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Executives

Tonya Chin – Director, Investor Relations

Peter Blackmore – President and CEO

Mike Healy – Senior Vice President and CFO

Don Girskis – Senior Vice President, Worldwide Sales

Kevin Gavin – Chief Marketing Officer

Analysts

Troy Jensen – Piper Jaffray

Steve O’Brien – JPMorgan

Edward Parker – Lazard Capital Markets

Sanjiv Wadhwani – Stifel Nicolaus

Douglas Ireland – JMP Securities

Ian – Northland Capital Markets

Rohit Chopra – Wedbush Securities

Gregory Burns – Sidoti & Company

Lynn Um – Barclays Capital

ShoreTel, Inc. (SHOR) Q2 2011 Earnings Call January 26, 2011 5:00 PM ET

Operator

Good afternoon. My name is [Kristin] and I’ll be your conference operator today. At this time, I would like to welcome everyone to the ShoreTel Q2 Fiscal Year 2011 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions)

Thank you. At this time, I would like to turn the call over to our host, Ms. Tonya Chin, Director of Investor Relations. Please go ahead.

Tonya Chin

Hello and thanks for joining us today as we report our second quarter fiscal year 2011 financial results. Joining me on the call today for the first time is Peter Blackmore ShoreTel’s new President and CEO; Mike Healy, Senior Vice President and Chief Financial Officer. Additionally, we have Don Girskis, Senior Vice President of Worldwide Sales and our Chief Marketing Officer, Kevin Gavin, who’ll be participating in the Q&A session.

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 revenues, gross margins, operating expenses and other financial and business-related information. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected.

Additional information concerning the risk factors that could cause actual results to differ materially from those in our forward-looking statements can be found in the company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2010, our most recent 10-Q for the quarter-ended September 30, 2010 and the current report on Form 8-K furnished today.

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

We will be discussing both GAAP and non-GAAP results throughout this call and I ask that you refer to our press release issued today for the reconciliation between these amounts. Our non-GAAP numbers exclude stock-based compensation charges, amortization of acquisition-related intangibles, other adjustments and the related tax impact.

And finally, let me take a moment to say that we will be at several investor conferences this quarter. On March 9, we’ll be in Boston at the [CFFD] Communication Equipment, Semiconductor and Networking Conference. On March 10, we’ll be in New York City at the Wedbush Technology, Media & Telecom Conference. On March 15, we’ll be in Boston at the Lazard Capital Technology & Media Conference. And on March 22, we’ll be back in New York for the Sidoti Conference. We love to see many of you there.

Now, I’m very pleased to turn the call over to Peter Blackmore. Peter?

Peter Blackmore

Thank you, Tonya and hello to everybody on the call. Before I get into the highlights of the quarter, let me start by taking a moment to thank Don Girskis for doing a fantastic job as Interim CEO. Under Don’s watch, the company executed on its objectives without missing a beat and ramped our revenue to its highest level in our history. And it’s great to see Don return to his role leading worldwide sales to make sure we sustained the momentum that he and the team have helped to build.

I would also like to share just a little bit about my background and what drew me to ShoreTel. I have spent my entire carrier in technology, holding senior positions at Compaq and later Hewlett-Packard and most recently, a CEO of UTStarcom.

When I learned about this opportunity at ShoreTel, what drew my interest and ultimately caused me to take the job is ShoreTel’s tremendous potential for growth. With a clearly differentiated product that is the simplest in the industry to install, to use and to manage, coupled with an extremely high customer satisfaction and loyalty, plus the benefit of a solid balance sheet, the talented leadership team and proven growing momentum, ShoreTel has all of the necessary ingredients for sustained growth. I saw the opportunity to grow this great small-company into a world-class business. I’m excited to be here.

Turning to the quarter, it is my pleasure to report the financial highlights for quarter two, which was a very strong quarter for ShoreTel. We were pleased to see the business continue to build momentum with record revenues of 47.7 million in the quarter, up 8% sequentially over the previous quarter and up 35% over the second quarter of fiscal 2010.

Non-GAAP gross margins were consistent with last quarter at 67.2%. We had a non-GAAP net loss of $1 million in the quarter or the loss of $0.02 on a per share basis. Changing gears, I’ve been at ShoreTel nearly seven weeks now and so I’d like to share some of my early observations.

I spent my first few weeks here immersing myself in the day-to-day operations. I had opportunities -- two opportunities to host eleven hours for our partner community plus numerous one-on-one calls with the largest partners.

I have spent quality time with our senior management team and engrossed myself in learning about how our products work and our unique points of differentiation. I have been doing a lot of listening and learning and put simply, I’m pleased with what I have in fact.

I have also spent a lot of time meeting with employees. I was pleased with the timing of our annual worldwide sales conference, allowed me to meet and address our entire sales team earlier this month. My interactions with the sales team as well as those throughout the whole organization have been very productive.

I’m encouraged by the caliber of the staff. And I’m confident that ShoreTel’s employees have the talent and equally important and the enthusiasm to take ShoreTel to the next level.

It is clear that the strategy, ShoreTel put in place over a year ago is gaining traction. ShoreTel has made meaningful investments in its products, the sales engine and the brand. The investments the company has made over the past five quarters have clearly driven growth. Furthermore, I believe that we need to continue to invest to further drive that growth in order to scale our business.

Based on my conversations with many of our partners, it is clear that ShoreTel has a very loyal and enthusiastic group of national and regional partners. These partners have been a key part of ShoreTel’s success and I am committed to maintaining these important relationships as the company grows. At the same time, I’m critical to that growth, ShoreTel must continue to sign and launch new larger offers.

When I look at the market opportunities for ShoreTel, I’m also excited about our outlook internationally. The company has already delivered strong growth in international markets over the past year, but I’m sure you’ll agree significant opportunity remains. And I know from my experience as General Manager for the European Enterprise Systems business at Compaq, which we grew four-fold to approximately 3 billion in just a few years that this potential can be realized when the proper infrastructure and enhanced channel strategy is in place.

Looking forward, one of our key initiatives is to continue advancing our mobility offering. Our acquisition of Agito Networks last quarter was a critical step in enhancing our existing mobile product line to bolster our advantage in this key growth area. This was a strategic, technology acquisition. So as expected, revenues from Agito were not material during the quarter.

We have now rebranded this technology as ShoreTel mobility. This product line had a nice level of bookings in quarter two and has a solid pipeline of business for ShoreTel’s mobility solution.

This new technology is getting a lot of buzz. We are encouraged by the enthusiasm we have seen from partners and customers alike for our offering. The entire sales team was recently certified on short-term mobility and with the internal team now trained, we will begin formal training for our partner network in this quarter.

The Agito acquisition holds much long-term promise but we’ve also been delighted by a few immediate benefits. This quarter we gained a few key partners as a result of the acquisition. We added Bell Canada and also Dimension Data for short-term mobility. And that’s very exciting news because that represents a new partnership with one of Cisco’s largest partners.

Moving on to more recent developments. Last week, we announced several important changes to our distribution model that I believe are critical to our continued growth. While ShoreTel has historically used a two-tier distribution model internationally, it has used single-tier distribution in the United States. This model is appropriate when ShoreTel is a much smaller company. However, in the last year, it became clear that in order to drive continued growth, we need to enhance our distribution strategy in the United States.

Our expanded relationships with ScanSource and with Westcon in the United States, both of which are value-added distributors is a step in the right direction to scaling ShoreTel’s distribution. As part of our agreement, ScanSource will support the ShoreTel channel with skilled, technical support resources as well as seamless global procurement capabilities. Westcon will support business for our service provider customers allowing this important channel to have a new means of global performance.

ShoreTel’s existing partners will benefit from these new relationships win, expanded credit terms, additional marketing programs and access to multiple vendors’ products. ShoreTel benefits include lower channel management costs, credit risk reduction and a new channel for expanded reach.

ShoreTel’s larger partners will be welcomed to continue to fulfill directly through ShoreTel, if they so choose, and will also have another option through our value-added distributors. Smaller partners will migrate to fulfillment through ScanSource over the next six months. We are now excited about this important change in our distribution model.

We continue to add sales professionals wholly dedicated to partner acquisition with emphasis on multi-regional and national partners. A number of the new sales team members hired in quarter two are part of that group. Our focus on this area has paid off.

During quarter two, we signed several multi-regional partners including PC Connection. We have revenues of approximately 2 billion annually and 650 sales representatives throughout the United States. Spencer Technologies, who are national IT provider for the retail vertical with approximately 30 million in annual revenues and data price with annual revenues of approximately 16 million and offices in Maryland, Washington D.C., Virginia, Pennsylvania and New York. Another notable new partner addition was IBM Global Services in Australia, a great first step with the IBM Global Services organization.

Additionally, we continue to gain momentum with larger enterprise customers including the college of William and Mary, which is one of the top-ranked public Universities in the United States. As customers initial order of over $0.5 million included 2,600 firms as well as our enterprise contact center solution.

ShoreTel recently signed (inaudible) a Farm Management Services Company with 6 billion in annual revenue. The initial sale included 600 extensions as well as our enterprise contact center.

We also had a great international win in Ireland with Superquinn. Superquinn is Ireland’s leading supermarket chain and plans to install ShoreTel in 26 of its locations.

Finally, let me update you on our core continued investments in our business. In terms of sales resources, we had 14 quota-carrying sales team members during the quarter and together with the eight new sales team members that started on January the 4th, we met our hiring goal for the period with nearly 10% increase in sales staff.

We also continue to invest in the ShoreTel brand. As a result of our recent campaigns, we significantly increased media exposure and overall brand awareness. We will continue to invest in branding activities over the coming quarters.

While I haven’t had enough time for a complete review, I have already asked our senior team for areas where we can enhance our product similarly to the way we did with Agito. I also believe that continued investments are critical to scaling the business. And now it is the time to take advantage of the disruption in our industry, to expand our distribution channel to maintain our momentum, and continue to enhance the ShoreTel solution to ensure we can scale to the next level.

In summary, I’m excited to join ShoreTel at this important moment in the company’s development. And I look forward to helping shape and execute the strategy so that we can achieve ShoreTel’s full potential.

And with that, I will turn the call over to Mike. Mike?

Mike Healy

Thanks, Peter. Yeah. I’m very pleased to report that ShoreTel delivered 8% sequential revenue growth, $47.7 million and once again delivered strong non-GAAP gross margin with 67.2%. Our non-GAAP operating expenses increased to 33 million mostly due to our acquisition of Agito Networks in October and therefore we had a non-GAAP net loss of $1 million or $0.02 loss per share. Including stock-based compensation of 2.6 million and amortization of acquisition-related intangibles with $150,000, our GAAP net loss was $3.7 million or a loss of $0.08 per share.

Let me review some of the important financial metrics for the quarter. Product revenues grew 8% sequentially and 36% year-over-year to $37.9 million. Service and support revenue also grew 8% to $9.8 million and represented 21% of our total revenue in Q2.

We added over 1,000 new customers in the quarter and that billing from new customers was up significantly to 50% of the total, an increase from 45% in Q1, partly due to a couple of large educational deals that we closed during the quarter.

International revenues were $5.5 million, up 15% sequentially from last quarter and represented 12% of our total revenue in Q2. Even more significant, our international revenues have grown 69% over the year-ago quarter.

We sold 130,000 end user licenses in the quarter compared to 103,000 in our September quarter, an increase of 11%. We continue moving upstream to larger enterprise customers as evidenced by one additional point -- data point that you might be surprised.

We analyzed our sales data with a different cut and determined that more than 30% of our cumulative licenses sold to-date are in businesses with more than 500 (inaudible). Our revenue concentration continues to be well distributed with only one partner representing between 5% and 10% of revenue for the quarter and those single end customer making up over 5% of revenue.

After reviewing our classification of reseller partners, in part due to WAN, we look at them internally, we have decided to reclassify certain partners in our external disclosures. In the past, we had classified CDW and Black Box in the category we call national partners.

Going forward, we will report on a new grouping called service providers instead of national partners. Loan service providers today include AT&T, Qwest and Verizon. We expect that this group will continue to expand, especially internationally.

This quarter we will provide metrics for both groups, but going forward, we will report only on the service provider volume. For Q2, billings from national partners was up 4% sequentially and represented 17% of our total business. Billings from service providers as a subset of the national partner grouping was up 16% sequentially from Q1 and represented 12% of our total business in Q2.

In terms of our major verticals, professional services, government and the education vertical market showed large increase this quarter over quarter with professional services continue to be our largest vertical. One real success story has been our education vertical, which is essentially double in size in one year and is now one of our top-three vertical markets.

In terms of our revenue metrics and leading indicators, most continue to improve in Q2. Ramp sales productivity climbed slightly, business from new customers increased five points to 30% of the total. Our service provider revenue grew by 16% quarter-over-quarter, our sales pipeline and our conversion of that pipeline continue to grow and both average deal size and total billings from our large deals increased. And the overall unified communications market showed good growth in September, which I expect to continue into the December quarter.

Moving on to gross margins. Our overall results remained very strong in Q2 with our non-GAAP gross margins remain steady at 67.2% for the quarter. Our non-GAAP service and support gross margins grew to 69.8% due to increased service revenues and a small increase in spending.

We are continuing to hiring our support organization but the timing of that hiring has not been happened as quickly as originally planned. And when coupled with the revenue increase helped us to achieve an all-time high of nearly 70% gross margins in the service and small business.

And our non-GAAP product gross margins were 66.6%, essentially flat with last quarter. Our non-GAAP operating expenses increased to $2.4 million to $33 million. The increase was primarily related to the hiring of 53 new employees in Q2 and the related compensation costs to support our investment in sales, marketing and product development.

In addition, we incurred some one-time fees of approximately $500,000 in the G&A line, most of which related to the Agito Networks transaction and costs related to special tax that we incurred in Q2 as a result of NOL.

Speaking of taxes, I have some really good news. I’m pleased to report that we have completed our work on the sections related to net operating loss for NOL recovery project, which received a favorable private letter ruling from the IRS a few months ago. That rulings coupled with additional valuation work we performed resulted in additional recovery of over $15 million of net operating losses.

These losses will be available to reduce our future federal taxable income and income tax expense thereby improving future earnings over time as these NOLs are utilized. We expect to realize over $17 million in cash, tax savings to ShoreTel over future periods.

In addition to this great news on our NOLs, we have more tax benefits expected as a result of the recent tax legislation extending R&D tax credit, which was reinstated retroactively to January 1, 2010. We estimate that we will generate an additional 2.1 million in R&D credits through June 2011 as a result of this legislation.

In terms of modeling our tax rates, we will continue to pay a minimal amount of cash taxes for certain states in foreign jurisdictions. But other than that, we should be able to offset approximately 100% of our regular taxable income and approximately 90% of our AMT taxable income with these NOLs in R&D tax credits going forward.

Next, let me review some of the highlights from of our balance sheet at the close of Q2. We ended with cash and short-term investments of $105.4 million, down approximately $10.8 million from last quarter. The decrease is mostly due to the all-cash acquisition of Agito Networks we made in October for $11.4 million.

Cash generated from operations was $1.1 million and capital expenditures for the quarter were approximately $1.6 million. Accounts receivables shrinked slightly to $24.6 million on higher revenues and days sales outstanding were 38 days, down nicely from 45 days last quarter.

Inventory increased 21% to $12.8 million as we grew our inventory levels on hand in anticipation of further revenue growth over the next couple of quarters. Total deferred revenue increased 4% to $31.8 million, driven by continued sales and maintenance contracts for our growing and satisfied customer base.

We recorded $7.4 million in goodwill related to the Agito acquisition and $4.2 million related to intangible assets that will be amortized over four to seven years. Approximately $3.1 million of those intangible assets began amortization this quarter, which resulted in the $150,000 of amortization you see on our GAAP P&L.

On a GAAP basis, depreciation and amortization were approximately $1.1 million for the quarter. And we ended the quarter with 565 employees, which represented a 10% increase in head count for the quarter.

Next, I’ll discuss our outlook for the March 2011 quarter. Based on our Q3 billings and bookings to-date and the momentum we have seen over the past three quarters, we expect revenue to be in the range of $48 million to $51 million. We expect non-GAAP gross margins to be in the range of 66% to 67%, GAAP gross margins are expected to be approximately 100 basis points lower.

We expect non-GAAP operating expenses to be in the range of $33.5 million to $34.5 million. And we expect GAAP operating expenses to be in the range of $36 to $37 million, including approximately $2.5 million in stock-based compensation expenses.

In summary, it was another very solid quarter for ShoreTel. We had record revenues that resulted in a third quarter in a row of year-over-year revenue growth in excess of 30%. Our focus on signing new partners is working well and our expansion into 2Q distribution with ScanSource and Westcon in the U.S. should help fuel our aggressive growth plan. We will continue to invest prudently given the opportunities in front of us and we will remain committed to turning to non-GAAP profitability by our fourth quarter.

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

Peter Blackmore

Thanks, Mike. As I said in my opening remarks, ShoreTel is a company with tremendous growth potential. There are not many companies in our space that can say they are growing at a pace that is more than 30% year-over-year.

And as you know, we’ve recently taken important steps to enhance our go-to-market strategy with two-tier distribution worldwide. Additionally, we will continue to look for strategic opportunities like Agito, where we can enhance our product and increase our addressable market. I am pleased to have joined the company at this exciting time in its history and look forward to playing a big part in taking it to the next level.

And with that, I’d like to open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question is from the line of Troy Jensen with Piper Jaffray.

Troy Jensen – Piper Jaffray

Thank you. Congratulations on the nice quarter gentlemen.

Peter Blackmore

Thanks, Troy.

Mike Healy

Thank you.

Troy Jensen – Piper Jaffray

So, Peter, I just want a follow-up. You made some comments about further investments in the business. Obviously, Mike, just talked about hitting profitability in the June quarter on a GAAP basis -- excuse me, on a non-GAAP basis. But could you just maybe go little bit deeper into that, are you talking about investments, are you going to take you guys back below profitability or just modest profitability levels in fiscal ‘12, anymore insight will be helpful?

Peter Blackmore

Thank you. Well, let me first of all reiterate what Mike said. We are planning profitability in our quarter four. I think that’s an important step. The investment question, we are still a small company. We are growing at a nice pace, 30% plus per annum basis.

We need to continue to invest and I’m sure shareholders will be pleased to see this because they want the company to grow. We need to continue to invest in sales. We’ve got relatively small coverage relative to our two major competitors. We need to therefore also increase investments and support people.

We have very high customers satisfaction that comes not just from a very good quality product, it comes from the support we give our partners and customers. Also, I want to make sure the R&D investments are put in place, so that we have the same leadership in four, five years time that we have today and that we keep this mantra of a very simple easy-to-use product, which is proving a clear differentiating in the market.

As Mike said, we will be prudent. My track record is prudent investments, but I do want to make sure that yourselves and the shareholders know -- and they continue to invest, but we want to meet profitability this quarter and we want to meet profitability going forward. Beyond that, I need a bit more time to give you a more detailed view.

Troy Jensen – Piper Jaffray

All right. That’s fair. But quick for Mike, with national partners up 4%, but service provider up 16 does that mean CDW and Black Box were flat to down this quarter?

Mike Healy

Yeah. I mean, your math is like one of them. We don’t disclose our -- each of our partner’s revenue, but your math would lead to one of them was down quarter-over-quarter, I guess.

Troy Jensen – Piper Jaffray

Okay. And how about -- one for Don, I think he is in the room.

Peter Blackmore

Don is here.

Troy Jensen – Piper Jaffray

Perfect. Don, hello. How is life now running the company? That wasn’t my question. It’s Microsoft, I think launched in December I think, I’m just curious to know if you’ve seen any more interest in it. Do you view that as legitimate competitor going forward?

Don Girskis

I’m sorry. I missed the first part of your question, Troy.

Troy Jensen – Piper Jaffray

Yeah. I was talking about Microsoft link was efficiently launched here, I think in December.

Don Girskis

You know what, not a lot of change on that. So we’ve run into it a number of times in the field and we’re not losing to it. We’ve seen a lot of companies evaluate, take a look at it but our position hasn’t changed. We’re not going to underestimate Microsoft by any stretch. But we’re not seeing them as the big competitors that we see with some of the other guys out there.

Peter Blackmore

But we do understand the need to make sure we integrate with OCS prior and length going forward too. So, that’s certain part of our offering.

Troy Jensen – Piper Jaffray

Keep up the good work, gentlemen.

Don Girskis

Thank you, Troy.

Peter Blackmore

Thank you. Next question please.

Operator

Your next question is from Steve O’Brien with JPMorgan.

Steve O’Brien – JPMorgan

Great. Thanks for taking my question. Could you help me understand, I guess to the extent, it’s has been mapped out the pace of hires and maybe the next couple of quarters both on the sales side and the operations and support side?

Peter Blackmore

Yeah. On the -- Don can give more color. But we have a budget plan for the next two quarters. We budget on a six-month basis as you know. So we have approved further hires in sales and Don is on track hiring those. So Don will give you the exact numbers. And in support, we were slightly behind support hiring in the last quarters.

So I gave that team a little bit of a push, because when you get a -- we don’t often get them, but when you get customers issues, you need to respond really fast. And I want the team to be -- have the right facilities. So that’s the color behind them. They’re consistent with the type of close you see at the last couple of quarters, so Don talk a bit more about sales.

Don Girskis

Yeah. So in the past we’ve been hiring roughly on average about 20 reps per quarter and you should expect that will impose well. We continue to see good productivity from our sales reps, clearly that is making a difference in the revenue numbers and we’re going to keep marching down that path.

Steve O’Brien – JPMorgan

Great there. How about on the two-tier distribution strategy or there’ll be any no small impact on the margins and when might we see them?

Peter Blackmore

Okay. So the two tier, it’s just been announced and the plan is a transition over the next six months. And what we mean by a transition is that, first of all, we’re piloting all the processes that you need for two-tier distribution to make sure everything is in place and it’s seamless. So that will take about six weeks and then again to encourage partners to start transitioning as soon as they’re ready and for the smaller partners we’ve given them a deadline, so they have six months to transition in and the launch of product is the choice.

So I didn’t see a lot of launching impact over the next two quarters because we’ll be in transition. Once you’re in a two-tier model, I guess everybody would understand the margin is slightly less, but properly implemented, that is compensated at a level of -- performance level, because you’re operating cost related to handling the partners, handling the transactions goes down. So long term, we see this is neutral to the bottom line, but you will see a slight reduction in margin.

Steve O’Brien – JPMorgan

Thanks for that Peter. And if I could, I mean, given your experience and you’re up in dealing with two-tier distribution, are you anticipating push back from either smaller partner or it’s still contributed predominance of revenue?

Peter Blackmore

Okay. That’s a good question. The smaller partners so far -- I mean, this requires threshold of partners small, large, intermediate had been very positive. We did a lot of handholding in terms of information, domain added to Webinars, because of the sales training two weeks ago, all of our channel managers were trained and lot of detailed about what to say to the partners. So I think they’ve had all the information they need and I know its early days, but it has been very positive.

And the other thing I’d point out is that the channel partners we’ll transition, because part of going to two-tiers, the larger partners have the choice, the smaller ones, we want to transition, they represent about 12% of our revenues to put that into context. And we will do a lot of managing, auditing, checking to make sure that transition is going well. And we’ll also track revenues from our partners before and after just to make sure it’s going properly.

So I don’t anticipate, it’s a bigger change for us. But I think it’s been well handled and I don’t anticipate any issues at the moment.

Steve O’Brien – JPMorgan

I appreciate that. And one more if I could, kind of a point of clarification really more than anything, but the – Peter, you mentioned that the Agito revenues are immaterial in the December quarter, but bookings were strong and healthy headed into calendar ‘11 here. When might we see -- what is the potential level of contribution I guess from Agito in the next couple of quarters or longer time, when it might be a significant contributor to the top line?

Peter Blackmore

Remember that we’ve -- only just on the internal sales training, the channel training started, I think it helps us in number of ways. One, it takes us into new markets because today with the ShoreTel customer we can sell mobility and they’re very excited about that, but we can also not go to a Cisco or VIA customer who perhaps is not yet ready to change the switch but talks about add adding mobility, our mobility, the short-term mobility to their solution and we already have some excitement about that.

So I think this is going to be significant going forward. But remember we did buy a company, which was strategic technologically but had a small customer base with small revenues. And Mike, let’s give some more color to that, because I think we need to set expectations right, but I’m excited about the future.

Mike Healy

Yeah. In terms of the revenue, Steve, as Peter mentioned, for Q2, very small, but we did have a good bookings quarter. And so, I expect some of that bookings will convert to revenue next quarter, one very large customer you’re pretty familiar with. Hopefully, we’ll get acceptance and be able to bill and recognize revenue on that customer. So that I think it will start going upward from there.

And then in terms of breaking out that level of the business or anything, it’s not something we typically do externally but we will, if it is exceeding our expectations and really helping our revenue and profitability, we’ll certainly share some insight on that mobility product line as it becomes more material to our overall business. But today it’s just not material enough to really spend and talk about.

Steve O’Brien – JPMorgan

Okay. Thanks, Mike. And thanks, Peter. Congratulations on your new role.

Mike Healy

Thank you.

Peter Blackmore

Thanks, Steve.

Operator

Your next question is from Edward Parker with Lazard Capital Markets.

Edward Parker – Lazard Capital Markets

Hey, guys.

Peter Blackmore

Hey.

Edward Parker – Lazard Capital Markets

I just -- going back to Agito, you’ve talked about it in the past of being a pretty small customer base, but barely important in terms of types of customers. And I wonder if you’ve had any initial success maybe leveraging that footprint and selling some of your core products into those customers?

Peter Blackmore

Yeah. They had typically larger enterprise customers, because their solution was very compelling to people that had a large Voice-over-IP network but wanted to add mobility and wanted a very, very strong solution for that. So I think wisely they targeted customers. Most customers were technically larger than the ones our sales force was traditionally been talking on.

So it’s given us an entree, which I’m very excited about. So now in terms of new wins, we’re not ready to announce names today. I think there are some good rumors out there and some of the key customers that have gone that way. So please be a little bit patient with us because our policy pronouncement is we do want to see revenue there, not just bookings. But say it all, by the time we do the March conference, we should be able to give much more clarity on this.

Edward Parker – Lazard Capital Markets

Okay. Great. Thanks.

Peter Blackmore

Thank you.

Operator

Your next question is from Sanjiv Wadhwani with Stifel Nicolaus

Sanjiv Wadhwani – Stifel Nicolaus

Thanks so much. Mike, just a clarification on the Agito acquisition you mentioned on some expenses in the December quarter. Could you just give us the numbers around that?

Mike Healy

Yeah. So I think last quarter we talked about the Agito transaction. I mentioned it was about $1 million of expense coming in -- that people and some other costs and starting to integrate the product into our mobility product. So that was essentially the incremental expense in the December quarter, probably a little bit less than we bought in mid-October. So that’s how much came in, certainly revenue did not set that amount but overtime we do think we will be accretive in four to five quarters.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. And then on ScanSource, you’ve talked about some of your smaller wars going through ScanSource. I’m curious whether overall you’ll see ScanSource bringing in a lot more wars that you didn’t have a presence in. For example, I think I don’t know the exact numbers, but ScanSource has hundreds of wars where you don’t have a presence. And I’m curious to see what the opportunity might be through those guys overtime, as far as selling your product through those wars eventually?

Peter Blackmore

That’s a great question. And there is opportunity, and I’ll ask Don to go through it. Please Don?

Don Girskis

Yeah. So actually with the ScanSource relationship, there is a number of ways that we are going to be measuring our success there. And one of them is looking at the existing smaller VARs that we transition over to ScanSource and looking at the growth rate of those VARs as a collective group. But also clearly ScanSource is one of the U.S.’ best value-added distributor in this particular segment and they have building relationships with hundreds of quality VARs in the U.S. and there is a lot of their partner base.

Actually, we have quiet a bit of overlap as it is today in terms of our partners and their partners. But we wouldn’t seek to add some of their current partners over on ShoreTel side, really emphasizing the quality partners rather than just the quantity and putting them in the end markets where we need them the most. But that is clearly part of the plan and the attraction to us.

Sanjiv Wadhwani – Stifel Nicolaus

Is it fair to assume that that’s sort of the second lag of the partnership in the sense you will probably go down that path that sort of once you successfully migrate all your small partners and see that ramp happening?

Don Girskis

So, it’s actually parallel path.

Peter Blackmore

Parallel, yeah. We don’t need to wait. We have a channel team, which Don has been growing and their job is to recruit new partners over the quarter. So we’re not going to wait. Obviously, we want to complete the transition of the smaller partners as I said within six months, but that doesn’t hold us back from working with ScanSource to recruit new partners, absolutely not.

Sanjiv Wadhwani – Stifel Nicolaus

Got it.

Mike Healy

Sanjiv, this is Mike Healy.

Sanjiv Wadhwani – Stifel Nicolaus

Yeah.

Mike Healy

Specific partner acquisition goals for ScanSource.

Sanjiv Wadhwani – Stifel Nicolaus

All right. That’s helpful. Thanks so much.

Peter Blackmore

Thank you.

Operator

Your next question is from Douglas Ireland with JMP Securities.

Douglas Ireland – JMP Securities

Thank you. Good afternoon.

Mike Healy

Hey Doug.

Peter Blackmore

Hi, Doug.

Douglas Ireland – JMP Securities

Hi. You mentioned that you saw that, maybe some further acquisitions would be a good way to scale the business. Now I’m just wondering if you could talk a little bit about where you saw opportunities to add to the ShoreTel platform to extend its capabilities in creating a larger tail?

Peter Blackmore

Yeah. And I was really putting a position statement up there, because I’ve only been here a few weeks. But I’ve already asked the R&D team to look at the product world map and whether it’s -- certainly also look more in mobility, because mobility is so strategic. I’ve been very specific there. So what else could we identify, but could be a buy candidate rather than a brilliant approach to accelerate our growth.

This is early days. So I haven’t even got to shopping this year. But I wanted the shareholder community to know that I’m open to doing those sort of things, because I think, as you choose exactly the right acquisition and if you can find other candidates out there, I’d would be all in favor bringing that to the board for support. So, there’s more of a positioning statement at this time.

Douglas Ireland – JMP Securities

Okay. Yeah. I was just trying to get a sense of what direction, when you’re thinking strategically, what direction you see in terms of hardware, software, mobility is an interesting area actually?

Peter Blackmore

It’s enhancing -- broadly it’s enhancing our intellectual property and looking at areas, which we think to accelerate in the future, mobility is a great example. And then, making sure our portfolio is stronger. So that’s the direction I’ve given to team.

Douglas Ireland – JMP Securities

Thank you.

Peter Blackmore

Thank you.

Operator

Your next question is from Mike Latimore with Northland Capital Markets.

Ian – Northland Capital Markets

Yeah. Hi, thanks. This is actually [Ian] sitting in for Mike today. Sorry, if I’ve missed it but I wanted to find out how the government have vertical performed for this quarter and sort of what kind of trends you’re seeing there during this current quarter?

Peter Blackmore

Thanks. And we do break out some statistics and so Mike would you take the survey?

Mike Healy

Yeah. So in terms of the verticals, I mean government we want education together with state and local government, which was up. Education continues to be very strong growth. It was very good quarter-over-quarter increase as well year-over-year. Superior state and local government, our government channel did well quarter-over-quarter and not as robust as education, but still we have good growth. So you haven’t experienced -- sorry, some of our competitors drop off in the government area.

Ian – Northland Capital Markets

Okay. All right. And then budget flows. Did you see any of that dynamic in the quarter?

Peter Blackmore

I’ll make a comment, and Don could add to it. I think we heard a little bit about that in selected regions. Certainly, it’s not like the old days where everyone have a capital budget and they had to use it. There was a little bit of tax incentives out there with companies to use. I think helped, influenced the spending in capital investment through the end of December, but I don’t know if I heard if there was anything significant.

Don Girskis

I think that’s a good care position. There was clearly some of that activity and that always gives us a bit of a lift there at the very edge of the year.

Ian – Northland Capital Markets

Okay. All right, all right. And then, I think you said your 50% of revs will come from new customers. Any color on where you see that going ahead the rest of the calendar year anyway?

Peter Blackmore

Yeah. That’s a good question. It’s not a number we predict or forecast. On Analyst Day, Don and I kind of said we would be surprised if we got up to 50. We really had two pretty good large education deals coming this quarter, really helped pumped that thing up to 50%. It would have been kind of 47 without those two large deals. So that helped.

So I think, going forward, it just depends on the mix of add-on business versus new customers. But I think it’ll move around between 45 and 50 quarter-on-quarter, it really get -- depending on if we get some large deals ended any one-time and if there are add-on deals or just new customers like college of William and Mary was a new customer in the education field, it really helped us that this quarter too.

Ian – Northland Capital Markets

All right. Good. Thanks for your time guys.

Peter Blackmore

Thank you.

Operator

Your next question is from Rohit Chopra with Wedbush Securities.

Rohit Chopra – Wedbush Securities

Hi, guys.

Peter Blackmore

Hi, Rohit.

Rohit Chopra – Wedbush Securities

Just a few questions here. Gross margin range up about 50 basis points, is that for this quarter? Is that really just the short-term mobility sort of already done or is there some competitive dynamics, which are better less discounting? Just wanted to get a sense on that range?

Peter Blackmore

Mobility really didn’t have an impact. So, Mike, how would you characterize that question?

Mike Healy

Yeah. So Rohit you mean Q2 was better than predicted?

Rohit Chopra – Wedbush Securities

Well, your range last quarter for your gross margin, the way that you guided was 50 basis points lower than where you’re guiding now. So I just wanted to see if there is anything positive happening, maybe competitively, maybe discounting, anything changing?

Mike Healy

Yeah. So just -- let me give you some insight on guidance gross margin. So we ended non-GAAP. Of course, we ended at 67.2% and the midpoint of the guidance for Q3 is 66.5. So I’m guiding down a little bit in terms of our overall gross margin. And that’s really solely due to the service and supportive.

Peter mentioned we’re trying to hire as much, as faster we can in the global services support group. And I do expect margins to go down from that 70% we almost posted in Q2, that is a much lower number in Q3. So that has a little bit effect on the overall company margin.

So that’s the reason for the decline in gross margin certainly better than the guidance last quarter -- on gross margins. Mobility, as it ramps up, it will have a positive impact, impact on gross margins. So we step to see how fast that moves up, but implicitly the guidance was not a huge number for mobility for Q3.

Rohit Chopra – Wedbush Securities

Okay. And then can you just talk about discounting and competition, what that was like in the quarter? Does it change from last quarter or last year?

Peter Blackmore

Yeah. I’ll talk about discount, and then I’ll let Don talk about competition too. Discounting was up just a tad and that may have been, we did sell a little bit more of our small business addition product, which is a bundled product which has a bigger overall discounting. So that really drove the discounting up a little bit.

What I really look at, did our product margins changed at all. As you can see, they were down one-tenth of a percent. So overall it was pretty comfortable with, we didn’t have to do anything strange or agree just in terms of discounting to get to the revenue -- high-end of the range of revenue numbers. So I feel pretty good where we are in terms of our mix between discounting and revenue, Don on the competition?

Don Girskis

So for us it’s all about being able to articulate the lowest total cost of ownership story. When we get a customer to understand that the upfront capital cost is just the tip of the iceberg in terms of their five year, seven year investment. Once they get back, we’re going to win that customer deal and the discount on the upfront.

Front piece of it becomes far less relevant, because one of the reasons why this competitive environment, we’ve been able to maintain strong product margins as we continue to grow the business. So we’re clearly not discounting more in order to drive the revenue. That is not what’s driving it.

Rohit Chopra – Wedbush Securities

Okay. And Don, I did see a video, so maybe do have a second career on TV? And my last question is…

Peter Blackmore

What was the question? Sorry.

Rohit Chopra – Wedbush Securities

Mike, just on close rate. I just want to get a sense on any changes there and did you make any changes in the assumptions or what’s changing there?

Mike Healy

In terms of win rate?

Rohit Chopra – Wedbush Securities

Close rate.

Mike Healy

Yeah. No, no big change. Continue to do well on our win rate and close rate. What did trickle up was our conversion of our pipeline did go up quarter-over-quarter, so the pipeline is getting bigger and the conversion of that. And I think a lot of that is due to the economies getting stronger every quarter.

We may just get our employments to go the other way. I think we feel a lot better. But one encouraging sign is that conversion rate of the pipeline going up is a very good positive sign for us.

Rohit Chopra – Wedbush Securities

Thanks, guys.

Peter Blackmore

Thank you.

Operator

(Operator Instructions) And our next question is from the line of Gregory Burns with Sidoti & Company.

Gregory Burns – Sidoti & Company

Good afternoon.

Peter Blackmore

Hi, Greg.

Gregory Burns – Sidoti & Company

A question in regards to Agito. It sounds like with the bookings, some new customers coming on but is there any early indications of how your existing customer base is receiving the products or how much of the bookings in pipeline that you’re seeing is coming from your existing customer base?

Peter Blackmore

Yeah. I’ll start. Kevin actually (inaudible) certainly will cover that. But broadly it’s been very positive. Kevin?

Kevin Gavin

Overall, the ShoreTel Mobility solution is extremely well received. We’re getting very, very positive feedback from every quarter. Again it’s early on. We haven’t really been aggressive in taking it out to our existing customer base. But as we talk to existing partners and as we talk to existing customers, there is tremendous interest and it does represent an opportunity for us to go back to the existing base and have a very nice add-on product to sell to them that we didn’t have before when they first purchased. So we do see an opportunity for the add-on business. We just really haven’t attacked it yet.

Gregory Burns – Sidoti & Company

Okay.

Mike Healy

Probably, I would add Greg, it’s Mike we call it mobility. So you won’t hear us talk about it here too much longer, it’s our mobility solution and that most of the bookings we got in Q2 were deals that Agito was working on and we’ve got closer on them after the acquisition. So you have we’ve a long way to go in terms of -- a lot more volume coming in to our existing customer base. But the majority of the stuff booked this quarter -- Q2 was from the Agito working at the front-end of the deal.

Don Girskis

And it was also just two weeks ago that we trained the sales force, the entire sales force went through extensive training. So now they are equipped and the next step is to take it out to partner training and then will move in to the actual customer revenue.

Gregory Burns – Sidoti & Company

Okay. And then I guess maybe, is there a timeline as far as getting the partners up to speed on your product?

Peter Blackmore

This quarter, the supply, this calendar quarter.

Gregory Burns – Sidoti & Company

Okay. Thank you.

Peter Blackmore

Thank you.

Mike Healy

Thanks, Greg.

Operator

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

Lynn Um – Barclays Capital

Hi, everyone.

Peter Blackmore

Hi, Lynn.

Mike Healy

Hi, Lynn.

Lynn Um – Barclays Capital

Would you mind us maybe walking us through the quarter and how linearity seeds up for you and in particular, you if might have seen any weakness in October that few other companies have referred to?

Peter Blackmore

Mike?

Mike Healy

Yeah. Linearity was pretty typical. It’s usually around 50% of our business comes in the first two months and 50% in the last month. It was less than 50% for us last month December and that was very typical same as last quarter. I would say last year, it was much more backend loaded. So we do a little bit better job of getting the orders in a little earlier same time last year but nothing abnormal in terms of October, November versus December.

Lynn Um – Barclays Capital

Okay. And then I think last quarter you talked about a few deals in Asia that got pushed into the December quarter, did those unfold as planned and just maybe just a little color on what you’re seeing internationally overall in terms of the demand environment?

Mike Healy

I’ll talk about the specifics and then Don or Peter can talk in total. As we talked about last quarter, international was down a little bit than it was really all in our Asia-Pac region. So that region came back very strong this quarter. As we mentioned those deals pushed out, so we closed a lot of those -- closed deals. And so the quarter-over-quarter increase for Asia-Pac was substantial which will improve the -- drove a lot of increases in our international revenue.

Peter Blackmore

Yeah. I mean year-over-year we were up 69% without international business. So we clearly have some momentum there building a nice base of larger partners in those markets. And as a matter of fact, Peter and I will be heading out on the international scene here very shortly as well.

Lynn Um – Barclays Capital

Okay. Great. Thank you.

Mike Healy

Thank you.

Peter Blackmore

Thanks, Lynn.

Operator

And there are no further questions at this time.

Peter Blackmore

Well, let me just close, first of all, thank you very much for listening and thank you for the good questions. I hope you are as excited as I am about the potential in ShoreTel. And I look forward to meeting you face-to-face or many of you face-to-face to discuss it in more detail. So the Investor Conferences on the East Coast to be held in March and Tonya will give you all the details. But look forward to seeing you out there. Thank you for joining the call. Let’s close the call, operator.

Operator

Thank you, sir. This does conclude today’s conference call. You may now disconnect.

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