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ShoreTel, Inc. (NASDAQ:SHOR)

F2Q12 Earnings Call

February 01, 2012 04:30 p.m. ET

Executives

Tonya Chin – Director of Investor Relations

Peter Blackmore – President, Chief Executive Officer and Director

Michael E. Healy – Chief Financial Officer and Senior Vice President

Kevin Gavin – Chief Marketing Officer

Analysts

Steve O’Brien – JPMorgan

Ryan Hutchinson – Lazard Capital Markets

Andrew Nowinski – Piper Jaffray

Sanjiv Wadhwani – Stifel Nicolaus & Company,Inc.

Greg Burns – Sidoti & Company

Rohit Chopra – Wedbush Securities Inc.

Lynn Um – Barclays Capital

Ryan MacDonald – Northland Capital Markets

Dmitry Netis – William Blair & Company

Operator

Good day and welcome to the ShoreTel Q2 2012 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Ms. Tonya Chin. Please go ahead ma’am.

Tonya Chin

Thanks for joining us today as we report our second quarter 2012 financial results. We will also be discussing Shore Tel’s planned acquisition of M5 Networks, which was also announced today. We have posted slides regarding this acquisition on the landing page of the IR section on our website.

Joining me on the call today are, ShoreTel’s CEO, Peter Blackmore; and Chief Financial Officer, Mike Healy; Kevin Gavin our Chief Marketing Officer will join us in our question-and-answer session.

Before we 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 revenue, 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 the forward-looking statements can be found in the company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2011, and in today’s press release.

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

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

One final housekeeping item, we are currently planning on presenting at the Pacific Crest and Stifel Nicolaus Conferences in February and the Sidoti and Wedbush Conferences in March. Also short term we will be holding an investor day at AT&T Park in San Francisco on March 14th from 1:00 p.m. to 5:00 p.m. I hope you will attend as we do a deeper dive into our business.

With that I’ll turn the call over to Peter.

Peter Blackmore

Thank you, Tonya, and thanks to all of you for joining us today. We are very excited both with our second quarter achievements as well as with our planned acquisition of M5 Networks which I shall provide more detail about later on the call.

First, I shall discuss the performance of our current premise based IP-PBX business during the quarter. In the second fiscal quarter of 2012 ShoreTel generated record revenues of $58 million, an increase of 22% of the second quarter of fiscal 2011 and an 8% increase from the previous quarter. Non-GAAP gross margins were 66.1% down slightly from last quarter. We posted non-GAAP net income of $1.4 million or $0.03 per share which represents a significant improvement of the last year’s loss of $0.02 per share.

We were pleased with our revenue achievements in what is typically a seasonally strong second quarter. We saw a solid improvement in demand from our U.S. regional partners this quarter in line with our expectations. Revenues from our U.S. service providers were also up in the quarter growing 20% sequentially.

We are continuing to deliver international growth with our international business growing 27% over the second quarter of last year, and up 6% sequentially. As it’s typical in our seasonally strong quarters, revenue from new customers grew as a percentage of our overall business to 52% up from 46% in the first quarter and at its highest level since fiscal 2008. Once again, we saw solid growth in our ShoreTel Mobility product line with a revenue increase of over 30% sequentially in the quarter.

We continue to be pleased with a customer and partner reaction to this growing area of our business. This quarter we also announced an agreement with Hewlett-Packard to make ShoreTel Mobility part of HP’s fixed mobile convergence solution portfolio. With the addition of HP as a reseller of ShoreTel Mobility we continue to extend the reach of our mobility solutions.

We are pleased that ShoreTel and HP will have their respective mobility solutions featured at the upcoming Enterprise Connect Conference in March which will be held in Orlando.

Now, let me provide some perspective on the market place. We were pleased to see the broader U.S. Enterprise IP Telephony market as well as the U.S. pure IP Telephony market return to growth in the September 2011 quarter after three quarters of modest declines. According to Synergy Research the U.S. Enterprise IP Telephony market grew approximately 9% in the September of 2011 quarter which is the most recent data available.

The worldwide Enterprise IP Telephony market also grew approximately 8% from the June 2011 quarter. ShoreTel’s market share within both worldwide and the United States have grown significantly year-over-year. We expect to build these market share gains and continue to close the gap between our current number three position and the number two player in the U.S.

Partner recruitment remains a top priority to support our growth ambitions. During the second quarter we signed a total of 60 new partners around the world, 38 of which came through our relationship with ScanSource. A few examples of significant additions include, Howard Industries which has revenues in excess of $1 billion. It is the largest employer in the state of Mississippi and is primarily focused on the government and education sectors.

It selected ShoreTel as its exclusive UC provider. We also added Netversant [ph] which focuses on mobility, enterprise communications, infrastructure, and security. With a strong national presence Netversant has over 600 employees throughout the United States.

Finally, we signed a new partnership with mindSHIFT Technologies which has offices throughout the east coast, an area where ShoreTel is still underpenetrated. mindSHIFT is known for its strong integration capabilities and for having a significant number of fortune 100 customers.

We also added a record of nearly 1300 new customers in the quarter, a sequential increase of 24% over quarter one. A few notable new customer examples include a significant win with First Republic Bank who will be rolling out ShoreTel’s UC solution including a ShoreTel Mobility to approximately 3000 of its employees at 65 sites throughout the United States.

We were also recently chosen by Brown and Coldwell, one of the largest environmental and civil engineering firms in the country. Brown and Coldwell shows ShoreTel chose Microsoft Link, and will be installing ShoreTel in 45 locations with over 1500 users.

We also signed Security Bank, our first financial services win in the Philippines. Security Bank is one of the Philippines top 10 private domestic universal banks. Security Bank purchased the ShoreTel UC solution including our Enterprise Contact Center for approximately 1000 its employees.

This quarter we also reached a significant milestone. Our total number of licenses sold worldwide surpassed two million as of the end of the quarter. We are pleased to have achieved this milestone in record time as we announced reaching our one millionth license just eight quarters ago. This achievement and the results we delivered this quarter demonstrate our momentum.

The strength and our cooperation create opportunities which bring me to our second announcement today. Our planned acquisition of M5 Networks. For those of you not familiar with M5, it is a privately held, hosted, UC company that offers voice over IP and UC as a hosted service. M5’s primary focus is on customers with between 50 and 500 seats. It has more than 2000 customers with over 60,000 recurring revenue seats in the United States. M5 has 200 employees and it is headquartered in New York City.

M5 is a recognized leader in the hosted UC market and was recently given a visionary position in Gartner’s Magic Quadrant for UC as a service in North America. We are very excited about this compelling acquisition for a number of reasons. First, it allows ShoreTel to strengthen our clear leadership position in on-premise unified communications by adding a proven hosted UC solution in the fast growing but still fragmented cloud telephony market. Gartner estimates that the hosted UC market is $700 million today and expects it to grow at a 36% compounded annual growth rate to $2.2 billion in 2015.

Secondly, after eight months of performing an extensive buy versus bill review we determined that the secret source in hosted UC is not just a well developed R&D solution, but more fundamentally experienced in running a very different business model.

The reasons we chose M5 are its low churn rate, its high average revenue per unit or ARPU, its very competitive customer acquisition cost, and its expertise in running in 7x24 datacenters.

I want to emphasize that the management skills required to run a hosted business are in many ways different from those necessary for the on-premise business. For us to build this expertise would have taken time and investment and would certainly have involved distraction and therefore risk to our current business. We therefore determined the best way to enter this market quickly and establish a strong position is to find a company with a proven business model, a significant recurring revenue stream, a good management team, and then bringing that organization into ShoreTel as a new business unit.

After looking at many companies we selected M5 as the ideal entry into this market. After a very diligent review of their assets we believe they have some of the best matrix in the hosted business. M5 also has a passion for brilliant simplicity and a focus on customer satisfaction. Both of these are very synergistic with the ShoreTel DNA.

Finally, this acquisition provides a recurring revenue stream that makes our revenues inherently more predictable. Approximately 80% of M5 revenues last year were recurring in nature. Therefore, with the addition of their business, the combined company is expected to have recurring revenues of over 30%, significantly improving our visibility and adding more predictability to our quarterly revenue.

For some time, we have viewed the hosted UC market as complementary to the premise based business we have today. The IP telephony and UC markets are evolving quickly, and we have seen a growing number of prospective customers interested in the flexibility that you see as a service office. This corresponds with the overall market trends towards cloud based services. We believe that with the addition of M5 we will be able to capitalize all these trends and accelerate the growth rate of our overall business.

We view and finds hosted UC service as a natural extension of ShoreTel’s brilliantly simple product offering. With the addition of M5, ShoreTel will now be able to live up to customer’s interest, either a world class on-premise UC system as we’ve offered for years or a hosted cloud UC service allowing customers to pay on a monthly basis.

ShoreTel will be uniquely positioned to give customers ultimate choice. We do know that customers tend to make a decision to buy on-premise or hosted before they approach the vendor. Today we obviously miss out on those hosted market opportunities. With M5 we can now answer these needs with no compromise.

For those customers who are unsure whether a premise based solution or a hosted solution is the best fit for their business, we shall be able to provide unbiased advice to help find the ideal solution. In short, ShoreTel will now be able to offer both solutions each of which is well differentiated from competitors based on the brilliant simplicity and high customer satisfaction we offer. ShoreTel’s premise based solution will continue to be sold through our strong reseller base with no changes to that distribution model.

I do want to emphasize that there will be no changes to our current distribution model for our current business. The hosted solution will operate as a separate business unit led by Dan Hoffman, M5 CEO. We shall keep the go-to-market model they have today for their hosted business which is a combination of direct and channel referral. ShoreTel resellers will be able to add the hosted business to their portfolio once they are certified. This will enable them to compliment their on-premise revenues with a highly profitable recurring revenue stream.

Since I began at ShoreTel a little over a year ago, I have strongly believed that the company needed a cloud UC offering to complement our on-premise business. Since our strategy presentation to the board in June, the management team and I have worked diligently to identify the best entry into this attractive market. I am very excited by the opportunity that a combination of ShoreTel and M5 presents.

I’ll remind you that the market for premise based PBX systems is $6 billion dollars today and growing in single digits. ShoreTel has momentum and we plan to continue to gain market share by growing our core business significantly faster than the growth of the overall on-premise IP-PBX market.

The addition of a cloud UC offering this is a very important strategic move for our company. We are entering the market at exactly the right time whilst it is still in its early stages and clearly fragmenting allowing us to build a leadership position. I am confident that the combination of ShoreTel and M5 will create a winning proposition that is unmatched in the market place. Now, I shall turn the call over to Mike.

Michael Healy

Thanks Peter. First I will review some of the key financial metrics for the second quarter and then I will provide more financial details regarding our planned M5 acquisition. And then finally I will discuss our guidance for our third quarter 2012.

Total revenues of $58 million for Q2 were segmented as follows. Product revenues were $46.3 million, up 10% from the first quarter. Service and support revenue which were 20% of overall revenues were up slightly from Q1 at $11.7 million and up 20% year-over-year.

Our international revenues grew 6% to $7.2 million and represented 12% of total revenue. We saw a growth from all of our geographies during the quarter with Australia showing the larger sequential increase.

Business from our service providers bounced back nicely in the quarter growing 20% sequentially posting a 32% increase over Q2 last year. Our newer service provider Windstream showed the largest quarter over quarter increase. As a group service providers represent 12% of business in the quarter as well. Our largest vertical segments in the quarter were financial, professional services, and entertainment. We saw growth in nearly every segment with the exception of government and education which was down in Q2 after a strong Q1.

It’s also notable that we had solid growth in customers between the 500 and 5000 user range during the quarter as we continue to penetrate large enterprise customers. We sold a 134,000 end user licenses up from a 113,000 in Q2 as of last year. As Peter mentioned we added a record 1300 new customers in the quarter bringing our cumulative customers sold to over 20,000.

Our total non-GAAP gross margins were 66.1% in Q2, our non-GAAP product gross margins were 65.7% in the quarter, down 60 basis points from last quarter. Approximately half of that decline related to an increase in the percentage of our volume shift through our North American bets, which climbed to 34% of our total billings in Q2, solid evidence that ScanSource transition is going well. As expected, we did not see a significant amount of revenue through our newest bid Ingram Micro in the second quarter where we expect them to ramp in the second half of our fiscal year.

The balance of decline in the product gross margins was due to product mix shifts and the increase in business from new customers which have a slightly lower gross margin in the quarter. Our non-GAAP service from support gross margins remains very strong at 68%.

Our non-GAAP operating expenses was $36.6 million flat with last quarter mostly due to reduction in employee benefit cost and a decrease in G&A expenses related to reduced professional fee. These were offset by labor increases associated with hiring of 22 employees in the quarter. Our GAAP operating expenses were $40.2 million and included a $500,000 settlement on an outstanding patent infringement claim as well as stock compensation charges and amortization of purchase intangibles.

We are pleased that our revenue performance in our seasonally strong Q2 combined with prudent management of operating expense allowed us to return to a non-GAAP profit. For the second quarter our non-GAAP profit was $1.4 million or $0.03 per diluted share. This strong achievement also allowed us to be profitable on a non-GAAP basis for the whole first half of our fiscal year.

Our GAAP net loss was $2.5 million or a loss of $0.05 per share including approximately $3.3 million of stock based compensation charges and $250,000 in amortization of intangible assets.

Balance Sheet highlights from Q2 included solid cash flow from operations of over $6 million ending the quarter with cash inserts from investments of a $115.9 million. This follows a strong performance in Q1 and brings our total cash flow from operations to $10 million for the first half of fiscal year 2012. Accounts receivable increased only $1.5 million or 5% to $30.9 million on increased revenue topped with another great collections effort.

Days Sales Outstanding or DSOs were down slightly to 36 days. Inventory increased by $2.4 million to 22.6, mostly due to shipments to our North American distributors that had not followed through by the end of December. Total deferred revenue increased by 14% or 5.5 to $45.2 million driven by continued sales and maintenance contracts to our customers and increase in billings related to our North American bids.

Capital expenditures of $984,000 were higher than in the past quarters due to investments in two lean item contract manufacturer as well as equipment for our QA labs. Depreciation and amortization expenses were approximately $1.6 million for the quarter.

As of December 31st we had 700 employees up 22 from the first quarter. Total sales quota-carrying headcount grew by 10, to 211 at the end of Q2.

Next, let me give you some more details on the planned M5 transaction. Keeping in mind we expect the transaction to close by the end of March 2012. Under the terms of definitive agreement, M5 shareholders will receive $84.1 million in cash and $9.5 million shares of ShoreTel stock which is valued at $62.2 million bringing the total initial consideration to $146.3 million.

In addition, the M5 shareholders are entitled to contingent consideration of up to $13.7 million. The contingent payments are payable over the next two years after closing, and are based on achievement of certain revenue performance milestones for the year ended December 31st, 2012. Hence the cash consideration of $84 million is a significant portion of our outstanding cash balance. We are planning to finance a portion of the purchase price with a line of credit revolver that we plan to close in conjunction with the acquisition.

After funding the initial consideration, drawing down some of the lines of credit and paying transaction fees we finally have close to $50 million of cash in short term investments on the balance sheet. In terms of overall revenue and cost, M5 is just starting the ride for the calendar year 2011 that ended December. But we don’t quite have final numbers from them yet. We expect for 2011 M5 will report revenue in the high $40 million range. It would be close to 50% growth year-over-year.

In terms of profitability, we have been investing for growth and running that close to cash flow break even in calendar 2011. Although we plan to run M5 as a separate business unit, we expect a number of revenue and cost synergies over time including leveraging some of our 600 channeled partners in the U.S. to extend M5 channel, casting leads for customers who prefer a hosted solution that we previously cannot address, adding the ShoreTel phones into the M5 product offerings, and taking our world class mobility offering into the clouds.

Over time we will be taking advantage of our UC product capabilities and extend them into our new hosted offering. In terms of cost synergies we will have the normal kind of activities you would expect mostly in the G&A areas like reduced audit and tax fees, insurance benefits, reduced interest expense on the M5 books and the overlap of certain positions.

We also plan to invest in few specific areas like, we plan to accelerate product development to make sure that ShoreTel phone product line is compatible with the hosted solution, enhance and scale their operating infrastructure. We will also have normal cost related to renaming and brand building as we transition M5 to the ShoreTel brand, and finally we need to ensure this division is SOX compliant by next year.

Based on our current projections and initial assumptions regarding these synergies, and excluding onetime transaction fees, we expect the acquisition to be modestly dilutive in calendar year 2012 and then slightly accretive to our earnings by the end of our fiscal year 2013, which is June 2013. We plan to share more with you about this new business at our March 14th annuals day.

Now, before I turn in the call back to Peter, I’ll discuss our outlook for the March quarter for our current business which excludes any impact from the pending acquisition of M5 including transaction fees. Based on our backlog entering the quarter our sales pipeline forecast in business book today we expect revenue for the second quarter to be in the range of $53 to $57 million. This guidance reflects a seasonal booking downturn in Q3 which we have experienced in the last few years. Some caution around the UC spending environment as others in our space have been mentioning and a slight downturn in our business expected from our service provider group.

We expect non-GAAP gross margins to be in the range of 65.5% to 66.5%. GAAP gross margins are expected to be approximately a 100 basis points lower due to inclusion of $400,000 in stock based compensation charges. We expect non-GAAP operating expense to be in the range of $38 million to $39 million, and we expect GAAP operating expenses to be in the range of $41 million to $42 million including approximately $3 million in stock-based compensation expenses.

The reason for our expected increase in operating expenses in the March 2012 quarter are the following: First, we will see an increase in our employee benefit cost due to the reset of payroll taxes that occur at the beginning of every calendar year. Second, labor and incentive compensation costs will increase due to the hiring of 22 employees in Q2 and a similar amount of hiring in Q3 which will mostly be in our North America sales through.

I do want to point out that we will incur a substantial amount of onetime fees upon closing the M5 transaction including banker’s fees, legal accounting valuation and tax cost. We will qualify these fees in the quarter we close, but on a preliminary basis expecting them to be in excess of $4 million.

The accounting for these transaction fees will be to expense them in the quarter the deal closes which will clearly call out on the P&Ls so you can adjust them as onetime charges. We plan to provide a lot more details around M5 and we expect to be able to give you a much better idea of timing on closing as well as how it will affect our financial model going forward at our Investor Day on Mach 14.

I look forward to seeing you at the home of the 2010 World Champion San Francisco Giants. With that let me turn it back to Peter for some closing remarks.

Peter Blackmore

Thank you Mike. Quarter two was a good quarter for ShoreTel as we continue to execute on our strategy. Specifically we returned to profitability on a non-GAAP basis for the quarter and the fiscal year to-date we delivered both record revenues and a record number of new customers.

As you heard from Mike our quarter three guidance reflects a seasonal quarter three decline. However, we continue to expect robust quarter four revenues to close our fiscal year. While 20% annual revenue growth remains a reachable goal with a very strong quarter four, given our current outlook we believe it is prudent to signal that a more realistic growth percentage is moderately under 20%. At our March Analyst Day we shall do two things.

First, we shall provide details on the M5 business model which I think you will find very exciting, and second we shall also update you on our growth expectations going forward. As a management team we understand our current revenue growth projection is not what we have planned. We are committed to strong revenue growth with leverage and plan to make the appropriate changes to get back on track.

There is a clear correlation between our sales force growth and our revenue growth, and therefore we are committed to invest in sales and lead generation resources as a first priority this is other operating expenditures. The March investor event will give us a great opportunity to talk through this in more detail.

In closing I want to reiterate how excited we are about combining with M5. M5 allows us to quickly enter the fast growing but highly fragmented hosted UC market at the right time with a well respected and industry leading solution.

In summary, we shall continue our legacy of offering the best product with the highest customer satisfaction in both the on-premise and now the hosted area in UC market. In my view ShoreTel has never been better positioned. With that I shall turn the call back to the operator for the question-and-answer portion of the call. Operator?

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] We will take our first question from Steve O'Brien with JPMorgan.

Steve O’Brien – JPMorgan

Hi. Thanks for taking my questions. If I could start off on M5, can you tell us how you plan to manage the channels here, maybe put a little more insight? I mean, is there potential for channel conflict with ShoreTel selling its legacy products and M5 offering a hosted solution to the same customer?

Peter Blackmore

Let me talk through that. The overlap first of all in the customers is fairly modest. They are targeting the 50 to 500 base, we target the 50 to 5,000 base. The next point, Steve, is that we do see hosted bids today. Just for your information, we lost to 14 hosted bids this last quarter an increase from the previous quarter. But when we get those bids, they are always at an RFP and the company which did the RFP says we want a hosted solution. I’ve never yet seen an RFP where the CIO says I don’t know what I want.

We find the potential for channel conflict or any other conflict to be very, very low, because we will treat a hosted request by M5 and we’ll treat a on-premise request by ShoreTel.

The other thing is that M5 does have a channel referral model today. We will enable our channel to have that, and I think you will find a lot of interest. Some of our channels have even adopted one or two other competitive hosted solutions today. So, I’d hope that they would then move to the ShoreTel solution. All-in-all, I think this is minimal risk, and frankly, I’d look at it the other way. We now have the best of both worlds because before we had the best of only part of the world.

Steve O’Brien – JPMorgan

Okay. Maybe I could ask the same question on – in terms of ShoreTel wires today that are using ShoreTel switch to offer either a hosted or a managed service, is there a conflict there with M5 offering? Then secondly, how about on the carrier channel as well? I mean, some of your big carrier channel partners, I believe, have been trying to offer a mix of hosted and premise based solutions too.

Peter Blackmore

Okay. That’s a good question, there are two parts. The first is power channel. If they offer a ShoreTel solution today, it might be on-premise, so the equipment gets shipped to the customer, or it’s a managed service in which case the equipment can be either with the partner or with the customer, but it’s charged on a monthly basis. It’s not a hosted solution in the pure sense of world, it’s a managed services solutions, so it’s more like a rental solution.

None of our partners could offer a ShoreTel hosted system today because we don’t have one. So if they did they’re using competitor, and hopefully they’d change. So, I think that’s very straight forward.

We will continue to offer a managed services solution for those customers and partners who want it. So there is no change there. But I’d like to stress that it’s not a pure cloud solution. It’s a very, very different answer.

The service providers, they will continue to want to purchase an on-premise that’s part of their business model. We are doing very well with those service providers, so I don’t see any conflict at all there. Obviously, they tend to use somebody else’s hosted solution. Perhaps in time we can talk to them about that, but at the moment our focus is just setting them on-premise.

Steve O’Brien – JPMorgan

Okay. Can you also maybe provide us some – help me understand how M5 offers its service? I mean, I think they have, what they call “a call conductor.” Is that based on proprietary software or is that based on licensed software? Is that running on competitors two ShoreTel’s hardware or is that based off of kind of standard shelf hardware.

Peter Blackmore

I’d just ask Kevin to answer that, because we’ve done a lot of due diligence…

Kevin Gavin

Yeah. M5 started out 10 years ago actually on a vocal data platform. And vocal data has since been sold and sold again, it’s run by Broadsoft. But many years ago, they made the decision to move off of somebody else’s platform and built their own homegrown, homebuilt platform. So, with M5 now, we have a platform that doesn’t rely on any third party to provide the technology. It is a completely proprietary and built by themselves technology platform.

Operator

Thank you, sir. We’ll take our next question from Ryan Hutchinson with Lazard Capital Markets.

Ryan Hutchinson – Lazard Capital Markets

Hey, good afternoon guys. I just want to understand the commentary on the guidance, you know, being a bit more conservative in consensus expectations. But, maybe you can just help us understand, were close rates brought down, did you see something in any particular geography or vertical that gives you caution? And then with respect to the 20% being modestly below, what does that mean? Then as we look to the integration of M5 with the run-rate of $40 million I’d assume that as we bake that into the second half that we should be well north of that 20%.

Peter Blackmore

Just a quick correction, the run-rate is high 40s. Perhaps it didn’t come across clearly as Mike was talking, but it’s high 40s which is way above $40 million.

Ryan Hutchinson – Lazard Capital Markets

Okay, yeah.

Peter Blackmore

So on the – Mike and I will do a little bit of a double act here, but one it’s a seasonal quarter. We have tried to educate you all on that, but even having said that quarter three is looking lower than we would like it to be, so we’ve given the range in guidance. We understand what is going on and it’s North America related and it’s driven by two or three factors, and I will talk to two of them now, but I’m also going to talk more broadly hopefully when you come to the March Investor Day, because it’s a longer conversation than just answering a couple of points.

I'm very confident in our long term model, but we have some short term execution issues and two of them are as follows: We’ve added ScanSource that’s been very successful. We have also added other value added distributors which have huge potential, but bluntly getting started the traction is slower we wanted. That’s on our dollar, I'm not blaming them. I think it’s our execution issues. It’s very fixable and fixable fast.

The next thing is that we have added in round terms 200 partners in the last 12 months. It’s a huge number. Just remember we put a dedicated channel team in place to achieve that, and they have been extraordinarily successful because we’ve never, if you back in history, have that number of ads, but what we have not done so well is ramping the revenue in those new partners, it’s significantly below what we expected. That again is our execution issue. We will make some changes to do it.

Also looking at some other changes, so Ryan I'm sort of taking this upfront. It’s us not the market. It’s fixable and it’s execution related in this quarter, but we will fix it fast.

Michael Healy

And then Ryan in terms of your question on guidance and resetting, so the way I see this playing out and it’s all subject to when it would close. Ideally we are closing by the end of March, we have a little bit of revenue, a little bit of cost from M5. We will book all our transaction fees in the March quarter and then soon thereafter when we announce the March results we will give you guidance for Q4 which will include most likely a full quarter of revenue from M5.

Ryan Hutchinson - Lazard Capital Markets

Okay, that makes sense.

Michael Healy

That makes sense?

Ryan Hutchinson – Lazard Capital Markets

Yeah, absolutely and then I guess with respect maybe flushing out the accretion and dilution, I know you touched on that briefly, but how dilutive should we think about it in terms of modeling moving forward if we were to look at it both – well, certainly taking into consideration M5. I guess maybe touched on it, but just the OpEx that we should consider – not that that’s going to be published tomorrow per se, but just respect to the longer term model would be helpful.

Michael Healy

Yeah, I mean we will certainly give you a better guidance on the analyst day because we are just getting through everything and trying to put them all together. But I think what we see characterized is slightly dilutive for the rest of calendar year. Well, sort of couple of pennies per quarter potentially to our numbers, dilutive, and then starts turning around and early 2013 and accretive by June 2013. Hopefully, that’s a little bit of help and would be able to give you a little bit more when we talk in March.

Ryan Hutchinson – Lazard Capital Markets

All right. Finally, just as a quick follow-up and I will jump back in the queue. When you talk about new partners ramping slower than anticipated, then does that mean that that’s something that you think is fixable by next quarter?

Peter Blackmore

It will be improved by next quarter, but remember that 200 partners is probably 50 every quarter. So it’s not all at once. The ones that we recruit – the first 100 we recruited in the first half of calendar 2011, actually we’ll get going, but the ones we just recruited in the last quarter may take us a bit longer. It’s an execution issue and we need to fix it.

Ryan Hutchinson - Lazard Capital Markets

Okay, and then just to be clear, and sorry, I just had one follow-up for clarification. When you say modestly below 20% it means – is that 15 or is that 17 or some sort of range to get everyone on the same page I think it would be helpful.

Michael Healy

Yeah, I mean at this point Ryan we are guiding through the guidance Q3 only. In Q4 its going to change with all the M5 numbers in anyway. So we didn’t think it was helpful to give you number and we know it’s going to change.

Operator

Thank you sir. Next we will hear from Andrew Nowinski with Piper Jaffray.

Andrew Nowinski – Piper Jaffray

Good afternoon. Just sitting in for Troy Jones [ph] on this one. I guess just a question on product gross margin. They had a seven quarter low and your guidance doesn’t really suggest they’ll improve in the March quarter. So, I was just wondering if – I know you’ve stated that new customer growth typically offers lower gross margin, but could you anymore color on what drove this quarter versus the last seven quarters on the product side?

Peter Blackmore

Yeah. The fundamental reason product margin has been declining is our ramp in Q2 distribution that started in kind of January last year, and so we warned people that would affect our margins by probably a couple of points as more of our business ramp through ScanSource and Westcon, because we have to give a few more points to make the channel work. And so that’s happening, every quarter as more volume goes through ScanSource and Westcon that’s going to have an impact on our gross margins. And then ideally we’re seeing the benefits of that and you’re certainly seeing in cash flow, for instance.

The reason we’re generating significant cash flow from operations is we’re getting the investment model with ScanSource down and getting paid relatively quickly according to our terms even before we’re getting the revenue recognized through sell-through.

So, the margins – product margins will come down mostly for that this quarter, that was about half of the decline on the non-GAAP product gross margins. The other half was mix a little bit, and then as we do have a stronger business from our new customers versus our existing customers, there is a margin difference of two to three points there and that business, we discount a little bit more to get a new customer than we do to add on orders for an exciting customer.

So the margin decline on the product side is absolutely expected. What surprised us a little bit is we actually got more volume through ScanSource this quarter than we expected. If you remember, we kind of thought we would have 30% of our business go through two tier this quarter and it was about 34%, so a little bit higher than we expected, which is a good thing.

Andrew Nowinski – Piper Jaffray

Right. I guess as a quick follow-up; I guess you did cite some short-term execution issues were on the value-added distributor side. Is it fair to assume that margins would have been even lower, had you had the execution issue or non-experience execution issues there?

Peter Blackmore

Well, just to be clear, I think what we’re trying to say is there is not – it was not an execution issue this quarter. What we expected is a better ramp in our other wads for Q3 and Q4, and that’s what’s affecting us coming off our 20% revenue growth. So we just expected those guys to ramp faster, maybe have a little revenue this quarter, but really we kind of lowered our expectations for them for Q3 and Q4, and that’s outside of ScamSource.

Kevin Gavin

We were pleased with – we had a great quarter, just come off, and this value added distribution strengthened from ScamSource was part of that. So no issues this quarter, it’s purely the rampant in new wads over the next two quarters.

Andrew Nowinski – Piper Jaffray

Okay, thank you, and then last question from me. What’s the price on the OpEx side that drove this whole OpEx below your guided range despite clearly exceeding the top-line guidance?

Michael Healy

There was no real surprises, right? We were trying to make sure of delivering some leverage to the model, and we are pushing out things that we can push out, and we’ve got a few credits from benefits and things like that and professional fees came down a little bit since we had higher fees last quarter, but no real surprises. Just we are trying to accurately manage to get some profitability and when you see the scale and the model when we over achieve a little bit it certainly helps us on the profit line and conversely if we miss then it really hurts us on profit.

Operator

Thank you sir, and next we will hear from Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani – Stifel Nicolaus & Company,Inc.

Thanks so much, couple of quick question in M5, so just to confirm the business model there they are running their own “datacenters” versus actually selling their technology to a service provider who would use that for a hosted solution?

Peter Blackmore

That’s correct Sanjiv they have three major datacenters today and they co-locate with other people, they don’t own the whole datacenter but they provide the complete end to end solution to their customer.

Sanjiv Wadhwani – Stifel Nicolaus & Company,Inc.

Got it. Is there any way you talk about the kind of dollars they get per seat, I think the usual range has been say let’s say $20 to $40, is it within that range or any color over there?

Peter Blackmore

Yeah Kevin will answer that.

Kevin Gavin

The ARPU, the average revenue per unit of M5 is substantially higher than other industry comparables. It’s really driven by two things, one is they also sell transport. So, in addition to selling seat license and the software that runs the PBX service, they also resell transport, T1 line or an MPL circuit, to the customer location. So it’s a combination. Of course also they provide the Telco services, long distance and origination and termination. The average revenue per unit is up in the $60 range with per seat with M5 and also one of them they do is they are also quite focused on business process integrations. So they sell nicely things like integration with Salesforce.com, NetSuite and other applications. It’s an application rich sale that includes transport and the ARPUs is in the mid 60s.

Peter Blackmore

Just to add to it, say business focus they have, number of hosted alternatives tend to be focused on the less than 10 seat, consumer or micro business. To my mind that’s a less attractive market. M5 can compete there, but they tend to focus on certainly above 30 seats, we said 50 to 500 thing, but they go below 50, and that is inherently better ARPU market.

Kevin Gavin

The average number of seats is over 30 unlike some of the other competitors you might be familiar with that are down in the teens.

Sanjiv Wadhwani – Stifel Nicolaus & Company,Inc.

Got it, that’s helpful actually. The other quick question on M5. Is this, are they sort of a fairly national player or are they kind of focused in a few geographies right now within the U.S?

Peter Blackmore

They are the sort of counter punch to us. They are East Coast and I think all but 15% of their revenues are East Coast related. We’re a bit more mature than that because we started a bit before they did. But I’d have to say we have a much better market share on the West Coast than the East Coast as we told you and the other investor before. So that was another attractive consideration for us. It balances our presence, both East Coast and West Coast, and I think we can help them expand on the West Cost with our very strong partner and other assets over here.

Michael Healy

Yeah, and that’s driven distribution. They have the ability and they have customers nationwide. So they sell nationwide today, but given their original presence on the East Coast, that’s where most of their distribution strength has been, and their distribution is growing outside of the East Coast, and that’s where we think our West Coast presence can help a lot.

Operator

Thank you, sir. Greg Burns with Sidoti & Company.

Greg Burns – Sidoti & Company

Hi, ScanSource has probably noted a little inventory build on the communications side of their business, so I was hoping if you could remind us how do you recognize revenue into that channel and is this impacting your guidance in any way?

Michael Healy

No, for all our bad, we recognize it on sell-through, which means we invoice and ship to them. We defer the revenue, and until we get POS reporting that they’ve sold it through a reseller that’s when you recognize it. So, as I said, some of our inventory increase, about half of it was due to an increase in inventory, and it’s almost all ScanSource. ScanSource did build up inventory for us as their volume is going up. But we’re not worried about any buildup or any channel problems there. They do have stock balancing and churn rates, but they have to put a corresponding order and they are going to balance their stock.

They’re typically trying to keep one or two months of inventory on hand to supply the 400 channel partners they’re working with ShoreTel.

Greg Burns – Sidoti & Company

Okay. And in terms of mobility, you mentioned a bunch of – I guess 100 trials I guess on the last call, can you give us maybe an update on maybe where some of those stands and have you expanded the number of trials that are out there.

Peter Blackmore

The trials are going well and hence the 30% growth rate that we referred to in the script. We’re adding new trials all the time, pleased with the momentum in the business. So, what we’ll do is give you the revenue growth rates and other statistics as they become meaningful so you can understand how the business is going. But basically it’s on track to what we expected so far.

Greg Burns – Sidoti & Company

Okay, thank you.

Operator

Next we will hear from Rohit Chopra with Wedbush Securities Inc.

Rohit Chopra – Wedbush Securities Inc.

Hi guys, just first question here on M5. Can you talk about the gross margin profile of M5 when your – yeah I think you said that 80% of the revenue is service. I just wanted to get a sense of gross margin versus what you have right now.

Michael Healy

As you can imagine their model has a little bit lower gross margin right now. Last year it’s probably around 50% or so in terms of gross margin. So certainly on a combination basis our margins will be a little lower from volume basis. But as they grow that customer base we do expect they will be able to expand those. You know, they are in pretty heavy investment mode building up their TELCO and their data centers, and that obviously has an effect on your gross margin until you get those customers ramped and you need to collect from them?

Kevin Gavin

Also that ARPU that I told you about was a combination of sort of software or high margin revenue, but also they resell TELCO and that TELCO resell has a lower margin. So the blend works out to work against them, but the good news is it is incremental dollar margin even though it brings down the percentage a little bit by selling TELCO.

Rohit Chopra – Wedbush Securities Inc.

Okay, and then can you talk a little bit about the seasonality of their business and how – when you guys looked at the financials how does that impact your business just qualitatively if you can give me a sense?

Michael Healy

Yeah. They are growing very fast. As far as I have seen not a lot of seasonality. In a recurring revenue mall you really don’t see seasonality just added to it. They have very low churn as well I may add. So it’s a great model, as a CFO you would love to get a recurring revenue model, I have had it before and I can't wait for it to get bigger as a portion of our total business. So no seasonality there.

Rohit Chopra – Wedbush Securities Inc.

I want to get back to one other question I think Steve O'Brien was asking this at the very outset. I'm just trying to understand why this wouldn’t cannibalize the lower end of your business? Is that – I just want to try and understand that if you can help us?

Peter Blackmore

Let me try again. Kevin or Mike can add, but first when we lose to hosted today it’s because we don’t have a lot of hosted solution, and the customer is very clear they want one, and therefore we just miss out on the market and we now will no longer miss out on the market. The second point was that our experience of when we receive RFPs, because obviously we have a lead generation program, people contact us, and they will ask us for hosted they will ask us for on-premise, but they are always very specific. They don’t say I don’t know. And therefore, you don’t have the – you can try and change their mind, but that’s a very hard route, an unlikely route, so I see very little cannibalization at the low end.

Remember, it’s how you approach the market, and we’ll be very disciplined on driving the lead generation from both parts of the company as we combine them, making sure we get the highest consideration rate, and then we’ll have separate sales forces.

One sales force will handle the on-premise together with the channel, and the other sales force will do it hosted. Once we’ve split that lead generation or got the info from the customer, we’re going to handle it in the most professional way. So, I don’t see this as big risk. Kevin or Mike, add to that.

Kevin Gavin

No, it’s true. I think, as we look at the lead-gen machine and we talk to customers, it’s very clear there is kind of two kind of people in the world. They seem to be biased toward hosted, they’re bought in, they believe in the cloud, they want recurring, they want the flexibility it offers, and that’s what they’re after, and that’s what they want. We just don’t win those today. Other customers still don’t trust the cloud, want to control, want to own it, want to touch it and feel it. They are the ones we have been winning today.

So, we think that there is just two kind of people. And to the extent that market shifts, and I think more and more are becoming open to cloud, and now we’re positioned as that shift happens to capture both markets. But generally it’s very hard to change somebody’s mind who is pre-disposed one way or the other.

Peter Blackmore

The final thing I would add is; as you know, we do sell below 50 seats, but it’s typically our small-business edition production. The revenue volume is relatively low every quarter and the gross margins are worse. So, even if a little bit of that business goes to hosted, we’re better off.

Operator

Thank you, sir. Next we’ll hear from Lynn Um with Barclays Capital

Lynn Um – Barclays Capital

Hi, thank you. I was wondering if you could talk about the U.S. regional partners, they were a weakness last quarter. Can you talk about some sales productivity issues, did that come back up to where you wanted it to be and just some of those deals that slipped on September come back into December quarter?

Peter Blackmore

Yeah. So with the results we posted, we had growth kind of everywhere and we did see a nice rebound from our base regional partners, as you would say. Some of those orders we talked about last quarter, I know one of them specifically Maxim I think I referenced pushed out last quarter and came in this quarter. So they did pretty well as a group in total and good growth, actually a little bit above the overall company growth, the U.S. regional partners if you will.

Lynn Um – Barclays Capital

Okay, great. And then on the service letter side, if I heard correctly, I think when you gave that guidance for March, you mentioned you are expecting a down trend from this group. Is it mostly because the Windstream bump that came in this quarter or are there other variables in play there?

Michael Healy

Yeah. I mean, it’s a little bit of everything. I don’t like the name names, but just the forecast wasn’t rolling up very strong for those service provider groups in total, and so that’s factored into our guidance and thinking on what we gave in terms of our new guidance.

Lynn Um – Barclays Capital

Okay, got it. Okay, thank you.

Peter Blackmore

Thanks Lynn.

Operator

Thank you, ma’am. Next we’ll hear from Ryan MacDonald with Northland Capital Markets.

Ryan MacDonald – Northland Capital Markets

Thank you. I was curious you mentioned a couple of times…

Peter Blackmore

Could you speak up a bit?

Ryan MacDonald – Northland Capital Markets

You guys mentioned a couple of times that the churn for M5 was very low. Do you have an approximate number for churn for M5?

Peter Blackmore

Yeah. I mean, there is a number of ways to measure churn. Number of customers, number of dollars. Personally I think dollars are most important churning up the revenue, and on an annualized basis that’s lower than 6% as our estimates on revenue.

Ryan MacDonald – Northland Capital Markets

Okay. Got you. And then, how are the maintenance renewal rates for the quarter?

Peter Blackmore

I didn’t – that’s the first time I have been asked that in a while. I didn’t get a report. I assume they are okay, I didn’t hear that there was any problems, usually they are pretty strong 80, 85 plus rate.

Michael Healy

We’ll get back to you on that.

Ryan MacDonald – Northland Capital Markets

Thank you very much.

Peter Blackmore

Thanks, Ryan.

Operator

Thank you, sir. Next we’ll here from Dmitry Netis with William Blair & Company.

Dmitry Netis – William Blair & Company

Just a quick question. I think Lynn asked the question on sales productivity in the quarter. I was just wondering – I think you said it snapped back up this quarter, is that correct?

Peter Blackmore

Yeah, our overall productivity did go up this quarter, yes.

Dmitry Netis – William Blair & Company

Okay. How many quarter-bearing sales did you have in the quarter?

Peter Blackmore

211, so up 10 from the previous quarter.

Dmitry Netis – William Blair & Company

Okay, great. And then also another sort of housekeeping question here. Given the service provider had a strong quarter for you, what was the contribution from the major accounts? How did those contribute in the quarter? Were they up sequentially?

Peter Blackmore

You mean our major accounts program?

Dmitry Netis – William Blair & Company

Correct.

Peter Blackmore

Yeah, our major accounts were down a little bit quarter-over-quarter. I don’t know if that’s a little bit of seasonality sometimes. Last Q2 they were down as well. So it wasn’t unexpected. Year-over-year they are still up about 20%, but sequentially was down a little bit, but it wasn’t unexpected.

Operator

Thank you sir. We will take our final question as a follow-up from Steve O'Brien with JPMorgan.

Steve O'Brien – JPMorgan

Hi, thanks for taking the follow-up. I just wanted to ask some housekeeping questions on transaction. I mean first off you’ll have about maybe $30 million in cash after the deal closes. I mean how much cash do you – would you like to run the business, and or will you be looking to just finance it, potentially some of this deal?

Michael Healy

Yeah, as I mentioned in the comments we are working on getting the line of credit established with some of our banking partners. Term sheets are already signed and commitment letters approved. So, we will close on that in conjunction with closing the transaction. I think you should expect us we are trying to manage, there is nothing magic about it, but we want to have around $50 million in cash on the balance sheet, cash and short term investments after the transactions complete and after the funding. So you can probably do a little math there and figure out how much we would have pulled in the line of credit, but we haven’t set that amount yet. But – I am not trying to evade the question. Ultimately I don’t know how much we are full, but probably no more than 60% of the total lines are going to be available to us.

Steve O'Brien – JPMorgan

I guess, are there any contingencies based on total share price, poor value – my clause kind of thing that we should be aware of.

Michael Healy

On the deal?

Steve O'Brien – JPMorgan

Right.

Michael Healy

No, standard customary turn of string, signing and closing, and the evaluation of price is that it doesn’t matter what the stock price does after yesterday.

Steve O'Brien – JPMorgan

Great, thank you.

Operator

Thank you sir and that is all the questions we have at this time. I’d like to turn the conference back over to management for any additional or closing remarks.

Peter Blackmore

Thank you, and just thank you very much for joining us today, exciting day. We look forward to speaking with you next quarter. So, thank you.

Operator

That does conclude today’s conference. We thank you for your participation. You may now disconnect.

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