definitely focused on the churn area, because I think that's such an important lever to be focusing on right now, because that's how customers vote. They vote with their wallet.

There's the cross-sell opportunity that exists, as part of the platform that we're highlighting. It's also the introduction and expanding out the applications, so that we get greater stickiness. We get the greater ARPU from the application attach rate right in there.

I guess, the way we look at -- at the market space right now, I think we're differentiating ourselves with our common platform, common applications and common end points right now, is that it is one ShoreTel solution solving a customer's business needs.

And based upon other business needs that they have, whether it's a premise, a cloud or a hybrid, that deployment model is also there. So there's ways that we look at it. And from a lifetime value, I think the key thing for us right now is making sure that we're giving the customers, the deployment options that are going to meet their needs. But for us, we do in a cost effective way by having on platform.

Mike Healy

Yeah. And I would add, I mean, our intent is not to force anyone to go one way or the other. Certainly the cloud market is growing faster than premise. But as we get larger customers, there are many, many of them, numerous CFOs I talked to are intent on staying on-prem and having a solution that way. That enables them to capitalize and improve their EBITDA versus taking a monthly charge.

So that does influence some of the decision making, capital versus op expense. So our job is to give our customers options, and the bigger customers certainly are looking at cloud more and more as evidence. But the larger deals we're getting every single quarter.

Operator

The next question comes from Greg Burns of Sidoti & Company. Please go ahead.

Greg Burns – Sidoti & Company

Good afternoon. You've announced a couple of direct sales teams focused on specific verticals. Do you get – do you see – focusing on those verticals, do you see like a corresponding increase in sales, are you more effective in those channels, and do you plan on, kind of, rolling out that model to a different – to additional verticals going forward?

Don Joos

Yeah. The reason we do have some vertical focus, as an example, we had done a press release announcing about the financial services, as an example. This gets into a segmentation strategy. The ShoreTel solution, I would probably put it more into a – it’s horizontal solution. It works well across many verticals.

What we have found is that, we do have success in key verticals, as Mike likes to highlight our sports teams that we get the sports and entertainment is a great vertical for us. Financial service is a great vertical. Part of with Mark Roberts coming on board, we’re looking at from a marketing perspective is – looking at certain verticals from a targeting perspective, you marry that up with how we're organizing our sales forces.

Because we believe there's just – there is greater opportunities for us in, in key verticals, there are solutions fits very well and with concentrated efforts, we believe we can gain growth from those verticals. So, yeah, we are making some conscious choices, about how we're aligning ourselves to those verticals for those reasons.

Greg Burns – Sidoti & Company

Okay. And when we look at premise versus cloud, how much of a head wind now is, kind of, the substitution or the migration to the cloud now on the premise business. And do you expect that to increase going forward?

Don Joos

I think, as we had said in our prepared script, as we look at the premise market right now, we don't have June data. But the March data did show an overall premise market contraction. But, we outperformed the market from that perspective.

I would put it into the framing it's hard to predict where the premise is going. Recent data has indicated there's a contraction. Recent data continues to show that there is a growth opportunity for cloud-based solutions.

That's why we're positioning the company for where the growth is in the marketplace. We also recognize and feel that we can remain competitive with the premise market, because I see the competitive as a strategic asset, as I said, it’s a part of – as we look at the total addressable market from a point call hybrid.

It is a key component, whether they're going to migrate now, whether they're going to migrate three years from now, four years from now, whether that's an outright migration or a hybrid model, all that fits in. So, to me we're positioned ourselves for the growth in the marketplace. But we also are positioned well to remain competitive with the premise wherever it goes.

Greg Burns – Sidoti & Company

Thank you.

Operator

The next question comes from Mike Lin of Stifel. Please go ahead.

Mike Lin – Stifel

Hi. I just had a follow-up question on the cloud partner program. I know you've said that in the past earnings call that the contribution to the cloud segment from the cloud partners was pretty immaterial.

So, I was just trying to get a sense of what percentage contribution they made to cloud revenues this quarter, basically trying to figure out how much potential capacity they could add on in terms of bookings growth in the future. Obviously, you guys have terrific cloud bookings this quarter 59% year-over-year. So, wondering how much they contributed to?

Don Joos

Sure. I'll make two comments into there. One, we just look at the overall lead opportunities for our cloud business. A significant percent of the leads come from our channel partners, whether they're an approved or they're enabled. So, I'll just make that comment.

I think your specific question as it relates to our enabled and our approved partners. Last quarter very early stage and so it was an immaterial amount. This quarter obviously we've added some more, as well as the ones who signed on in our Q3 have had more time to mature and build up the pipeline.

What we saw was an increase in regards to their contribution to the overall bookings number. I would say it's still early stages, but it was an improvement and it was in line with what we were expecting to see from these partners at this time.

I think what's probably very encouraging to us, to your point as it relates to capacity, the two large deals that I'd highlighted in my prepared comments at the 1,900 seats and the 1,000 seats, did not come from these new partners that had recently signed up. That came from the existing partners.

And so for us that's good news, because that is continued momentum coming from the partners that were there and we're still in the early stages. So, there's a lot more capacity for large deals to come from these enabled and improved partners we recently signed-on.

Mike Lin – Stifel

Okay. And just a follow-up question on that. What is the plan going forward in terms of increasing the number of channel partners going forward? I guess I'm just trying to figure out how much large of a partner program you guys can build at this point?

Don Joos

Well, I would say there is more partners that can be signed up. But for me this is not the quantity of partners. This is about the through-put that they're creating for us. So, if you were doing some of the math and comparing our Q3 versus Q4, as an example, the quantity of participants that we signed up in Q4 was a little bit less.

That's not a negative. That's about us throttling, because right now this is with about getting the partners signed up, then it's about getting them trained and taught, having them work their own internal business model mechanics and their own compensation plans, building up their pipeline, us working with them.

So, to me, this is not just sign-up as many as we can, this is signing up the right amount and making sure they're becoming as productive from a sales capacity perspective as quickly as possible. And then we'll continue to add.

So, I would say I don't have a specific number in my mind that says we must get to X. I would say its north of where we are, but it's going to be balanced against the really focused more on the through-put.

Mike Lin – Stifel

Okay.

Don Joos

More opportunity at the end of the tunnel.

Mike Healy

I would say we're very pleased with the quantity we got. There's about 600 partners in the U.S. premise partners and so we're almost one third of the way there signed up. So, you know, that's a good progress in really two quarters.

So we're very excited about where we are. As Don said, it's really about the bookings we're going to bring and not about them signing up to be a partner.

Mike Lin – Stifel

Okay. Great. Thank you.

Mike Healy

Thanks Mike.

Operator

The next question comes from Mike Lattimore of Northland Capital. Please go ahead.

Mike Latimore – Northland Capital

Thanks a lot. Excellent quarter and particularly on the cloud and cash flows I think.

Don Joos

Thanks, Mike.

Mike Latimore – Northland Capital

Just following up on the channel partners, I mean, the pipeline fully enabled and the approved partners are developing, is it pretty clear that the fully enable had a bigger pipeline than the same or numerous approved partners?

Don Joos

In pipeline are you asking just in sheer volume or are you talking about deal size?

Mike Latimore – Northland Capital

Just absolute opportunity, yes. The dollar opportunity.

Don Joos

Yeah. We have – I don't have actual pipeline off the top of my head between the two – between the two, right now. So that would be actually hard for me to comment on that.

Mike Healy

For our year, we do expect more bookings from the approved partner base than the enabled partner base, just because there's going to be a lot more in terms of volume…

Don Joos

Volume of partners.

Mike Healy

Volume of partners. Is the way we've modeled it today. Q4 we had very good traction in terms of the total bookings from the partner base, between enabled and approved. Enabled was a good chunk of the total number that came in. So that was little bit probably ahead of our expectations. Overall, there's just going to be much stronger population of approved partners.

Mike Latimore – Northland Capital

Okay. Great. You talk about seeing the number of large deals. I guess, has the average deal size gone up in the last year. And if so, is that because you're having more partners or is that more of a market dynamic?

Don Joos

Yeah. So the average deal size we quote is our installed base, right. So the 44, 45 seats, 45 this quarter, is really in the installed base. And by the way, the large deal we booked last quarter that has started to install in Q4 and the two ones this quarter will start installing here relatively soon.

So overall that does move it up, but it takes a little time as you know, Mike, between getting that booking and then getting that customer installed, provision and then installed.

So I would expect more larger deals we get, that's going to drive up our volume. But there's still healthy volume in that under 50 seat customer level, too. There's certainly an expectation that those are easier to get. And ramp our volume, too.

Mike Latimore – Northland Capital

All right. And just thinking about deployment and implementation, you know, as you get more and bigger deals, can you talk a little bit about the plan to make sure that you're able to handle the provisioning and implementation, sort of smoothly, that can often become a little complicated?

Don Joos

Yeah. We have – one of the things is we have a decent size of customers who are large already. So this is not a new experience for us. We've just been highlighting them over the last couple of quarters. But we have a decent size of customers, over 1,000 already. So we do have experiences with that. Part of our plan and what's built into our plan as part of the growth is we're making assumptions on deal sizes and what the provision tools that are required.

Part of our improvement programs, too, is looking at tools to do this in the most cost-effective way. So we feel very comfortable with the pace that we're at right now and our ability to continue to move these things through the cycle and get them into the revenue stream as quickly as we can. Working obviously at the customers' pace.

Mike Latimore – Northland Capital

Great. Thank you.

Operator

Our last question, due to time constraints today, will come from Spencer Mitchell of Odeon Capital Group. Please go ahead.

Spencer Mitchell – Odeon Capital Group

Hey, guys. Nice quarter. Thanks for taking my call. Congratulations on a great year as well.

Don Joos

Thanks, Spencer.

Mike Healy

Thanks, Spencer.

Spencer Mitchell – Odeon Capital Group

Really quickly can you talk a little about how you're leveraging your internal sales team, as they migrate your existing client base to ShoreTel's cloud versus pure play competitors. And how you feel the competitive advantages you feel you enjoy when competing against the same clients for new clients?

Don Joos

So, yeah. I'll start and I'll let Don chime in. So in terms of leveraging our sales rep base, right, you just keep in mind, we're partner-focused organization. And our reps align with our partners and so they're there as a confident of the partner and they're encouraging that partner to make on cloud services and ramp them up.

One, because it's part of their quota; two, because they see that's where the market's going. So it's really a good relationship between our partner managers and our partners that ramp into cloud.

So that dynamic has been there since 14 years ago when we starred going with supporting our partners a long time ago. So we have long standing relationships with a lot of these key partners that we see every year. And ask them for feedback constantly of what's working and what's not, within our ShoreTel system and dynamics.

So, yeah, I can't give you too many specifics, Spencer, there, hopefully that gives you a sense of the relationship and how we work with – our sales reps work with our partner base.

Spencer Mitchell – Odeon Capital Group

Sure. And what are the advantages you feel you enjoy when competing against pure-play guys with the new clients?

Don Joos

I think, there's a couple of advantages that I would say that we have right now. One is, as we're looking at just new opportunities. One has to do with how we look at the market. We look at the total addressable market on a cloud, a prem, and a hybrid. And others who are pure-play, either prem or a pure play on a cloud are only looking at one particular segment.

And we're finding that a lot of customers are looking for the flexibility in deployment options, based upon their business needs. And that ability to have that flexibility is important. Two is I think as we look at the common platform, as I was describing in that flexibility the data produces as well as feature functionality, I would say is a key area.

I also think what's different, too, is that as you start to get into larger customers, which we're into already. But as the adoption starts to expand, those customers are typically used to working with the value-added reseller or a partner because that's where the relationship lies and we already have an existing channel, so we're not moving into a channel. We have a channel; we have a highly loyal channel and a great channel that’s been with us for many years, as Mike had said.

And we're now just enabling them. And that's where these relationships lie. They're the trusted advisor to their customer. So I also see that as a distinct advantage. And really the fourth is we are set up to handle large customers. That's really the adoption. As evidenced by the deals we're booking.

As evidenced by we have lot larger customers 1,000 plus in our 12 base already. So we are designed for that type of a model already. And I think that's where we have a distinct advantage.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Don Joos, Chief Executive Officer for any closing remarks.

Don Joos

Okay. Thank you. Tomorrow will be exactly one year to the day since I was announced as the CEO of ShoreTel. And I'm extremely proud of the company, the employees, and our channel partners, in what we've been able to accomplish in such a short period of time.

It is the collective enthusiasm, energy, and the overall momentum of the business as to why I love doing what I do. And it's because of this that I'm excited about what we can accomplish over the next 12 months and beyond. Thanks, everyone for joining the call today.

Operator

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

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Source: ShoreTel's (SHOR) CEO Don Joos on Q4 2014 Results - Earnings Call Transcript

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