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ShoreTel, Inc. (NASDAQ:SHOR)

F3Q 2011 Earnings Call

April 26, 2011 5:30 p.m. ET

Executives

Tonya Chin – Director, Investor Relations

Peter Blackmore – President and CEO

Mike Healy – Senior Vice President and CFO

Kevin Gavin – Chief Marketing Officer

Analysts

Troy Jensen – Piper Jaffray

Edward Parker – Lazard Capital Markets

Sanjiv Wadhwani – Stifel Nicolaus

Gregory Burns – Sidoti & Company

Rohit Chopra – Wedbush Securities

Lynn Um – Barclays Capital

Steve O’Brien – JPMorgan

Douglas Ireland – JMP Securities

Ian – Northland Capital Markets

Rohit Chopra – Wedbush Securities

Operator

Thanks so much for holding everyone, and welcome to the ShoreTel System third quarter 2011 earnings conference call. Just a quick reminder; today’s call is being recorded.

And now, at this time for opening remarks and introductions, I’d like to turn the call over Ms. Tonya Chin, Director of Investor Relations. Ms. Chin, please go ahead.

Tonya Chin

Hello and thanks for joining us today as we report our third quarter fiscal year 2011 financial results. Joining me on the call today are Peter Blackmore, ShoreTel’s President and CEO; Mike Healy, Senior Vice President and Chief Financial Officer. Additionally, we have our Chief Marketing officer Kevin Gavin, who will be participating in the Q&A session.

Before I begin, I’ll 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 31, 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 as well as the related tax impact.

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

Peter Blackmore

Thank you Tonya. Hello everybody and thank you for joining the call. It is my pleasure to report the financial highlights for our third quarter during which ShoreTel generated year-over-year growth about 30% for the fourth consecutive quarter.

We delivered record revenues of 51.6 million in the quarter, up 8% sequentially over the previous quarter and up 39% of the third quarter of fiscal 2010.

We reported a strong improvement in non-GAAP gross margins, which at 68.6% represent another record. And we are very pleased to reach an important milestone to show non-GAAP profit one quarter earlier than expected with non-GAAP net income of $602,000.

Four months into my tenure at ShoreTel, I am even more energized about the future prospects of the company than I was when I first joined. The growth opportunity here is significant, and I’m even more convinced of that today.

ShoreTel has a winning product based on the principal of simplicity. It offers a unique and superior architecture, the lowest total cost of ownership and the highest customer satisfaction.

The changes that we are making to expand our distribution both in the United States and internationally, and to improve our brand awareness, provide a significant opportunity to further grow ShoreTel’s market share for the coming quarters.

In fact, we took another great step in that direction in the December 2010 quarter as the investment we made in our sales and marketing engine of the past several quarters clearly paid dividends, but in terms of ShoreTel’s accelerated revenue growth and market share.

According to synergy research based on revenue, ShoreTel increased its United States enterprise IP market share to 6% from 5.5% in the September quarter. In the United States pure IP market, which excludes hybrid systems, ShoreTel’s share also grew nicely to 8.4% from 8% in the September quarter. Our worldwide market share also improved sequentially .

I’d like to point out that we delivered this growth in December quarter despite a 4% sequential decline in the overall U.S. enterprise IP telephony market.

International revenues represented 12% of total revenues in the third quarter and were up 6% sequentially from quarter two. We are making solid progress in Europe. Our revenues were up strongly quarter over quarter and were up 66% year over year. Revenues from our contact center business in the U.K. doubled quarter over quarter, demonstrating growing traction for that area of our business.

Additionally and importantly, we’re thrilled to be selected by Vodafone to be their preferred provider in the 100 to 500-seat market in the U.K. We were awarded the status after competing for it against all of our main competitors. And we are pleased that ShoreTel’s unique value proposition was acknowledged by Vodafone with this new relationship. We expect this new partnership to yield significant revenue growth to our U.K. business over the coming quarters.

Moving on to Asia-Pacific, revenues were down sequentially due to a few deals taking longer than expected to finalize. However, Asia-Pacific was up 40% from the year ago quarter.

As planned, we continue to invest in three key areas of our business which includes expanding distribution, enhancing brand awareness, and continuing our focus on product development.

First, we continue to invest in expanding our sales force and distribution with the net addition of 17 new quota-carrying sales team members. These resources will add to an already strong sales organization that is delivering strong revenue growth.

As the result of a lot of hard work by our employees and our partners, we have continued to expand our awareness in the marketplace as evidenced by our revenue growth. It took us just three quarters to increase revenue from the 40 million to $50 million range.

While we are very pleased with this achievement and our current revenue growth, we are far from satisfied and I’m exploring many opportunities with my team to grow faster.

Next, I’d like to share an update on the branding front. When we embarked on our investment plan, we conducted a survey to understand ShoreTel’s brand awareness and reputation amongst both IT and business decision makers. This benchmark survey in 2009 showed that ShoreTel had fairly low awareness, both aided and unaided, but for those who had heard of ShoreTel, they had a very favorable impression of us.

We recently performed this survey again to track our progress and we’re pleased to see that our aided and unaided awareness nearly doubled over the last four quarters; a clear testament to the fact that our investment in branding is paying off.

And brand awareness is crucial because, as we have mentioned to you before, when we’re considered, we win more than half of the time.

Additionally, I’m happy to report that the investments in product development are also bearing fruit. In the past quarter, we released our new IP655 high-end executive phone, with a large color touchscreen and direction-sensitive microphone that is getting rave reviews from customers and partners.

This quarter we will be releasing ShoreTel 12, which includes our new unified communications conference bridge, which is currently in beta test. This new conference bridge represents a breakthrough by offering highly desirable unified communications including audio conferencing, desktop sharing, and instant messaging, in an integrated ShoreTel appliance that is low cost and brilliantly simple to install, manage, and use.

Next, let me share a few of our key customer additions in the quarter. We continue to make notable progress with larger size customers. A great example is the Cleveland Clinic, the fourth largest hospital in the United States with 46,000 employees and the number one hospital in the world for heart surgery.

ShoreTel was selected to improve the clinic’s efficiency’s, and streamline operations of patient logistics using our ShoreTel communicator. This installation includes ShoreTel’s Enterprise Contact Center for the clinic’s hospital transfer and critical care transport divisions. Cleveland Clinic is truly a premier customer and one we’re proud to serve.

Another example is Baker Distributing, a customer we signed through our relationship with one of our carrier partners. ShoreTel won this 4,000-extension installation in 420 locations and 11 distribution centers over Cisco based on our lowest total cost of ownership, enabled by our inheritantly simpler technology.

And finally, we continue to observe tremendous success with increasing license shipments with a large global enterprises. Dover, a worldwide industrial products manufacturer consisting of 36 individual companies, now has more than 5,500 ShoreTel licenses. One of their subsidiaries alone, [inaudible], uses ShoreTel at 25 sites in over 20 countries. We look forward to serving more of their employees and companies.

Next, I’d like to share an update on our recent distribution enhancements. Our transition to two-tier distribution in the United States is progressing very well. We have been busy putting the systems and processes in place to accommodate the ramp-up at ScanSource and Wesco.

We remain on track to have all targeted smaller partners transitioned by this August. In addition, we are very pleased with the new partner opportunities that our relationship with ScanSource is delivering.

This quarter we also welcomed a strong addition to our service provider portfolio Woodsteam, which also contributed it’s first revenue in the United States during the quarter. Woodstream is a public telecommunication company with revenues of 3.7 billion a year.

We also had a very strong quarter in terms of new partner additions. As we told you last quarter, we recently realigned our sales organization and created a dedicated team to focus solely on recruiting and ramping new partners. This group is being very productive and signed a results record number of new high-quality partners in the quarter.

One example is [inaudible], a subsidiary publically traded company’s CSP inc. [Inaudible] reported 2,010 revenues of nearly 100 million. Another great addition to our partner network, is Holergy, a private company with offices throughout the United States.

Moving on to mobility, an area which I am increasing excited about due to both market potential and ShoreTel’s competitive advantage. While still a small component of our revenues, we had a good increase in sales of ShoreTel mobility during the quarter and the sales pipeline is growing rapidly. To ensure that ShoreTel mobility ramps effectively, we shall be forming a dedicated sales team with the aim of selling both to ShoreTel and competitive PDX customers.

As a reminder, our technology integrates very well with winning PDX platforms. Additionally, we have been busy training and certifying our key partners including AT&T and Bell Canada to resale ShoreTel mobility.

Another area I see as a good opportunity to further development is that of strategic relationships. During the quarter we announced an enhancement to our relationship with Polycom, and also are we’re pleased to be added as a member to HP’s Alliance 1 program. These are both very promising relationships for us going forward. I believe there is a significant opportunity to do more in this area, and we’ll keep you updated with our progress over time.

Lastly, I’d like to take a moment to welcome a new member of my leadership team, Don Joos, who is Vice President of Global Services. Don was brought on board to lead our service organization, which I firmly believe is a critical part of our strategy as we scale the company.

Don, previously spent nine years as a Vice President at Avaya in various roles leading teams that channel transmation, integration work, and global customer satisfaction. He brings a wealth of industry strategy, operational, and execution experience to ShoreTel and we’re happy to capture this type of talent.

In summary, I am pleased to see ShoreTel’s investments in sales, branding, and research and development pay off. The more time I spend in ShoreTel’s employees, our partners and our customers, the more enthusiastic I become about the tremendous prospect for this business.

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

Mike Healy

Thanks, Peter. ShoreTel had another strong financial quarter and I will now cover the highlights for you.

Revenues of 51.6 million were an 8% sequential increase from the second quarter, and marked the sixth consecutive quarter of accelerating revenue growth on a year-over-year basis, with this quarter growing 39% year over year.

Non-GAAP gross margins climbed to a record 68.6% for the quarter, our non-GAAP operating expenses were 35.2 million, and as a result, we returned a non-GAAP profitability with non-GAAP net income of $602,000 or $0.01 per diluted share. Including stock-based compensation charges of 2.8 million and amortization of acquisition-related intangibles of 185,000, our GAAP net loss was $2.4 million or a loss of $0.05 per-share.

Both our GAAP and non-GAAP quarterly results showed significant improvement over last year and last quarter, mostly driven by the strong revenue growth and improving gross margins. I am pleased we are able to achieve the important milestone of returning to non-GAAP profitability in Q3.

Next, let me review some of the key financial metrics for the quarter. Product revenues grew 9% sequentially and 43% year over year to 41.3 million. Service and support revenue grew 5% to 10.3 million and represented 20% of our total revenue in the third quarter.

International revenues were 5.9 million, up 6% sequentially from last quarter and represented 12% of our total revenues in Q3.

The strongest growth this quarter came from Canada and the U.K. Canada, traditionally one of our competitor’s strongest market, has shown over 100% year-over-year growth as we were seeing the benefits of adding sales resources in that market.

Billings from service provider partners were up 13% sequentially and represented 12% of our total business, which is consistent with last quarter.

As Peter mentioned, we had our first meaningful revenue from Windstream in the quarter, and have included that amount in the service provider group which also includes AT&T, Quest, and Verizon.

In terms of our major verticals, health, financial and services show large increases quarter over quarter with financial institutions our largest vertical in the quarter. The government and education verticals declined in the quarter after showing strong growth in Q2.

Our revenue concentration continues to be well distributed. We had two reseller partners representing between 5 and 10% of our revenue for the quarter, and no single end customer making up over 5% of revenue.

We increased our customer base by 6% by adding close to 1,000 new customers in the quarter. Billings from new customers was 44% in the quarter which was the same percentage as last year’s Q3.

We sold 115,000 M-user licenses in the quarter compared to 113,000 in our December quarter. Our revenue metrics and leading indicators continue to improve in Q3. Our gross sales pipeline – our in-quarter sales pipeline and our conversion percentage of that pipeline continue to grow.

International revenue growth continue in both average deal signs and total billing from our large deals increased slightly. Our discounting for the quarter dropped noticeably which helped drive record-high product gross margin. As Peter mentioned, our market share increased again in the December quarter.

We ended the quarter with 184 quota-carrying sales people. Over the last three quarters, we increased our sales force by 39%, and will most likely have close to a 50% increase in headcount for the year by the end of the June quarter in the sales area.

Moving on to gross margins, our overall non-GAAP gross margins climbed to 68.6% in Q3, an increase of 140 basis points over Q2. Non-GAAP service and support gross margins declined slightly as expected to 67% as we ramped up on some overdue hiring in the support organization.

Our non-GAAP product gross margins were at an all-time high of 69% and were up 240 basis points over Q2. Product gross margins were higher than expected due to increase in revenues coupled with a noticeable drop in discount across all of our geographies, which helped margins on both our phones and switches.

GAAP gross margins of 68% were also up included in approximately $300,000 of stock-based compensation charges and amortization of acquisition related intangibles. Our non-GAAP operating expenses increased by 2.2 million to 35.2 million. The increase was driven by labor cost related to the hiring of 52 new employees and higher incentive compensation costs that are tied to our financial results.

In fact, the entire increase in operating expenses in Q3 was in the areas of sales, and research and development where the bulk of the recent hiring has taken place. Marketing and G&A expenses both had declines quarter over quarter.

GAAP operating expenses were 37.9 million included in approximately 2.7 million in stock-based compensation expenses. From a tax prospective, we benefited from a favorable tax rate this quarter due mostly to the one-time true up of our federal income tax expense, per our provision to our recently filed federal income tax return.

Going forward, you should continue to model a minimum tax expense – income tax expense each quarter which is comprised of income tax determined from our foreign and U.S. state jurisdictions in which we operate.

We do not expect to incur any U.S. federal income tax expense until such time as we utilize all of our available federal net operating losses and income tax credit carry forward.

Next, let me review some of the highlights for our March 31, balance sheet. We ended the quarter with cash and short-term investment of 102.6 million, down 2.8 million from last quarter. The decrease in cash is mostly due to the use of cash flow operations of approximately 2.2 million.

Accounts receivable increased 10% to 27.1 million on higher revenue and day sales outstanding were great again, dropping to 36 days, down from 38 days last quarter using the monthly rollback method.

Inventory increased 29% to $16.5 million as we grew our inventory for a couple of reasons. First, we purposely increased our phone and switch inventory to ensure an adequate supply to support our expected revenue ramp over the coming quarters.

Second, we do have a few piece parts that are nearing end of life that we are making last time purchases for in order to ensure an adequate supply until we roll out a new line of phone.

And finally, due to the unfortunate disaster in Japan, we have examined our supply chain closely and have several individual phone parts that may have supply issues. The good news is that based on our current projections, we appear to have an adequate supply of inventory all the way through September 2011 quarter. For those individual phone parts affected, we are using other vendors to fill the supply void in making spot purchases.

I do not expect these actions to have a material negative impact on our gross margin.

Total deferred revenue increased 4% to $33.1 million driven by continued sales of maintenance contract. On a GAAP basis, depreciation and amortization for approximately 1.3 million for the quarter and capital expenditures were approximately 1.1 million.

We ended the quarter with 617 employees, which represented a 9% increase in headcount for the quarter with over 90% of the hiring in Q3 taking place in the support, R&D, and sales organization.

Next, I’ll discuss our outlook for the June 2011 quarter and give you some insight into 2012.

Based on our Q4 billing, bookings, and backlog to date and other factors, we expect revenue to be in the range of 53 to $56 million. We expect non-GAAP gross margins to be in the range of 67 to 68%, GAAP gross margin are expected to be approximately 80 to 100 basis points lower than non-GAAP gross margins.

We expect non-GAAP operating expenses to be in the range of 35.5 to $36.5 million and we expect GAAP operating expenses to be in the range of 38 to $39 million including approximately 2.5 million in stock-based compensation expenses.

As we look forward to our next fiscal year which begins in July, we expect continued strong revenue growth coupled with modest non-GAAP profitability. In terms of the enterprise IT telephony market, we have looked at market growth estimates from Synergy, IBC, Infranatics, and Gartner, and while each have slightly different expectations, we are currently modeling market growth of 8 to 10% in our fiscal year of 2012.

Also as we look to fiscal year 12, I want to remind you of our Q1 seasonal spike in expenses from marketing and G&A of approximately 1.5 million, mostly due to our partner conference in July, and year-end fees for audits, [inaudible] and tax work. As such, while we expect fairly linear improvements in our operating margins going forward as revenue increases, Q1 fiscal year ’12 operating results could be lower than Q4 fiscal year ’11 due to these two incremental items.

Our final operating results will certainly depend on our Q1 revenue achievement in that quarter.

I will now turn it over to Peter, to discuss the full-year 2012 in a little bit more detail. Peter.

Peter Blackmore

Thanks, Mike. So to wrap things up, I would like to take a minute to discuss our expectations for 2012. As Mike said, we are very excited about our growth potential and very encouraged by the strong results that we have seen from our investments in our business.

Assuming no significant change in the overall business environment, we are currently expecting at least 20% revenue growth in 2012.

After speaking with many investors, we understand that they are looking for us to demonstrate some of the leverage that we are confident is in our model.

Normally, we would wait to talk about fiscal 2012 until our Quarter 4 earnings call. But we realize that investors are very eager to understand our investment philosophy for the coming fiscal year.

We constantly weigh the goal of achieving growing profitability against the need to invest in longer-term opportunities which create and grow long-term shareholder value. Given that balance, our current plan is to achieve modest, non-GAAP operating income in the low single digits for fiscal 2012.

By doing this, we believe we highlight the operating leverage in our model while striking the appropriate balance that in driving toward our long-term profit model and investing in to continued growth of ShoreTel in fiscal 2012 and beyond.

In summary, ShoreTel has a winning product and has been building momentum in the market, but there is more we can do to realize the company’s full potential. Now that I’ve had time to become immersed in the business, I’m working with my management team to map out a plan that will deliver profitable growth, which will help ShoreTel capture an even greater share of the enterprise market, and make this company a true industry leader.

I would now like to open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). We’ll take our first question this afternoon from Troy Jensen at Piper Jaffray. Troy.

Troy Jenson – Piper Jaffray

Hey, congratulations on a nice quarter everyone.

Mike Healy

Thanks Troy.

Peter Blackmore

Thank you.

Troy Jensen – Piper Jaffray

Hey, so let’s start off with Mike here. Product gross margins all-time high, 69%, do you think that’s a sustainable level?

Mike Healy

Yes, good question, Troy. We are very pleased with the gross margins popping up like they did. And for the most part, it was really due to pretty steep decline in discounting in the quarter. So I think over time our sales forces get better and better selling the ShoreTel advantage and our TCO advantage. I’m not going to go out and say we’re going to continue to have that kind of increase in product gross margins.

I do think some of it was due to the high percentage we had of add-on business, i.e. we probably discount a little bit more when we have new customers versus add-on business. And if you go back and look at our trends over time, that has proven out. So obviously, with my guidance for next quarter, I’m modeling gross margins and product margins down a little bit as I expect a pretty big ramp up in new business from customers.

Long explanation, but we’re pleased with where we were or are with those product gross margins, but I do think they may come down just slightly next quarter.

Troy Jensen – Piper Jaffray

Okay, fair, and then you made a comment on state and local. I think you said Gov. and education down sequentially. Just want to get your thoughts on, could you quantify how much it was down and just kind of thoughts going forward.

Mike Healy

No, we didn’t quantify it as with all our verticals. We talked about just directionally if they’re up or down. There’s a fairly significant decrease in both education and government as others in our space have experienced this quarter. So it didn’t surprise us that it was down like it was. I do expect Q4 to come back especially in the education area. But not surprising where it landed this quarter.

Troy Jensen – Piper Jaffray

Fair, last question and I’ll seat the floor. Tier One or Gold Partners, I’d just be curious to know if there’s any other near turn opportunities in your guys’ pipeline.

Mike Healy

You mean in terms of our service providers?

Troy Jensen – Piper Jaffray

Yes.

Peter Blackmore

We have, obviously United States, we’ve got the big ones. There are some second tier service providers we could attract. And we just added Bell Canada on mobility. We talked about other international companies. So there’s lots of international opportunity as well.

Troy Jensen – Piper Jaffray

Okay. All right, perfect, keep up the good work gentlemen.

Peter Blackmore

Thank you very much.

Mike Healy

Thanks, Troy.

Peter Blackmore

Next question please.

Operator

Next now to Edward Parker at Lazard Capital

Edward Parker – Lazard Capital

Hi there. Just a quick question here on the R&D side. It looks like it actually accelerated your year-over-year in terms of growth. Maybe you could help us understand maybe what’s going into R&D and how you expect that to trend here over the next few quarters, if it’s going to sort of wind down or do you expect a lot of spending on the R&D here.

Peter Blackmore

Well, we’re fine with the R&D spend for this last quarter. We have been getting ready to launch ShoreTel 12. ShoreTel 13 is not far behind that.

And as we’ve explained to many investors, we’re going through a slight bubble where converting the call code to minutes, which will be a tremendous benefit when we complete that in about 15- months’ time. And we’ll also design and completely arrange very exciting phones. So there’s a slight bubble there. But I think the R&D spend is very well considered, so I’m comfortable in it. And over time, you’re absolutely right as a percentage of revenues that will come down. And once we’re through these two big items such as Linux, then we’ve got flexibility in the model.

Edward Parker – Lazard Capital

Okay, understood, and then quick question for Mike, did you give a user license number in the quarter?

Mike Healy

Yes, 115,000 user licenses.

Edward Parker – Lazard Capital

Okay, great, thanks guys.

Peter Blackmore

Thanks ED:.

Operator

And we’ll go next now to Sanjiv Wadhwani of Stifel Nicolaus.

Sanjiv Wadhwani – Stifel Nicolaus

Thanks so much. Congratulations on the profitability.

Peter Blackmore

Thanks Sanjiv.

Sanjiv Wadhwani – Stifel Nicolaus

Two questions on my side. Mike, I think you talked about it a little bit, but your drop in discounting, I know you mentioned that you had add-on business with existing customers and that helped. But I’m wondering if that’s also reflective of what’s going on in the competitive environment out there.

Mike Healy

Well, yeah, I don’t want to say it’s just all because we had a bigger percentage of add-on business. I have to give my sales force a lot of credit that they do a great job selling against two larger competitors who have much better scale than we do. And they go to them head-on-head. And we typically don’t always have to match price because we’re doing our job right in selling TCO over a five or ten-year period, it’s pretty obvious we’re going to win and have the lowest cost of ownership. So our sales force is doing a great job in terms of selling the value proposition that is ShoreTel. And it’s showing up in the lack of discounting this quarter.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. And Mike, just an update, I know you last quarter call you said you planned to hire 20 people in June. I don’t know if you provided an update on that number on this call, 20 new sales people.

Mike Healy

Yes, so in my prepared remarks if you – to get to 50% increase in our sales head count year over year, that would be about 15 heads added in the quarter. So that’s the hiring goal. We’ll see if we get there. So it’s a little bit less than the 17 we added this quarter.

Sanjiv Wadhwani – Stifel Nicolaus

Got it. Last question, I’m just curious to get some details on sort of Agito. I know there has been at least one or two customers that have decided to sort of go mostly the Agito route versus deploying desktop phones. Can either of you talk about the economics of that and how that works overall if more customers decided to do that? Thanks

Peter Blackmore

What I’d like to do is get Kevin to talk about mobility and what he’s seeing because I think we have an exciting story to tell. Then Mike will talk about the model of the phones versus mobile.

Kevin Gavin

Certainly the mobility acceptance and reaction to the marketplace has been very, very positive. Both partners as well as customers removing a number of very large companies sort of Fortune 1000 companies into pilot mode. And these larger companies tend to do pilots before they roll out large deployment. So it’s going quite well.

We also completed a third party independent certification process to validate and prove what we’ve known. And that is that the short-time mobility solution works well against Cisco Avaya. We’re completing the confirmation testing against Nortel as well.

So mobility continues to move along very nicely. And our observation experiences that while there are some number of employees that can go without a desk phone, when they get mobility, they can use their Smartphone. We’re seeing the majority of the people that are buying are keeping the desk phone and using it as a complementary or supplementary phone. And to the extent that those salespeople or mobile workers that don’t spend much time at their desk do in fact give up their desk phone. The revenue we generate with short-term mobility offsets any loss that might have otherwise occurred. So it seems to be going the way we hoped.

Mike Healy

I would say to add to Kevin’s comments, right, and the economics are, the first is our tax rate on phones is actually up this quarter over last quarter between license and phones sold. So that’s good news. And I look at it as if a customer is going to take phone and a software license versus mobility license, the overall gross margins on the mobility license sale would be higher than a switch and a phone sale. So we consider that a very good positive. Depends on how much we discount on each side of it obviously.

But as Kevin said, with the majority of what’s happening is it’s not a replacement of the phone and a mailbox license. It’s an add-on as we move forward. So that’s just added revenue and added gross margin percentage for us. It’s higher than our corporate average.

Sanjiv Wadhwani – Stifel Nicolaus

All right, that’s all. Thanks so much.

Mike Healy

Thanks, Sanjiv.

Peter Blackmore

Next question please.

Operator

We’ll take the next question now from Greg Burns with Sidoti and Company.

Greg Burns – Sidoti and Company

Thanks for taking the call. Question on the progress transitioning the partner base to ScanSource and Westcon. Just maybe like the early feedback from some of the partners and maybe ones that have transitioned over to kind of, are you seeing any productivity gains or what kind of incremental benefit are you getting from their early transition?

Peter Blackmore

Okay, the progress is absolutely on track. A lot of the activity this last quarter was building the systems, doing some additional orders from the distributors, the value-added distributors, and moving just a small number of partners across. That accelerates in this coming quarter. And then it culminates in all of the partners moving by August. So we’re very confident it’s on track.

In terms of what we’ve seen, it’s too early to see productivity because only less than 20 partners have moved so far. But what we have seen, and this is very positive, we have seen ScanSource have a big pipeline of partners to recruit in addition to the ones we’re transferring across. And that’ very positive news to date.

Greg Burns – Sidoti and Company

Okay, thank you. And on the 2012 guidance I guess targeting at least 20% revenue growth, but low single-digit non-GAAP profitability. I’m just trying to kind of reconcile that with your profitable on a non-GAAP basis this quarter. The guidance implies a little improvement here, so just wondering why you’re not getting more leverage from the sales growth next year.

Peter Blackmore

Please remember what we’re trying to do here. It’s very early, but we met many, many investors in the February-March timeframe. And what they asked is, please give us an indication to your confidence in growth in 2012. And your confidence in operating leverage.

So what we’ve tried to do is put a stake in the ground and illustrate that. What will come back is, we’ll obviously have, as we always do, we’ll have detailed quarter one update in August. And we’ll give more detail around that.

But I wanted this just to position it. And obviously, many people on the phone may have other questions and ask you to be patient. And say, your met your requirements for statement. Please bear with us for another three months. And then we can be more specific. But we did want to beat your requirements this early on.

Greg Burns – Sidoti and Company

Okay, and one last one. Is the Vodafone relationship just U.K., or is that like a European deal? And if so, is there opportunities to expand that partnership?

Peter Blackmore

It’s currently with Vodafone U.K. Vodafone runs this by country. Clearly if we do well, there will be an opportunity to expand it in other Vodafone entities.

Greg Burns – Sidoti and Company

Okay, thank you.

Peter Blackmore

Thank you.

Mike Healy

Thanks, Greg.

Peter Blackmore

Next question please.

Operator

Next to Rohit Chopra at Wedbush Securities.

Rohit Chopra – Wedbush Securities

Hey, guys. Three questions for you. I know you lump a lot of stuff now into the SPs or service providers, but can you just tell us whether the Telecom companies actually grew quarter over quarter?

Mike Healy

We talk about those service providers in total, which today our AT&T, Verizon, and now Windstream, and we can’t give out confidential information by each of those companies. So in total, that group as we said, grew 12, what was it, 12% quarter over quarter. And is – grew 13% and they’re 12% of our total business.

Rohit Chopra – Wedbush Securities

Right, and isn’t CDW and Black Box included in there or something?

Mike Healy

No, remember we changed our classification last quarter. And so CDW and Black Box are not in that service provider classification anymore. It’s just those four we mentioned.

Rohit Chopra – Wedbush Securities

Okay, and then on the Asia Pacific region, you mentioned there was some delays. Were you able to resolve those delays as we went into this quarter? I mean are those deals gone or they still there?

Mike Healy

No, they’re still there. It’s just delays for board approvals and things like that would cause the miss more than anything. Some of them come through and some of them, we still need to close on.

Rohit Chopra – Wedbush Securities

Okay, and then is there any way to quantify the sales productivity that you’re seeing today on a – I don’t know, what do you want to look at it on a same-store basis, kind of look at the sales people that way?

Mike Healy

Yeah, so sales productivity if you do the simple math and divide revenue by the quota-carrying head counts, you’ll calculate a flatish. I think it’s down 2% this quarter versus last quarter. So with the amount of people we’ve been adding in the last nine months over 50, we were hard pressed to expect that we’d have an increase in sales productivity with that kind of level investment. So we consider it good that it’s staying flatish with that kind of level of increase. But obviously, we’re looking for it to grow over time.

Rohit Chopra – Wedbush Securities

Okay. That’s it, thank you.

Roger Blackmore

Thank you very much.

Mike Healy

Thanks, Rohit.

Roger Blackmore

Next question please.

Operator

Next now to Lynn Um of Barclays Capital.

Lynn Um – Barclays Capital

Hi, thanks for taking my questions.

Mike Healy

Hi, Lynn.

Lynn Um – Barclays Capital

Hi. I guess media question on international. Sounds like some regions have been doing pretty well. Maybe just kind of what you see the next shifting towards. It seems like it’s still 88, 12% [inaudible] international. How that mix they thought may be in fiscal 2012?

Peter Blackmore

I think there’s a lot of upside international. And yes, it’s still 12% of our revenues, but we’re growing – we grew 39% internationally smaller numbers. So to get a relative share, it has to grow faster. So Europe grew 66%. And Asia-Pac grew 20%. And Canada grew 100%. So I’m pretty pleased with those rates. And we will come out with a detailed explanation of how we’re going to expand international in 2012. I do think this is a huge opportunity, but I want to do it in a very focused and disciplined way so we get the return.

Lynn Um – Barclays Capital

Okay, and then maybe just a quick question on the services margin. Sounds there was some catch-up hiring that happened this quarter. Is there more still to come or do you feel that it’s pretty much where you want it to be right now?

Mike Healy

Yeah, so the good news is we’ve caught up on some hiring. And bad news, gross margins on the service side went down a little bit. I think we’ve caught up, but there’s certainly plans to continue to hire in the service organization. So I’m not initially keeping those margins exactly flat last quarter. I’m modeling those down a little bit given the overall margins are modeling down a tad. So there’s still more hiring to do. It’s really dependant on how fast we’re growing revenue every time – we’re adding 1,000 customers a quarter, I certainly have got to increase that support organization.

Lynn Um – Barclays Capital

Okay, sounds good. Congratulations.

Mike Healy

Thanks, Lynn.

Peter Blackmore

Thank you. Next question please.

Operator

(Operator instructions). And we will next now to Steve O’Brien at JPMorgan.

Steve O’Brien – JPMorgan

Great, thanks for taking my question. I appreciate it’s sort of a preliminary outlook for 2012, but maybe you could help me understand a couple points in there, a couple assumptions in that outlook. I guess one being any color on sort of the pace of hiring you expect through 2012 relative to 2011. And then secondly, on the gross margin side as you transition the partners to two tier in August, what kind of assumption are you embedding for gross margin to decline?

Peter Blackmore

Let’s answer the gross margin question first. As Mike and I have said on a call, we see a couple of points decline as you move to that percentage of the business due to [inaudible]. Remember, it’s only a percentage. But over time, we see that offset in the operating margin because we’ll have lower costs whether it’s technical support, costs, or managing auto management for these partners, so it gets offset. So I think we’re confident it will be a wash over time.

And then in terms of hiring, we haven’t given indication yet for hiring in 2012. We’ll complete our strategic plan by the July timeframe. And we’ll give you that indication then. But we’re very confident in regardless of the hiring, we’re confident of growth. And we’re confident we’re delivering an operating profit. And we’re confident we’ll be able to invest as well as delivering an operating profit to enable us to take advantage of the revenue opportunity we clearly see out there.

So if you’ll just be a little patient, Steve, and we’ll come back with those details. But remember what we did today is putting the stake in the ground so you could see our thinking.

Steve O’Brien - JPMorgan

Thanks for that Peter. Maybe if I could just talk on or ask question on the near-term and Mike’s comment regarding the fiscal Q1 operating margin could potentially decline. I think normally the company has talked about fiscal year Q1 being a challenging quarter over the summer months and coming off the year end in terms of the top line. So is there any color or thought process on the top line you bake into that potential for a sequential margin decline in the first quarter?

Peter Blackmore

It’s early yet. We’ll give that in August. It will depend on the revenue we mentioned we have. All we’re doing is we didn’t want to talk about the operating profit percentage, but without just putting a caution about quarter one for the year. We just wanted to put it in perspective.

Mike Healy

You’re right, Steve. Q1 is usually a little bit tougher in terms of bookings. And it’s lower in the summer and we have our partner conference in July. So we just wanted to make sure you guys recognize that in your models in terms of expense side. And then, we’ll certainly give you the revenue guidance after we close Q4.

But there is as we said, there is a chance that the results could go a little bit south of where we end up on Q4. Obviously, the big variable is what the revenue will be. We just don’t have that kind of visibility to tell you two quarters from now what it will be.

Steve O’Brien - JPMorgan

Okay, fair enough. Maybe one more if I could. Cisco announced a refreshed SMD product line towards the end of March with new price points. I think availability starts pretty soon. Are you sort of running up against a new product line? And if so, how is the TOC tool holding up?

Peter Blackmore

Kevin will answer that.

Kevin Gavin

We always have and we will continue to compete against Cisco. We think our total cost of ownership is really driven fundamentally by the simplicity and needs of administration. And we continue to maintain that ease of administration simplicity advantage. We see nothing in the new product line that’s going to take away our fundamental competitive advantage. And we continue to compete and win against them in that space.

Steve O’Brien - JPMorgan

Thanks, Kevin.

Peter Blackmore

Thank you. Next question please.

Mike Healy

Thanks, Steve.

Operator

We’ll take that question now from Douglas Ireland at JMP Securities.

Douglas Ireland – JMP Securities

Good afternoon.

Mike Healy

Hey, Doug, how are you?

Douglas Ireland – JMP Securities

Great, thank you. A little housekeeping question first. The shirt count was up a little faster than I expected. I may have missed something. Should we expect it to grow like that more often?

Mike Healy

Yeah, I think, Doug, what you’re seeing is just a reflection of the stock price and some option exercises, things like that. So I’m modeling a little bit higher increase in share count with a higher stock price than we’ve seen in the past. Yeah, I would model it up a little bit more.

Douglas Ireland – JMP Securities

Yeah, it’s been a very a good quarter for new stock.

In terms of the VAR recruiting, I know that part of your plan in dividing the sales force and having specific sales people going after VAR recruiting, could you talk a little bit about how the progress was in the quarter? And maybe how you want to see that play out over the next few quarters in terms of VAR numbers?

Peter Blackmore

Okay Douglas, the whole process there has been very, very good to see because we’ve now got a team that is dedicated to go recruit and manage the [inaudible] experience with the VAR. And then we have a separate organization, which is if you like an overlay sales force, to work with the partners, help grow the partners, and provide some very high level selling skills when they’re needed. So expanding up has really paid off.

And our pipeline of recruitment, we don’t say what it is, but I can say that it’s increased very nicely both in two categories. The number of partners and also even more important to me, the number of large high-quality partners that are coming to us. Clearly, they’re coming from competition because they exist before, but they want to add up fairly their very serious interests. So we had a record recruitment for bars in the last quarter. And I think we’re going to do even better in the next quarter.

Douglas Ireland – JMP Securities

Okay, that’s good. I know that you had maybe, was it 585 VARs before. And are, do you have a target number for the next year?

Peter Blackmore

We don’t have a target because what is going to happen, remember the distributors are going to be responsible for the smaller partners were very valuable to us. But it’s a better economic proposition than to work with the distributors. We’re then focused on recruiting larger partners who can really help us to good system integration and sell to larger customers. And you don’t need 100s of those to do well. You just need the right number of very high-qualified partners. So it’s more a quality gain than a numbers gain.

Douglas Ireland – JMP Securities

Go ahead, sorry.

Mike Healy

I’m sorry, Doug. That being said, as Peter mentioned, we did have our highest recruiting of partners this quarter ever. So that team, even though we were just formed the beginning of the quarter, they certainly paid off. And so we do expect them to ramp up. And adding high quality channel partners is one of our keys to growth, absolutely.

Douglas Ireland – JMP Securities

I agree. Finally, I was just wondering if you could talk a little bit about any implications that you see in [inaudible] putting its’ enterprise business up for sale. They say it’s doing $125 billion in revenue. It seems like that could be a European version of the Avaya-Nortel deal. I’m just wondering if you see anything in that as an implication for ShoreTel.

Peter Blackmore

It’s very early to tell you yet and there’s lots of conjecture out there. But no factors yet, but I see any disruption of the market place as positive for us because we’re very focused. We have very good plans. It’s up to us to execute well. So while the rest of the industry perhaps goes through M&A or different strategies, I think it opens the door for us.

Douglas Ireland – JMP Securities

Okay, well I’ll look forward to hearing more as the more news comes out.

Peter Blackmore

Thank you so much.

Mike Healy

Thanks, Doug.

Peter Blackmore

We have time for one more question.

Operator

(Operator instructions).

Peter Blackmore

Let me wrap up. First of all, I’d like to thank you for joining the call. Thank you for your questions.

As a team here, we’re thrilled at the accelerating revenue growth. We’re thrilled at getting the non-GAAP profitability. Obviously, we’re taking share. And we’ve got a very, very clearly defined policy to provide leverage but to take full advantage and invest in the opportunities that thrive long term revenue growth to market share growth.

So I think the best is yet to come. And with that, let’s close the call.

Operator

Thank you Mr. Blackmore. Ladies and gentlemen, that will conclude today’s ShoreTel Systems’ Third Quarter 2011 Earnings conference call. Thank you all for joining us and we wish you all a great afternoon.

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