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Executives

Peter Blackmore - CEO, President and Director

Michael E. Healy - CFO, Principal Accounting Officer and SVP

Kevin Gavin - Chief Marketing Officer

Tonya Chin – Director of Investor Relations

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Sanjith Singh - Wedbush Securities Inc., Research Division

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

Michael Latimore - Northland Capital Markets, Research Division

Gregory Burns - Sidoti & Company, LLC

Christian Schwab - Craig-Hallum Capital Group

ShoreTel, Inc. (SHOR) Q4 2012 Earnings Results Conference August 14, 2012 5:00 PM ET

Operator

Good day and welcome to the ShoreTel Fourth Quarter 2012 Earnings Conference Call. Today's conference is being recorded. At this time, I would 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 fourth quarter and fiscal year 2012 financial results. Joining me on the call today are ShoreTel's CEO, Peter Blackmore; and Chief Financial Officer, Mike Healy. Additionally, Kevin Gavin, Chief Marketing Officer is joining us for participation in our question-and-answer session.

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 Annual Report on Form 10-K for the fiscal year ended June 30, 2011, its 10-Q for the quarter ended March 31, 2012 and the current report on Form 8-K furnished today.

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, other adjustments and the related tax impacts. During today’s call we will be discussing both our fourth quarter and full fiscal year 2012 results.

And finally, ShoreTel management is planning on attending the Mizuho Securities USA Technology Summit on September 11th in Boston and the Deutsche Bank 2012 dbAccess Technology Conference in Las Vegas on September ‘12. And we have to see there.

Now I will turn the call over to Peter.

Peter Blackmore

Thank you, Tonya. Before Mike discusses the financial results and metrics, I would like to share a few highlights of the quarter and the year and our strategy heading into the fiscal 2013. I’m proud of the teams’ accomplishments for the quarter, which kept off a significant year for ShoreTel.

During the fourth quarter, we delivered revenue growth of 39% with revenue of $78.5 million, which was above our guided range of $72 million to $77 million. In fiscal 2012, our revenue rose to $246.6 million, a 23% increase over the last year. Even if you exclude the revenue from our M5 acquisition. Our growth was a healthy 15.5% year-over-year, which I’m confident we will be better than the overall IP Telephony market share when we see the final results for June. And we delivered non-GAAP operating profit for both the quarter and the year.

I shall now spend a few minutes discussing the results of our premise business. Our premise revenue of $64.2 million grew 17% sequentially and 14% year-over-year. In addition, the fourth quarter was our best ever in the government and education sector with revenues growing 38% sequentially over the third quarter.

With the budget constraints that these organizations face today, this is solid evidence of ShoreTel’s compelling value proposition, which resonates very well with resource constrained customers. Additionally, our pipeline remained strong throughout the quarter, an encouraging signal as we head into our new fiscal year. Despite the macroeconomic uncertainty, we drove continued growth and captured market share.

Based on the latest data from Synergy Research, for the quarter ended March 31, 2012, based on revenue in the U.S. enterprise IP Telephony market, we achieved our largest quarterly gain ever growing a 120 basis points in one quarter to 7.7%. This progress further solidified our number three position in the marketplace.

And in our sweet spot, the pure IP U.S. telephony market with less than 5,000 users, we displaced Avaya to secure the number two position. Even in Europe, where economic concerns continue, we grew our market share. With regard to our partners, we saw most of our sequential increase coming from our regional partners as well as strength from all of our international locations, which helped to drive our better than expected results.

Additionally, Ingram Micro, our newest value added distributor ramped up well with revenues growing over $1 million from our third fiscal quarter. In the last few months we made important changes to our sales organization to further drive growth and enhance our focus on both our domestic and international markets. In fact our results this quarter indicate that these changes are already making a positive impact. I’ve been heavily involved in this process and I’m confident that these steps will help improve so its productivity.

Additionally, I’m pleased to welcome David Petts as our new Senior Vice President of Worldwide Sales. I had the pleasure of working with David during my time at HP and Compaq and on first hand of his leadership skills and strong drive. Most recently David was at Nokia, where he held various executive leadership roles in sales and marketing and over saw the global relationship with AT&T.

This quarter we secured several notable customer wins for our premise business, including a large add on order from Vertex Pharmaceuticals, a U.S. based company with sites in the United States, Canada and the United Kingdom. Vertex’s deployment includes both a 3,000 licenses and a total sale was in excess of $1 million. Vertex’s move to ShoreTel was driven by its desire reduce operating expenses of its legacy Nortel system and improved calibration between its sites.

We’re pleased to see EOG resources and existing ShoreTel PBX customer and our mobility solution to its unified communications platform. EOG is one of the largest independent oil and natural gas companies in the United States and is a Fortune 500 company with approximately 2,300 employees. EOG originally ordered our mobility solution for 200 employees that work in remote field locations in order to leverage Wi-Fi at these facilities where the cellular signal is not available. After the initial deployment, EOG added an additional 800 mobility licenses for general deployment throughout the Company.

And finally, we’re proud to name yet another technology leader in the social media market to our roster of clients. This quarter we added Twitter, one of the top 10 most visited websites. As part of its plan move to a new office, Twitter was searching for a UC front system for its 900 employees. Twitter was considering Cisco, which shows a ShoreTel system that allow the company to seamlessly interact with business applications, including salesforce.com.

We also continue to strengthen our product portfolio. Last month we announced the global availability of ShoreTel 13, which includes enhanced capabilities for video communications and IM for overall employee productivity. ShoreTel 13s video capabilities are built using open standards to support the most popular video room systems. This enables ShoreTel communicator users to participate in room based video conferences using their desktop or laptop computer either in the office or working remotely and adding a new level of simplicity to productive video collaboration.

ShoreTel 13 also introduced instant messaging for ShoreTel communicator giving every ShoreTel user access to instant messaging at no additional costs. To further enhance ShoreTel’s total cost of ownership advantage, ShoreTel 13 also includes enhancements to ShoreTel SIP Trunking Integration. These enhancements make it easier to customers to take advantage of the cost savings of SIP Trunking.

Now I will move to some highlights from our Cloud Division. During the fourth quarter, we were very pleased with the demand for our cloud business, recording strong bookings that were 43% better than M5’s performance in the June quarter last year. Our bookings rate continues to exceed our install rate, resulting in over $0.5 million backlog of monthly recurring revenue as of June the 30th. This increasing demand validates our confidence and the recently acquired M5 business and strengthens our confidence in the potential for the cloud markets. But it also requires us to invest in the infrastructure, so we can ramp installs even faster.

Our high monthly recurring revenue is a validation of our premium service, which customers are willing to pay for and also uniquely positions us in the cloud market. The acquisition of M5, it was based on our belief that the cloud represents a tremendous opportunity as well as provide ShoreTel a stable and growing, recurring revenue base. We expected revenue benefits such as access to our channel partners and shared lead generation. But our original plan was not built around significant cost synergies.

As we have progressed through the last few months, we believe that there are a number of opportunities to capitalize on cost synergies in product development. The integration of ShoreTel mobility into our cloud solution is an early win on this front. We successfully ported on mobility technology to our cloud solution in the first 90 days, and have already started offering ShoreTel mobility to our cloud customers.

During the integration process we’ve been pleased to discover greater opportunities for synergies that will deliver cost savings over time and more importantly lead to creative new products and services. We believe that we can develop most applications collaboratively and deliver them to both premise and cloud customers, which would improve the impact of our research and development investments.

Overall, we expect this will reduce our fiscal 2013 R&D expenses as a percentage of sales by 3 to 4 points from fiscal 2012. Looking to what lies ahead for fiscal 2013, we’re in the midst of significant industry change. Unified communications are developing at a tremendous pace to adapt to both the growing demands from mobile solutions by end users and a shift to cloud based solutions that is happening faster than many expenses – expected.

Our solutions solve the complex problems created for unified communication in the mobile workplace. Today work never comes to a complete stop. We are no longer bound to our desk and workers want more than desk phones and PCs they demand, desktops, laptops, smartphones and tablets. Whether in a conference room, at home or on the road, workers need all of today’s tools at their fingertips and it needs to be easy to use, to encourage adoption and maintain high productivity.

The role of IT has clearly changed in this new era of mobilized workforce. Today the end users experience and needs reigned supreme. It is no longer the gatekeeper for our technology and tools, but an enabler to help maximize productivity. Speed and ease of use are crucial. We are confident that mobility and the cloud will play a central role in the UC industry in the years to come and I’m convinced that ShoreTel is in the leadership position as we enter this new era.

Our heritage of industry leading premise based solutions combined with our mobility and cloud technologies make us a visionary leader in this space. The 43% year-over-year growth in cloud division bookings this quarter strengthens our conviction and validates industry focus that show cloud solutions growing from 6% with market today to reach 15% to 20% of IP telephony sales by 20-60. This represents an annual growth rate of over 30%.

Cloud business is ramping faster than we had anticipated, so we need to accelerate some investments in infrastructure and operations to ensure a robust customer experience for all cloud customers. We plan to continue to have modest profits in the premise business of fiscal 2013. We see the overall premise market expanding in single-digits in fiscal ’13 and we expect to continue to take share and grow substantially faster than the overall market.

We have adjusted our spending to drive further profitability and also reallocated some spending to develop a hybrid solution architecture. Using this new architecture, we plan to build applications, once that enable implementation in either the cloud or on premise significantly leveraging the R&D effort with a combined product roadmap.

There are many ways this technology could be used, including users that want to deploy a premise based system for all the headquarters, receive the benefits of a cloud solution for their satellite opposites. Other customers they want to have a premise based UC system that prefer applications for example mobility, call center and collaboration to be delivered from the cloud.

We’re also focused on further enhancing the short-term mobility experience to ensure it delivers on our brilliantly simple promise. We have found that most Voice over IP players in the unified communication space have not integrated mobile technology effectively. This is emerging as one of our key differentiators, and a contributor to our market share gains.

In summary, we strongly believe that ShoreTel has the technology to win in this ever changing work place with unrivaled choice and flexibility.

Our premise solution offers a simple, feature rich and scalable system to both IT and the end user. We now offer cloud solutions through a dedicated division, and are delivering state-of-the-art mobile solutions were both premise and cloud configurations. We also plan to extend this with the development of hybrid solutions, which allow users to have a seamless combination of on-premise and cloud applications.

We believe these enhancements will build upon our strength in premise, mobility and in cloud and take us a step closer to market leadership. We have an opportunity to owe the market leadership position and we intend to claim it.

With that, I will now turn the call over to Mike.

Michael E. Healy

Thanks, Peter. I will first review the financials of our consolidated business and then cover some specifics of our premise and cloud businesses separately. In the fourth quarter total revenues increased 39% sequentially to $78.5 million, which include our first full quarter revenue from our cloud division. Excluding the cloud division revenues of $14.3 million, our organic premise based revenue grew a healthy 17% sequentially to $64.2 million.

Specifically in our premise business, we saw a 20% sequential increase in product revenues to $51.1 million. Service and support revenues were up 4% in Q4 to $13.1 million. International revenues were $8.1 million for the quarter, up 14% from the third quarter on the strength of a large sequential increase in EMEA. International revenues represented 13% of our total premise business.

And now surprisingly our service provider business showed a smallest sequential quarterly decline of 3%, which is consistent with what many others in the industry have been seeing from this customer group. Service provider billings represented a 11% of our total premise billings. Within our vertical markets we have best ever quarter in our government and education segment. With three of our top 10 deals coming from this vertical.

Financial, education, and government, and industrial continue to be our largest segments in the quarter. Billings from new customers represented 45% of our premise business billings, up from 41% last quarter. And we added over 1,200 new customers, our second best achievement in history. In our premise business we shift approximately 151,000 end user licenses in the quarter, an increase of 20% over the last quarter and had over 500,000 Licenses shift in our fiscal year.

Our sales pipeline continues to grow and the conversion rate of that pipeline increased nicely over Q3. Notably, we had a record number of large deals this quarter and our two-tier value added distributors ramped nicely due to a strong increase from Ingram Micro. 39% of our premise revenue shipped through our North America VADs in the quarter. Now turning to our cloud business. Q4 marked up first full quarter of activity as the M5 acquisition closed on March 23. Revenue of $14.3 million reflected the change we instituted this quarter for revenue recognition on installation fees that I mentioned on last quarter’s call that requires us to recognize these fees over time typically either over the contract term or expected customer life.

One new important revenue metric we will continue to share with you is our recurring revenue as a percentage of total revenue, but Q4 recurring revenues represented 30% of our overall business including the monthly recurring revenue from the cloud division as well as support amortization revenue from our premise customers.

Bookings in the cloud division significantly exceeded our internal projections as we hit an all time high. We added 135 new customers in the quarter and continue to track larger customers who see counts in the 100s. Our monthly average revenue per user or ARPU was $62 and our average revenue number of seats per customer increased slightly to 34. I will remind you that ARPU metric includes transport that we resell that could as a percentage of our business decline over time, as our average customer size increases and therefore they are more apt to have their own networks already established.

Our revenue churn rate declined quarter-over-quarter to 0.03% on a monthly basis. Our gross margins in the cloud business was slightly lower than expect at 42.2% as we ramped up operations in customer premise equipment costs. Our Q4 combined non-GAAP gross margins were 62.6% with non-GAAP product gross margins of 67%, support and service non-GAAP gross margins of 67.5%. I was pleased to see our product margins hold up nicely in Q4 even though we had a fairly large increase in billings from new customers which typically tends to negatively impact gross margins in our seasonally strong quarters.

Q4 non-GAAP operating expenses were $48.5 million at the top-end of the guided range of $47 million to $48.5 million. Operating expenses rose from Q3 due to a full quarter of expenses from the cloud divisions in addition to higher expenses related to increased incentive compensation driven by higher revenue and bookings achievement across both divisions. We saw excellent improvement in our sales productivity in the quarter and in the quarter with 230 premise quarter carrying sales people an increase over 11 in the quarter and a 21% increase for the year.

In the cloud division we have approximately 16 quarter carrying sales people as of the end of June. Therefore we had a small non-GAAP net loss of $210,000 of breakeven in terms of earnings per share. The net loss includes $663,000 of other expenses which includes $450,000 of foreign exchange losses related to the unfavorable impacts associated with the movement of the pound and euro against the U.S. dollar and $263,000 of interest expense offset by a small amount of interest income.

Our GAAP net loss of $5 million or $0.09 per share included $3 million of stock compensation charges, $1.9 million of amortization of acquisition related intangibles, other charges and the related tax adjustments. I’m pleased to report that we generated non-GAAP operating profit in the premise business of an estimated 2.5% in the fourth quarter. Now let me review some of the balance sheet highlights.

Cash and short-term investments were down $5.8 million to $55.5 million. For the quarter we generated approximately $374,000 in cash flow from operations mostly related to a reduction in inventory levels. The decrease in our cash from last quarter was the result of pinning down our line of credit by $5 million in the quarter which now stands at $20 million with $30 million of additional credit capacity available to us if needed.

For the year we generated over $10 million of cash flow from operations. Looking forward we expect to continue to generate cash flow from operations in fiscal year ’13 and plan to continue to pay down our line of credit while maintaining our cash balance near the $50 million level. Accounts receivable of $34.2 million were up $1.5 million on the $22 million sequential increase in revenue in the quarter. On a combined basis, using the quarterly average method our day sales outstanding were great at 39 days.

Inventory decreased by $3 million to $20.2 million due to seasonally strong sales and a slight decrease in inventory held at our value added distributors. Deferred revenue was relatively flat in the quarter at $49.5 million due to reduction in deferred revenue with our value added distributors. Capital expenditures were approximately $1.6 million and depreciation and amortization was approximately $3.8 million. And we ended the year with 933 employees up 24 from the third quarter.

Next let me do a quick recap of fiscal 2012. Revenues of $246.6 million were up 23% from fiscal 2011. This included 15% organic growth in our premise business and 8% attributable to the acquisition of M5 in March of this year. Non-GAAP gross margins were 65.4% down from 67.3% in fiscal 2011, mostly due to the impact of cloud business gross margins in the last quarter of the year.

The non-GAAP net loss in fiscal 2012 was $1.4 million and included $1.7 million of foreign exchange losses in the interest expense. This compares to the non-GAAP net income of $0.7 million or $0.01 per share in fiscal 2011. We did meet our objective at delivering a small amount of operating profit of approximately $200,000 for fiscal 2012. Now let me review our progress in our premise-based business.

We had spoken with many investors over the last couple of quarters that strongly urge us to show profit in the premise business. After realigning the headcount resources in early July, we reduced our expenses in R&D to be more in line with the industry average and expect that for fiscal year 2013, R&D expenses will be 16% to 17% of revenue versus the 20% we averaged in fiscal 2012. With these changes, as well as the expected increase in revenue in fiscal 2013 we expect our premise business to continue to show above market revenue growth and continued profit leverage.

As Peter mentioned, we plan to use these profits to fund the investments we need to make in our cloud business in the operations, systems and infrastructure areas. On a consolidated basis our current expectation is to generate a small amount of operating profit in fiscal year 2013. Next I'll discuss our outlook for September 2012 quarter.

Based on our backlog, billings and business book-to-date, we expect revenue to be in the range of $69 million to $75 million which represents 28% to 39% increase over our first quarter of fiscal 2012. While we have not seen much impact from the macro environment through July, our guidance reflects a level of conservatisms on the macro conditions as well as seasonality which drove 5% decline in revenue in our premise business from Q4 to Q1 last year. I want to remind you again to adjust your models to reflect the seasonality in our business which typically has slower and negative revenue growth in the September and March quarters.

For the September 2012 quarter we expect non-GAAP gross margins to be in the range of 62% to 63%. GAAP gross margins are expected to be approximately 200 basis points lower due to the inclusion of $1.3 million in stock-based compensation and other charges.

We expect non-GAAP operating expenses to be flat or down slightly in the September quarter and therefore expect Q1 non-GAAP operating expenses to be in the range of $47.5 million to $48.5 million. We expect GAAP operating expenses to be in the range of $51.5 million to $52.5 million including approximately $4 million in stock-based compensation and other expenses.

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

Peter Blackmore

Thank you, Mike. I would summarize fiscal 2012 as a year of significant change which I believe position ShoreTel both continued share gains and both the premise and cloud markets. We have good leverage opportunities in both our cloud and premise businesses. As we look ahead to fiscal 2013, I am inspired by the opportunity that lies ahead. I am convinced that ShoreTel has the right people and the right technology to claim a leadership role in the new era of unified communications. Much work is before us, and I look forward to sharing our progress next quarter.

With that, thank you, and I would ask the operator to open the line for questions please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll take our first question from Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Thanks so much. Just a couple of questions; Peter, I was wondering on the education and government vertical, could you talk about what the expectations are going forward in the upcoming September quarter. How large it is and sort of in the percentage of revenues and then, Mike just on the profitability part of the equation, I am guessing that you’re basically skewed towards the second half of next year in terms of getting to profitability if you’re looking at just a slight profit for the full-year, any color on that would be helpful. Thanks.

Peter Blackmore

So thank you Sanjiv, and on the first part of your question, just remind you that we also saw good progress in our other strong verticals such as financial, legal and we’re very pleased to see the education and government and I think that can continue in the current quarter. Our team there, we have a dedicated team that works with these businesses and I’ll make sure the procurement processes and everything are organized, so they continue to be positive about that.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

And how large is this, sorry – [in terms] of how large it is …?

Michael E. Healy

Yeah, in terms of size Sanjiv, the government vertical which is we put education in there, it ranges every quarter kind of between 15% and 20%. This quarter certainly we saw a much bigger increase in the education side of that vertical than the government side, but that’s one of our strongest verticals and before we mentioned, usually it ranged between 10% and 20% each of those four. And to answer your second question on profitability, yeah you’re right it’s more skewed to the second half, given the seasonality we’re expecting to see in Q1, we’re obviously guiding to a small loss depending on the range, but after that assuming we continue to grow revenue we should see profits on the premise side.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it. Thanks so much.

Michael E. Healy

Okay, Sanjiv.

Peter Blackmore

Thank you. Next question please.

Operator

Our next question comes from Rohit Chopra with Wedbush Securities.

Sanjith Singh - Wedbush Securities Inc., Research Division

Hi, this is Sanjith Singh for Rohit Chopra. Thanks for taking my questions. Peter, I wanted to get some clarity on the areas for leverage. So I think you mentioned about rationalizing product development cost between the two business divisions, so R&D would come down. I think you said about 3 to 4 points. Would that be offset by the other areas of the business. How should we think about sales and marketing? How should we think about G&A?

And then my second question, obviously large deals in the quarter certainly helped in Q4. How do you feel about the overall strength and momentum in the business? Are you seeing more caution out there in the environment relative to your Q1 guidance? How do you feel about the business going forward?

Peter Blackmore

Okay. Thank you very much. I’ll ask – answer the second one first, which was your overall momentum in large deals. Our pipeline was strong all the way through the quarter. We had a strong close that continued in July which is the first month of this current quarter. We’re obviously aware that some of our peers are seeing less favorable conditions, so we’re a little bit cautious looking forward, but we have not seen any impact to last at this stage.

And then the area about leverage, remember we have two businesses now. There’s leverage in both businesses. In the premise business the leverage comes from improvements in R&D, we have made the steps already in July to do that. We have invested a little bit back into this new hybrid architecture that I talked about, which I think will help give further leverage for the year and this is a plus in terms of the synergies over and above what we originally intended, because our engineers have come back to us and said; gosh, we can really build once and deliver twice, which is a tremendous thing for an engineer to tell you. So, we can deliver an application and put it in premise or cloud and you have one effort but two results.

And we also see this development of hybrid which will strengthen both premise and cloud by giving customers more flexibility. Now as the business keeps scaling, we do need to increase sales a little bit. We have modest increases in quarter four, 11 people. We’re driving for further productivity improvement, that is an ongoing activity this year, and it’s something that I am very focused on. So, we’ll give you results as we come on with that. And then we’ve already made the synergy savings I think from finance, IT and HR, there were not many there but as we confine those aspects of the two businesses. But in the cloud business obviously you have a fantastic recurring revenue model.

What we’re doing at the moment is taking advantage of this tremendous growth. We were planning 30% growth. It actually came out at 43% which is 13% better than we were expecting and our bookings are ahead of the ability to install, so we just need to put some more infrastructure in. It’s a very – if you like good model’s and they got 16 sales people today delivering all of that. We do see further synergies as we told you about before which is synergies from our channel.

We have allowed our channel to sign up for the referral program, many of them are now waiting for a selling program with cloud which we plan to announce at our partner conference which is coming up in November and then we see also synergies like porting mobility to cloud and that’s only just started but there’s leverage there. So, there’s lots and lots of leverage here were being – I think managing the business well to enable this high growth, but also illustrate that the premise business is good leveraged today and the cloud business will have tremendous leverage as we go forward. Hope that answered your questions.

Michael E. Healy

Going ahead Sanjith, you mentioned about sales and marketing leverage and there’s less cost synergy there, but there’s more upside revenue leverage. We will be announcing the rebranding of M5 to become ShoreTel branded in September and so there will be some efficiencies and some increased momentum being able to drive the single brand and having both solutions. So it’s less in that front of that cost savings and more about assisting in driving additional revenue.

Peter Blackmore

Good point.

Sanjith Singh - Wedbush Securities Inc., Research Division

I appreciate it. Thank you.

Peter Blackmore

Thank you. Next question please?

Operator

Our next question comes from Dmitry Netis with William Blair.

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

Nice quarter guys.

Michael E. Healy

Thanks, Dmitry.

Peter Blackmore

Thank you.

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

Okay, let’s talk about the guidance. So, one thing I am trying to understand obviously its light and I realize the seasonality in the business, but if I factor in the midpoint of your guidance I am at roughly – so, I am at $72 million for Q1 which would imply you’re sequentially down about 8% versus last year’s 5%. And clearly you’re indicating your pipeline is doing well and you have this opportunity with M5 to increase your revenue. Why, guidance the way – why guided the way you provided this for Q1, so if you could elaborate on that, that will be great.

Peter Blackmore

Yeah, I’ll let Mike elaborate, but it’s a combination of two things, risk seasonality just so like there was last year, and we’re being cautious about the overall environment. It hasn’t affected us yet, but we don’t know. So, it’s a combination of those two things. So, Mike.

Michael E. Healy

Yeah, I would just add that seasonality is a pretty big influence on our business. Our end of fiscal year is June and so the sales guys are really moving fast and hard to get to the quarter of the year-end results and then we always have a little bit of drop off in the activity in the September quarter, and so that’s reflected and then, we look around and we see a number of our peers and our competitors talking about slowdown and while we haven’t seen too much so far in July, we got to be cautious that it’s not – we’re not immune to some of those macro economic conditions at times.

And then the service providers were making some investments there. We need that business to start coming back and rebounding too, but a lot of our peer companies have not been getting a lot of revenue out of the service providers, the big token of this you will. So all that factors into how we set the – certainly set the guidance and at the top-end of the guidance is 39% year-over-year which is pretty close to the 40% we kind of said at analyst day that on a combined basis we would be shooting for. I look at that and say we’re not too off from what we said in March.

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

Okay. And then if we were to sort of break into the product lines here, clearly the on-prem business probably is going to decline in Q1. Since you have the subscription revenue and you have a nice backlog there on M5 side, that’s what basically that means, you’re not providing M5 revenue for September, are you? Or basically how should we look into M5 business, if we were to take the recurring revenue $14.3 million this quarter and added that backlog that you mentioned, I think you said $0.05 million that would get me to about $14.8 million for September. Would that be the right way to look at your M5 business for September quarter?

Michael E. Healy

Well, yeah clearly our expectations is that cloud business will be up over the June quarter. But, I am not going to split the guidance up between the two divisions. I'll give you the actuals when we report them. That MRR backlog – the backlog takes anyway from 0-90 days on average to install and then really what you have to do is layer it in each month how much MRR you’re getting and add that. So if it all installed the first day or the first month of a quarter you could add three times that amount, right, but it layers in and numbers are prorated and stuff. So that whole backlog may get in, in the quarter, I don’t think so and then we get new bookings in the quarter. So, we do expect an increase but it’s not as simple as just taking the 500K of backlog and then add it to what we did, because it layers in over time.

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

Okay, that’s very helpful, great. And couple of more questions if I may?

Michael E. Healy

Sure.

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

On the gross margin, how should we think about your gross margin profile for both on-prem and the cloud business. M5 was at 42.2% that’s below the guidance. What should we be assuming going forward for M5 and equally for your on-prem product gross margin?

Michael E. Healy

Yeah, so Dmitry it’s that – we want to make sure we understand. We’ll have a new name for you soon, but it’s – the cloud division is what we call the (indiscernible)

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

Short-term cloud. Fair enough.

Michael E. Healy

That’s short-term cloud, so the gross margins last quarter non-GAAP were 42.2%, that was a little lower than expected and part of that was due to the – we had a little bit of miss on the revenue line, and then a little bit more investment we’re making on the cost side contributed to that. So going forward, I am still sticking with my guidance there that, that gross margin in that business should be in the mid 40s, going forward, ideally its scaling up as the revenue grows, but there’s always going to be some incremental investments you have to make in data center build-outs and customer CapEx those kind of things.

Now, and on the premise side; it goes up and down a little bit, but nothing expected significantly to change if we’re dropping revenue like you were kind of guidance you this quarter obviously there’s a little bit more stain because there is a little bit of fixed element on the cost side of things. So, I predict margins to go down a little bit potentially on the premise side and then this quarter obviously as cloud is the bigger percentage of our total revenue that has a little impact negatively on the total company gross margins.

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

Got you. I was just going to say the product, on-prem product as you ramped, so are you through ramping your, I know Ingram probably is still ramping, but all the others – all the other VADs are there ramps where you are comfortable, where your gross margin kind of got shake out going forward, so there’s no more impact from that?

Michael E. Healy

From the VADs?

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

Yeah.

Peter Blackmore

Yeah, the VADs were 39% of our business this quarter. We still want them to ramp up as our revenue scales, but I don’t think you’ll see a wholesale increase that they increased substantially, certainly we want them probably between 40% and 45% of our business …

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

And it shouldn’t impact your margins going forward? Okay.

Peter Blackmore

Yeah I mean, not in a material amount. A little bit because the business through the VADs is a little bit more discount but nothing significant like you’ve seen over the last couple of quarters as it ramped up.

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

Understood, okay, great. And then last one here, just sort of as we look out into fiscal 2013, and I need to go back to your analyst based predictions of 20%, 25% organic growth, but can you give us sort of your new thought process around that guidance and what you just mentioned that you’re planning to grow above the market revenue growth, which to me seems it might be low single-digits, flat to low single-digits kind of is how I’m thinking about the market growth here. How should we think about your growth, vis-à-vis that made guidance?

Peter Blackmore

That’s a fair question Dimity and you put your finger on it. The change from March what we are talking 20% plus has been, it’s a slower projection for market growth, that time we were talking 7% to 9%. Right now it’s flat to even slightly down in the last quarter they reported which was Q1, we’re waiting for the report for Q2. And as I said I think we will have gained shares again in quarter two, so given that background we intend to grow as fast as we can and grow profitably, but it’s not going to be at the 20% level.

Michael E. Healy

And then I would add on the cloud side, we’re very comfortable with the guidance we gave of 20% plus on the cloud revenue. We’re not going to give annual revenue guidance or anything but we’re very comfortable that it will be greater than 20%.

Peter Blackmore

And remember we’ve consistently been able to grow 15 to 20 points above market in the premise – that’s the premise business. Cloud business is towards a different dynamic, but that’s something you should think about and in terms of because we’re not giving guidance for the year, but that’s something you should think about in terms of planning.

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

It sounds like you might not be growing your on-prem business that 15%, 20% above market or will you – I am just trying to sort of nail the thing?

Peter Blackmore

I’ll say that’s historically what we’ve done. So, I think if it’s a – such financial debt so you can take that into account; it depends a lot of the underlying market growth which has certainly slowed down and that’s the different between now and March.

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

Very good. Okay, I appreciate that. Thank you very much. I will cede the floor.

Peter Blackmore

Thank you.

Operator

And we’ll go next to Mike Latimore with Northland Capital.

Michael Latimore - Northland Capital Markets, Research Division

Hi, thanks. Good evening.

Peter Blackmore

Hi, Michael.

Michael Latimore - Northland Capital Markets, Research Division

See on the, this new hybrid architecture, and as you sell a hybrid solution is that going to be, is all the revenue going to be recognized over 12 months or is there going to be some upfront recognition?

Peter Blackmore

If it’s a typical recurring revenue model it’ll be recognized a month at a time. So, we haven’t enhanced any products yet, so this is a strategic statement about the additional revenue streams we’re getting excited about as we look at the power of the combined companies and we’ll give you more detail once we come to a product announcement, but we do believe we are in a very strong position to build on the promise of hybrid capability which will give us further growth.

Michael Latimore - Northland Capital Markets, Research Division

Got it. And I know it’s the short-term could, you’ve only had a – basically a referring program so far, but did you have any deals through that referral program in the quarter?

Michael E. Healy

Yeah, a little.

Peter Blackmore

Basically 13 partners have signed up, they have given some of the cloud growth. We do not break it out. What the partners are mostly waiting for is a genuine sell through model, today it’s just a referral model and as I mentioned we will be delivering that model to them at the partner conference in November.

Michael Latimore - Northland Capital Markets, Research Division

Yeah, got it. And then just on the standard support revenue or I guess maintenance; did you have a renewal rate percent for that revenue line?

Michael E. Healy

Yeah, the renewal rate if I remember correctly it’s in the 85% to 90% rate on the premise side maintenance agreements.

Michael Latimore - Northland Capital Markets, Research Division

Yeah. And roughly what percent of the support and other services is maintenance?

Michael E. Healy

Of that support and service line?

Michael Latimore - Northland Capital Markets, Research Division

Yeah, is it pretty much all maintenance or is there some other (indiscernible)?

Michael E. Healy

Its – well there is training fees, there is installation fees and there is professional services. And that’s usually $2 million to $2.5 million of that total number.

Michael Latimore - Northland Capital Markets, Research Division

Yeah.

Peter Blackmore

And yeah, the renewal rate – sorry, the renewal rate is above 96% of our customers are on support.

Michael Latimore - Northland Capital Markets, Research Division

Okay. So about 96% renewal rate?

Peter Blackmore

New customers, yeah.

Michael Latimore - Northland Capital Markets, Research Division

Got it. And then just to be clear on the $500,000 or so of backlog, is that a quarterly backlog or is that an annual number?

Michael E. Healy

That’s a monthly recurring number. So that’s a value of each customer’s monthly bill when they get installed.

Peter Blackmore

Mike, can I jump in, I think that 96 you’re talking about, that’s a percent of new customers that takes support, 87% is the renewal rate as we go forward.

Michael Latimore - Northland Capital Markets, Research Division

Okay. Got it. And then last question, any – you talked about number of large deals in the quarter, is there any kind of stat around that, percent of revenues for major accounts or year-over-year growth, I think?

Peter Blackmore

Our major account business did well again quarter-over-quarter. Grew – outpaced the growth of the Company. We didn’t have any huge deals, but as you heard in my prepared comments, we did have a record number and what we classify as large deals, the most we’ve ever had. So we’re continuing to move up the stack. All the metrics are pointing to that. But it was kind of steady as we go and our major accounts group did a good job of getting larger and larger accounts, just like they do almost every quarter.

Michael Latimore - Northland Capital Markets, Research Division

Yeah. Okay. Thanks.

Peter Blackmore

Thank you. Next question please.

Operator

Our next question comes from Greg Burns with Sidoti.

Gregory Burns - Sidoti & Company, LLC

Good afternoon, thanks for taking the question.

Peter Blackmore

Hey, Greg.

Michael E. Healy

Hi.

Gregory Burns - Sidoti & Company, LLC

Thanks for the additional metrics that you kind of broke out and the year, the release. I just have a couple others that I was hoping you can maybe provide particularly the number of businesses that are currently with the cloud division – how many customers of cloud division currently has and potential the size of the new customers that are being added, the average size there?

Peter Blackmore

Yeah the cloud division has around 2,000 customers, just over 2,000. Like I said, we added 136, we churned out a little bit. And the average size of customers added this quarter was over 40. So the average of the new customers is certainly bigger than the average of the whole installed base.

Gregory Burns - Sidoti & Company, LLC

Okay. Thanks. And in terms of, I guess, given what you had said [tonight] about investing some more in the cloud division, how does that look in terms of that becoming accretive, I guess, the original target was sometimes in the back half of fiscal ’13, is that now pushed up to ’14? How should we think about that?

Peter Blackmore

Yeah, good question Greg. So, in terms of the accretion for the cloud division, with the additional investments we’re making, I think originally we said accretive by the end of 2013, with the premise business being profitable. Right now it doesn’t look like it would be accretive in 2013. We are striving to get it to kind of break even by the fourth quarter of 2013, the cloud division. We get revenue ramped up, we should be able to get close to break even in Q4. But in terms of accretion, yeah that would push out to 2014.

Gregory Burns - Sidoti & Company, LLC

Okay. Thanks.

Peter Blackmore

Yeah.

Operator

And we will go next to Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Great. Thanks for taking my question.

Peter Blackmore

Yes, Christian.

Christian Schwab - Craig-Hallum Capital Group

I’m just trying to figure – how are you? I’m just trying to figure out when you’re going to make money? I mean, when Peter when he came here, you had a company that was struggling to making money, but had a great balance sheet and then we’ve done some acquisitions, we increased the sales force to take advantage of what, I think it’s a wonderful product we uses at our firm and to drive future sales and now we do a ton more revenue and our balance sheet are little bit more challenged that it was and we still don’t make money. And we’re going to go an entire another year, without making any money. I’m just trying to figure out the sensitivity wise, let’s look beyond reg FD. Let’s look out two, three, four year’s, just can you give us an idea of what we’re building this business to be?

Peter Blackmore

Well, I think there is huge leverage in this business. Near questions are good one. First stage was to build scale in the premise business and we can show you with the scale we’ve already built there is profit there. We delivered profit in quarter four. The aim is to give profit for the whole of this year and we will be pushing hard to improve that. And I think the big driver there is improvement in productivity, which we’re working on. We’ve got a much better ratio of R&D. Good ratio of the rest, so that’s got good leverage.

The cloud business has accelerating faster, that we thought. And we made a bold acquisition. We did use equity and obviously some cash. I think it was a very good move. I’d argue with this because the business is taking off so much. It illustrates if we had left the decision of it late, due to probably not been able to do it. I think the timing was 2020 onsite, but the timing was very good. And having made that investment, if its growing 30% faster than you thought when you made the investment, I think its appropriate to capitalize on that.—and that hold back the growth. But that raw model has got huge leverage as you get going. So what you’re asking for is a very fair question, one is the model, model to premise and model to cloud, that’s something Mike and I will share with you as we go through the various analyst conferences in due course. But really is great leverage here and what we’re building is to make sure the leverage is very good to shareholders by having more scale, so we can deliver more.

Michael E. Healy

I would add, the goal on cloud right is, there is no clear market leader. And Kevin can maybe chime in here. But there is no clear market leader and so we’ve got this great asset we purchased. We want to capitalize for our shareholders and investors on maximizing the return on this investment and when we’re booking as much as we’re doing in there getting the uplift from the ShoreTel brand name and security around a larger public company. We want to capitalize on that and again the short-term its going to cost us a little bit more money that we originally planned. In the long-term to build up that recurring revenue base, derisk the balance sheet, derisk the revenue forecasting, we think its very important to do and so that’s the focus is to get that thing ramped up going become the number one cloud player in the industry and when you get number one, it will forward you a number of distinct competitive advantages.

Christian Schwab - Craig-Hallum Capital Group

Great. Thank you.

Michael E. Healy

Sure.

Peter Blackmore

Thank you. Next question please?

Operator

We have no further questions in our queue at this time.

Michael E. Healy

Well, thank you all very much for joining us, I appreciated. And look forward to talking to you next quarter. Thank you. Let’s close the call. Thank you.

Operator

That does conclude today’s call. Thank you all for your participation.

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