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ShoreTel, Inc. (NASDAQ:SHOR)

Deutsche Bank dbAccess Technology Conference Call

September 12, 2012 5:40 am ET

Executives

Michael E. Healy – Senior Vice President and Chief Financial Officer

Tonya Chin – Director of Investor Relations

Analysts

Kip Clifton – Deutsche Bank Securities, Inc.

Kip Clifton – Deutsche Bank Securities, Inc.

Good afternoon, everyone. I’m Kip Clifton; I’m on DB’s Wireless Equipment Research Team. I’m joined by Mike Healy, the CFO of ShoreTel; and Tonya Chin, who works in Investor Relations. To start this off, Mike is going to give a brief presentation and then I will start off some Q&A followed up by offering up to the audience.

So with that I will hand it over to Mike.

Michael E. Healy

Thanks, Kip. So we will have a few slides to go through and then we will get to Q&A. I just want to give an overview. Sorry, just reminding you that everyone that I may make forward-looking statements and are referred to our Risk Factors in our SEC documents including our 10-Ks and 10-Qs to adequately evaluate those risk factors.

So, ShoreTel, little bit of change since we were here last year, but we are a IP Telephony UC player. We’ve got a cloud business and a premise business and as well as mobility business. We acquired our cloud business through an acquisition of M5 Networks in March. So June was the first full quarter of revenue with that organization.

We are wide in presence over 24,000 customers, about 22,000 on the premise side and 2,000 customers on the cloud side. Target market and kind of both areas is really 50 to 5,000, is our sweet spot. That’s where we have the majority of our customer wins, but we do go up. Our largest customer today is Robert Half, over 10,000 licenses on the premise side. And then on the cloud side, we have customers with 100s of seats if not moving away to see customers with 1000s of seat.

In terms of – we on the cloud side, we’re a service organization. You outsource all of our IP Telephony operations to our company. And on the premise side, we sell our products through value-added resellers and of course one step resellers. And we are on that deck as part of under Shore. So the markets we are in are pretty large as you would imagine. I am here, I am showing you 2011 to 2015 for IP Telephony UC applications contact center and cloud UC and Telephony, these are all from IDC, the numbers vary in range, first of all in the cloud side since it’s a new market. But what they are all consistent on in the cloud side is the CAGR over the next four or five years is going to be around 30%. So that’s what attracted us to get in to the hosted market and we found a great partner and then bought a network.

On the premise side, you can see IDC is estimating kind of 12% CAGR over next couple of years, in fact that we think next year’s growth will be a little slower than that single-digit. For our fiscal ’12 that just ended the growth, both on a worldwide basis and on the U.S basis was about flat and we grew our revenue about 15.5%. So again, we took a pretty substantial market share frankly. In the last two quarters, we’ve had our largest market share gains ever on the premise side.

And UC application is – all the other applications you have whether video or chat or mobile or presence and we incorporate all those into our UC offerings. Contact center is a separate offering that we provide to customers both on the cloud side and the premise side, a little smaller market, but generally important for our larger customers.

In terms of our offering, we are merging some of the things together like mobility is offered both on the premise side and the cloud side. But on the premise side, our product revenue consists of IP phones, switches and software. The phones are the largest pieces of revenue.

And people may ask you how the attach rate looking, are you seeing a progression towards softphones or people not buying the softphones and just going mobile. And in fact we are seeing – our mobility revenue continues to grow, but it’s more complementary to our revenue than taking away from the premise side. So our attach rate frankly is the highest it has ever been last quarter, the June quarter, on the premise side of the phone.

So we haven’t seen a big drop off and people moving away from desktop phones in the short term, but we are well prepared if that were to happen to our mobility technology. The IT Director, who wants to outfit his sales guys just with – being on the PBX and having them use their smartphone, they need to take a license to do that.

And on the cloud side, again as I mentioned, it’s a service that we provide, you kind of outsource your IP to IP vendor, you outsource your longest local and you're servicing, so it an all-in-one solution, its monthly recurring revenue and we bill our customers directly and the key there is keeping them happy, keeping the churn low, and we have an extremely low churn less that 4% annualized in terms revenue measurement.

And then between the two, there is presence, mobility, some things we've already ported over our mobile offering for instance into the cloud offering and down the road we're going to look at a hybrid structure where essentially you produce the application or the product once and you deliver it twice, both on-premise and cloud. So that’s where we're headed in terms of our architecture and how we are structuring R&D organization as we move forward.

This chart shows you our revenue, our fiscal year ’12 revenue $231million, that's only the premise revenue, our total revenue was $246 million, which includes $15 million of cloud revenue for the June quarter and a little bit of March. And so I measured that against with the market debt and we typically as you’ve seen always beat the market in terms of growth, at least by 20%. This year, fiscal year ’12, we grew 15.5% or 16% and the market was essentially down 1%. So we continue to outpace the market in terms of growth.

And then finally, two healthy lines of business, on the premise side, we’ve made some reductions to ensure profitability for the year on the premise side given some modest growth in revenue, we’re expecting our gross margins – non-GAAP gross margins to continue to hold steady, between 66% and 67%, some of the highest in the industry. And we’re focused on producing enough profit there to fund growth in our cloud business.

Cloud has taken off much faster than we expected. Bookings growth last quarter, year-over-year was 43%. Our ARPU is one of the highest in the industry and we do ARPUs about $62 per customer per unit last quarter. And that does include some teleco services, T1 that we resell as part of our servers. We find it’s better to control that process and work that with the customers, so we can get the install done quicker and faster.

We average about – our average seat size in a customer is about 34 seats today. And as I said, we have a very low churn. In terms of – I know it’s in the loss, so I’ll get to it now, in terms of how the quarter is going. And we measure every month, how we’re doing in very week. So through the end of August, we were on track in terms of getting to our guidance numbers we gave, which were $69 million to $75 million on a consolidated basis.

Now, I’ll show you that and then also comment a little bit that, as most of you know that ShoreTel, about 50% of our volume comes through in the last month of the quarter in September and that’s no different in this quarter, especially the July and August, quarters are usually a little slower due to the summer vacations. But based on history we are on track to get to those guidance numbers we gave when we released our Q4 numbers.

And here is our long-term target operating model, kind of scoop that out around $425 million level, getting up to 8% to 13% operating profit. But that leverage will come on the R&D line as you see there; in fiscal year ’12, we are about 19% that we expect to drop four or five points; a little bit leverage on the marketing line and on the G&A line really to get that operating margin up.

So that’s how we are going to get to others, nothing magical we have to do. Gross margins I expect to be relatively stable between 62% to 64%, that’s with cloud margins in the mid-40s and then the premise margins in the mid-60 to high-60. So there is a little bit of cost we can take out of the equation and we’ll continue to look at where we can reduce cost in other area. So with that, I will sit down and we will start some Q&A.

Kip Clifton – Deutsche Bank Securities, Inc.

Thanks. Great, Mike. I will start us off here and ask a few questions and I’ll open it up to the audience if you guys have anything. So firstly, when you are competing for enterprise customers, some of the smaller enterprise customers that’s less than 5,000 users in the organization and you go up against people like Cisco and Avaya, what is – are you competing both on price and kind of what’s your value proposition to get them to buy you over like Cisco or Avaya?

Michael E. Healy

I mean quite simply the value proposition is driving simplicity with their tag line, you can say and there is a lot that goes behind it, but it starts with how we architecture the product from the ground up IP based and we are pretty fanatical about when everywhere adding new elements to that, we incorporate it in. So from a user perspective it’s seamless, so they don’t have to login, do a different admin rights or anything where it’s E911 or chats or presence or video.

So we make a special point of making sure everything is in the base package, which by the way you get if you’re upgraded on support. So when we are competing against, the Cisco and Avaya, and Mitel, what we see the most, it’s usually comes down to total cost of ownership equation and why we’re getting the customer to focus on the long-term cost prior to 10 years. We have the substantial cost advantage because of the way that the product was architected from a cost standpoint.

So we love to get into demos and the IT users can come in and see how easier it is to use. We love to put the product out into the customers premise unless the customers decide what they like to use and by the way the (inaudible) we use does not include any productivity savings or self cost as you would call it and some of the announces.

So it really comes down to how it’s architectured and the total cost of ownership and the ease of use. So you don’t have to train people to move that and changes are substantially easier on the ShoreTel system than any of our competitors.

Kip Clifton – Deutsche Bank Securities, Inc.

I see. Okay. And then talking about the development of that architecture probably was a lot of R&D spent. And I see, to get this leverage that you are lowering R&D as a percentage of sales. How do you continue to compete when you’re going up against these guys with huge balance sheets or can spent whatever on research and development like Avaya, like Cisco. How do you continue to stay at the leading edge?

Michael E. Healy

Yeah, I mean we have a pretty big percentage of our revenue growth and R&D, whether it’s 19 or it’s way down to 15% or 14%. So it’s a little easier because of the way that product was designed, we don’t have to worry a heck of a lot about multiple integrations because most of the technology, we’ve built ourselves, we haven’t acquired it over time. And so it’s a lot easier to integrate it into the product. We have a number of things on our roadmap; we’re looking to roll out here in the next couple of years that we think will continue to keep those in the forefront of technology.

For instance, one account we just did, we just did a major custom work with a whole Mac shop to integrate into Salesforce.com. And that we just did through our professional services organization, it worked well and that was other Mac shops we can sell that to them. So lot of what happens is the larger customers they want certain customized work done, we do that and then we can utilize their leverage on other customers.

Kip Clifton – Deutsche Bank Securities, Inc.

Talking about your customers, you guys just signed up a Twitter last quarter. It was a large customer, maybe talk about some of the strengths that you guys offer, that they saw and the reason why they chose you all over somebody else?

Michael E. Healy

Yeah, Twitter is a great win and it continues with our wins in the social media space whether it’s Yelp or LinkedIn, we’re doing very well on that space. Twitter specifically is the example why it is put out there, all Mac shop, they wanted some customized work integrated with CRMs. So we did that and they loved it. There were biggest concerns for security as you could imagine, kind of important and reliability and I think that’s why we won over our competitors. It was a fairly on sales cycle and they kicked the tires immensely. But when they saw the customized work we’re able to do for the Macintosh environment, it was frankly an easier win that way.

Kip Clifton – Deutsche Bank Securities, Inc.

Yeah, stepping back for a second and just looking at geographic trends here. I know you guys had a strong quarter last year in EMEA. There has been a lot of caution obviously around that region. How do you see that going forward? Do you feel as though that is going to continue to be strong for you all or do you feel like that was just a one-off and might come back in the upcoming quarter?

Michael E. Healy

Surprisingly we did quite well in Europe in the September – June quarter. We had one of our largest gains in the – I think we got our second highest revenue ever out of EMEA, which is mostly Europe and mostly UK. We have a great team there. The G.M. of that EMEA region is doing a great job and he is continuing to drive business. Some of our competitors I think are struggling a little bit, making reduction and cuts and those kind of things and the customers see that and say ShoreTel is continuing to grow. So I expect we’ll continue to show progress in EMEA. We have been somewhat insulated from the recessionary worries in Europe and I contribute that to the product and the sales team doing a great job.

Kip Clifton – Deutsche Bank Securities, Inc.

It sounds like you feel pretty good about it.

Michael E. Healy

Yeah

Kip Clifton – Deutsche Bank Securities, Inc.

In terms of just the – going by vertical and then in government, you guys also had a strong quarter in government. How do you see that going forward in terms of the next quarter and fiscal year in here?

Michael E. Healy

So our verticals in June, we did well on government, but it is really all education, as you imagine state and local government are really trying, but education will roll up as for the government. So we had a great quarter in education, a big increase quarter-over-quarter. And that’s all the way K–12, all the way up into public and private universities. I think three of our largest – three of our five largest deals were government education, frankly related in the quarter. Similarly the other stronger vertical, we do well in professional services and financials that’s where the other half is and get in front of those type of customers. And retail/industrial is the other vertical. And none of those verticals are more than 20% of the total. They range between 10% and 20%, go up and down a little bit each quarter depending on what deals come in. So we have pretty well diversified vertical analysis that we go through every quarter and where customers came from.

Kip Clifton – Deutsche Bank Securities, Inc.

Got you.

Question-and-Answer Session

Kip Clifton – Deutsche Bank Securities, Inc.

I’ve got some more questions here, but I want to give the audience a change to participate. Does anybody else have a question?

Michael E. Healy

Jonathan.

Unidentified Analyst

Can you talk a little bit about why – you guys are having – started integrating M5 with your sales organization of your on-promise business in that sales part of that. Why is that going so well, I mind that’d surprise you?

Michael E. Healy

Yeah, I mean M5 integration was – it’s a good question. Let me just a quick overview and then I will answer your specific question. So when we acquired M5, we said we are going to keep it as a separate standalone cloud division, which by the way we’ve renamed Sky as of the beginning of the last week. So our ShoreTel Sky business is really our cloud product and so we wanted to keep it separate, but it is a different go-to-market.

We’ve integrated the G&A functions pretty much, finance, IT, HR and those kinds of things, but we’ve sales and marketing and to some extend R&D separate because we really wanted to keep them focus on delivering their plan. Over time now we are going to start merging more of the R&D organizations together and they are kind of working on joint projects, some of this hybrid architecture that I talked about. So we will continue that. That’s another area we hope to drive down R&D as an expense of percentage of revenue.

On the overall, why we’re doing better on demand? We really haven’t kind of instituted too much of the synergies, we’re going to get from the revenue side, for instances, selling M5 with the Sky division to sell the ShoreTel phones yet, that is coming out next year. We really haven’t ramped up our premise base, resellers yet to sell ShoreTel. We’ve had a few sign up to be a referral partner. And we’re working on rolling out our go-to-market strategy with our partner base, which again should provide a pretty big uplift in demand.

So today, I think a lot of demand; it’s just coming from the overall ShoreTel or having a more viable company, we’re not worried about viability from the M5 side. So I think that’s helping and the sales guys are doing a great job, which is creating demand and the market is growing relatively fast.

Unidentified Analyst

You said bookings grew 30% higher than you expected. Can you talk a little bit?

Michael E. Healy

Yeah, bookings have been higher than we kind of planned for internally. What we need to do is, the bookings were coming in, we’re getting the orders, we’re sort of backlog, our installation is growing, so we had to focus on getting all that MRC or MRRs we call that installed and that’s what generates the revenue increases.

Unidentified Analyst

And the working (inaudible) that backlog and like how are you doing on getting the installation people in place and within (inaudible)?

Michael E. Healy

Yeah, we’re doing pretty good. And some of the reason we’re a little – loosing a little money on the cloud side is we’re making some investments on the infrastructure side of the business for a systems and personnel standpoint. So we’re trying to hire operation people as fast to possibly get the installs in and get support done. And I think we’re doing pretty good. We are a little bit behind in our hiring plan there, but our goal is to drive that backlog number down to a more reasonable number and it does take us about on average 90 days to get a customer installed on a cloud site from when we booked to install part of that’s getting the lines provisioned from tier level through and getting DIDs set up and assigned and planning to switch over.

Unidentified Analyst

Michael we were maybe behind our own plan. We have made some progress, in a quarter ago towards getting installations set up at that.

Michael E. Healy

Yeah, yeah, very true. Now we have got the plan, we’re working towards it, but we are making some progress there.

Unidentified Analyst

When you expand Skype through (inaudible).

Michael E. Healy

Yeah

Unidentified Analyst

What investments are going to be necessary to really go after the opportunity, really around the country?

Michael E. Healy

Yeah there shouldn't be too much substantial increase in investment needed to expand beyond in the U.S., certainly if we were in UK or Australia we got to do some more investments, but keeping the U.S. we got the support team in New York and Rochester. It will just be a function of how much more cover space we need to get to support the customer base, and that doesn’t actually matter if it’s in New York or for California. But there are good opportunity because ShoreTel was more a west coast centric than east coast centric and certainly M5 was certainly concentrated on east cost in New York City, so it's another reason we – the synergies of buying the company. So getting them ramped up on the west coast is one of the major initiatives and it shouldn't require any additional investments other than having a few salespeople geographically dispersed.

Kip Clifton – Deutsche Bank Securities, Inc.

Good question, Jonathan. Any other?

Unidentified Analyst

I was wondering if you could maybe comment a little bit about what you are seeing relative to the competitive landscape in terms of sort of share shifts or pricing behavior and then if anything in particular? And then secondly, there has been some I guess discussion in the last couple of quarters about some inventory builds specifically within the SMB channel and at the distributor level, I’m wondering what you are maybe seeing there, what your sense is off those inventories maybe clearing? Thank you.

Michael E. Healy

Okay. So on a competitive front, it’s been pretty similar – or I suppose are pretty aggressive especially when they know we are in a deal. They will just kind of little heavier, because the last thing they want to know, they want to do is get into side-by-side demo where attributes of our product really shine in terms of the users and the IT guys. So usually it gets pretty aggressive at times. If we were doing our job on the sales front, we don’t need to discount or discounting has been relatively consistent over last quarters, it goes up and down a little bit depending on how big revenue we have from our new customer base versus our existing customers and that’s one reason we’ve been able to hold our margins pretty consistent. So those are aggressive but no big challenge.

Two of them have a substantial amount of debt related to their total balance sheet that customers worry about. And then from an inventory standpoint, I was happy with the last – sort of first time in a long time, we dropped our inventory by – not an intriguing amount and some of that was due to a drain down and we have about 39% of our volume goes through our value added distributors ScanSource being our largest and does a great job. So last quarter, we’d actually drained inventory from the quarter before and ScanSource, which is – a good sign of demand and they’ve reordered as we got into the new quarter and build up their stock backup for quarter end rush again for this quarter. So I didn’t see any issues in terms of our distributor inventory, in fact it was down a little bit for us at the end – in the June quarter.

Kip Clifton – Deutsche Bank Securities, Inc.

Any other question?

Unidentified Analyst

Just a higher level question here. This long-term transition from TDM to IP, how do you think – where do you think we’re in the process? When you look at the addressable market the number steeps out there, when you look back five, ten years ago, in terms of what TDM and – how much of that customer base do you think has transitioned to IP?

Michael E. Healy

Well, that’s a good question. Who – Tonya, who is the one – the source we had?

Tonya Chin

There is a recent report out. I forget those.

Unidentified Analyst

Okay.

Tonya Chin

I mean, it’s a relatively known industry player, puts it at 30% worldwide of IP versus TDM. So install base, obviously, now in any given quarter the vast majority of the lines sold are IP, but in terms of the installed base, it’s still in the relative early innings, that’s right around 30%.

Michael E. Healy

And U.S is obviously higher, Japan will probably be the last to go, India and some other countries will be a little bit slower in terms of adoption, but I’ve seen number all the way from 30% to 50%. So we kind of said, no more than half the market has converted to IP and certainly a lot of the new thing – new deals coming in are all IP related. No one takes an old TDM system and moves it anymore, they just throw it away.

Unidentified Analyst

Okay. And then I guess the previous question was really on a competitive shift, you guys obviously had a pretty strong quarter with revenues, I think on an organic basis in the mid-teens. Obviously Mitel had disappointing numbers. A sense on how your other big competitors I guess Cisco and Avaya kind of faired in the June quarter?

Michael E. Healy

Yeah, so we – just to recap, on the premise side, we grow our revenues 17% sequentially. So we had about $64 million in revenue on the premise side, which showed good market share growth as you mentioned. We look at synergy that gives out some market share data. Avaya published their 10-Q and I believe their revenue was relatively flat in the June quarter.

Tonya Chin

Sequentially flat.

Michael E. Healy

Sequentially flat, yeah. And then I think Cisco grew a little bit according to synergies; Cisco doesn’t publish their UC numbers externally. And then Mitel, you guys have seen their announcements of down quarter and missed their guidance, so all of those helped to contribute to us gaining a good chuck of market share again. And as you’re seeing we just – in the press release, I think yesterday or this morning talked about our market share gains through the end of the June quarter.

Kip Clifton – Deutsche Bank Securities, Inc.

Any other questions?

Unidentified Analyst

(Inaudible) your Chairman and CEO are buying stocks or why are they buying stock?

Michael E. Healy

We are buying stock to make money just like all of you. So yeah, our Chairman Gary Daichendt last quarter bought a lot almost, if I remember correctly $0.5 million of ShoreTel’s stock in an open window, and Peter our CEO, a smaller amount, but a pretty substantial sum last quarter around the $4 stock price. They fundamentally think we are significantly undervalued in terms of those stock price. The multiples would tell you that, so in the long run we feel like they’re going to make, even though they have a substantial investment in ShoreTel stock already, with the open market purchases or a sign that they feel $4 is a ridiculously low price for ShoreTel stock.

Tonya Chin

We also have Ken Denman and other board member of – and actually Peter also bought several quarters ago I think so he has got a pretty fair amount of open market five over the last year.

Michael E. Healy

Yeah.

Unidentified Analyst

(inaudible), basically it looks like it will be 2016 or so before you get to that, potentially get to that model, if you’re growing top line 12% or so CAGR. Is that – if that math is somewhere accurate?

Michael E. Healy

It’s still longer than my internal model.

Unidentified Analyst

I was going to ask you like, where is that wrong or is that, I’d seen them for long term investors a little far out. Does the acquisition speed up the top line growth? Where might that come in sooner?

Michael E. Healy

Yeah, so certainly the acquisition helps the top line growth and we were little faster. In terms, I think what we said publically is that getting there to that plus $400 million based on our current projections is a couple of years out, so I wouldn’t – 2016 is a little too conservative I think. We haven’t given guidance on that, but we feel like we continue, we can outpace the market on the premise side and the cloud side, market is growing 30%, we think we can do better than that. So you put those together and I think you can find your way to $425 million or so in a couple of years.

Kip Clifton – Deutsche Bank Securities, Inc.

Any other questions?

Unidentified Analyst

How do you guys, how do you feel about your balance sheet? Now you have the acquisition, profitability, going forward for the next year, year and a half. I mean when you just look at the model, feel comfortable?

Michael E. Healy

Yeah, I mean. I feel good about the balance sheet. It’s – we took a risk with the acquisition and we took a little bit of the line of credit to help fund cash to do that. So we had about $55 million of cash. We generated $10 million of cash last year from operations. I don’t feel like we need a substantial cash balance. I think we will manage around $50 million, our customers I think like to see that kind of stability. I mean, I expect to generate cash this year even though we may not have – feel much non-GAAP operating profit. We are doing a great job on collections and deal. So inventory will work down quarters, and then they may go up as we move to a new phone line and work through that transition. But overall, I am happy where we are, we’d obviously like more cash the better, but we do have liquidity available to us through our line of credit up to $50 million if we need to use it for whatever reason.

Unidentified Analyst

Yeah. For almost at a time, I just want to ask one last question. So how should we think about – or how do you want investors to think about you in a valuation basis?

Michael E. Healy

Good question.

Tonya Chin

Thank you, Brad.

Unidentified Analyst

Yeah.

Michael E. Healy

We are in a little bit of a quantity right now in terms of what I would call value trap and that – we know it’s important to show leverage in our model in terms of profitability, but at the same time we want to grow the cloud business, it’s not possible because we spend a good chunk of our balance sheet, we got this great asset and it has a chance to grow fast. And so we want to invest in that as much as we can to grow that and get into a dominant market share position. So, one area that continue to grow.

Cloud business, if it makes a little money, great, but right now we are investing for the future. And then on the premise side, continue to grow profitability. We haven’t been able to demonstrate great profitable growth in the past and so that’s more of our focus for the company and use that profit to fund the cloud business.

A couple of years from now, I think we will have a good section of both businesses, where both doing well, both profitable and good growth margins and so I would encourage our investors to look one to two years out and see what this company will look like, it will be substantially much healthier from a profitability stand point in balance sheet than it is today. And we are excited and encouraged to make that path go as fast as possible.

Kip Clifton – Deutsche Bank Securities, Inc.

All right. We’re out of time. Thank you. Thank you, Mike, and thank you, Tanya.

Tonya Chin

Thanks for having us.

Michael E. Healy

Thank you, guys.

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