ShoreTel's (SHOR) CEO Don Joos on Q2 2016 Results - Earnings Call Transcript

| About: ShoreTel, Inc. (SHOR)

ShoreTel Inc. (NASDAQ:SHOR)

Q2 2016 Earnings Conference Call

January 28, 2016 5:00 PM ET

Executives

Barry Hutton - Director, Investor Relations

Don Joos – President and Chief Executive Officer

Mike Healy – Chief Financial Officer

Analysts

Barry McCarver – Stephens Inc.

George Sutton – Craig-Hallum

Greg Burns – Sidoti & Company

Mike Latimore – Northland Capital Markets

Dmitry Netis – William Blair

Operator

Good afternoon and welcome to the ShoreTel Second Quarter Fiscal Year 2016 Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded. May I also add that we at Chorus Call use ShoreTel telephones. In fact, I am speaking to you right now on a ShoreTel telephone.

I would now like to turn the conference over to Barry Hutton, ShoreTel’s Director of Investor Relations. Please go ahead, Sir.

Barry Hutton

Hello and thanks for joining us today as we report the financial results for our fiscal second quarter of 2016. Joining me on the call today are ShoreTel’s President and Chief Executive Officer, Don Joos, and ShoreTel’s Chief Financial Officer, Mike Healy.

Before we begin, I will remind you that during today’s call, management will make forward-looking statements within the meaning of the Safe Harbor provision of federal securities laws regarding the company’s anticipated future 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 most recent Form 10-K and 10-Q and the current report on Form 8-K furnished today. The information in this conference call related to projections and 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. Additionally, ShoreTel maintains a presence on Facebook, Twitter and Google Circles that it uses from time to time to republish company news.

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 those amounts. Our non-GAAP numbers exclude non-cash charges and non-recurring adjustments and their tax related impacts. We ask that you please keep your questions to the operational and financial results announced today.

And now I'll turn the call over to Don.

Don Joos

Thanks, Barry. The fiscal second quarter of 2016 showed our execution across a range of strategic initiatives. Most importantly, the ShoreTel Connect platform gained market acceptance in its first full quarter of availability and built momentum each month as the quarter progressed, representing a meaningful portion of new customer cloud bookings. We continue to innovate by introducing Connect Hybrid sites so customers can combine cloud and on-premises environments across locations.

Our channel partner community contributed almost 95% of our new customer cloud bookings, the highest percent ever. We executed two acquisitions to expand our hosted offering, which are directly tied to our stated strategic priorities. And we continue to deliver strong non-GAAP and GAAP net income.

During our Analyst Day in November, we stated that we have just begun the third and final phase of our strategic transformation, the acceleration phase. That day, we provided details on our five catalysts for growth, which will accelerate our cloud business in late fiscal 2016 and into fiscal 2017. These catalysts are, one, the rollout of ShoreTel Connect our common platform for cloud, on-premise, and Hybrid deployments; two, the global expansion of our cloud offering; three, the leveraging of our channel partners to sell cloud solutions; four, our established success in the mid-market and enterprise cloud customer segments; and five, leveraging our premise installed base to grow our cloud business. The actions we took in the second fiscal quarter are directly aligned to these five catalysts for growth.

Now, let me provide some financial highlights from the quarter. Total revenue in Q2 was $90.4 million including hosted revenue growth of 20% year-over-year. In the quarter, our recurring revenue, consisting of our hosted plus support revenues, grew to become 52% of the total revenue. The ongoing strength of our financial model is evidenced by the non-GAAP operating margin of 9% and a non-GAAP EPS of $0.10 per diluted share.

To recap the December quarter, I’ll start with comments on our cloud sales progress. In the period, our cloud bookings grew 8% on a year-over-year basis. As we said before, the quarterly cloud booking results will have some variability from quarter-to-quarter, although the hosted revenue stream should remain relatively predictable throughout the year. But I recognize the bookings growth rate in Q2 was lower than the prior quarter’s level and below our expectations. However, I’m very confident in the strength of our growing pipeline and that our bookings growth in the March quarter will exceed our prior September quarter growth rate of 24%.

The December quarter cloud bookings growth rate reflects two factors that temporarily worked against us. First, was the timing of some larger deals closing. We had multiple larger deals in our December pipeline, but they did not close. Second, we experienced a temporary elongation of the sales cycle for a handful of the opportunities in our funnel, as customers transitioned from evaluating our Sky offer to evaluating our new CLOUD Connect offering.

These deals do remain in our pipeline and I remain confident that our March quarter bookings will rebound above the Q1 growth rate of 24%. I’m pleased with the overall breath of customer wins in Q2. We signed 400 new cloud customers which equalled our all time high and reflects strong market demand. And we continue to win mid-market and enterprise customers as we signed multiple contracts with over $10,000 of monthly recurring revenue.

It’s clear that momentum with the Connect offering is building and in Q2 we saw Connect represent a meaningful portion of new customer cloud bookings. In the next few quarters, we expect Connect to represent the majority of the bookings.

The introduction of ShoreTel Connect was a major milestone on our technology roadmap. A Connect was not just the technology advancement for ShoreTel. We also transitioned our software development to an agile methodology that enables us to deliver features and capabilities on a more frequent release cycle. We are now making monthly feature enhancements, coupled with larger anchor releases, roughly twice a year. It’s the hybrid environment and our pace of innovation that uniquely position ShoreTel to address the customer’s growing business needs.

The hybrid offering is directly related to our five catalysts for growth. Today, we have customers that use ShoreTel Connect to combine a premise solution with applications delivered through the cloud, an offering we branded, Connect Hybrid Apps.

Our most recent Connect release included the introduction of Connect Hybrid sites. This solution lets customers simultaneously operate some locations in the cloud and other locations on-premises, yet maintain a consistent user experience and network integration. This environment is perfect for customers trying to link together a headquarters office with its remote offices. We have not only released Hybrid sites, but we have also had customers implement it. For example, View Dynamic Glass is a manufacturer that serves commercial builders and architects. They are now using Connect Hybrid sites to link multiple office locations in a combined cloud and on-premises environment. The existence of these two Hybrid environments, Hybrid apps and Hybrid sites provide customers with an integrated and consistent experience with tremendous operating flexibility that can solve their specific business problems.

Importantly, it also creates a clear path towards leveraging our premise installed base to accelerate our hosted revenue. We are also rolling out programs this quarter to actively promote our on-premises customers to migrate completely to our cloud offering.

One outcome of our strategic transformation is our significantly improved financial flexibility. As a result, we periodically review our use of cash objectives. At this point, our priorities are to invest for financial resources both organically and through acquisitions towards our stated strategic priorities and catalyst for growth.

During Q2, we announced two acquisitions that are directly linked to these priorities. In November, we closed the acquisition of M5 Australia which gives us a cloud footprint in another key global region where we will leverage ShoreTel’s existing brand name, resources, channel partner network, and customer installed base.

In addition, our prior knowledge of their code base will allow us to leverage existing tools to migrate to ShoreTel’s current cloud offering. In December, we announced the acquisition of Corvisa, a provider of cloud solutions with technology that is highly complementary to our existing business. This transaction closed in early January and achieves four primary objectives for us. First, the transaction further accelerates the pace of innovation we can release to the market. Corvisa’s open standard APIs and software development kits enable us and third-party developers to quickly create and integrate applications with the ShoreTel ecosystem.

Second, the acquisition creates a new source of hosted revenue for our channel partners and ShoreTel. By acquiring Corvisa, ShoreTel is now a provider of SIP trunks which lets our partners sell a combined offering that generates revenue and attractive gross margins. Importantly, this is a global offering and therefore aids our geographic expansion effort.

Third, the acquisition also creates another new source of revenue with the stand-alone Contact Center offering which expands ShoreTel’s presence in a rapidly growing hosted Contact Center space, allowing for integration with non-ShoreTel communication solutions. This differs from our current offering that is tightly integrated into the Connect platform and thus satisfies a different customer need.

And fourth, the addition of employee talent is key to accelerating our product roadmap. Following the close of the transaction we hired 94 Corvisa employees primarily talented in key technical roles.

Before Mike reviews the financial details, I want to reiterate by prior statements regarding strategic initiatives, potential acquisitions, and our commitment to profitability. Our priority is to accelerate our hosted revenue growth. To achieve this objective we are willing to accept a short-term impact to our profitability for an opportunity to accelerate our hosted revenue growth over the mid-term. The Corvisa acquisition completed this month is such an opportunity.

That said, we do expect to return to non-GAAP operating profitability in the June quarter. We continue to expect our mid-term financial model to earn non-GAAP operating margins in the range of 6% to 11%.

In summary, our fiscal second quarter was an important start to the acceleration phase of our strategic transformation. ShoreTel Connect platform gained market acceptance. We executed against our product roadmap by introducing Connect Hybrid sites. Our channel partner community contributed almost 95% of the cloud new client deals and we have now closed two acquisitions, directly tied to our strategic priorities.

Importantly, we achieved these milestones while generating high levels of profitability. So I remain confident in our strategic direction, execution of our hosted growth plan and the overall strength of our business model.

At this point, I'll turn the call over to Mike.

Mike Healy

Thanks, Don. In Q2, we reached a number of noteworthy milestones while continuing to validate that our financial model can generate strong and profitable operating results. As a reminder, our acquisition of M5 Australia closed in mid-November. So the Q2 financial results and metrics, I won’t mention, will include the results from that business, unless or otherwise noted.

Our Corvisa acquisition closed on January 6. So other than certain M&A fees there is no impact from the Corvisa business on Q2. Our Q3 guidance will include expectations from both of these acquisitions. In Q2, total revenue was $90.4 million including the 20% year-over-year growth in hosted revenue. We also had year-over-year improvements in gross margins, operating margins, net income, and earnings per share. Collectively, Q2 was a fundamentally strong quarter for us both strategically and financially.

Now I’ll provide some financial details for the key areas of our business starting with the hosted business. In Q2, our hosted bookings growth was 8% year-over-year. Hosted revenue was $30.5 million, up 20% year-over-year. Our Q2 results include a very small revenue contribution from M5 Australia. Also a recent change in accounting for revenue recognition on the installation services, created a small negative impact on revenue. You may have noticed that our press release indicate that we along with our auditors decided to change our accounting related to the recognition of installation revenue and costs, which is a small part of our overall hosted volume.

In the past, the amortization period for recognizing these revenue and costs were based on our cloud customers’ average contract term. However better match the accounting of these items with the average customer life we’ve changed to a longer amortization period. I want to be clear this is not a material adjustment to any past reported periods. In Q2 the adjustment reduced our Q2 hosted revenue by approximately $120,000, and our hosted COGS by a similar amount. These changes are not material to our financial statements and the related financial results in prior period metrics, have been revised to reflect the changes.

We ended the December quarter with 4,760 cloud customers, totaling 205,600 seats. Year-over-year increases of 27% and 23% respectively. Our cloud installed based metrics continue to reflect our ability to serve the mid market and enterprise customers. Our combined customer base has an average seat size of 44 and an ARPU of $52.

Our average cloud customer pays us $2,244 in hosted monthly revenue. In Q2 we had annualized cloud revenue churn of 6.4%, which is well below the results reported by our cloud competitors.

Our recurring revenue comprised of hosted revenue, plus support revenue totalled $47.2 million in the quarter which was 52% of total revenue. This represents an annualized recurring revenue run rate of $189 million. Our product revenue in Q2 was $41 million, down 13% year-over-year and reflects our increased focus on cloud opportunities and a comparison against Q2 last year, where we shift our largest single on premise deal ever of 13,000 end points. Sequentially product revenue declined only 1%. In Q2 we shipped 126,000 licenses from our premise business.

Our support and services revenue in Q2 was $18.9 up 4% year-over-year. This amount includes support revenue of $16.8 million, which grew 7% year-over-year and reflects our continued high attach rates of support contracts. The remaining $2.1 million of services revenue shrank 14% year-over-year and includes professional services, installation and training revenues. These revenue elements tend to follow the growth trajectory of the product revenue line.

In Q2, our international revenue was $7.7 million, which was up slightly over the prior year and up 5% over the prior quarter. International revenue now represents 9% of our total revenues.

As I turn the discussion to gross margins, operating expenses an profitability, I refer to non-GAAP amounts unless otherwise noted. In the second quarter, our total gross margins were 65.4%, representing the second highest level in the past three years. This is an improvement of 240 basis points over last year, but down 70 basis points from last quarter’s level. The margin improvement over last year reflects a significant expansion of our hosted gross margins which reach 57.3%, up a 11.5 percentage points from a year ago. Our model continues to benefit from business scale and operational focus on our cost structure.

As similar to Q1 in this quarter we also realized another benefit of roughly three percentage points from savings in the telecom tax area due to the release of reserves no longer needed after we finalize our tax filings with certain jurisdictions. The product gross margins in the quarter remained strong at 66.7%, down 30 basis points from a year-ago and 90 basis points sequentially. Mostly due to lower product revenue.

The support and service gross margins were 75.7% in the period, down a 130 basis points year-over-year. The Q2 operating expenses of $51.2 million were up just $500,000 year-over-year, mostly due to hiring in engineering areas. Our business model has produced consistent results in revenue gross, margin and expenses. Thus, we earned an operating margin of 8.8% or an operating profit of $8 million, representing the second highest level of operating profit in the Company’s history. We earned a net income of $6.7 million or $0.10 per diluted share.

Looking at the results on a GAAP basis reflects our third consecutive quarter of GAAP profitability. We earned a GAAP net income of $2.5 million or $0.04 per diluted share including $434,000 of M&A fees, charges for stock compensation of $2.2 million and amortization of acquisition related intangibles of $1.7 million.

As you can see, our ability to execute our business plan has resulted in consistent levels of profitability. Even as we moved into acceleration phase of our strategy, ramp our cloud business and made strategic acquisitions. We have improved our financial flexibility and our balance sheet. On December 31 we had a $170 million in cash and short-term investments, we continue to have no debt outstanding and we have a $100 million line of credit in place. Excuse me.

Our cash flow from operations in the quarter were $3.6 million, bringing the first half total to $23.2 million. Our capital expenditures during the quarter were $2.2 million as we continued to invest in our cloud business and equipment purchases to further the innovation on ShoreTel Connect. Meanwhile our total Q2 depreciation and amortization was $4.9 million.

Accounts receivable increased by just $300,000 to end the quarter at $28.8 million. And our day sales outstanding improved to 29 days. Inventory at $14.4 million, was up $900,000 sequentially. At this point we are substantially complete with our recent transition to our 400 Series SIP phones.

On the liabilities side of the balance sheet our deferred revenue at quarter-end was $73.3 million, the bulk of this deferred revenues for support agreements on our products that we have billed an collected upfront. Over 70% of this deferred revenue will be recognized in the next 12 months. And we finished Q2 with 1,086 employees.

At this point I will comment our business outlook in the context of the market conditions, our strategy and the two acquisitions that have closed since our last conference call. In forecasting our hosted revenue growth for fiscal 2016 I remind you that both of our recent acquisitions were relatively small in terms of current revenue. At this time we expect our fiscal 2016, hosted revenue growth to be at or around 20%, reflecting a modest revenue acceleration in the second half of this fiscal year.

Next, let me give you the financial outlook for the third quarter of fiscal 2016 which includes a full quarter impact from both of our acquisitions. We expect Q3 total revenues to be in the $86 million to $91 million range. We expect Q3 non-GAAP gross margins to be in the range of 62% to 63% while the GAAP gross margins will be roughly 1.5 points lower due to adjustments for stock-based compensation charges and amortization of acquired intangibles.

We are guiding gross margins below our recent levels due to the inclusion of both acquisitions which have lower gross margins as they are in the early stages of ramping revenue. Our expectation for Q3 non-GAAP operating expenses is in the range of $57 million to $58 million. The sequential increase reflects additional operating costs related to 111 new employees hired via acquisitions. And higher sales and marketing investments in our cloud business.

Also impacting Q3 expenses, are higher labor costs associated with incremental employer payroll taxes of $1.6 million that start over at the beginning of each calendar year. In Q3, the GAAP operating expenses will be approximately $3 million higher reflecting intangible amortization related to the acquisitions, stock compensation expenses and M&A fees.

I would not normally make a comment looking ahead two quarters on profitability, but in light of our recent acquisitions I want to emphasize our expectation to return to non-GAAP operating profit in our fiscal Q4.

As we look, our Q2, we saw that our business fundamentals indicated a solid performance and we continue to deliver high-profit margins and strengthening balance sheet. Our new common platform, ShoreTel Connect, will generate continued enthusiasm and traction in both our premise and cloud businesses. Now with the release of hybrid sites we have fulfilled the promise of delivering a flexible common platform for our customers.

And finally, an update on our sports relationships. Now that Don’s [ph] New England Patriots have lost you can assume most of us at ShoreTel will be rooting for our customer the Carolina Panthers to win the Super Bowl.

Now let’s open up the call for Q&A.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Barry McCarver of Stephens Inc. Please go ahead.

Barry McCarver

Hey, good afternoon guys. Good quarter.

Don Joos

Good afternoon.

Barry McCarver

And thanks for talking my questions. Let me start off by publicly apologizing for Don for handling him on what to with all that cash. Once you [start doing] [ph] an acquisition, you roll-off, two in two months a good job.

Don Joos

Thanks yes. Just the way they work sometimes, they come in groupings.

Barry McCarver

Yes. So as it relates to M&A, should we consider maybe a pause here or are you still actively looking like you have always been?

Don Joos

Yes, we’re continued to be active and looking for the right opportunities. The two acquisitions we had done were very complementary to our business. They are going to be easy for us to integrate and they tie to our stated priorities. So we have an active pipeline right now, but we're obviously very thoughtful about that nothing breaks the momentum that we have in our business, right now. But we are continuing to be active looking for the right opportunities that are tied to our priorities.

Barry McCarver

And then just one follow-up, on the return to profitability that you indicated for 4Q, the 6% to 11% you gave is pretty darn specific, how much of that is driven just on the cost side of the equation versus the revenue ramp? If you can help with that?

Don Joos

Yes, I’ll start and I’ll let Mike chime in. I mean, it’s a mid-term target 6% to 11%. That was our target before. So we're not changing that. What we have done right now is as I had highlighted, we’re willing to take a very short-term impact here to our profitability really because we believe that this is going to further accelerate our hosted revenue growth. These are two acquisitions that we have done that are in the early stages of the revenue ramp. So for me, I view this as this is all part of a scaling. We have proven over the last two years about – really that we have a solid business fundamentals, right now. We've created this flexibility. So this is the scale. And that will create leverage within our model.

So I look at it more from that perspective. Naturally with acquisitions Barry there is always opportunities just from operational efficiencies, so you do gain some from a COGS perspective or just overall cost perspective.

Mike Healy

Yes, so let me clear Barry the 6% to 11% is our mid-term target model that’s certainly beyond one year. So we are not saying Q4 will be in that range. Q4 will have a recovery from Q3 as business ramps up and typically that’s our seasonally strongest quarter on the product side of revenue and we’re expecting pretty healthy increase on product revenue in that June quarter.

Barry McCarver

Got you. It’s very helpful. Thanks, guys.

Mike Healy

Thanks, Barry.

Operator

And our next question comes from George Sutton of Craig-Hallum. Please go ahead.

George Sutton

Thank you, I wondered if you could address what you define as the elongation of the sales cycle relative to the cloud. If you could just give us a practical sense of the customer that was in your pipeline that saw the new offering and decided to put more work into the decision-making just so we understand that.

Don Joos

Yes. I’m happy to talk about that. It was a couple opportunities actually that fell into that category. What this was is they were in our pipeline, we were working with them, looking at from our Sky Offering because that's what we had at the time as the Connect offering came into the market they were very attracted to it, which does not surprise me at all. They're very attracted to our new offering.

And so in a sales process which just caused us to not go back to square one but just take a step back and we began the sales process going through the evaluation of that offering. And so that’s where it just added some time to the process and it causes it to spill from one quarter to another. They’re very excited about the product and what it can do for them in solving their business problems. For us it’s just a temporary issue, really for me I view this as more of just a transitional issue as the new product comes out from the December to the March quarter and it’s really isolated to that.

George Sutton

Okay. Got you. Now, you mentioned a program that was upcoming that would enable you to migrate premise customers to the cloud more rapidly. Can you give us a sense of what is behind that?

Don Joos

Yes, so what we’re doing is two things. With the Connect product out in the marketplace right now I mean one is we actually have had customers from the installed base already starting to move over and that is more where our customers are just proactively raising their hands. So it’s already happening. What we’re looking to do as part our channel program is more programmatically work with the channel to go out and touch the installed base to promote them, to move to our cloud offering or take advantage of the hybrid offering. And if they’re not ready yet at least we’re touching them with the capabilities that we have so when they are ready they know where they are.

And so that’s really is more of a programmatic way for us to go into that installed base because as I’ve said before our premise installed base in a strategic asset for us and we see this as another growth source in our hosted revenue, because customers are converting and we have four million end points out there that are there for us to touch. And we believe that the cost of acquisition for our installed base is a heck of a lot cheaper than from a new logo. We think it’s about 20% to 40% and we think the cycle should be quicker. So we have programs that we’re going to be rolling out on that.

George Sutton

Perfect. Then the last question from me, relative to the Corvisa acquisition are you going to continue to support long-term your Contact Center that you have on your platform today, A. And B, when is the Corvisa offering available for the channel?

Don Joos

So two parts. Yes. So right now with the acquisition we have two contact centers but they serve two different markets; the ShoreTel contact center that we have had is deeply integrated into the ShoreTel Connect and it’s really targeted at the people who need a contact center, or contact center is their primary business. And so with the deeply integrated it fits that market well. With the Corvisa, that is a highly customizable solution. And that’s really designed for it’s an over the top, it’s for people who are focused on our contact center business and it’s agnostic to the business communications. Meaning is that it could be any vendor who does not see ShoreTel that expands the addressable market for us in the rapidly growing hosted contact center space.

So one is it is designed for a market that need a contact center and it’s deeply integrated into the ShoreTel product. The other one is designed for those that need a highly flexible customizable solution and contact centers is a core part of their business. So for now we’re going to continue to have those two products, as we work more into the integration we’ll find opportunities along the way, but for the foreseeable future we’re going to have those two products because we’re solving two different markets. I would say is available for the channel, naturally with any integration we’re going to go through from a sales operations, go-to-market, we are quickly having that integrated into our overall go-to-market programs. But what we’re doing right now is we’re not slowing down their business right now. I mean, they are actively selling and we’re working with our channels with them, but the integration is just more programatically having this rolled out. And that’s really over the next couple of months.

George Sutton

Okay very good color. Thank you very much.

Don Joos

Thanks.

Mike Healy

Thanks George.

Operator

And our next question comes from Greg Burns with Sidoti & Company. Please go ahead.

Greg Burns

Just a couple of questions on Connect. The customer that you’ve announced, the Hybrid sites customer, was that a new customer or an existing ShoreTel customer?

Don Joos

That’s actually an existing ShoreTel customer so that’s an example of our premise installed base starting to help impact the beginnings of a hosted revenue because they upgrade to the Connect platform and then we get incremental sites on a subscription base for the remote offices. So it was an installed base that was migrating over.

Greg Burns

Okay. And now, in terms of the Hybrid apps, can you just give us a sense of the number of apps that are available now through the cloud or maybe some examples and what the roadmap there looks like for additional apps in the future?

Don Joos

Yes. Right now, I’d say because of the [Connect] [ph] that were in the obviously at the early stage right now. So there is only handful of apps. One example I would use is as we have a major league base ball team that has recently signed and they are working on a premise-based solution for their main stadium plus their [farm] [ph] system teams. And then they are using the scribe applications on a subscription base and so that’s about 300 users. And so that generates about $21,000 of MRR just on the application side. That’s a great example of a Hybrid app scenario.

Our roadmap and now that Connect is out, that’s what I’ve always said, Connect coming out was not an ending milestone that was a beginning milestone for our business. Our roadmap now has us adding more apps to the solution. One of the next upcoming ones is going to be is from a Hybrid for a Contact Center perspective. So that will be probably the next app you’re going to see from a roadmap perspective.

Greg Burns

Okay. And then in terms of the hosted gross margins what percent of your hosted revenue is coming from transport now and what is the margin profile except that lower margin transport revenue?

Mike Healy

Yes, Greg its Mike. So the hosted margins of circuit business if you will, keep shrinking every quarter I think this quarter it’s down about 12% of the total business. The margins are still relatively low. So without them our margins are pretty significantly up into the 60s, high 60s. And we expect that continue to shrink as a percentage of our business. It’s been going down about one percentage point a quarter, in terms of – contribution on the hostage revenue lines.

Don Joos

Part of the reason I think we continue to see it shrink as you get larger customers there and you have their own network there, their infrastructure so we’re just paring our network with their network. And so that’s going to be a contributing factor to that decline, and that’s [indiscernible].

Greg Burns

Okay thank you.

Operator

And our next question comes from Mike Latimore of Northland Capital Markets. Please go ahead.

Mike Latimore

Okay thanks, nice prophecy on this quarter you guys.

Don Joos

Thanks Mike.

Mike Healy

Thanks Mike.

Mike Latimore

Just on the growth progress margin is the Connect cloud gross margin sort of some more to sky presently or what’s kind of – as this Connect [indiscernible] what that mean about from cloud gross margin standpoint?

Mike Healy

Yes, I mean, it’s a little early but Connect should have bit Connect cloud should have better gross margins than kind of this current Sky offering. So that customer base ramps up I do think that will have an incremental positive impact on cloud gross margins.

Don Joos

Yes and I would comment it’s little apples and oranges I’m going to absolutely agree with what Mike had said, I would just keep in mind is the infrastructure that we had built as I talked about our transformation and the foundation phase, the infrastructure we build with our datacenters and the architectures designs that is actually we’re leveraging both for the historical Sky offering now Connect is all running off the same infrastructure. So we’re getting a lot of leverage on that perspective and that’s another contributing factor to our margins.

Mike Latimore

And when you rolled Connect cloud out I think you had a – or you do have a couple of bundle prices here I guess sort of low, mid and high-end. What are you seeing in terms of customer interest in terms of the different bundles? Is one sort of pre dominating here or is it even across the different tier?

Don Joos

Yes. Just as a context the pricing with the Connect cloud, you are absolutely correct is in tiers and they are bundles which is different than our Sky offering which is more of an Ala Carte. So it’s hard to do a comparison between the two, because we did three different pricing methodologies. It is on a five tier approach and pretty much as you would expect on a bell curve, you are going to find that the middle ones are going to be our highest volume, that’s pretty much what we had modeled and so far the early indication that bell curve is pretty well aligned with our expectations.

Mike Latimore

Great, and I guess the last question. If you look at the pipeline or just activity early what the – what percent of the deal are seeing where they actually do want a contact center at the same time as cloud phone system?

Mike Healy

Most companies have some form of a contact center in them I would say now that we have closed the acquisition of Corvisa and we are seeing more, and more and more opportunities because now we have a more relevant offering in the marketplace. So its growing and I expected to continue to grow.

Don Joos

Mike, on those deals, right the larger the deal the more likely that they’re going to have a contact center element. So for instance if our top 25 deals this quarter, I’d say 25% to 30% of had some kind of contact center.

Mike Healy

The one thing I would comment is just for a clarity to is the existing ShoreTel contact center that’s integrated with the ShoreTel solution was designed specifically for the market segment we went after that sub 5000. And so it had – it went up to a certain size from an aging perspective, the attractiveness of Corvisa is not only that is and over the top but from a scaling perspective, we can go into much larger contact centers. So this standalone contact center is much great scalability and with that is also going to come a much higher ARPU.

Mike Latimore

Okay, thanks.

Don Joos

Thanks, Mike.

Operator

[Operator Instructions] Our next question comes from the line Dmitry Netis of William Blair. Please go ahead.

Dmitry Netis

Thank you. Nice quarter, guys

Don Joos

Thank Dmitry.

Dmitry Netis

Quick question on Corvisa, it’s an M5 actually. Combined was their revenue contribution be under $1 million per quarter?

Mike Healy

Yes Dmitry I mean it's very – this quarter it was M5 Australia and very, very small next quarter still expect it to be very small we're not going to break it down. It's all going to roll up under the cloud business and as it becomes more material we'll assess what the important metrics are to share with our investor base about the different elements of our cloud business, but for now it's pretty small. We're going to lump everything together.

Dmitry Netis

Okay. And then on the other side the OpEx side of that acquisition would it be fair to assume not only to words in your mouth, but would it be fair to assume you slowdown maybe hiring Silicon Valley now that you’ve on boarded 94 technical engineers and technical talent? Is it something you are thinking or are you continuing to hiring Silicon Valley, how do we think about that path for you?

Don Joos

Yes Dmitry, how we think about that right now is we have a presence of technical talent in the valley, we have it in Austin, we have it now in Milwaukee, we have it in Bangalore, we have in our New York office. So what this does is it distributes our technical workforce which actually allows us to say where is the talent we need and then we have a host of options for us to look at it. So I wouldn't necessarily say we’re living in California. It’s just opens up the possibilities for where we can get the right technical talent for the needs that we have at that time.

So for me, I look at it and say I think that greatly reduces our business risk because we’re not dependent upon a singular geographic market.

Dmitry Netis

Okay. So you expect to continue to hire then in the Valley and may be cost [indiscernible].

Don Joos

Yes we’re going to continue to hire the talent that we need obviously different markets, have different cost structures associated with it so that factors into our thinking, but again I would say is that we’re going to go – we’re going to get the right talent that we need and whether that's through organic and sometimes inorganic?

Dmitry Netis

Okay and maybe – just maybe to look at the same issue sort of different way. And I appreciate you providing this mid-term target and sticking with it, that 61% but just purely from dilution perspective of Corvisa, its roughly $0.05 diluted this quarter, you know, you're saying you're going to be generating operating profit next quarter. But it will still be a bit diluted is to meet somewhere in the $0.02 to $0.03 range. When does this impact sort of goes away? Is that a three-quarter, four-quarter phenomenon? Can you sort of update us when that acquisition becomes break even or incremental to – to overall operating profit?

Don Joos

Well let Mike starts and I will chime in at the end.

Mike Healy

Yes. So remember this is a technology acquisition, right? We did not buy them Corvisa for the revenue. It’s really about the technology and the people and what we get from that. So we are going to functionally integrate the groups relatively quickly in order to make sure we get the proper leverage. And then it’s really dependent on the revenue ramp from the different elements chunking [ph]. And contact center, contact center being the largest revenue element there. So it’s hard to answer that question till I see how the revenue is going to ramp. Again, it’s only been three weeks since we closed the transaction so we’re working on all those integration activities.

Don Joos

Yes, I would expect as each quarters goes by the impact gets smaller because as the topline grows. But as Mike says as we get little deeper into it we’ll be able to provide some better insights. I would say is that I think what we have done over the last two years in our business model in creating that flexibility does allow us to observe these types of transactions when they are right opportunity to accelerate our business.

But like we said, once we get a little deeper into it well, we’ll get some better highlights on it.

Dmitry Netis

Okay. All right, that’s good. And then maybe a couple of more quick one on the margins. This 57, which is very nice. Mike did mention that’s three percentage points of impact due to taxes. How should we think about that going forward? Is 57 a good run-rate going forward and should we assume maybe slightly lower because of the tax issue? Which may not recur but yet you’re – and the lower sort of gross margin contribution from Corvisa and M5 as you go along maybe that’s the improve but sort of for the next near-term couple of quarters what should the gross margin kind of on the hosted side look like?

Mike Healy

Yes, so let me just frame up hosted gross margins. So in Q1 and Q2 we’ve got three points of benefit for two different related tax activities as we resolve some filings and things like that. So I do not expect that will get that much more repeat of that kind of credit if you will next quarter growing [ph] out that. That activity generates those credit is pretty much finalized with those agencies. So I don’t expect that, so the 57 naturally would have been about 54.

And then in Q3, we’re obviously having the impact of the acquisitions where the revenue is small but especially on the Corvisa side we have relatively good cost structure built up to support the revenue ramp. So the margins are lower both on M5 Australia and Corvisa than our regular hosted margins. So there will be a decline in hosted gross margins…

Don Joos

[Indiscernible]

Mike Healy

In aggregate in Q3. And then any ways revenue ramps up, then they start coming back and increasing overtime.

Don Joos

Yes, so if you had – I think there is three drivers two of it Mike said that will cause the incremental steps up. One is just general scale within our business as we continue to grow. Two, is we have lots of operational efficiency programs that are going on, that has been contributing to the year-over-year increases that we've been highlighting for last couple of quarters. And then as Mike has said, as the deals, the two acquisitions that we had done as the revenue continues to ramp that’s just going to create more gross margin leverage for us.

So the combination of those three is what's going to allow the gradual steps up on a quarter-over-quarter basis.

Dmitry Netis

Right. Okay. And then lastly, I look at the some of the metrics you provided. I'm looking at the average MRR per customers and the ARPU has been coming down a little bit in the last couple of quarters, you just talked to what’s the cause of that is greater SMB exposure or anything else that might be going on in the business, any color there will be great.

Mike Healy

Yes, so I mean, the biggest impact was on the average revenue per customer. The real impact was because we included the M5 Australian metrics in the total metrics. So that drove that number down because they have smaller average revenue per customer. So that’s the biggest impact as you kind of merge those two together. Then next Corvisa [ph] will have – the Corvisa business included as well. So those numbers can move around a little bit. The impact on customer seat size and ARPU was relatively small because of the M5 acquisition in U.S. just a smaller piece of the total business.

Don Joos

But what I will say is, as Mike had highlighted earlier as the circuits become a smaller part of our business, on an ongoing basis that does have a gradual impact to those overall numbers, but that also helps from a gross margin perspective so that’s a trade-off I’m completely fine with.

Dmitry Netis

Okay great. Very helpful. Keep up the good work gentlemen.

Don Joos

Thanks Dmitry.

Mike Healy

Thanks Dmitry.

Operator

And this concludes our question-and-answer session. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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