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ShoreTel, Inc (NASDAQ:SHOR)

Barclays Capital Global Technology, Media and Telecommunications Conference Call

May 23, 2012 11:45 am ET

Executives

Peter Blackmore - CEO

Mike Healy - SVP & CFO

Analysts

Good morning everyone. Thank you for joining us. We are delighted to have ShoreTel here with us this morning. ShoreTel is a leader in the unified com space and very recently also entered into the hosted VoIP space. Today we have Peter Blackmore, CEO; Mike Healy, CFO and also Tonya Chin here as well. We will go through like I said a brief slide presentation and then maybe a question or two at the end and with that I will pass it off.

Peter Blackmore

So a very good morning to all of you. It’s my pleasure to be here. I’ll move through the slides fairly quickly and then hopefully we'll get some good questions from you. The Safe Harbor statement, which I am sure, you understand we have to pay attention to. Let me start with the presentation and those of you who have followed the company, there is a number of changes in this because recently we closed on our M5 acquisition. We've also updated it with our mobility references. So, as you see on the left hand side, we’re now a much richer company from our application viewpoint and even better positioned to accelerate in the market place because as well as a very strong on-premise offering, we have a excellent cloud offering and a strong mobility offering.

With that, operations are now on the East Coast as well as the West Coast. ShoreTel started in California. So we have premises in Sunnyvale and then we extended out to Austin. With M5, we have premises in Manhattan, in Rochester, New York and Chicago and that will help our growth going forward because one of the challenges we've had about growing in the East Coast in New York is not having a physical premise here, we now have that.

Our customers, we target the market from 50 to 5,000 seats and that’s really important because that is the SMB market. It is not the enterprise market. We’re still seeing very good growth in the SMB market. Our pipeline is very strong and this focus in this area, I think is important. Our target markets are IP telephony, but all of the applications around that, when we sell to a customer, it is a unified communication sale and that’s a very rich sale in terms of productivity tools, conferencing, call center, video, obviously voice. And that differentiates us because of the way we integrate the platform and make it much easier to use and we are public listed company with SHOR as its ticker.

The market has continued to grow and when you look at the market I'd ask you to look at the total of all the bar elements because although telephony is the largest part, the blue bar, the unified communications and contact center enable the complete market. So when we talk to customers, we’re embracing all of that. So it’s a large market in financial year 2013, 17 billion still growing at a single digit pace. We’ve been growing much faster than the market.

We’re also now in the cloud market or hosted market, at the moment a smaller market but accelerating at a compound annual growth rate of 32%, so in financial year 2013 above a billion dollars and moving very quickly to $2 billion within a couple of years time after financial year 2013. Huge opportunity which is why we made the move into cloud and I'll address more of that later. And this is our record of how we’ve outpaced the market and this is purely on-premise statistics because obviously cloud has just been added to the portfolio.

And you can see that the IP market has been variable, declined during the recession in the 2009 period, accelerated again and is now growing in single digits. We’ve typically grown 20% faster than the market and we’re still doing that this year. This financial year we grew at 22% in our first quarter, 22% in our second quarter, down slightly in our third quarter and then we’re looking at higher growth in the current fourth quarter.

Our ability to do that is driven by some very clear winning factors which I will describe. We are a software company, we have 220 developers in our premises company and 30 plus developers in our cloud company. We only have 10 hardware engineers out of that total of 250 people, they design the phones. We built the systems on a distributed architecture for premise which gives very high up time, very high reliability and it is the highest reliability in the industry. We've built a rich portfolio of applications around that and I have mentioned a number of them in the messaging, contact centre, desktop video web conferencing are all part of that.

These are the elements, if you look at the competition they would have a similar portfolio on their unified communication system. The differentiation is ease of use. How ease -- good it is for a customer to take full advantage of all these applications, do it without a lot of complex training and hand holding and make their employees very productive. That’s where we differentiate, we have by far the easiest system to use. That is not because the competition deliberately make it complicated. It's due to the history of how unified communications was built. We are the only company to start from a clean sheet of paper, everybody else build their portfolio by acquisition and they have to decide how do you do that integration? Do you just simply put the parts together in the best way you can which will have an underlying complexity or do you rewrite code to make it very simple. And they chose the shortcut which is to put the applications together, but they are inherently more complex to manage use both for your system administrator as well as the user and that gives us a huge differentiation in the market.

We added a mobility offering 18 months ago, we bought a company called Agito. This has proven to be a very successful acquisition. It's doing a number of things. It enables us to offer unified communications capability, not just on a desk phone which I am sure you've all used in your own offices, but also on a smartphone or a tablet. So you get the unified communications functionality on the go. You have a complete mobile suite that you can affect. It also enables you for example in this hotel, you could make a call using Wi-Fi or using 3G.

So I was on the call earlier this morning, used Wi-Fi, went out for a walk, it moved automatically from Wi-Fi to 3G, came back in the hotel, recognized the Wi-Fi signal is strong again and moved back to Wi-Fi. So you have a lot of ability to take advantage of very low roaming charges. It also enables you to deposit its link to our unified communication system to have the capacity to use your four digit internal number, search for anybody else in the company using their four digit number, have all of the presence tools, voice recording, anything else you want through the system. So it really is a desk phone in your pocket. This is helping us to accelerate our premise business because people increasingly are not just putting desk phones out there, they are adding up a variety of smartphones, whether it be Android or Apple or Blackberry to enable the employees to have even more productivity.

Our platform where we do have hardware, we have a switch, extremely reliable, no moving parts, again a big differentiator. We design our own phones and this complete new range of SIP phones coming out in a few months time which will accelerate I think the phone pick up and then we have our best secure appliances to complete the portfolio.

We don't manufacture. All our manufacturing is done by Flextronics either in the United States or in Asia. In terms of total cost of ownership, we continue to differentiate. The price of the upfront price is not that different from the competition but if you measure the cost of ownership over three, five or seven years typically we have a 50% advantage and that is huge. It's driven by the ability to manage the system much more effectively and you can see that the Aberdeen Group in 2011 gave a system management costs and worked out the number of full time employees per a 1000 phones, the average salary and then built a comparison versus the competition.

So when we are talking to a potential customer and we are not just with the CIO, we are also with hopefully the CFO, this is my goal for our sales force because the company can look at their costs over the lifetime of the installation and we have a huge advantage.

We've added Cloud into our portfolio. Now, why did we do that? You saw the market growth on the earlier slide, the compound annual rate 32%. I have been in the technology industry a long while and my observation is every time cloud has become an accepted alternative for on premise, it will accelerate and take a significant part of the market.

I wanted to make sure the company was in the unified communications business just not on [premise] part of it. That way we can offer the customers a choice. We can offer them best of breed and we looked very hard at this market before we stepped in to it.

We wanted to make sure, should we build or should we buy. We made the decision to buy because all our research showed that it would take three to five years to build. By that time, the market would have moved on considerably and I felt entering the market now at this time is very important.

And then we've looked at 25 voice cloud companies, not because all of them were potential targets, but we really wanted to learn what were their business model is, how they differentiated, what was their secret source and what was their value of proposition?

Out of that, we have some very specific criteria. One was, we wanted the company with the best churn rate in the industry. When you’re selling softwares and service, you want to obviously maintain that customers as long as you can because after a certain number of months and you charge them monthly upfront, all that return comes to you.

So the churn rate is low, the application is very sticky, you got a winning proposition. We wanted a prudent sales model. You sell cloud as a service very differently the way you sell on premise. We wanted an R&D team who had a good understanding of the market and build a differentiated product.

The other thing we decided is we wanted our own intellectual property, our own code. The reason is that gives us enormous ability to integrate applications in the cloud, for example, the company we acquired M5 had already got a very tight integration with salesforce.com to enable the applications to talk in the cloud and to give the customers an even richer solution portfolio.

We also wanted strong gross margins, high ARPU and this company has one of the highest in the industry and where we looked at the leverage obviously across the two companies. We started doing this evaluation in April last year, we first talked to M5 in September, we have a shortlist stand of nine companies out of the 25 we talked to, by November we were down to shortlist of three. We signed the letter of intent early January and closed the transaction on March 23.

I couldn’t be more pleased, M5 bookings are ahead of any projection they gave us of last quarter and this quarter they are on a role and we’ve clearly got a company and a management team and a capability that is with us in cloud.

The other way we differentiate is in customer satisfaction, and this is from [Synergy] research we have been top of the customer satisfaction rankings eight years in a row and this is a big deal with customers.

We’ve also recently done in the last 12 months move to a Net Promoter Score rating and those of you understand Net Promoter Score this is used across industries not just in technology, and enables you to see how people really rank your company versus the competition because it's an independent approach that everybody can use and you can also compare outside the industry.

On that Promoter Score in this current six months is 63. And anything above 60 is world class. Very few technology companies up there. Google would be one that is, so that is a huge impact on our ability to win customers.

We also get good ratings from Gartner. This is for the on-premise business, they are rating it to the small medium business market in North America. This was the latest assessment which is July last year, there'll be another one coming out in the summer of 2012. My point out we are the only company to have a strong positive rating. Again, a huge added value for us when we talk to customers.

Our partners in the channel are very important, we are a 100% channel centric in the on-premise. In cloud, we also go direct which is normal for a cloud company. We have got a good service provider relationships AT&T, Verizon, CenturyLink and Windstream. That is approximately 13% of our business and growing, we have large regional partners CDW, Black Box and others.

CDW, Black Box together grew 58% year-over-year in last quarter, huge growth. We then have and this is relatively new in last 15 months, value added distributors. Our channel is getting so large we decided to add two tier to the smaller partners would move to the value added distributors and the larger partners have the choice of working with distributor or not. And we initially added ScanSource and Westcon have been very successful and in the last six months we added Ingram as well which is ramping nicely.

And then we have a whole host of vast value added resellers who are very loyal to us and help the business grow. So the (inaudible) channel strategy is one of our strengths. And very proud of our customers, a lot of the leading names in the social media you can see LinkedIn, Yelp, Groupon, MySpace and others that we'll announce in the quarter time we [won] some more, lot of folks, franchises, the Giants back in our home State of California we do very well in consulting and finance.

We see some huge names down there. The government but we do not sell much to the Federal Government which in the current economic climate is probably a good thing we do very well in state and local government and education. For example, in California there are 140 major cities in California, we have a 100 of them on our platform. And we are trying to extend that out to other states, so to [speak] governments tend to talk to one another a lot about how is the relationship, what's your understanding, you are enjoying it?

So we get very, very positive references from the government. And last quarter, three of our biggest customers were state, local, governments. So despite any slowdown other people talk about we are not seeing it. Manufacturing, construction (inaudible) not such big markets for us but we do well there non-profit in retail and consumables.

Well basically we sell anywhere where there's a carpet because voice over IP and presence and unified communications helps productivity. On last quarter, revenues were up 9% that included tiny part of M5 we closed on the March 23. Our margins were better than expected so we are winning the business but not discounting.

Our margins are actually are a point above what our guidance was. Our market share gained Synergy research has just come out and our market share is now above 10%. We are one of the few companies to gain market share in the last quarter, doing very well and we are generating cash from operations over the last three quarters, its [$10 million]. And we are looking at a very good quarter.

We've given guidance to the current quarter. I said this at the conference last week, I am repeating it now. Our pipeline is very good. Our close rate is good. We are on track for this quarter feeling good about it. And I would just like to reflect because the market on technology, market’s a bit down and technology is getting a little bit hammered. We are in the SMB market and our pipeline is very strong so that maybe different to the enterprise market.

In Europe, we have a small business primarily in the UK but any downturn in Europe has a minimal impact on us so that's a positive. We also as I said earlier don't sell to the Federal Government and we see still growth in state and local. So we're seeing it a little bit differently. Our pipeline is good. We're on track for the quarter. And we're positive about the next six months into the year. Now, things may change but that's the way I see it at the moment. And I get update every week from the sales force about their pipeline, their close rate, and how the quarter is going.

Internationally, it's growing part of our business, particularly in Asia. It's 12%, grew 52%; lots of opportunity, particularly in Asia and Latin America, for obvious reasons. We've got lots of opportunity in Europe, but I think given what's happening in Europe, that there'll be less growth there. Canada, Mexico and Asia are really strong. We are going to continue to invest internationally. Our market share is much lower than it's in United States. Huge upside for us.

And M5, the cloud business, is present in the United States. In Canada, it's not that hard to take cloud overseas. So we will be looking for that as a further growth potential in the next year. We've got a long-term model with a combined cloud and on-premise and mobility solutions. We see margins in the 62% to 64%, and R&D declining as a percentage of revenue. At the moment, it's quite high. We've been growing fast. We're building out our portfolio.

But we now have a very rich offering in both on-premise -- we need to do a little bit more investment in cloud. So the R&D can come down very naturally because you don't need to scale the R&D as fast as we're scaling revenue. We do invest in sales and marketing. It's still a relatively small company, where our market share in California is much higher than our market share on the East Coast. That is because we need more feet on the street.

We need more channel partners on the East to balance the market share. Operating margin, we see by -- $400 million average annual revenue, operating margin in the 8% to 13%. And today, we're getting close to $300 million. So we are very positive about our growth opportunity. We're positive about our ability to deliver profit. And I've said at the investor conference that we had in March, our objective is to deliver operating profit for financial year '13, which starts in July. So, we're feeling good.

So let me stop there and we'll have some questions. Please?

Question-and-Answer Session

Unidentified Analyst

Can you just review why someone would choose a cloud offering versus on-premise, and to what extent does cloud have a potential to cannibalize your on-premise sales? And sorry -- profitability between -- difference between cloud and on-premise?

Peter Blackmore

All right, so I'll let Mike answer part of that. So I'd give him a chance to talk. Let me talk about the fundamental issue; will there be cannibalization between cloud and on-premise. Our observation is that before we had cloud, we were seeing an increasing number of RFPs coming in, which specific they want cloud.

We used to talk to those companies, and it was pretty much a waste of time getting to try and think differently. Their CTO or their CIOs had made a decision which applications go in the cloud, which applications go on-premise. So it was becoming very obvious to us that it's not cannibalization so much as you miss out on a growing part of the market, unless you have both solutions.

When we presented to our Board how the combined markets would look, we said there may be some small cannibalization under 50 seats, but once you get above 50 seats, we really don't see that. And certainly, that's our brief experience so far. We did see lots of synergies. For example, M5 is a competitive hosted platform where our R&D team is enabling ShoreTel to go on their solution.

At the moment, they have a good channel but we have a 600 channel organization in the United States alone. Many of our channel partners have said to us, we were looking at alternatives because we didn't know what your view was on hosted until you announced M5. We are now engaging with M5. They are very excited. So that's the synergy.

We also couldn't handle some leads where people wanted cloud but not on-premise. Now those are being passed directly to cloud. And we are already using advantage of R&D leverage. They've taken our mobile phone offering, demonstrated at investor day and we're launching it. So, lots of synergies. So Mike, could you cover the other parts of the question.

Mike Healy

Yeah, on profitability, just a couple comments. So for fiscal year '12, we're hoping to get to profitability. If we hit the high-end of the range of guidance we gave on revenue and gross margin, then there's a chance that we can get profitability for the full year. That wasn't the specific guidance, but if we do better than expected we can get there, and we're striving to try to achieve that. For fiscal year '13, we said we're committed to profitability.

We'll have some -- we'll make a few adjustments to our cost structure to get there. And then you saw the long-term margins of 8% to 13% operating margin. This split between premise and hosted, in the long-term hosted probably would be higher operating margins and obviously lower gross margins from where we are today. And then on the premise business, I think we can get into double-digits as part of that.

So in the long-term, more of the growth would probably come from the -- profitability would come from the hosted business as that recurring revenue model just continues to kick in. Remember, it's a -- most of the revenue in that is monthly recurring revenue. It's about 80% of that. So as long as you keep your customers happy, continue to book new business, which we are, then that model works very well.

Peter Blackmore

Any other questions?

Unidentified Analyst

Peter and Mike, if one looks at the revenue line over a couple of year basis, then there's been tremendous progress. They are 50% higher, plus or minus, a couple of years ago. At the same time, the EPS continues to bump around break even. Help us sort of reconcile sort of revenue growth with the profitability. And then, I think the more important question is why should -- where's the -- what should give us the confidence that the profitability will start to inflect over the next year or two?

Peter Blackmore

The growth over the last few years was fueled by adding channel partners, changing to their distribution, and adding sales people regeneration. For example, in 2011, we increased the sales force by 30%. 2012, we're increasing it by another significant percent. And our sales force is about 230 people, so it's not huge. But we needed to get to a certain critical mass. Now we still plan to grow the sales force that you start to get more leverage in the model.

The leverage comes from R&D. The leverage comes from G&A. And we can look at our sales force's productivity effectively and dial that increase up or down. So we now have good visibility going into various growth models next financial year. We feel very comfortable about delivering the profit. And that's a little bit different from what we've done in the past, which is reinvest all of the things to get us more growth leverage. We're now at a scale where we can start delivering the profit.

Unidentified Analyst

I think we'll need to move to the break-out. Liberty 5. Thank you.

Peter Blackmore

We're happy to answer your questions offline. Thanks again. Pleased to hear, thank you.

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