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Mitel Networks (NASDAQ:MITL)

Q2 2014 Earnings Call

August 07, 2014 8:30 am ET

Executives

Michael W. McCarthy - Vice President of Investor Relations

Richard D. McBee - Chief Executive Officer, President and Director

Steven E. Spooner - Chief Financial Officer and Principal Accounting Officer

Analysts

Todd Adair Coupland - CIBC World Markets Inc., Research Division

Richard Tse - Cormark Securities Inc., Research Division

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Gregory Burns - Sidoti & Company, LLC

Spencer Mitchell - Odeon Capital Group LLC, Research Division

Paul Treiber - RBC Capital Markets, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Mitel June Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Mike McCarthy, Vice President of Investor Relations. Please begin.

Michael W. McCarthy

Thanks, Latoya. Good morning, everyone. It's my pleasure to welcome you to Mitel's discussion of our second quarter 2014 results for the period ended June 30. Earlier this morning, the company issued a press release and filed its Form 10-Q with the U.S. SEC and Canadian Securities Authorities. A copy of both the release and our 10-Q report are available on our website at mitel.com. A replay of this call will be available through the close of business on Friday, August 15, at 5:00 p.m. Eastern. To access that replay, all callers can dial in at (404) 537-3406 and enter passcode 72200477. The webcast will also be archived on Mitel's Investor Relations website until the company reports September quarter results in early November.

On the call this morning is Rich McBee, Mitel's President and CEO; and Steve Spooner, our CFO. Before turning the call over to Rich, I'd like to remind listeners of the live call and subsequent rebroadcasts that some of the statements made during this call are forward-looking statements and may contain forward-looking information within the meaning of applicable U.S. and Canadian securities laws, including forward-looking statements pertaining to, among other things, our future economic performance; general and market conditions; our business strategy, plans and objectives for future operations; industry conditions and growth in the markets in which we compete; and other factors.

Forward-looking statements speak to the date that they are made and are the result and reflect the currently available information or our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Therefore, undue reliance should not be placed on any such statements.

In making these statements, we made certain assumptions regarding, among other things, no unforeseen changes in the -- occurring in the competitive landscape that would affect our industry generally or Mitel in particular; our ability to achieve or sustain profitability in the future; stable foreign exchange and interest rates; a stable or recovering global economic environment; our ability to successfully integrate the acquisition of Aastra and to continue to realize certain synergies; and our ability to implement and achieve our business strategies. Actual events in connection with Mitel's financial results and performance could differ materially from those contemplated, expressed or implied by such forward-looking statements as a result of the various risk factors and uncertainties, including the risk factors described under the heading Risk Factors in Mitel's Transitional Report Form 10-K for the 8-month period ended December 31, 2013, and Mitel's 10-Q for the period ended June 30, 2014, which is filed with the SEC and Canadian Securities Authorities today. Except as required by law, we do not have any intention or obligation to update or make revisions to any forward-looking statements, whether as a result of new information, future events or otherwise.

With that, I'd like to now turn the call over to Mitel's President and CEO, Rich McBee, Rich?

Richard D. McBee

Thanks, Mike, and good morning, everyone. I will begin this morning by covering some highlights from the quarter and then provide a brief update on the status of our integration activities. I will then turn the call over to Steve for a detailed review of our financials.

In Q2, Mitel delivered another strong quarter reflected in impressive financial metrics. Revenues for the quarter came in at $288.7 million, a record for Mitel, with gross margins of 52.6%. I'm pleased to report that execution on all of our major initiatives, growth and integration has been outstanding. The team has been working hard to converge opportunities with a high degree of efficiency, and our intense focus continues to pay off through further improvement in our margins, strengthening of our EBITDA and cash generation. As a result, we again are able to announce another voluntary prepayment of $25 million against our existing credit facility, which Steve will cover later in the call.

Our Cloud business had a fantastic quarter. Recurring seats were up by 53,000 over the previous quarter and 37% sequentially to a total of 196,000 seats. This equates to an increase of 98% year-over-year. From a revenue perspective, this represents growth of approximately 34%. With the volume and scale increases we are driving in our Cloud business, which is already consistently profitable, we see potential to further expand our Cloud operating margins in the future.

Our total seat metrics also posted strong growth as Mitel and our strategic channel partners deploying the Powered by Mitel solutions continue to build out cloud capabilities. Now at 750,000 total seats installed, up 128,000 seats, up over 21% from the previous quarter.

I want to take this opportunity to highlight and thank our channel partner, Integra, for being Mitel's top cloud partner in North America for 2013. From 2012 to 2013, Integra recorded an increase of 86% year-over-year cloud sales revenue growth with cloud solutions Powered by Mitel. This is a real world example of the explosive growth and opportunity cloud communications offers for Mitel and our channel partners.

We also continue to see strong interest from partners globally who are increasingly looking to expand their service offerings that include cloud-based unified communications. At the beginning of June, we announced the expansion of our MiCloud Enterprise communications as a service, or UCaaS, offering for channel partners in the U.K.; and last week, announced the availability of the same service for partners in Canada, our third market introduction this year since launching in the U.S. in March.

Our performance in our cloud contact center business has also been impressive. In a market estimated at growing at approximately 8%, Mitel recorded year-over-year growth of 37%. The sales growth we're enjoying in this market is evidence that our broadened set of contact center solutions is hitting the mark.

In addition to the extensive scalability of our contact center offering, which allows us to address the needs from small business to enterprise, one of the unique differentiators for Mitel is also our ability to seamlessly integrate with -- into Microsoft environment for customers looking to maximize existing Lync investments. Mitel customer Freebridge Community Housing in the U.K. is a great example of this pragmatic approach that we've taken. Mitel's MiContact Center for Lync is delivering critical functionality to Freebridge's contact center environment, implemented in collaboration with Mitel partner, Chorus. The Mitel solution integrates seamlessly with Microsoft Lync to deliver a contact center capability that enhances the housing team's ability to support over 7,000 tenants in a managed home across Norfolk, England.

Revenues in our Premise business declined slightly in the quarter. This was offset by the anticipated business shift to cloud-based services as evidenced by approximately 15 million in recurring cloud bookings in the quarter. As an example, this included the implementation of a 3,000 seat deployment for one of the top 10 independent mortgage companies in the U.S., which had previously been a premise customer. They selected Mitel as the best path to the cloud. We expect our large Premise business, which continues to provide great gross margin expansion and contributing to the strong cash flows we reported today. We will continue to deliver GDP-like growth in this segment.

Industry data also indicates that Mitel is outperforming several key competitors and is taking market share. In July, we announced the leading -- we announced that the leading industry research firm, MZA, confirmed Mitel's #1 position in both Western Europe and EMEA overall and the #3 market share position in the IP extensions market in North America.

This week, Gartner published their 2014 Magic Quadrant for Unified Communications. Mitel was the only company to move into the leader quadrant. This is a great achievement for the company and the team responsible for our UC communications portfolio. It's because of their hard work, dedication and innovation that we reached this significant milestone. Mitel made another significant move into the challenger quadrant in Gartner's Magic Quadrant for Contact Center Infrastructure, another independent third-party acknowledgment of the progress we are making in our strategic expansion into the contact center business.

Finally, we are also delighted to announce earlier this week that the National Joint Powers Alliance, a municipal contracting government agency that serves education and government agencies across the U.S., has for the second time selected Mitel as one of its elite qualified vendors. The contract, which was awarded following a stringent selection process, includes Mitel's portfolio of communication and collaboration products, contact center solutions and cloud services, enabling us to bid on procurement projects for NJPA's 50,000-member agencies across multiple verticals.

Now shifting over to our progress with the integration. First, we are well on our way towards meeting our goal of realizing $20 million in synergies on an annualized basis by the time we exit calendar 2014. Critical in achieving this has been the disciplined execution of 3 phases of our integration plan.

Phase 1, when we announced the Aastra deal in November and ramped up quickly following the merger, which closed on January 31, focused on extracting the immediate value from the merger and rapidly integrating into a single operational and reporting structure. To do this effectively, we established a formal integration management office dedicated to bringing Aastra into Mitel. This structure enabled us to fully orchestrate the integration through each function, while freeing the majority of the organization to focus on the management of our day-to-day business. In early July, based on post-merger performance, Standard & Poor's upgraded our corporate rating, noting that our successful integration should drive a sustainable improvement in earnings and strengthen our market position.

In Phase 2, between now and the end of the year, we will be concentrating on removing all the seams so that we can maximize the operational efficiency of our business on a truly global scale. In this current phase, we see a real opportunity to expand our synergy activities beyond going on -- of the ongoing cost-saving initiatives, but to maximize channel cross-selling of our product portfolio and leverage our large combined channel. Phase 3 begins at the start of the new fiscal year and is where we will truly be able to unleash the full potential of the combined organization as one team, one company with one vision.

We have 60 million end users in our installed base today. Some will move to next-generation premise-based solutions, some will move to the cloud and some will move to a hybrid of the 2. Mitel, with our broad technology offering, common suite of applications and best path to the cloud is ideally equipped to be their supplier of choice when and how they choose to upgrade. We are delivering consistent and solid financial results that show consistent improvement, and we are generating cash, which we are in turn reinvesting back into our growth opportunities or using it to pay down debt.

Finally, the energy and enthusiasm in and around Mitel is at the highest level I've seen since joining the company. We are seeing that momentum and global leadership regularly recognized and validated by respected independent analyst firms including MZA, Gartner and Standard & Poor's. This is attracting new opportunities for Mitel internally and externally. Mitel is clearly a company on the move.

I will now turn it over to Steve to review the financials.

Steven E. Spooner

Thank you, Rich. Good morning, everyone. As Rich outlined for you, Mitel continues to execute on its strategic plans, gaining momentum and further building out our position in the global markets we serve as a leader that our customers look to for innovative and cost-effective UCC solutions.

Along that line, I will review our current quarter results, providing a year ago comparisons on a pro forma basis as if Mitel and Aastra had been a combined entity for the June 2013 period. Results reported on an actual basis are presented in the press release and in the 10-Q we filed this morning. I will also present our cloud operating metrics that we began reporting back in May so as to provide analysts and investors a transparent view into the size, growth and profitability of our rapidly expanding cloud business. And I will briefly recap one more time an explanation of the new segmented reporting that we introduced last quarter. Lastly, I will expand on Rich's comments to provide an overview of our integration activities before closing with our guidance for the third quarter.

As a reminder, effective with the reporting of our March quarter results, the company is reporting its financial performance based on 2 segments: Premise and Cloud. Where non-GAAP measures are used, a reconciliation of non-GAAP to GAAP measures was included in our earnings release. Also included in our release is a set of pro forma data going back to the 2013 June quarter, presenting the information as if Mitel and Aastra had been a combined entity as of January 1, 2013, to assist investors in evaluating the progress of the combined business. All comparisons in my prepared remarks today will be in reference to the 2013 June quarter pro forma information presented there.

The primary financial measures of performance in our segments are revenues and gross margin, which include segment revenues less cost of sales. The company does not allocate operating expenses to its segments as management does not use this information to measure the performance of the individual operating segments. In addition, total asset information by segment is not presented in the financials because the company does not use such measures to allocate resources and assess performance. The accounting policies of reported segments are the same as those described in the company's financial statements.

Our Premise segment sells and supports products and services for premise-based customers. This includes the company's premise-based IP and TDM telephony platforms, desktop devices and unified communications and collaboration and contact center applications that are deployed on the customer's premise. Premise-based sales are typically sold as an initial sale of hardware and software, with ongoing recurring revenue from hardware and/or software maintenance and other managed services that we may also offer.

The Cloud segment sells and supports products that are deployed in the cloud environment. Our Cloud segment revenues are comprised of retail offerings and wholesale offerings. For our retail cloud offerings, the company's typically pay a monthly recurring fee for these services, which includes UCC applications, voice and data telecommunications and desktop devices. Our wholesale offerings enable service providers to provide a range of cloud communications offerings to their end customers. Our cloud offerings include unified communications, voice and video calling, SIP trunking, call center, audio conferencing and video and web collaboration services.

Our wholesale cloud offerings are also sold to large enterprise customers who run their own data centers and private cloud or hybrid cloud networks, with management provided by Mitel or by one of Mitel's channel partners. Revenue in our wholesale cloud offering is billed either as monthly recurring fees or as an upfront sale of hardware and software or both. Mitel's cloud offerings, in short, comprise both retail and wholesale offerings and are billed either on a monthly recurring model or as a capital sale or both.

In the interest of being comparable to many other cloud service providers whose offerings are limited to a retail recurring revenue cloud offering, we have taken a more conservative view to what we present on the income statement as cloud revenues. We have limited our presentation on the income statement to cloud revenues sold on a recurring revenue model only. However, in our segmented note disclosure, we highlight our 2 business segments, Premise and Cloud, referenced earlier.

In that note disclosure, we capture our total cloud business revenues irrespective of whether a customer has chosen to pay for some or all of the service as a capital purchase rather than via recurring monthly charge. The strength of our wholesale cloud revenues is a testament to Mitel's unique ability to complement our own direct retail cloud offerings, with cloud deployments sold by a growing number of service providers and channel partners who choose to white label Mitel's cloud solutions to offer cloud services to their end customers.

Now to the financial review. As a reminder, I'll be comparing our actual results for the June 2014 quarter to the June 2013 quarter period as presented on a pro forma basis. Total revenues for the second quarter ended June 30, 2014, were $288.7 million compared to $293 million for the quarter ended June '13, representing a 1.5% decrease versus the prior year, reflecting the mix of cloud business sold predominantly on a monthly recurring revenue basis.

Product revenues totaled $200.9 million compared to $207.1 million in the prior year quarter. Service revenues totaled $66.9 million compared to $70.3 million in the prior year quarter. Cloud recurring revenues totaled $20.9 million, up from $15.6 million in the prior year quarter.

Gross margins for the second quarter ended June 30, 2014, were 52.6% compared to 48.6% in the quarter ended June 2013. Product gross margins were 57.6%, up from 54.2% in the prior year quarter. Service gross margins were 38.9%, up from 32.9% in the prior year quarter, and cloud recurring gross margins were 48.3%, up from 45.5% in the prior year quarter.

Turning now to our segment results. In the Premise segment, revenues for the June 2014 quarter were $261.2 million compared to $270.7 million a year ago. The decline in Premise revenues is the result of: one, the shift into cloud-based services; two, a decline in hardware maintenance and legacy CLEC services; and three, seasonality in the heritage Mitel geographies as the June 2013 quarter includes a portion of the historically stronger fiscal fourth quarter ending April 30, 2013.

Premise gross margins were 52.8% for the June 2014 quarter compared to 48.6% in the year-ago quarter. The improvement in Premise gross margins was primarily the result of the acquisition of prairieFyre, which prior to the acquisition, was a third-party OEM partner to the company. In addition, we have also benefited from ongoing cost-reduction efforts enacted on both products and services versus a year ago.

Our Cloud segment recognized total recurring and nonrecurring revenues of $27.5 million, up 23% compared to the June quarter last year. Within our Cloud segment, recurring revenues were $20.9 million, up 34% year-over-year. The growth in recurring revenues was seen in both our U.S. retail and our global wholesale offerings.

And as of the end of June, Mitel had approximately 196,000 recurring cloud seats installed, which is almost double the recurring seats we had installed as of June 2013 and up 37% from March. Our average number of seats per retail customer increased sequentially from 32 seats to 34 seats, and our average revenue per retail user was $47.

Gross margins for our overall Cloud segment were 50.9% compared to 49.3% a year ago. The increase in margins is primarily the result of increased scale as the growth in revenue year-over-year far exceeded the growth in costs.

On a geographic basis, revenues in the Americas were $121.6 million, down $10.8 million over the prior year quarter. This decrease was primarily due to the shift into cloud-based services and a decline in hardware maintenance and legacy CLEC services. EMEA revenue was $155.9 million and was up $5 million over the prior year quarter due largely to the favorable impact of currency movements. In addition, the effects of seasonality from the prior year Q4 were not as strong in Europe given the majority of the revenues were from the heritage Aastra.

Revenues in the Asia Pacific region came in at $11.2 million, up $1.4 million versus the prior year quarter.

Non-GAAP operating expenses for the June 2014 period were $122 million or 42.3% of revenue compared to $117.3 million or 40% a year ago. This excludes special charges and restructuring costs of $10.9 million versus $7.5 million in the prior year; amortization of acquisition-related intangible assets of $14 million versus $13 million in the prior year; and stock-based compensation of $1.7 million, which was up from the $1.1 million a year ago. Investments in R&D during the June 2014 quarter totaled $31.9 million, consistent with the prior year and represented 11% of revenues.

Non-GAAP SG&A expenses were $90.1 million, which equates to 31.2% of revenue, up from 29.2% in the year-ago quarter. The non-GAAP SG&A expenses excludes stock-based compensation. In absolute dollars, we saw an increase in SG&A expenses year-over-year, driven primarily by our investments in cloud and contact center as well as the additional expenses attributable to acquisitions completed in the last year.

Special charges associated primarily with the acquisition and integration of Aastra were $10.9 million in the current quarter compared to $7.5 million in the prior year quarter. Adjusted EBITDA was $38.8 million in the quarter compared to $35.2 million in the year-ago quarter. Adjusted EBITDA margins improved 140 basis points, driven primarily by gross margin expansion.

GAAP EPS was $0.01. This was down compared to $0.05 in the year-ago period, primarily as a result of acquisition-related special charges. Non-GAAP EPS increased to $0.21 from $0.19 in the year-ago period.

Moving now to the balance sheet. At the end of the June 2014 quarter, we had $134.2 million in cash and cash equivalents compared to $40.2 million at the end of the fourth quarter ended December 31, 2013. Our cash position is supplemented by an undrawn $50 million line of credit, providing us with $184 million of total liquidity. During the quarter, we generated $25.8 million in cash flow from operations, up from the $25.3 million generated in the June 2013 quarter. Our focus on running a disciplined business model and quickly capturing near-term synergy opportunities has resulted in a strong cash position.

Consistent with our commitment to investors that we will not leave excess cash idle on our balance sheet, I am pleased to announce that today, Mitel will voluntarily pay down our existing debt by a further $25 million. This brings our total voluntary debt repayments to a total of $50 million since completing the acquisition just 6 months ago. Our net debt, as defined under the credit agreement, now stands at 1.9x trailing EBITDA.

Mitel ended the quarter with a total headcount of 3,437 personnel, down from 3,612 at the end of March. The sequential decrease in headcount is a direct result of our driving operational synergies in the business.

Now let's turn our attention to our progress on the integration and towards meeting our synergies targets. The Mitel team continues to make progress consistent with our expectations to realize some $20 million in synergies on an annualized run rate by the end of 2014. The initial investments have been made, and we should begin seeing the returns on those investments as we move through the third and fourth quarters of the year. We continue to expect that we'll realize an additional $30 million of annualized run rate synergies in 2015 and the balance of 2016.

As a reminder, when we increased our synergy targets from $50 million to the current $75 million during our last quarterly report, we increased our onetime cost estimate to achieve these synergies from a previous $59 million estimate to our current view of $83 million. These estimates remain unchanged.

Now to our business outlook. Please note that statements regarding our future financial performance targets are forward-looking statements. I refer you back to the forward-looking information caution we provided to you earlier on this call.

We are providing the following financial outlook for the third quarter 2014 ending on September 30. We currently expect revenues for our September quarter to be in the range of $261 million to $276 million; gross margin percentage to be 51.5% to 53%. Revenue and gross margin reflects an estimated $1.6 million reduction relating to the effect of deferred revenue purchase price adjustments. Adjusted EBITDA margins to be 10.5% to 12%, and non-GAAP EPS to be in the range of $0.14 to $0.16.

With over half of our business now conducted in Europe, our guidance reflects that revenues will exhibit the typical historical seasonality in the September quarter. And while we are not providing specific guidance for the December quarter at this time, our current view is that the December quarter should, under ordinary conditions, be the seasonally strongest quarter of the calendar year. We will provide detailed guidance around the December quarter when we report results for the September quarter later this year.

So before we turn the call to Q&A, I would like to conclude by summarizing that Mitel is executing well. We are aggressively driving our integration plan. We are seeing early realization of attractive operating synergies. We are investing in technologies and capabilities, both organically and via M&A to support our growth strategies in contact centers and the cloud. We are expanding gross margins and strengthening our capital structure. We have expanded our float to improve stock liquidity, and our strong business performance has been rewarded with debt rating agency upgrades. And as Rich indicated, we are taking market share and enjoying heightened recognition as a leader in our industry. So bottom line, we are pleased with how the business is performing, and we remain confident in our ability to deliver superior returns for our customers, employees and shareholders.

With that, we will open up the call to your questions. Operator, if you could please review the process for asking questions and open up the lines.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question is from Todd Coupland of BIBC (sic) [CIBC].

Todd Adair Coupland - CIBC World Markets Inc., Research Division

I wanted to ask you about your Q3 outlook, if I could. So you're talking about a little bit more seasonality than I think both myself and the Street was expecting. In that seasonality, are you seeing any greater softness in Europe as a result of the various economies perhaps not coming back there, volatility in Aastra results? Or is it just that we're still digesting the combined company, and our seasonality forecast for the third quarter perhaps were not baked into our models? An update on that would be [indiscernible].

Richard D. McBee

Yes, so this is Rich, and then Steve will may be add into this. So when we look at the third quarter, there's basically 3 things happening. We have natural seasonality of the European market, and Europe is, now with Aastra, a much bigger part of the business. We're also being prudent because the synergies and the actions that we're taking in terms of headcount and restructuring are happening in the third quarter in Europe. So that's a variable that we're being conservative to deal with. The actual funnels that we have, if you look at the funneled business is not materially down. It's purely a seasonality thing. It's a caution around the restructuring activities that we're going to take. And then at a macro level, it's also the shift. I mean, we have incredibly great Cloud business, is growing very, very quickly. So we're seeing the recurring revenue -- the transition from Premise-based revenue to recurring revenue, which doesn't show as much growth but it's good -- a long-term recurring revenue stream, is growing very significantly. I mean, with the 53,000 seats added in the quarter, the over $15 million in bookings, that Cloud business, which is growing extremely fast for us, is coming in a little bit at the price of the Premise business.

Todd Adair Coupland - CIBC World Markets Inc., Research Division

Okay. And then my second question, if I could. So your OpEx was up a little bit sequentially on a non-GAAP basis. What kind of trend line should we expect on that? I would've thought it would be down a couple million quarter-on-quarter?

Steven E. Spooner

Yes, it's Steve. Yes, I think what you should see over time with the -- starting to realize some of the synergies, you shall start to see some improvement in that OpEx trend. But I think the thing that we've been balancing here is with the great traction we're getting in cloud, we've been ramping up our investments in cloud capabilities, sales capabilities, operational capabilities. We're also continuing to invest heavily in contact center where we're seeing great traction. So I would say modest improvement in the next couple of quarters, and then we'll start to see more and more impact of synergy realization going forward.

Operator

The next question is from Richard Tse of Cormark Securities.

Richard Tse - Cormark Securities Inc., Research Division

Rich, can you maybe talk about sort of in a bit more detail the milestones for restructuring, like the next phase is that -- I think you touched on it a little bit, but is it sort of specifically around facilities consolidation? Like -- and maybe some examples of what needs to be done here in the next little while?

Richard D. McBee

Yes, so basically, there's couple elements to synergies. Obviously, there's the headcount synergies that you're gaining, and then there's operational synergies. That's the consolidation of facilities and manufacturing and ERP and all those kind of things. As we sit here today, all of the workers councils (sic) [works councils] have been notified of the synergy actions we're taking, and we're in process of working through those. And every country around the world is a little bit different. U.S., you can move very quickly, and we did right from the get-go. France and Germany and those company -- those countries, you work through the workers' councils (sic) [works councils], and we're in process of doing that right now. So everyone, from a headcount perspective, every organization, every workers' council (sic) [works council] has been notified of the actions and we're in process of moving those today. Facilities, take time to consolidate the facilities. I'll give you an example. In Dallas, we had 2 facilities. We're consolidating to one. That will happen basically October 1. And so just around the world, there are about 16 duplicate facilities. We're just literally in process of working through the leases on those things and to consolidate them into one -- into the new headcount footprint, but also into the new physical footprint. On the operational side, the inventory, the MRP systems, all that stuff is work in process, where we've got plans and it's just phasing in the time and implementation schedules to get the work done in the most appropriate and cost-effective manner. So we're looking at both of those things simultaneously. So what I think is when we go into the new fiscal year into '15, we really said that this is -- right now is when we want to remove a lot of the seams in the business. And the seams, what I mean is where you've got -- you might need a way to handle the Aastra -- previous Aastra sets, for example. So all the contracts aren't modified. Just -- if you take a contract with a channel partner and you want to modify it, it takes 90 days' notice to begin with. So what we want to do in the second phase of the integration is make sure that we remove the seams, and so that we can sell the cross portfolio from a Mitel perspective, that the partners are trying to sell both product families. We've already communicated the road maps, how they work, what customer segment. So that's all done. Now it's just kind of making sure that country by country by country that we remove the seams and the teams really start moving and selling the entire portfolio, not just the pieces that they had before. And with an eye on exiting this year in a really good and strong position, you can't discount the fact that moving into the leaders quadrant is going to create a number of new opportunities for us. Many enterprises use that Magic Quadrant as a beacon for, "Okay. Well, those are the only vendors I'm going to consider." And so we've already seen the uptake in request for quotes in contracts of the larger customer base. So this is a very methodical, very well-thought-out approach to the integration that we have. And we're talking less and less about it, Aastra and Mitel, when we're talking about the new Mitel. That's the new seamless organization that we want to really make sure that we hit the new year with. And literally month by month, or actually week by week because that's how we look at it, we're just consistently having that pressure to remove seams and act as one company globally.

Richard Tse - Cormark Securities Inc., Research Division

Okay. That's really helpful color. My other question has to do with the Cloud business. I recognize that you've got 2 pieces, the wholesale and the retail side. On the retail side, we've seen some pretty big moves here with guys like RingCentral recently and 8 x 8. What's your sort of go-to-market strategy relative to some of those competitors? And what are you doing on that front here looking into 2015?

Richard D. McBee

Well, I think that we're actually very pleased with the growth rates that we've got. We've got kind of a, I think, a great competitive advantage. First of all, we have a very large installed base. And that large installed base is going to move through the cycle of going from a premise-based solution maybe to a hybrid, if they're bigger, or to a public or a private cloud. And we have the ability to serve all of that. Then in the greenfield opportunities, where customers are not a customer of ours today and they stick their head up and say, "Hey, I want to see what's out there in the market," we have very, very competitive solutions. Retail, which is what we basically sell ourselves and through channel partners through agency, or wholesale where we're enabling others and carriers and service providers to provide our service. So we look at it from a perspective of we just want a piece of the action. It doesn't matter whether it's a set, the call control or applications, and whether we're selling it or channel partners. Either one of those are very good for us, and they're force multipliers. So we continue to expand and add the number of cloud partners that we have. The number of service providers that are taking up our solution continues to increase for us on a global scale, and I think that's one of the things that we do have an advantage of. The U.S. market was the first to move in cloud, and that's where we've seen a very fast transition. And in the European markets, we see a lot of the service providers, and enterprise integrators are looking at various capabilities today. And we think that we're very well positioned with that huge installed base that we have that when it tips over in Europe and starts to move very fast, we're going to be extremely well positioned for that.

Operator

[Operator Instructions] And the next question is from Prab Gowrisankaran of Canaccord.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

A couple of quick questions. One on the Premise segment. I know you explained the transition to the cloud as kind of slowing it down. Do you expect it to continue to decline? Or do you expect to get some benefits from the Aastra acquisition and expand into new customers? If you can add -- provide some more color on the Premise segment?

Richard D. McBee

Yes, I think there's a couple of things for us. It's -- it may seem a little strange, but a premise deal or a cloud deal are roughly the same price for us. So there's basically no difference between the 2 other than the fact that one is usually over 36 -- we get paid over 36 to 60 months versus getting all the money upfront. So what we've really tried to do is make sure that because we have a complete solution that can cover the premise solution, hybrid solution or cloud, that we really aren't driving the customer one way. We're trying to figure out what's best for the customer, and his solution is long-term strategy. And that's where hybrid solutions come in, which we think is a key differential advantage for us. We can provide a solution -- as the customers get bigger, they got multiple sites. They got multiple -- they may have acquired several companies over time. And so they might not be ready to move the whole thing to cloud. They may want a premise-based solution for 75% of the company and cloud based for the other 25%, and we can seamlessly integrate those in a hybrid solution for them. So what we see is that market-by-market -- and we really got to look at that. It's not a European market. It's Germany, it's France, it's the U.K. In Europe, we are seeing the U.K. is moving very quickly. We've introduced our UCaaS solution. And so as we look at each country, the path is the same, i.e. premise, hybrid and cloud, but the timing is going to be way different. And so we have a holistic strategy of making sure that we can serve the premise customer and give him the best path to the cloud. And he may not want to go to the cloud today, but he may want to make sure that he can if he chooses to do that in the future. And we have a lot of customers that want to see the cloud solution as well as the premise solution and then they pick.

Steven E. Spooner

Prab, it's Steve. I'd just add that from a -- realizing -- I think your question is, are we going to realize benefits from the acquisition of Aastra? Absolutely. If you look at -- we can back to the user base of 60 million users that Rich touched on earlier. I mean, recognize, we're 5 months into this integration. We have really not even scratched the surface on getting the legacy Aastra channel partners knowledgeable about how to sell and position the legacy Mitel products and vice versa. That installed base, as it continues to age and those customers look for opportunities to go forward, as Rich touched on earlier, we will -- in our mind, we are extremely well positioned to be the vendor of choice, whether it's a premise, cloud or hybrid solution. So directionally, we think the acquisition has been incredibly strategic to us in terms of us being positioned to be the best path, the best vendor of choice. And notwithstanding the fact that there have been some other recent competitor results that indicate that the premise business overall has been fairly soft, I mean, we're consistently seeing indications that Mitel is gaining share. So we feel, frankly, that we're executing well on the Premise business as well as the Cloud.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Okay. That's very helpful. And so in terms of us trying to forecast it out, I know you don't provide guidance. So just kind of, one, is this softness plus integration? So once you get over that, you should see some growth in premise based on your combined product portfolio?

Steven E. Spooner

I think -- so directionally, we have consistently said that we think overall, this is kind of a GDP growth business. And we are going to see that the challenge for us to forecast, and, frankly, any of us in this industry, is the pace at which that aging installed base starts to migrate forward to newer technologies, and the pace at which we will see customers go to cloud versus premise and whether they prefer to go on a monthly recurring model versus the capital sale model. So there's a lot of variables that are in the mix. But the industry projections are more or less indicating that the Premise business overall, I think, is flattish for the near term and that there's double-digit growth projections for cloud. And our expectation is that Mitel should be able to perform. That's certainly in line with the overall market. And clearly, we're going to drive to be better than that.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Okay. And the second question I had was on the Cloud segment, it looks like the cloud recurring revenue is a clear growth driver, right? The products on that segment, can you explain, it's up 2%. Do you expect it to pick up from there? If you can explain the difference.

Steven E. Spooner

Yes, and that really is a function of -- in our Cloud segment, we capture both the cloud recurring revenues as well as nonrecurring. So the cloud product includes some purchases of cloud solutions where our customer has chosen to go with a capital sales model. Now that can be -- it can be lumpy directionally. We are -- we tend to lead now with a recurring offering. But clearly, as Rich indicated earlier, our job is to deliver what our customers need. We certainly have carriers, for example, who are cash-rich, and they love the Mitel Cloud solutions, but they want to pay upfront. And we have others who really like to align their cost model with their revenue model and are choosing to go with the recurring revenue model. So that's what really you're seeing there in that product and service under the Cloud segment that's not showing up in the recurring line is those capital sales.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Okay. Great. And the last questioner I had was back to the other synergies. In terms of OpEx, you said probably flattish at these levels for the second half and then we should see a tick down. Is that how to interpret your -- I know your synergies are split between gross margins and OpEx.

Steven E. Spooner

Yes, that's right, and I think -- so I would say towards the latter part of this calendar year, we'll start to see some impact of the synergies hitting. Again, we're 5 months into things. We're -- we think we're making great progress. Frankly, we're ahead of where we thought we'd be. So we should start to see the impact. Q3 as a percent of revenue, just given the seasonally softer revenues, you're not going to see that operating leverage. But with a seasonally strong Q4, we'd expect to start to see that operating leverage come through in the fourth quarter.

Operator

And the next question is from Greg Burns of Sidoti & Company.

Gregory Burns - Sidoti & Company, LLC

Last quarter, you gave a total contracted cloud backlog as of the end of the quarter. Where does that stand currently?

Steven E. Spooner

Yes, it's in around the same ballpark. I mean, we're still kind of fleshing out what we feel are the kind of the right cloud metrics. And I think one of the things we're looking at is whether -- we noticed that most of our cloud competitors don't report that. So -- but I think it's -- in around the $126 million range, so still a very strong, great compelling indication of future revenues to come in our Cloud business. We're also looking at some other metrics that we may roll out in quarters ahead.

Gregory Burns - Sidoti & Company, LLC

Okay. When looking at the recurring cloud revenue book, $15 million. And then Premise, I guess, the Premise segment was down about $8 million or so. So net-net, should we net out those 2 numbers? And when we're looking at the combined growth of the company, how should we be looking at this going forward? Because obviously there's going to be a headwind on the Premise side from the conversion to Cloud. But should we be looking at those numbers net of each other as the total growth of the business?

Steven E. Spooner

So certainly, as we look at the -- there's a couple of variables as we talked about. So growth in cloud is going to come for us from 2 sources: A, existing Mitel customers who choose to go with cloud solutions going forward, and that will create some headwinds on the premise side if traditionally they would've bought a premise solution. And the headwind is largely driven by the fact that they'll be purchasing typically on a recurring revenue model as opposed to the upfront revenue recognition that we typically have in a premise sale. The other portion of our cloud growth will be from the selling to new customers who have not historically been Mitel customers and clearly, through new channels that have not been historically Mitel channels. So that cloud growth would not be cannibalizing, if you will, Mitel premise sales. In the premise side of the house, we have the headwinds of legacy hardware maintenance declining, which we've talked about several quarters. But we also have nice attractive software assurance growing to offset that. We've moved away from kind of focusing on our direct business, more to channels. So there's a lot of variables. But I think back to my earlier comments, I think near term, we expect seasonality. Longer term, we expect to be able to more or less work on the thinking of this business as a GDP growth business with, likely, the majority of that growth driven by the cloud, but us continuing to perform at market or better levels on the premise side of the house.

Gregory Burns - Sidoti & Company, LLC

Okay. And in terms of the timing of when a cloud customer is booked to when you start realizing revenue, what's the time frame on that? And given the growth in the quarter in terms of the recurring seats, should we expect cloud growth to accelerate going forward?

Steven E. Spooner

So the actual -- when a -- there is typically, depending on the customer, we could have a deployment as quickly as a couple of weeks from receipt of order to actually turning up a cloud service and starting to bill for it. It could be as much as 60 to 90 days before we actually install. And often, that's driven by customer preferences more than anything else where, particularly with some of the larger, multi-site implementations, they need to coordinate the logistics internally of a new implementation. So there's a fair amount of variability there. But the other thing I would also indicate is that given that as well we have various channel partners out there, so on many of them, we typically see an order SKU that is heavier in the third month of the quarter. So the opportunity -- we could be closing business in-quarter that actually doesn't generate any revenue in-quarter. So that's why you may see a seat count we'll report -- a seat count increase that you might not be able to easily correlate to the in-quarter sequential revenue growth, but it is indicative of revenue generating potential in the business going forward.

Operator

The next question is from Spencer Mitchell of Odeon Capital Group.

Spencer Mitchell - Odeon Capital Group LLC, Research Division

A quick question. I see your gross margins continue to grow nicely in the cloud space. Can you give us an idea of what your target gross margins are here going forward?

Steven E. Spooner

We haven't -- we've given a target overall for the business. We haven't specifically in cloud. But I will say that this is a business that there's a certain amount of kind of fixed cost that needs to be built in terms of systems, data center capabilities, sales force, administrative capabilities, et cetera. So as the business -- the scale of the business grows, we would expect to see some incremental notch up in the margins over the -- as it grows.

Richard D. McBee

It's a classic volume-driven improvement. So as that business continues to grow for us at a pretty rapid clip, the fixed cost to generate it is relatively fixed. So we bring up a data center in a particular country. That has a fixed cost. The variable cost associated with that was basically nothing as the volume comes across. So we get effects of volume on our cloud business, and that will positively impact the margins in it.

Spencer Mitchell - Odeon Capital Group LLC, Research Division

Great. That's helpful. One last question. We're seeing some significant growth in your contact center. Can you talk about that some more and give us some additional color on what differentiates you from your competitors here?

Richard D. McBee

Yes, I think there are several things, obviously. We just have refreshed our contact center portfolio. So the 2 new capabilities that we have -- the key things that we have brought forward is some of the social media capabilities integrated into the contact center. So those have been very well received by the customer base. And then we also have not only a stand-alone contact center, but we have the capability to seamlessly integrate with Lync. So we've got kind of both sides of the market really covered very well there, and we're seeing really good adoption. Contact centers are -- I mean, it's a great business. It's basically all software, so it's got really high margins for us. When people buy contact centers, there's a great opportunity to sell them call control and sets back into the business when they see the capabilities. And most customers at kind of difficult economic times will look at, "Do I upgrade my call control in my full company, or do I upgrade my customer-facing part of my business first?" So usually what they'll do is -- if they're in such a situation, what they'll do is they'll upgrade their contact center first. And then kind of once the camel's nose is in the tent then we work back into the business and upgrade the whole thing. And we've seen that play out multiple times. And actually, for a contact center, we -- when we sell a contact center into a customer, we usually end up selling 1.4x as much telephony equipment over time. And so that's something that we actually track and watch, and that's become a key thing for us. So we have a very competitive contact center capability in the market. We think it's differentiated through some of the social media, but we also have both -- we're not just a Mitel-only house. We have the capability to serve Lync customers as well as some of our other competitors' customers as well.

Operator

And the next question is from Paul Treiber of RBC capital.

Paul Treiber - RBC Capital Markets, LLC, Research Division

You've owned Aastra probably about 6 months or just over 6 months now. In your discussion with the customer base in Europe, do you have a better appreciation for the age of their telephony systems and then the potential for upgrades and the cross-selling of software into that base?

Richard D. McBee

Yes, I'll start [ph] and then let Steve comment, too. It may sound crazy, but I was pleasantly pleased with the age of their systems, which means they're very old. And I think that, that was part of the deal's thesis that we had that their -- the market was a couple years behind the U.S. market in terms of making the transition to next-generation technology. So there's actually still a lot of TDM equipment out there, so there's a great choice for them. "Do I upgrade to IP, or do I just go straight to the cloud and managed services?" So what we saw in that large installed base -- and what we got with Aastra, we talked about, was about 50 million end users. And that installed base, I would say, a very small percentage has converted to the next-generation technology. So we're very optimistic that if you treat the customers very well, they'll stay with you. And if you've given them a pass so they don't have to forklift their infrastructure out, and we have done both of those things. So we're in conversations with a huge amount of the customer base about how they upgrade their systems to the next-generation technology. So we're -- that was one of the things that we're extremely pleased with that we didn't buy a company that had everybody already on the new technology. They -- we bought a company that has a great customer base, a very loyal customer base who's getting ready to modernize the Aastra customers -- the former Aastra customers who were very pleased with Aastra and they want to stay with them. I mean, changing vendors in this space is an expensive and a risky matter. So if you can provide a solution that's cost effective for them, they'll stay with the same vendor that they've had, especially in the European markets. And so we think that, that conversion is going to be coming over the next year, 2 and 3 years and a good revenue stream as they upgrade. And the key thing here is as they upgrade to these next-generation technologies, you got to remember that those next-generation technologies are primarily software. And being software-oriented, we're going to get tremendous leverage in terms of gross margin and service assurance. And those are the transitions from traditional maintenance and hardware that you sold them, and so we're excited and bullish about that.

Paul Treiber - RBC Capital Markets, LLC, Research Division

And then what -- could you just speak to the history of what has maybe inhibited them from upgrading in the past and then what you think would be the catalyst for upgrades in the future?

Richard D. McBee

Yes, I think that -- if you kind of go back in time, you look at Y2K, that was a big event in the marketplace. Everybody upgraded their systems. The life of these systems is usually approximately 8 years. That's kind of what we use and what we see. If you fast forward to 2008, which is when they should have been upgrading their systems, worldwide recession, everything's falling apart. The last thing that they're going to upgrade is the phone system because they still got dial tone, they can still make phone calls, et cetera, et cetera. Everyone's rightsizing their businesses, sweating their assets, all that stuff's going on. So what we're seeing now in the customer base is you got these systems that are roughly 14 years old, 14 to 15 years old. And if you think back, just as an analogy of -- for cellphone, what did a cellphone look like 15 years ago versus a smartphone today? The technology is radically different, radically different. So they're seeing that the competitive advantage in the market place, the costs, all those kinds of things. Now they're starting to -- the telephony systems finally got up on the pecking order. The CIO's out there to take a look at both for the value that they can get from cost reduction and the technology that they can get in terms of addressing customer needs, being available 24/7, teleworking, remote working, all those kinds of things. And so a lot of them are starting to look at, "Okay. How do I do this?" And the advantage of the cloud, and I think this is one of the things that they're going to be looking at is now they've got the decision, "Do I make it an OpEx or a CapEx decision?" That was not a decision they had when they bought these systems originally. And so there's a lot of technical discussions and cost discussions and value discussions going on in the marketplace. But the fact is that the majority of the systems in the European market, which is primarily what we got with Aastra, are aged and are looking to upgrade that technology. I think the hybrid approach that we have is an incredibly key differential advantage that, for example, a company can say, "Well, my nomadic guys, I want to put them in the cloud, so they get the full UC suite. But all the back office people, I'm going to leave. I mean, all they need is voice mail and dial tone, so I'll leave them. I'd like to upgrade their sets, their phones. So we'll upgrade the desktop for them, but everyone else gets a cloud." And this is where the hybrid solutions become really, really important for our customers. And being able to have a path that says, "Okay. Well, maybe I'll go to the cloud, or maybe I'll only go part way to the cloud." And having the ability to upgrade the premise or the sets and then also offer the cloud in that same environment is incredibly important to the customer base. And that's what we have, and that's what we're offering and that's what we're working through with the customers as they select their next systems.

Paul Treiber - RBC Capital Markets, LLC, Research Division

And just lastly, I just wanted to touch on Microsoft Lync. Have you seen any change in the momentum of Lync in the market? And then could you also comment on your success on selling Lync-compatible products, like maybe the phone sets or a PBX to go with -- the software PBX to go with Lync?

Richard D. McBee

I think Microsoft, they're doing well in the marketplace. There's no question about it. Enterprises that have a Lync infrastructure are looking -- they're leveraging it. They're trialing it. We see that in the marketplace. They've had very good growth. This is a humongous market. A lot of players in the marketplace. I think that they're taking share primarily from some of the other players in the marketplace because we don't see it in our funnel activity, in our monthly calls, at the same rate that we would compete with the other players. We are seeing -- the growth on the Lync attachments, for lack of a better term, is solid for us. We're good with it. We -- like I said, we have a fully compatible contact center. So those sales cycles take longer. The upgraded product guide just came out a couple months ago. But we had -- at the Microsoft's big show they had a few weeks ago. I mean, we were at that show with our contact center, and we had a tremendous response from Lync customers who really liked our [ph] contact center solution. So the growth is good, but on low numbers, and we would expect that growth to continue to get bigger over time on a bigger set of numbers, a bigger base.

Operator

And at this time, there are no further questions in queue. I'll turn the call back over to management for closing remarks.

Richard D. McBee

Okay. Well, in closing, in the second quarter and the first half of the year, Mitel made outstanding business progress in executing our strategy and integrating our rapidly expanding company, and we actually drove significant shareholder value. Our Q3 guidance reflects appropriate prudence in the market that begins to slowly shift from nonrecurring to recurring revenue, the seasonal slowdown in Europe, which is a big region for us, and the ongoing implementation of activities associated with the integration and restructuring in Europe. As we look ahead to the end of the year, we continue to see the opportunity to clearly deliver strong full year results. We'll look forward to updating you again on the progress and results again for the third quarter. So thank you very much for attending today.

Operator

Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day.

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Source: Mitel Networks' (MITL) CEO Richard McBee on Q2 2014 Results - Earnings Call Transcript
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