Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

ShoreTel, Inc. (NASDAQ:SHOR)

Q3 2012 Earnings Conference

Apr 30, 2012 5:00 pm ET

Executives

Tonya Chin – Director of Investor Relations

Peter Blackmore – Chief Executive Officer

Michael E. Healy – Chief Financial Officer

Analysts

Lynn Um – Barclays Capital

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc.

Mike Latimore – Northland Capital

Dmitry Netis – William Blair & Company, L.L.C

Gregory Burns – Sidoti & Company, LLC

Rohit Chopra – Wedbush Securities, Inc.

Operator

Good day, and welcome to the ShoreTel Q3 2012 Earnings Conference Call. As a reminder, today’s conference is being recorded. At this time, I’d like to turn the conference over to Tonya Chin. Please go ahead.

Tonya Chin

Hello, and thanks for joining us today as we report our third quarter 2012 financial results. 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’d like to 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’s done in a public forum.

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

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. I’ll start with the financial highlights from the quarter. Revenues of $56.3 million were up 9% over the third quarter of fiscal 2011, and were seasonally down 3% from the previous quarter.

Non-GAAP gross margins were better than expected at 67.2%, which was above our guided range. For the quarter, we recorded a non-GAAP net loss of $1.5 million or $0.03 per share.

Let me begin by sharing the metrics from our premise-based business, which excludes the Cloud Division numbers. Revenues of $55 million were up 7% from the year ago quarter. A few notable specifics, our quarter three achievement included a 68% improvement in revenues from CDW and Black Box for the quarter three of fiscal 2011.

Additionally, revenues from our service providers were flat with quarter two coming in a little better than expected, and representing 13% of our premise-based business. International revenues were solid in the quarter showing a 19% year-over-year increase, making international revenues 13% of our total premise-based revenue.

Our competitive win rate remains very strong, and we were pleased to have added more than 1000 new customers in the quarter, which is consistent with recent quarter’s achievement. Some examples, working with Verizon, we added SAGE Publications, a leading international publisher of journals, books and electronic media for academic, educational and professional market.

SAGE shows ShoreTel over Microsoft link because of our lower total cost of ownership and more robust voice and contact center capabilities. We also continue to make progress showing large global implementations as we have done over the past few quarters. A good example of this is Brunswick Corporation, which has over 19,000 employees worldwide.

Brunswick is the parent company for brands such as Life Fitness, Mercury Marine, Sea Ray and Brunswick Bowling and Billiards, a plan to rollout ShoreTel to 80 global sites. Brunswick joins The Good Samaritan Lutheran Society, is one of our largest global customers. Both are planning installations with well over 10,000 seats.

We are also seeing more wins with large enterprises such as the Belgium Ministry of Finance that currently has 600 users on ShoreTel Mobility and is planning to add 400 more, for its workers using iPhones. They use ShoreTel Mobility to ensure their employees of UC capabilities on their smartphones, as well as to substantially minimize costs of cellphone roaming charges.

According to the latest data from Synergy Research, the global and United States market showed only slight growth in the December 2011 quarter. Therefore, ShoreTel’s market share both worldwide and the United States increased.

With year-to-date revenue growth in our premise business of approximately 16%, we have again significantly outperformed the market. As we outlined in our Investor Day presentations, we’ve recently made a number of changes to our sales team. We have divided our worldwide sales team responsibility between two seasoned ShoreTel executives, each with over five years at the company.

Tim Gaines, a former Regional Director in sales will lead our North American Sales team; and Mark Arman, who most recently headed business development will lead our international sales team.

We believe this dedicated focus will further enhance our ability to drive revenue growth. These two leaders are making additional changes to their sales organizations to improve both our productivity, and our overall growth.

In addition, I’m pleased to announce that Joe Vitalone, most recently the VP of North America sales of LifeSize and a former Head of Sales at ShoreTel is starting with us this week. Joe’s new role will be Vice President of Channel Management reporting to myself. His responsibilities will include growing our partner base and being an advocate for our channel partners within our organization.

I expect these new leadership changes will provide great focus and accountability within our sales team. I have taken a very active role in all of these changes, and will continue to spend a significant portion of my time focusing on our sales performance and growth drivers going forward.

Next, let me reiterate the highlights from our acquisition of M5 Networks, which closed on March, 23. This was an important milestone in ShoreTel’s history, and a strategic move into a fast growing market. The addition of M5 position ShoreTel as one of the leaders in the rapidly accelerating cloud telephony market. ShoreTel now offers our customers the choice between the lowest total cost of ownership of our premise-based business for our best-in-class Cloud UC service.

I’m pleased to announce that M5 delivered solid financial results in the March quarter. We were pleased to see that net bookings for the quarter were higher than our expectations. We were also pleased to see that the average number of seats for their new customers signed in quarter three, increased significantly to over 50, reflecting their increased penetration into the enterprise. Cloud revenues for the last eight days of the quarter were $1.3 million, and are included in our consolidated results for the March quarter.

With the acquisition closed, we are concentrating on capitalizing on revenue synergies that we have previously identified. We are initially focusing on four key revenue areas. First, our R&D organizations have been working together to add ShoreTel firms to the cloud service offering, and we are currently expecting to have this work completed at the first quarter of fiscal 2013.

Second, we have started the process of introducing our cloud service to our existing base of channel partners, while just the tip of the iceberg, it was encouraging to see that our cloud division had already signed ten of ShoreTel’s existing partners by quarter end, including some of our largest and most well-established partners. We have seen a very high level of interest for our cloud based offering from our existing partner base, and will be accelerating the roll out to our channel.

Third, we have begun sending leads on prospected customers to our Cloud Division, and are confident this will drive incremental revenue, which would not have been captured by ShoreTel in the past.

And finally, our engineering teams are working to capitalize on technology that could be leveraged between our two solutions. As we demonstrated at Investor Day, we have already ported our mobility technology on to the cloud platform, and will be offering it to customers as a monthly service relatively soon.

With the benefit of having worked as one company for over a month now, I am even more convinced of the characteristics that made M5 an attractive acquisition. Let me take a minute to remind you of some of these key points. M5 supports ShoreTel strategy to continue to move into the enterprise, with its overall average customer having over 30 seats and increasing steadily, M5 has demonstrated the ability to serve the largest small-medium business and the lower end of the enterprise markets.

As you may recall, we recently highlighted M5’s customer, Randstad at our Investor Day in March. With over 1,000 users and growing fast, Randstad is one of M5’s largest customers. They recently purchased a company with over 1,000 users on Cisco’s Communication Manager Solution, that they will be moving to our card service in the near future, demonstrating their satisfaction and commitment to M5’s cloud solution.

Additionally, M5 is some of the best metrics in the cloud business. Some of these include a high average revenue per unit or ARPU, a low churn rate, a very competitive customer acquisition cost, and expertise in running 7/24 data centers.

Importantly, over 80% of M5’s revenue is recovering in nature. And with their addition to ShoreTel, the total recurring revenues of the company will be over 30%. This adds more predictability to our revenues.

We were attractive to M5 also because of their strong management team, and I am pleased to have retained Dan Hoffman, as well as the Senior Executives to run the ShoreTel Cloud Division. This team has many years of experience successfully running a cloud business and we’re very happy to have them at ShoreTel.

It is fate also be able to say that M5’s cloud technology and our premise technology both share a core attribute of brilliant simplicity, a true differentiating factor in the competitive landscape.

In summary, the acquisition of M5 was a bold move at a strategic time that will allow us to capitalize on the shift towards the cloud and as a compliment to our proven premise-based business. ShoreTel as a result is very well positioned in both the markets. I am very excited about our prospects as we move forward.

And now, I will turn the call over to Mike.

Michael Healy

Thanks Peter. First, I’ll review some of the key financial metrics for the third quarter, and then I will discuss our guidance for our fourth quarter of 2012. Also the metrics and guidance that I will discuss take into account both the premise business and our new Cloud Division unless otherwise noted. Total revenues of $56.3 million for Q3 were segmented as follows.

Product revenues were $42.4 million up 3% from the third quarter of fiscal 2011. Service and support revenues were $12.6 million, which represented 22% of our overall revenues and we’re also up 22% from Q3 last year. In addition, days of M5 cloud business contributed revenues of $1.3 million for the quarter.

Our international revenues were $7.1 million representing 13% of total revenue, essentially flat in the last quarter and up 19% from Q3 2011, with Asia-Pac and Canada showing the largest year-over-year growth. Revenue from our service providers came in a little stronger in the quarter, than we expected with the [Windstream] showing the best year-over-year growth. As the group service providers represented 13% of our total overall revenue and were flat in Q2 at $7.4 million for the quarter.

Volume through our 2-tier value-added distributors in North America grew slightly, and for the quarter represented an approximately 37% of total premise revenue. And I am happy to report, that our newest VAD, Ingram Micro has begun ramping as expected.

Our largest vertical segments in the quarter were financial, retail, special services and industrial. We also had some very nice swings in the social media category. And other area of notable strength was education, which was up nicely in the quarter.

In our premise-based business, we saw the 126,000 end user licenses, up from 115,000 in Q3 of last year. We added over a 1000 new premise customers in the quarter, bringing our cumulative customers sold to $21,000. And as it is typical for our third quarter, the percentage of business from new customers came down to 41% in the quarter, which had a positive impact on both discounting and gross margins.

Speaking of gross margins, our consolidated non-GAAP gross margins were 67.2% in Q3. Excluding them, prime activity for eight days our total gross margins would have been 67.7% for the quarter. Our non-GAAP product gross margins were 67.3%, up 160 basis points from last quarter, reflecting the declining discounting level in a higher percentage of business coming from our installed base in the quarter. Non-GAAP gross margins for the M5 Cloud Division were 45%.

Our non-GAAP service and support gross margins were up a 100 basis points from Q2, grew 69% due to a 7% increase in revenue and a smaller increase of 3.6% in cost. GAAP gross margins for the quarter were 66.2% and reflect the impact of a portion of stock compensation charges and amortization of intangibles that is included in cost of sale.

Our non-GAAP operating expenses were $39.2 million are up $2.6 million in the quarter and reflect approximately $500,000 of M5 expenses, as well as increases in labor fringe benefits and payroll taxes associated with the hiring we’ve done over the last few quarters.

Our GAAP operating expenses were $46.7 million and included one-time deal-related transaction fees of $4.5 million, stock compensation expenses of $2.9 million, as well as amortization of purchase intangibles. The non-GAAP loss for the quarter was $1.5 million or a loss of $0.03 per share.

Our GAAP net loss was $8.5 million or a loss of $0.17 per share including $3.2 million of stock-based compensation charges of $428,000 in the amortization of intangible assets. The GAAP loss was partially offset by a tax provision benefit of $964,000. This credit to the P&L was primarily the result of a discrete tax benefit of approximately $1 million resulting from the release of evaluation allowance associated with the acquisition of M5 networks. Pursuant to SFAS 141R, which requires that any valuation allowance release related purchase accounting we reported as an income tax benefit.

Balance sheet highlights from Q3 included cash and short-term investments totaled $61.3 million. The decrease from last quarter reflected a net of $59 million from cash used in the M5 purchase. Cash used from operations for the quarter is approximately $250,000, but I will point out that we’ve generated nearly $10 million in the operating cash flow year-to-date.

Accounts receivable increased to $1.8 million or 6% to $32.7 million due to the inclusion of M5 receivables as of quarter end. Days sales outstanding on the premises business were down two days through an outstanding 34 days. Inventory increased slightly to $23.2 million as volume expanded with our U.S. value added distributors and by this, you would expect very low inventory.

Total deferred revenue grew by 9% or $4.2 million to $49.5 million. This increase was due to slightly more product volume through our value-added distributors that did not go through by the end of the quarter, as well as the increased billing to support maintenance agreement.

Capital expenditures of $1.2 million were due to lab and computer equipment purchases. And depreciation and amortization expenses were approximately $1.9 million for the quarter. As of March 31, we had just over 900 employees, which includes approximately 200 employees from the M5 acquisition. Our on-premise quarter carrying sales headcount grew by 8 to 219 at the end of Q3.

In terms of the M5 purchase accounting, you will note that few new items on our consolidated balance sheet. Let me talk you through some of them.

M5 asset for cash, accounts receivable, fixed assets and normal liabilities were added to our balance sheet as you will see. We also added approximately $41 million of intangible assets for existing technology customer relationships and in process R&D that were required as part of the transaction.

These intangibles were amortized in our GAAP income statement over their useful lives. In the June quarter, you will see a full quarter increase in expenses for amortization of intangibles that were approximately $750,000 in cost of sales and another $900,000 in the SG&A operating expenses line only on the GAAP P&L. Because of these costs are non-cash in nature and relates to the amortization of intangibles related to acquisitions, we do not include them in our non-GAAP income statement has been our practice with all such charges, including those related to our Agito acquisition.

The allocation of the M5 purchase price created approximately $112 million in additional goodwill to the balance sheet. And finally, we have contingent consideration payments that are based upon the Cloud Division revenue achievement for calendar year 2012, which is recorded at an estimated fair value of $12.5 million, split between current and long-term liability.

Next, let me give you some of the final details of the acquisition of M5 as well as custom changes in accounting treatment which will affect our Cloud Division results going forward. I will also discuss some details of the purchase accounting and its effects on our balance sheet and P&L.

Under the terms of the final definitive agreement M5 shareholders received $80.6 million in cash and 9.5 million shares of ShoreTel stock, which was valued at $53.7 million at time of closing for an initial, total initial consideration of $134.3 million. In addition, the M5 shareholders entitled to contingent consideration up to $13.7 million which is payable over the next few years of certain revenue performances milestones are met for the year ended December 31, 2012.

ShoreTel also assumes small amount of capital leases and deferred payments related to M5’s prior acquisitions. The $80.6 million cash portion of the purchase price was funded with $55.6 million from our existing cash balances and a draw down of $25 million on our line of credit with from Silicon Valley bank. This line of credit has $50 million of capacity, a five year term no prepayment penalty and interest only payments due monthly till the end of the term. The interest rate is based on LIBOR plus and EBITDA calculations and this is currently around 2.5%.

The audit of the M5 financials for the year ended December 31, 2011 is nearing completion, and we expect a few adjustments to revenue cost of sales and operating expenses. One adjustment that will affect revenue and gross margins going forward will be revenue from installation fees, which M5 had historically recognized upfront upon building the customers. These installed fees should be amortized over the customer life, which will reduce cash and future revenues reported and therefore lower gross margins by about two percentage points going forward.

One other significant benefit of the transaction is that we have inherited at least $25 million of net operating loss carry forward that will be able to combine with our $50 million of NOLs to offset future taxable incomes. Next I’ll discuss our outlook for the June quarter, which includes the full quarter impact of M5 acquisition including the change and accounting for installation fees. Based on our backlog entering the quarter, our sales pipeline forecast and monthly recurring revenue billed to-date; we expect overall revenue to be in the range of $72 million to $77 million.

Taking into account the impact of the Cloud Division in gross margins which are expected to be in the mid 40s, we expect non-GAAP gross margins to be in the range of 62% to 63%. GAAP gross margin percentages are expected to be approximately 200 basis points lower due to the inclusion of $1 million in amortization of intangibles as well as 300,000 in stock-based compensation charges.

We expect total non-GAAP operating expenses to be range of $47 million to $48.5 million. And we expect GAAP operating expenses to be in the range of $51 million to $52.5 million including approximately $3 million in stock-based compensation expenses and 900,000 for amortization of intangible.

Overall, we had another solid quarter and we’re looking forward to sharing with you a progress on our financial results with the new Cloud Business, once we have a full quarter of activity under our belts.

With that, let me turn it Peter for some closing remarks.

Peter Blackmore

Thanks Mike. As we said at Investor Day, we are very focused on continuing growth in our premise business as well as building a strong Cloud Division. We are pleased that our new Cloud Division has exceeded their booking goals in the March quarter a solid indication that things remain on the right track.

In terms of our premise-based business, I am confident we have made the right changes to our sales and channel management organizations. Our pipeline going into the fourth quarter is strong in both lines of business premise and cloud. And we are focused on delivering good growth and versus the current quarter and our fiscal year 2013.

We’ll now open up the line for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). We’ll go first to Lynn Um with Barclays.

Lynn Um – Barclays Capital

Hi, thanks for taking my question.

Michael Healy

Hi, Lynn.

Lynn Um – Barclays Capital

Hi, I guess I just wanted to first ask about the product revenue growth accelerated a little bit front about 3% in the recent quarters, could you may be just expand a little bit on what were the drivers there?

Peter Blackmore

Let me start and I’m sure Michael have some comments that we did on the last earnings call, we guided to the quarter, we just reported on saying that there were two factors, one was the ramp in new partners was lower than we expected, and the other one was our new VAD, did not ramp quite as fast as we expected. We’re all over this, we’ve taken all the appropriate actions, so the expecting the product revenue growth to get back on track in the next quarter and improve even more in the quarter following that.

Lynn Um – Barclays Capital

Okay. And then I guess may be just a question on the mobility business, I think last quarter it grew about 38%, any updates you can provide on the revenue or may be, new customers or partners would be helpful.

Peter Blackmore

On mobility we are pleased with progress is tracking as we expected. And also we were very pleased about the Halo effect is having on the broader premise business, we win many deals, because of the strong capabilities we have and so I’m very satisfied with where we are and I just remind people, we bought this company for $11 million. It was a very good acquisition, best-in-class IP. And we are going to continue to ramp this business, but the revenues are not, still not material enough to break out and as soon as they are, Mike will do that.

Lynn Um – Barclays Capital

Okay, thank you and good luck.

Peter Blackmore

Thank you.

Michael E. Healy

Thanks, Lynn.

Operator

We’ll go next to with Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc

Thanks, so much. Mike on your guidance for the June quarter of $72 million to $77 million. Are you going to breakout sort of what we should expect from the premise-based business and, what we should expect from M5?

Michael E. Healy

No, on our guidance we’re only going to give kind of one revenue number, we are managing the company as one, we have two divisions but internally we’re managing as one. So we’re certainly going to report the results from the Cloud Division at least on the revenue and the gross margin line going forward as you will see on the P&L. But in terms of the guidance, you know it’s only one number that we’ll report how we did. I would say last year sequentially the premise business grew about 10% quarter-over-quarter, Q3 to Q4 without giving you the specific number. Our assumptions there is that it would be similar growth, plus or minus some.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc

Got it. Is it fair to say that the M5 business let’s say last year its $50 million in revenues, you are probably tracking quite a bit higher than that number at this point of time. I know eight days of what you’ve reported which was $1.3 million it’s only 8 days and sort of equates to about $58 million for the full year but again that’s only eight days or obviously not a good indication, but is it fair to say that it’s tracking quite a bit ahead of that $50 million number in terms of where it is today?

Michael E. Healy

Well, so a couple things. One the calendar year ‘11 numbers will show up in an 8-K filing from us in June. So that number will be less, certainly less than $50 million, as I commented on some of the prepared remarks. We’ve got to make some adjustments for these installed base and things like that. But in terms of the, what I would comment is on there is a portion of the revenue that’s what I call MRR or monthly recurring revenue lenders, non-recurring usage base, regulatory those kinds of things.

So the MRR is tracking very nicely. We had a great bookings quarter in the March quarter, but I wouldn’t pro-rate the eight days and try to get to a number or anything. Once we get a full quarter data and numbers from the cloud division, the M5 division then we’ll be able to talk about a little bit more.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc

Got it, okay, one last question…

Michael E. Healy

We’re just tracking nicely.

Peter Blackmore

Yes, the question is the speed of installs, when the bookings are great, you’ve got to sort of think a couple of quarters ahead before you start recognizing monthly revenue. And once you start it recognizing, as long as you keep that customer, its money in the bank. So it’s a very nice model. But I think you’ll have a better understanding once we’ve completed a full quarter.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc

Got it, fair enough. One last question, I know you said you had a good quarter with social media. Those types of customers seem to be prime examples of where Agito would fit in well. Any color on whether Agito actually did well with those guys or was it fairly broad based and may be more skew towards your traditional premise based offering?

Peter Blackmore

We continue to do well and it’s adversely on premise and some mobility and we had another big win. We just we’re going to get the name when the next quarter comes out because we only just want it, but we’ve done very well and these companies are very fast growing. So it’s an exciting business to be looking moment.

Michael E. Healy

But all the big social media guys we’ve got, they’re certainly on premise and then in terms of how much our mobility we’d have to go looked at. But I know all the big wins are all the UC solution.

Sanjiv R. Wadhwani

Got it. All right thanks so much.

Michael E. Healy

Thank you, Sanjiv.

Peter Blackmore

Thank you, Sanjiv.

Operator

We’ll go next to Mike Latimore with Northland Capital.

Mike Latimore – Northland Capital

Great, thanks a lot. You mentioned that the M5 in each of the average customer was at about 50 lines or 50 employees. Is that a blended average for the overall M5 business or is that for new M5 customers in the quarter?

Michael E. Healy

Yeah, good question Mike that 50 over 50 was for new customer signs in the quarter that see the average sheet size of the M5 customers as we at the end of December was just over 30. But what we’re trying to show you there is in this quarter, we’ve got a few pretty big customers in kind of almost double the average sheet size, but it was only for those installed this quarter.

Mike Latimore – Northland Capital

Got it. And then can you give me a little more detail on what kind of compensation structure, your channel, the ShoreTel channel might have to sell M5 services? What was that look like relative to selling an on-premise ShoreTel system?

Michael E. Healy

At the moment the people that have signed up Mike did it on the legacy M5 contract, which was referral only. We have not yet rolled out an improvement on that we plan to. The improvement would be that the channel would contribute to the install and also the sale, at the moment M5 completes all the sales, that just a referral from the channel. And we are discussing that with the channel partners in fact 12 of them were in our offices this week. So we get it right. And then you would see the ramp in partners two fold. One, people just want to stay on the referral program, and then one’s who would like to offer a fuller service and we’ll update you on that when we announce it.

Mike Latimore – Northland Capital

Great. And then sometimes you would give a metric that indicates growth in major accounts or larger customers give any metrics around that those categories this quarter?

Michael E. Healy

Yeah, I mean our major accounts program did better than the overall company average are about flat quarter-over-quarter. One area we had unusual strength in was education. Five of my top deals, three of them were education or government customers. So a good showing on in that area surprisingly not more in education than in government, but a fair share government based deals, counties and states, things like that.

Mike Latimore – Northland Capital

Okay great. Thank you.

Peter Blackmore

Thank you.

Michael E. Healy

Thanks, Mike.

Operator

We will go next to Dmitry Netis with William Blair.

Dmitry Netis – William Blair & Company, L.L.C

Hey, guys, how are you?

Peter Blackmore

Good. How are you, Dmitry?

Dmitry Netis – William Blair & Company, L.L.C

Good. A couple of questions. First I wanted to see if you guys are close to announcing a new head of sales. I think you’ve alluded to announcement being close and you have mentioned Joe, stepping in and if I understand he was a former head of sales at ShoreTel. So one is when can we expect announcement there and what are you looking for in your new head of sales. And then I have a follow-up.

Peter Blackmore

No, no fine. What we’ve done Dmitry, is actually split the worldwide role. I felt that it will be beneficial to the company to get more focus on North America, which is U.S. and Canada, and Tim Gaines announced in that role and started 1st of April. And then we separated out international and that is Mark Arman was also announced in that role and started 1st of April. And the benefit is focus. If you’ve got somebody in North America, who does not have to travel to Sydney, Australia, or London, England, they can obviously spend more time in the United States and I felt that would benefit our growth here. And then also I’ve got great hopes for the international growth, and I think Mark Arman will do a good job.

And then Joe Vitalone, the role there is very specifically in channel management, we wanted to strengthen how we worked with our traditional channel partners, drive growth even better out of them. And Joe signed up for that, he’s actually starting today. So I’m very pleased with these three individuals, I think will help improve our growth in revenue, I’ve no doubt about it.

Dmitry Netis – William Blair & Company, L.L.C

Okay great. And then another follow-up, I have here is with respect to gross-margins for the M5 business. I think you’re exiting last year you guys indicated that the gross margin there was about 47%. Are you guiding mid-40s now heading into the June quarter? So I’m a little perplexed, I’m looking at some of the public competitors and their gross margins fall in including hardware potentially somewhere in mid-60s. So can we expect you guys to sort of ramp there essentially at some point in the future and what are some of the steps you need to take to get there?

Michael E. Healy

Yeah, good question. So let me go back in time and so at Analyst Day we showed you 47% gross margins for the calendar year ’11, data information that was unaudited. Those you are going through the audit, as I mentioned, we have to take installation fees now and kind of backing out of revenue and take them over time. So that has at about a two-point hit to gross margins, so instantaneously that 47% becomes 45%.

So that’s kind of move the baseline now where we are, and then as we ramp up the business, then we expect them to go up. As Peter mentioned, one thing affecting gross margin will be, as we overachieve bookings like we did in March, and we have to ramp the provisioning and installation grew a little ahead of that that all hits in cost of sales, that’s a little impact on gross margin.

And then there is a telco piece of our business where we manage all the circuits or the customer, which don’t have as good as gross margins as the core services we have. So that may bring down gross margins. As we get larger customers, the trend is for them to have their own private networks that we don’t need or want to manage and so that will help gross margins and we will start to experience that a little bit as we move forward.

In terms of getting to the 50% on that, really ready to guide to that number, yet I think we’ve got to get our hands around all the activity at the Cloud Division, so for next quarter the guidance would be mid 40s and in terms of non-GAAP gross margins. Peter…

Dmitry Netis - William Blair & Company, L.L.C

Got it. Yeah. Well, that’s helpful. I’m sorry. Go ahead.

Peter Blackmore

No, no, no, I think the two things as the business scales you’ll get an improvement in margin, it will happen. And then also these carrier revenues that we bundle into the monthly fees, if a large account does not want those and typically they don’t because they maintain their own contracts with the carrier, the underlying margin is much higher.

Dmitry Netis - William Blair & Company, L.L.C

Okay, okay. And then also, some of the peers actually in the PBX, on print market two partner with some of the circuits or network guys, so is it something you consider down the road, to maybe upload some of that circuits business to a partner?

Michael E. Healy

Well, we have the choice now to either include it as a bundle or separate it out, so that’s already – have the ability to do it. When they, I think when M5 typically sold to smaller customers they wanted it bundled, as they sell to larger customers. The customer preference is usually keep its own contract with the carrier so that will enable the margins to improve.

Dmitry Netis – William Blair & Company, L.L.C

Okay. And then last one more question from me, and I will cede the floor, but it has to do with the OpEx guide. Obviously, you did 39 this quarter you’re guiding 47, 48.5. So a material step-up here on the operating expense line, which basically keeps you in the road for the next quarter again. So when can we start to see you coming out of the road and what sort of embedded in this OpEx guide for the next quarter?

Michael E. Healy

That’s a good question. This is our philosophy. We’ve been focused on growth, which require some investment. Remember the Investor Day, we said our objective was 20% growth in premise and the same 20% plus growth in cloud. As we go through quarter four, we will assess that substantially at 13, and will make the appropriate adjustments to get the right profits as well as the right growth.

Dmitry Netis – William Blair & Company, L.L.C

Okay, thank you.

Michael E. Healy

Thank you.

Peter Blackmore

Thanks Dmitry.

Operator

We will go next to Greg Burns with Sidoti & Company.

Gregory Burns – Sidoti & Company, LLC

Hi, good afternoon, thanks for taking the question. In terms of the M5 business, could you share with us what your typical cost of acquisition is for new customer or maybe the average pay back period with the new customer?

Michael E. Healy

It’s typically $8 or $9 of cost of acquisition for a dollar of revenue, so it is an upfront cost that we pay and then the revenue comes over time.

Peter Blackmore

And that includes sales costs, the marketing costs, the commissions to the channel, all that to generate that dollar of booking upfront.

Michael E. Healy

Correct.

Gregory Burns – Sidoti & Company, LLC

Okay, and the average pay back period?

Michael E. Healy

I don’t know if I have that in front of me. We’d have to get back to you on that Greg. But I think it’s 8 or 9 months, that I’ll have to double check.

Gregory Burns – Sidoti & Company, LLC

Okay.

Michael E. Healy

And after that, it flows primarily to the bottom line. So as long as you retain the customer, remember M5 has, as far as we know the lowest churn rate in the industry it’s a very profitable model.

Gregory Burns – Sidoti & Company, LLC

Okay. So I guess so given those dynamics, I guess, relatively quick pay back time and you are keeping these customers well over 10 years on average given your churn. What’s your view or how you are going to manage customer acquisition? I mean does it make sense to get really aggressive, just growing the customer base?

Michael E. Healy

Clearly, this is a business which is growing very fast. As we mentioned in Investor Day, the underlying compound annual growth rate is 30 plus percent. We’d like to take full advantage of this and it’s also a market where there is no market leaders yet, M5 is up there with two or three other people. So we think, we can really do well in this business, so that’s our objective.

Gregory Burns – Sidoti & Company, LLC

Okay, thank you.

Michael E. Healy

Thank you.

Peter Blackmore

Thank Greg.

Operator

(Operator Instructions). We’ll go next to Rohit Chopra with Wedbush.

Rohit Chopra – Wedbush Securities, Inc.

Hey guys.

Michael E. Healy

Hi, Rohit.

Rohit Chopra – Wedbush Securities, Inc.

I have three areas of questions, but I just wanted to go back to the Analyst Day and then the rough guidance you gave for fiscal ’13. Can you just confirm that what you laid out for growth expectations are similar to what you are expecting now. And maybe we can just start with top line, I think, Mike you mentioned inorganic revenue for the company will be 40% to 45% from the top line, is that – we still there?

Michael E. Healy

What we said at the Investor Day, as we gave an objective for what we thought was very doable in the cloud and on premise business that was 20% in both, that’s still our objective. And we also said that those growth levels you get an operating profit of 3% to 5% that would be fair, what we’re going to do though is give guidance rather than objective, guidance each quarter. And we will confirm exactly the growth and the, the operating profit the end of this quarter, end of quarter four, as we think that’s the right way of doing it and keep the old models intact, but the objective is absolutely there.

Rohit Chopra – Wedbush Securities, Inc.

Okay. And then can you come back to, you said that, I think it was revenue from existing customers was a little bit higher this quarter. Can you just explain why it was higher and I understand how it impact your gross margin, I just want to get a sense of why it was, why it was stronger from existing customers this quarter?

Michael E. Healy

Yeah Rohit, it’s Mike. There was revenue from existing customers was 59%, 41% from new customers. And that’s on the premise side only. And that’s pretty typical I think last year Q3 was 44%. So we have some seasonality in the business that I have cautioned you both from a bookings perspective, our Q1 and Q3 are usually stronger, or weaker in terms of getting new customers in Q2 and Q4, stronger in the December and June quarters.

So this is pretty typical, it’s probably a little lower than we expected. The good thing around that is, and it’s pretty obvious now, whenever we have a lower percentage from our new business, from our new customers, our gross margins are better. As we’ve said before, we discount less on those add-on orders, than we do on more orders, and so it always has a positive impact on gross margin.

So as much as I like as many new customers as possible because they typically order, continue to order more and more afterwards. I do like the gross margin impact we get from the installed base ordering as much as they did. So there wasn’t anyone specific reason other than this was kind of typical seasonality we experienced in the Q3 quarter.

Rohit Chopra – Wedbush Securities, Inc.

Okay. And did you notice and the reason I was asking was, I was just trying to figure out were there any pauses by any new customers maybe who were evaluating whether to look at the premise-based solution or the hosted solution. Can you confirm that maybe your sales people saw or didn’t see that?

Michael E. Healy

We haven’t seen any fundamental change, obviously we know when we could not bid on a deal, prior to having the advantage of the cloud division, and there has been no change in dynamics, but as I said at the Analyst Day because we are selling to businesses, people typically make their mind up first or they begin to buy on-premise or cloud and your ability to get into change their mind that’s pretty marginal. So we feel we’re in the best of both worlds now and we haven’t seen any particular change in the two and the sort of requests for RFP in the two businesses.

Rohit Chopra – Wedbush Securities, Inc.

Okay. And then my last question is close rates. Are they, can you just confirm that there are up down the same, I need a number?

Peter Blackmore

The close rates haven’t materially changed, this last quarter. It still rises very good.

Rohit Chopra – Wedbush Securities, Inc.

I appreciate it.

Michael E. Healy

Thanks Rohit.

Operator

(Operator Instructions)

Michael E. Healy

I don’t think there are anymore questions, so let me thank everybody for spending time with us, I really appreciate it. Thank you all. Let’s close the call now.

Operator

And ladies and gentlemen, once again that does conclude today’s call. We do appreciate everyone’s participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: ShoreTel's CEO Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts