IPO Analysis: ShoreTel May Be Offering A Superior IP Product

| About: ShoreTel, Inc. (SHOR)

On June 23, Bill Simpson wrote an analysis of ShorTel (NASDAQ:SHOR). ShoreTel Inc. shares soared 27.5 percent on their first day of trading Tuesday July 3 after a lawsuit delayed the company's first attempt at an initial public offering last week. Shares closed the day at $12.15, after the company priced 7.9 million shares at $9.50 a share, at the midpoint of its projected range between $8.50 and $10.50.

The text of Mr. Simpson's original writeup follows:

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ShorTel plans on offering 7.9 million shares at a range of $8.50 - $10.50. Lehman and JP Morgan are lead managing the deal, Piper Jaffray, JMP, and Wedbush co-managing. Post-ipo SHOR will have 41.3 million shares outstanding for a market cap of $392 million on a $9.50 pricing. IPO proceeds will be utilized for working capital and general corporate purposes.

Crosspoint Venture Partners will own 22% of SHOR post-ipo. Note that Lehman and JP Morgan related venture funds will own a combined 22% of SHOR post-ipo also.

From the prospectus:

We are a leading provider of Internet Protocol, or IP, telecommunications systems for enterprises. Our systems are based on our distributed software architecture and switch-based hardware platform which enable multi-site enterprises to be served by a single telecommunications system. Our systems enable a single point of management, easy installation and a high degree of scalability and reliability, and provide end users with a consistent, full suite of features across the enterprise, regardless of location.

Enterprise IP communications systems: Products consist of ShoreGear switches, ShorePhone IP telephones and ShoreWare software applications. SHOR sells 9 switch products and 5 different IP phone systems. SHOR sells its products through 3rd party sales channels (resellers). As of 3/31/07, SHOR has sold to 4,500 enterprise customers through 400 different channel partners.

Of note, SHOR's enterprise IP telecommunications systems received PC Magazine’s Best of the Year 2005 Editors’ Choice designation. In addition, for the past four years, IT executives surveyed by Nemertes Research, an independent research firm, have rated ShoreTel highest in customer satisfaction among leading enterprise telecommunications systems providers. These two nuggets make this SHOR ipo at least worth a closer look.

Sector - This is a fairly large sector with an estimated $17 billion in overall worldwide enterprise telephony systems equipment revenues. The past few years have seen a shift by enterprises from separate voice and data networks to a single IP network for both. SHOR operates in the voice and date IP niche, expected to grow 19% annually, far outpacing overall enterprise telephony growth. It is estimated that currently the voice and data IP systems equipment market alone will be nearly $8 billion by 2010. As would be expected there is substantial competition in the space.

The usual communications equipment players all offer some form of enterprise IP telecommunications equipment, including Cisco (NASDAQ:CSCO), 3Com (COMS), Alcatel-Lucent (ALU), Inter-Tel Incorporated (NASDAQ:INTL), Mitel Networks Corporation (which recently announced plans to acquire Inter-Tel Incorporated) and Nortel (NT). In addition Microsoft (NASDAQ:MSFT) is entering the space and appears to be developing an IP partnership with Nortel in which Nortel will produce IP-based communications equipment that will be integrated with the Microsoft systems and Office Communicator.

SHOR's IP solution: Many of SHOR's competitors offer a hybrid IP telecommunications solution, meshing it with existing legacy communications equipment and products. SHOR offers switch-based IP telecommunications systems for enterprises that address the limitations of hybrid and server-centric IP systems. SHOR lists the usual benefits in these prospectus including scalability, ease of use, reliability etc... A few highlights:

1) Personal Call Manager allows end users to control their phones from their PCs, regardless of their location, and integrates with enterprise software applications, such as Microsoft Outlook and salesforce.com (NYSE:CRM).

2) IT management via anywhere using browsers.

3) SHOR believes its system costs less to install and operate.

In these filings every company states why their products are superior. In this case, SHOR has PC Magazine and four years' worth of IT managers' recognition to back its claims up. It would appear from gross margins below and awards that SHOR may indeed offer a superior product.

Historically SHOR has sold its products to small and medium size enterprises. A key growth strategy going forward in FY '08 is to begin selling into larger companies.


$2 a share in cash, no debt.

SHOR's fiscal year ends on 6/30 annually. FY '07 ends 6/30/07.

Revenues have increased sequentially each quarter for over two years. I always like to see this. Revenues past four quarters (ending 3/31/07) were (in millions) $19, $20.5, $22.5 and $26 million.

FY '07 (ending 6/30/07):

2 quick points: SHOR has booked more stock compensation expenses in FY '07 than it will post-ipo. I smoothed this out a bit by 'pro forma'ing' the stock comp numbers for FY '07 cutting them slightly. SHOR does not have excessive options dilution in its future and stock compensation charges annually should be around $1 million, while for FY '07 pre-ipo they'll be in the $2.5 million ballpark.

2nd point is taxes. SHOR has substantial deferred losses as it did not shift into profitability until FY '06. Its effective tax rate for FY '07 and FY '08 should be in the 10% ballpark.

Revenues for FY '07 with one quarter to go should be in the $97 million ballpark, a strong 60% increase over FY '06. Gross margins for this type of highly competitive communications equipment sector are very strong at 62%. Gross margins are up in FY '07 from FY '06 56%. SHOR attributes this to the release of higher margin products. We've seen a slew of very aggressively valued networking equipment ipos with 40% gross margins, SHOR here in what should be a somewhat commoditized sector is doing something very right to be garnering 62% gross margins.

Operating expense margins have risen pretty evenly with revenues. Ideally you want to see expenses decreasing as a % of revenues as revenues increase. With SHOR we're not seeing that quite yet. For the past four quarters operating margin expense ratio has been in the 52%-55% of revenue range. Going forward I'd like to see SHOR be able to lower that operating expense ratio. That will be a key to future profit growth.

Operating margins for FY '07 were 8%. Plugging in taxes, earnings per share should be $0.17.

FY '08 (ending 6/30/08):

If the past three years are indicative, SHOR should continue to grow revenues sequentially each quarter. I would estimate FY '08 revenues in the $120-$125 ballpark, a 25% increase over FY '07. Gross margins should be in the 60% ballpark again. I'd like to see the operating expense ratio dip. However I'm not going to plug in much of an operating expense ratio dip as it has not demonstrated it has been able to do that past four quarters. Operating margins should be in the 9%-10% ballpark. Earnings per share should be in the $0.25 - $0.30 range. On a pricing of $9.50, SHOR would be trading 34 X's FY '08 earnings.

Conclusion - The only negative here is that earnings have not quite caught up yet with valuation on ipo. Still a number of things to like here:

1) Award winning product;
2) Gross margins actually increasing in a very competitive sector;
3) Quarter to quarter top and bottom line growth;
4) A valuation on ipo, that would make it a very attractive buyout candidate;
5) Directly benefiting from the enterprise switch (pun!) from legacy communications systems to an integrated single platform all IP network.

Definite recommend here in range. I like this one quite a bit in single digits. I've no idea if this works initially, but mid-term plus I can envision SHOR much higher down the line due to the factors.

Disclosure: tradingipos.com owns shares in SHOR at an avg of $10.10.

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