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Executives

Peter Blackmore - President and CEO

Mike Healy - SVP Finance and CFO

Tonya Chin - IR

Analysts

Jeff Kvaal - Barclays Capital

ShoreTel, Inc. (SHOR) Barclays Capital Global Technology Conference December 7, 2011 12:30 PM ET

Jeff Kvaal - Barclays Capital

Okay, everyone. Welcome to the ShoreTel session. I am Jeff Kvaal. I am part of the common equivalent franchise at Barclays. We are delighted to hear from the team at ShoreTel today. For those of you that don’t know ShoreTel, you feel like you should, either because of the stock itself, or because of the product, I certainly don’t have advantage of ShoreTel voice UC system, unified communications system in our offices. Moving is kind of a pain in the neck I would say.

So what we’d like to do is spend some time with management from ShoreTel. And I’m delighted to have Peter Blackmore here. He is the CEO. Mike Healy, the CFO is here. And also, Tonya Chin is with us as well. So what I will do is I’ll just pass it to Peter.

Peter Blackmore

Thank you. A very good morning to you all. Great pleasure to be with you and thank you for your interest in the company.

I’d just like to draw your attention to the normal safe harbor statement before I start. I’ll move through the slides pretty quickly because I think hopefully most of you know a little bit about the company. And that will give more time for Q&A.

The company was conceived, so it was – had an application which was absolutely designed for internet telephony and unified communications. That gives u a lot of inherent advantages which I’ll go into.

We’re based in Sunnyvale, just down the road. Another major facility is in Austin, Texas. And other than that, we don’t have any major facilities, just regional sales offices. 19,000 customers, we grow customers, new customers every quarter. Typically 45% of our business every quarter is from new customers.

Our target market is a small medium business market, 20 to 20,000 employees. We also quote on saying 50 to 5000 seats. But we can now scale up to 20,000 seats. So that takes you up into the enterprise. And obviously we’re listed on NASDAQ.

We’re a software company. We’ve got about 220 R&D development people, and less than 10 are hardware designers. So they typically design the telephone systems. So we really are a software company.

It was built as a very easy-to-use platform, single image. That means that everybody in the company that’s on the system can access and see everybody else. When you add an employee, immediately that person’s details are available throughout the system.

We believe we have the highest degree of reliability in the industry. And there are reasons for that. We’re switch software as well as an application software. We have N+1 redundancy built into the architecture, and we’ve got a very, very rich set of applications to make it a complete unified communications system.

The hardware, the switch is a very interesting device. The only moving part is a fan. So it’s inherently reliable, above five 9’s reliability. And we have a complete set of secure appliances, such as concentrated SIP technology and mobility routers.

Our phone systems, and this is about a 30 plus percent of our revenues. They’re a complete range of phones for individuals for conference – conferencing. A lot of design goes into this, and they’re very, very popular with our customers. And we have not seen any reduction in phone attach rates despite the fact we have a very strong mobility offering. So it’s important for you to understand that we see a lot of longevity in this part of the application.

Our mobility, it’s been with us for twelve months, and we bought a company, if you remember in October of the previous calendar year called Agito. We’ve had to do a lot of work to get this ready for market, because what we bought was outstanding intellectual property but there really wasn’t a revenue stream. There was no big sales and marketing effort.

We have ramped that up. We’ve invested in sales, put a lot of branding and marketing in there. If you look at a number of magazines, such as CIO magazine or Businessweek, you’ll see we have an ability of branding and advertising right as we speak. And we have an ability to be PBX agnostic. And we’re only aware of one other company in the industry. It’s a small company that does that.

Other people have mobile phone systems but it tends to be designed for their PBX so that, that limits their ability to go to a Fortune 100 type of company, which typically has multiple PBXs, either through acquisition, or deliberately as a buying decision by their CIO so they’re not dependent on one platform. We’re, therefore, very attractive to large corporations for this mobile offering.

Go-to-market proposition is we’re easier to use than other platforms, and we have the lowest cost of ownership in the industry. And there is a slide later on that.

This compelling advantage is unlike to change, because this was built into our architecture. The system was designed over 10 years ago. And the comparison with our competitors is all of their systems were built by M&A. In other words, they bought companies to complete their portfolio suite. They integrated them as best they can, but they are inherently more complicated to use and inherently more costly to run from a day-to-day running operation.

This is the total cost of ownership. And we are 50% better than whether you look at Cisco, Microsoft, Avaya, Mitel or the traditional multiplex systems. Huge competitive advantage. We have a tool, a TCO tool, which is available to customers. They can actually put in their own numbers. They can configure their own systems, do the comparison. And this is a big part of our go-to-market and selling process.

The other aspect is very high customer satisfaction. We use an organization to test this called Nemertes Research. And over eight years running, we have been the leader and still are the leader. Internally, we also now have a net promoter score test and we are at the 55 plus level in net promoter score, which puts you out with people like Google and other world-class companies. A typical technology company would be 40 or below.

And these research results are very compelling. We use them when we’re selling. Our customers tend to be evangelical. And it really does help our promotion and selling.

We’re popular in many brands. The ones in the top left is a lot of social media companies. We’re very proud of that, very large organizations, very strong in state and local government, as you can see in the middle path. And then we have not only the baseball franchise with the Giants. We’re very proud to be – support them but also other sports franchises, and they’re very large organizations, legal companies such as Robert Half and others. Very broad spectrum.

We sell everywhere where there are people that -- consultants, lawyers, financial organizations, sports, professionals with social media companies. We meet their requirements very well, particularly if they are multi-site, and also, not only domestic but international.

Gartner rates us best in class. This has been had for a couple of years now. We’re the only organization in the small medium business market, which is given a strong positive rating. Again, very compelling, we’re in selling to organizations.

Our channels are quite rich. And we’ve made a lot of improvements in the channel organization in the last 12 months. We have gone into two-tiered distribution in the United States. We announced it in January this year. We’ve migrated a lot of our smaller partners to ScanSource, which is one of the first two value added distributors that we signed up with. That transition was complete by the end of September, went extremely well, very, very pleased.

We still have a lot of gold and silver partners working directly with us. But it makes it much more manageable for us because the smaller partners are now with a professional value added distributor. They do a very good job. The larger partners, our channel and sales force, could work with them directly.

We’ve also just added Ingram in the United States. We signed them up in November. So they will be ramping their business January onwards, and that we see has a lot of potential for growth through obviously an extraordinary powerful organization.

And we also have Westcon, which is a specialist in providing value-added distribution to service providers, such as Verizon, CenturyLink, AT&T and so on. So we’re well positioned and growing our channel quickly. Every quarter we give you details of how many people we’ve recruited. And last quarter, it was about 55, the previous quarter it was a similar number.

So those organizations are now ramping adding revenue streams. So we’ve been very successful in attracting new channel partners. And clearly those partners are currently doing business with one of our competitors, because we want people who are very experienced in internet telephony and unified communications. So that is the people we’re attracting to ShoreTel.

We’ve been investing a lot to propel our growth and this has been a deliberate strategy and it’s driven by – we have a very win rate. As you see it’s above 50%. But we’re still under distributed in the United States and obviously internationally.

So let me talk about the United States first. We have reasonable distribution on the West Coast. That’s where we started. We’re still low distribution on the East Coast. And given the number of tremendous organizations in the New York, New Jersey area, whether they’re law firms or financial consulting, or finance houses, obviously there is huge potential there.

So what we’ve been doing is adding channel partners as quickly as we can, adding sales force to service those channel partners and building up the organizations. So in the financial year ’11, we increased our sales force to 40%, which is what propelled our growth of 30 plus percent for five consecutive quarters.

We’re still focused on finding large, new partners. We want our partner organization to be able to scale with us. So clearly we want organizations to have some capital, have a strong management team and can scale with us. Although we have a very strong product line, you have to keep it up to date. We’ve been investing in that, adding new features, and also now investing in the ability. Even though Agito IP was excellent, to make it a really, really strong product, we increased the R&D investment in that and it’s paying off.

And our branding is important. Although we are number three in our industry now, our brand is obviously still less well known than the two larger competitors. But we doubled our brand recognition, whether aided or unaided, during the last calendar year, which was a huge achievement on a very modest budget. So our branding process is really working.

Our growth has been outpacing the market. We continue to believe we can absolutely do that. We’ve got projections this year which we can talk about and said, we’ll do at least 20% growth to drive that above the market space and gain share. So that is what we are doing.

And we’ve obviously driven profitability as we showed you in the third and fourth quarters last year. And we aim to be profitable this year with that 20% growth.

And this is our performance over the last few years, which is strong. And we’re pleased with where we are in this quarter, which is our quarter two, we’re on track.

Our margins continue to be good. We are a software company. And although it’s a competitive industry, our margins over the last few quarters have not materially changed. We continue to hold our own. And it’s based on the total cost of ownership. We do not have to discount to win because that 50% cost of ownership puts us in a very, very strong position. So we see this continuing.

Balance sheet, we’re very pleased with. We had $109 million in cash, no debt, and we built cash during the last quarter – cash from operations is $4.1 million. And extremely good days sales outstanding, I think, leading in the industry. And we also have $40 million in deferred revenues on our balance sheet.

Quarter one highlights. We grew at 22%. We were disappointed in that growth in quarter one. We would have liked to do a little bit better. There were some reasons for that. We were – some orders slipped out at the end of the quarter. Plus our gold and silver partners were little bit less performance than we normally liked. But we had very strong performance from CDW, from Black Box, strong performance in service providers. Canada was a record quarter. So we saw this quarter one as a little bit of a one-time blip and we’re back on track in quarter two.

The margins were strong, and we now have over 10% market share in the pure IP telephony market, which is reinforcing our number three position. And as I said earlier, we completed our transition to two-tier, which is a very important just milestone as we move to two-tier distribution.

The long-term model which Mike and we have put together, we see gross margins in the 62% to 66%. We dropped it slightly to the 62 level as expand internationally and obviously do more of our business through two-tier distribution, just single tier-two distribution but the margin model stays very strong.

We spent on R&D in an appropriate amount, and as our revenues ramp, we will get the R&D ratios to what we believe are industry standards of 16% to 17%, obviously investing in the sales and go-to-market organization and G&A is very modest. So long term operating margins in the 10% to 17%. This model has a lot of leverage. What we are doing in the short term is to grow the company to position ourselves better. We’re number three but obviously a little bit behind the number two and a long way behind the number one.

We can gain share, we’ve proven that. So our emphasis in the short term is to really drive for that little bit of a land grab, build up the company not only domestically but build it up internationally and position the company for very good shareholder return as we get a higher market share. We think we are in a very good position to do that.

The value proposition, very straightforward. We’re absolutely focused on this market. We do nothing else. We’ve proven we can drive revenue consistently faster than the market. We believe that the industry is a little bit disrupted and therefore we have an advantage versus our competitors. A lot of them are “distracted” for many reasons.

Our product differentiation is very solid. And we reinforced that, we built that. Channels are very strong and we’ve made some important changes in the channel model, in the last 12 months which I am very pleased with. Win rate, above 50%, very consistent. Investing properly in the business and we think an attractive proposition versus our peer group given our stock price.

So with that, I moved through as I promised quickly and happy to take your questions along with Mike.

Question-and-Answer Session

Jeff Kvaal - Barclays Capital

Could you talk broadly about the UC market? And when do organizations typically make the decision to pull out their old TDM legacy phone system and go with UC? Why do they do that? And then the second part of that is, what drives them to pick ShoreTel, why is your win rate 50% plus, versus Cisco and Avaya? We know both of those guys are struggling to various degrees.

Peter Blackmore

So the overall market, only 50% of the total telephony market has moved to internet telephony. So there is a lot of upside in terms of transition from multiplex to the next generation. People typically make a buying decision when the telephony system is getting a little bit antiquated. So it’s one of those decisions which can’t be put off any longer. They also make the decision if they’re buying companies, or moving a building. They don’t want to move a system to a new building, if they know in a 12 months time they’re going to replace it anyway. So usually the decision point is very clear.

What’s also happening very interestingly is that people don’t see it just as a voice application, they do see it very much as a unified communications application. And there is enough evidence out there that the productivity for employees really does improve. And therefore we see that this is now in the ranking of applications a CIO takes very seriously. It’s now in the top 10. And that is driven very much by this unified communications. And I think adding mobility to that was a huge positive for us. We’re now winning not only mobile solutions just as a standalone solution but we’re increasingly winning very large bids such as Pima County, which was a big $1 million win last quarter, because we have our mobile solution.

They didn’t even buy it in the first trench but it was a big factor in their overall decision. And then the competition we take all of them very seriously. But in the market we are in, which is the small medium business market, we clearly have the best proposition on why does the win rate stay at 50%? It’s – Cisco would have to rewrite their code. Avaya would have to rewrite their code. It’d be as fundamental as that. And therefore, their ability to make a dent in this 50% TCO is extremely hard.

And as long as we are in a proper evaluation where we’ve got our sales force or the channel absolutely talking to the decision makers such the CFO and the CIO, that TCO comparison is really compelling. That keeps us at 50% win rate right where it is.

I hope I answered all your multi-part question.

Jeff Kvaal - Barclays Capital

You just mentioned that you guys are more of a software company. How does – what hardware do you use? Do you buy off-the-shelf hardware? And is there any sort of customization with the hardware when you deploy the software? And how does that compare with the competitors solutions like Avaya, or Cisco?

Peter Blackmore

The hardware is the switch, application servers and the telephone systems themselves. We design the switch and the telephone systems. Flextronics, our partner, they build all of the phones on all of the switches now. The servers are just an industry standard server from Dell or whoever. So very, very simple hardware business and different from competition. Most of the competition does not have a switch, the way we design it, they tend to put it on an application server, it works. But it’s inherently less reliable than our switch that we build.

Unidentified Analyst

(inaudible)

Peter Blackmore

Correct, yes. So the question was switch and multiple servers. That is the implementation you put into a customer.

Unidentified Analyst

With enterprises focused on mobility, why is the – why you feel like the hardware – your hardwire piece is going to have such a long-tail and what are some of the drivers for that when you could just have a cell phone on your desktop, or on your PC?

Peter Blackmore

So if I understood the question correctly, was it at the phones or was it just more broad? Yes. We watch this because when we’re selling to customers, they have the choice now to buy the mobile solutions as well as the desk solution with the phone. And they are adding the mobile solution but they are not diminishing the number of attach rate of phones. Now over time that may happen but it has not happened yet.

And from a margin perspective, longer term the software on the -- whether it’s an iPhone or an Android or BlackBerry -- is actually a higher margin than our desktop phones. And long term we’re in good position either ways is the short answer.

Jeff Kvaal - Barclays Capital

So your target sales and marketing is 26%, 27%, you’re at 36%. When do you think you will see the inflection point in your OpEx? And I know that you are working on expanding internationally and all that. Is that next year, or can we expect it middle of next year, end of next year, any sort of guidance?

Peter Blackmore

It’s driven by our position in the overall market. As long as we can grow 20% above and hopefully higher, then I think investing in the sales and marketing is appropriate. Should our growth slow down, then obviously Mike and I can make adjustment to show more leverage to the bottom line. But in the very short term window, we think it’s appropriate to keep investing. I don’t know any better than you do. Two years out, quite a lot will happen to the market.

So what we can say to the investors is, and I do ask this question to every investors I talk to, given our position now, what would you do? And the vast majority would say you’re doing the right thing. You’re taking advantage of the market. But they want to make sure there’s leverage in the model. They want to make sure we’re responsible and know when to make that choice.

And the other aspect and you’d obviously have to do the arithmetic but if we get to 15% market share, then typically you wouldn’t be growing at the same rate and therefore the model by default would have changed and we would be investing more slowly.

Unidentified Analyst

(inaudible) low end of your customer base?

Peter Blackmore

So the question was: is the low end moving towards the hosted model? We see traction in the hosted model below 10 seats. And we don’t really compete in that market. We’re not competitive much under 20, 30 seats. But if you know the company as well as I do, and we’ve done a lot of research, that is where it’s taking off. I ask every quarter the partners, are you losing to the hosted model? And the answer is no. They do provide private cloud. So our partners today provide a private cloud and that seems to be quite effective.

But we watch it very carefully and obviously if the hosted market accelerates in our core business, then we would add a hosted capability. But in the small company, it’s better to stay focused and win it what you are good at.

Unidentified Analyst

(inaudible) for the year – for the first half of the year, you’re sort of at or little bit below that trajectory? What picks us up in the second half of your fiscal year?

Peter Blackmore

I’ll ask Mike to help me here as well. But we got 22% in the first quarter. We haven’t completed the second quarter yet but our objective is to get to the 20%. And then the second half, what we’d like you to reflect on is we’ve made so many improvements in our model that are not yet reflecting in revenue, like Ingram, huge organization, revenues ramped second half onwards.

ScanSource, what they’ve done is digest the 400 partners that we transitioned to them. They actually have together – we’ve added 40 additional partners with their recruitment and our recruitment. That’s nothing. We want them to grow even faster. Then the mobility revenues, obviously the ramp is being modest because we’re selling to large organizations, and the pilot and the valuation take time but that will ramp.

The new partners, we’ve been adding 50 plus every quarter. That ramps. So we see many, many factors that give us confidence in second half of 20%.

Mike Healy

The couple of things I would add would be, we assume the market to be relatively stable going forward into our second half; it declined. The September quarter, it looks like it went up little bit but prior to that had declined. And then we do expect an increase in our productivity of our sales people going forward. That’s kind of built into our model. Our productivity is down in Q1, we’ve been pretty verbal about that. We do expect it to come back with some of the things Peter had mentioned.

Jeff Kvaal - Barclays Capital

(inaudible) you very much.

Peter Blackmore

Thank you very much all of you. Appreciate it. Thank you.

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