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ShoreTel, Inc. (NASDAQ:SHOR)

F1Q2013 Results Earnings Call

October 30, 2012 5:30 PM ET

Executives

Tonya Chin - Director, Investor Relations

Peter Blackmore - Chief Executive Officer

Mike Healy - Chief Financial Officer

Kevin Gavin - Chief Marketing Officer

Analysts

Sanjiv Wadhwani - Stifel Nicolaus

Rohit Chopra - Wedbush

Mike Latimore - Northland Capital

Greg Burns - Sidoti and Company

Trevor Bacon - Lazard Capital Markets

Christian Schwab - Craig-Hallum Capital Group

Operator

Please standby. We are about to begin. Good day. And welcome to the ShoreTel First Quarter Fiscal 2013 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 first quarter fiscal 2013 financial results. Before we get started, we wanted to say that our thoughts and concern with all those affected by Hurricane Sandy and its aftermath, including many of our customers, partners, employees and many in the investment community.

Joining me on the call today is 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 growth, gross margin, 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, 2012, and in the current report on Form 8-K furnished today.

The information in this conference call related to the projections or other forward-looking statements is based on management’s current expectation. The company does not intend to update its forward-looking statements should circumstances change. As a matter of policy, ShoreTel does not comment on financial guidance during the quarter unless it’s done in a public forum.

We’ll be discussing both GAAP and non-GAAP results throughout this call, and I ask that you refer to our press release issued today for the reconciliation between these amounts.

Our non-GAAP numbers exclude stock-based compensation charges, amortization of acquisition related intangibles, other adjustments and the related tax impact, which we do not feel are core to evaluating our operating results.

And finally, ShoreTel management is planning on attending the Stephens Fall Investment Conference on November 13th in New York. We hope to see you all there.

Now, I’ll turn the call over to Peter.

Peter Blackmore

Thank you, Tonya, and welcome, everybody. Before Mike reviews the detailed financial results and key metric, I’d like to share my perspective on where the industry is headed, plus a few highlights on our business this quarter. So let’s start with the vision of the industry as we see it.

Our industry is at an inflection point and there are number of factors driving this. In fact we’ll change the dynamics of the industry and create a new paradigm, which will dictate who are the winners and losers in that industry. We believe several trends and unified communications have converged to create this opportunity.

But first of these, is that we are seeing a significant increase in the focus on the mobile worker. Frost and Sullivan estimates that 84% of customers now have mobile workers. Companies are embracing tools and technologies that support the productivity of their mobile work force. The key for us is that decision makers understand the opportunity to improve productivity and that unified communication tools are right at the center of that.

Second, the end-user is growing and influence and making a significant impact on many aspects of IT decision-making, ease-of-use has a key role and whether a technology is enthusiastically accepted or never lives up to its potential. ShoreTel has always led an ease-of-use but we are taking nothing for granted and are extending our advantage in this area.

And third, the move to the cloud is gaining speed. This represents a new business model. The cloud UC market is estimated to be growing at a compound annual growth rate of 30% over the next few years and is expected to be 40% of the combined premise and cloud UC by 2015.

ShoreTel is ideally positioned to capitalize on these trends. We offer a combination of premise, cloud, mobility and in the future, a hybrid solution that gives us significant advantage in the marketplace.

As it relates to mobility and bring your own device, our feature-rich and easy-to-use mobility solution enables us to help our customers empower their mobile work’s. We have two years experience in offering our mobility solution to the market and have continued to improve in it during this time to ensure it remains in a leadership position.

A recently acquired Cloud Solution is considered to be one of the best in the industry giving us a solid position with huge growth potential. We believe our product serves the Cloud business customers in ways our competition does not.

For example, our integration with business critical applications such as Salesforce.com linked to our voice and UC capabilities puts our solution and class by itself in terms of value add to businesses. We plan to have several other third-party integrated solutions over the coming quarters.

Today most customers still choose premise-based systems. However, we are increasingly seeing customers express interest in a pure Cloud Solution and also the ability to migrate to cloud in the future.

In addition, customers will soon have the choice of hybrid solution, which enables them to have a premise system with some applications, such as mobility installed in the cloud. This not only gives the customer a very business model, but also allows them to pick and choose which applications go to into the cloud when.

In the coming months, we will also be able to show customers a clear path to the cloud from their premise system, enabling a simple migration at the time of their choosing. We believe we are better positioned than any of our competitors to provide this range of choice.

Let me now move to financial highlights of the first quarter. In summary, we delivered another strong quarter in quarter one. We recorded revenue of $75 million at the very top of our guided range of $69 million to $75 million, and up 39% from the first quarter of fiscal 2012.

Taking a closer look at our premise business, we generated premise revenue of $59.3 million, a 10% year-over-year increase in what is a seasonally lower first quarter. In addition, the first quarter was marked by strong performance from our regional partners, many of whom outperformed our expectations.

We continue to outpace the overall market growth and to capture share. According to the latest data from Synergy Research for the quarter ended June 30, 2012, and this is based on revenue in the U.S. enterprise IP Telephony market, we grew our market share from 7.3% in the March quarter to 8.1% in the June quarter.

We also increased our market share in the U.S. pure IP Telephony market from 10.0% to 10.7% in the same period. This further reinforces our position as the third largest voice over IP vendor in North America.

We also delivered strong results in international markets. International revenue grew 19% from the first quarter of last year that broadens our strength in Europe, Asia-Pacific and Mexico.

In Europe, we revamped our distribution strategy with newly signed agreements with Ingram Micro Inc. to extend our relationships with them across that region. This move is an important part of ShoreTel strategy to increase our global presence by consolidating and improving our channel international.

During the quarter, we added over 1,100 new premise customers and are pleased with the growth and diversity of our customer base. One such new customer is Utah State University, a large public research university that was looking for a unified communications solution that offer the best total cost of ownership and was the easiest to use.

Utah State selected ShoreTel over Cisco and Avaya for a solution that includes 3,600 licenses, as well as ShoreTel conferencing, enterprise contact center and ShoreTel Mobility. We plan to expand to 5,000 licenses by 2014.

Internationally, we had a large win with the U.K.-based company called In Practice Systems. In Practice Systems develops, supplies and supports clinical software tools. It purchased a complete ShoreTel solution, including unified communications, enterprise contact center, ShoreTel Mobility and ShoreTel conferencing in a competitive bid over Avaya and Microsoft Lync. They chose ShoreTel because of its lowest total cost of ownership.

Additionally, large global enterprises seeking to reduce international roaming charges and enhanced unified communications availability are increasingly turning to ShoreTel Mobility to meet these challenges. We recently signed an initial deal with Flextronics. Flex chose ShoreTel Mobility to run on its Cisco PBX, because of our rich set of product features.

And ShoreTel continues to attract industry recognition. We were gratified to earn Gartner’s strong positive rating in its 2012 Unified Communications for SMB MarketScope Report for North America.

This report focuses on the premise-based UC market for small and medium-sized businesses between 220 and 500 employees. This is a notable achievement and we encourage you to obtain a complementary copy of the report from our website.

ShoreTel also won three 2012 XCellence Awards at the Midsize Enterprise Summit West in the categories of Best Midmarket Software Solution, Best Demonstration of ROI, Best Execution of a Midmarket IT Solution. Competition was fierce and we are proud to be selected over companies such as Microsoft, Google and Oracle.

Additionally, ShoreTel received the Australian Telecommunications Vendor of the Year in the 2012 ARN IT Industry Awards, further enhancing our presence and brand in this key geographic market. In terms of new technologies, earlier this year we increased the capacity of our conference bridge product with introduction of the SA-400.

The adoption of this recently introduced ShoreTel conferencing product has been fantastic. For example, Current TV implemented ShoreTel conferencing to enhance communications amongst their employees, vendors and customers. They quickly became advocates and describe it as a game changer for their business.

And earlier this month, we introduced ShoreTel Mobility 5.0. This new mobility software includes several new capabilities such as support for voice over IP over cellular data on Android, and support Android 4.0 for selected smartphones. It also enables Instant Messaging and Presence for Android, Apple iOS and Blackberry with Microsoft Lync/OCS.

I’ll now turn to the cloud division. During the quarter, we rebranded ShoreTel cloud offering as ShoreTel Sky delivered the power of the ShoreTel brand. We have seen the total number of seats deployed increased to 78,000 as of September the 30th, a 36% increase over a year ago.

Cloud bookings were up 22% over the September quarter last year. Our backlog of monthly recurring revenue that is not yet installed increased over $550,000 and we are working diligently to speed up the installation process.

Our cloud division continued to deliver great metrics in quarter one, with extremely low revenue churn, a robust ARPU and a growing number of seats per customer. Together these are clear indicators of the strength of our cloud business, as well as our strong competitive position in the market.

We are encouraged by reports from independent industry analysts that validate our vision for cloud solutions to play an increasingly central role in the industry. For example, Infonetics recently reported the number of seats for hosted business voice-over IP and unified communication services, is on track to more than double between 2012 and 2016.

Since this is a relatively new market, the sizing of the hosted market does vary between industry analysts. But one fact that they all agree on is the 30% plus compound annual growth rate expected over the next few years.

Our cloud business continues to attract larger customers with more robust deployments. This quarter, Gateway Mortgage Group, a privately held mortgage bank with retail branches nationwide selected ShoreTel Sky for its 40 locations and 425 users.

In addition to the phone service, Gateway will also deploy ShoreTel Sky contact center and mobility. The solution will be implemented with ShoreTel Sky’s expert start which is the name for our white glove, on-site, installation and training service.

In September, we were excited to participate in Dreamforce 2012, the industries’ largest cloud computing and enterprise technology event hosted by Salesforce.com with over 70,000 registered attendees. One of our key differentiators is our ability to integrate third-party applications such as Salesforce.com into our UC System.

This highly differentiated offering has allowed our Cloud Solution to appeal not only to the CIO but also to the head of sales. Industry analysts are very positive about our growing presence in the cloud market.

For example, ShoreTel Sky was recently recognized by Frost & Sullivan with its Customer Value Enhancement Award in the area of hosted IP telephony and UC services. To quote the award, with it’s compelling product offering, flexible infrastructure, tight focus on customer service and support and continued innovation, ShoreTel is poised to continue it’s ranking among the top-hosted communication service providers in North America. We are proud of this running endorsement of our product and customer service efforts.

Moving on to the integration of our cloud division, we are on track with our plans. We have completed the integration of our human resources, finance and IT systems. We are about to launch our partner program that will enable current premise partners to serve cloud services. I will be announcing this in our partner conference next week.

Additionally, we’re not originally contemplated. We plan to consolidate our product management and research and development engineering teams. The benefit of this will be a single roadmap, faster time to market and the ability to build once and deliver multiple ways.

And finally, I think it is worth mentioning that we receive the strong vote of confidence from the former top six shareholders at M5, now ShoreTel Sky indicating their intent to hold their shares of ShoreTel for at least another six months, despite the fact that the lockup agreement on half of these shares ended in September.

It is clear that these stockholders believe as we do that ShoreTel stock is undervalued. We are confident that with continued good execution, we will demonstrate our stronger shareholder value of the coming quarters.

And with that, I’ll now turn the call over to Mike.

Mike Healy

Thanks Peter. I’ll first review the financials of our consolidated business and then cover some specifics of our premise and cloud businesses separately. In the first quarter, total revenues increased 39% in Q1 of fiscal 2012 to $75 million. Revenue declined 4% sequentially and are seasonally down in Q1, which in comparison declined last year by 5% in Q1.

For Q1, total recurring revenues, including the monthly recurring revenue from the cloud division and the support revenues from our premise customers grew to 33% of our overall business. We are making good progress on our goal driving up recurring revenue and starting to see the financial benefits that come along with our larger and more stable recurring revenue base.

Specifically, in our premise business, we saw a 9% increase in our product revenues to $45.8 million over Q1 of fiscal 2012. Service and support revenues were up nicely 16% from a year-ago quarter to $13.5 million. From a channel perspective, revenue from our retail partners was better than our expectations but our service providers were slightly weaker than planned.

Service providers were approximately 9% of our billings in the quarter. International revenues were $8 million for the quarter, up 19% from the first quarter of fiscal 2012. Our broad-based strength from Europe, Asia-Pac and Mexico, international represented 14% of our total premise revenue.

In terms of our North American two-tier value-added distributors, billions declined slightly quarter-over-quarter and represented 37% of our total premise volume in the September quarter. Within our vertical markets, we saw financial, professional services, retail entertainment and industrial as the strongest in the quarter. In our premise business, we shipped up approximately 135,000 end-user licenses in the quarter, an increase of 10% over Q1 of last year.

Now, let me turn to our cloud business. Revenues of $15.7 million were strong, up 27% over last year and up 10% from Q4. We had another quarter of similar revenue churn at only 0.3% and a solid increase in the volume of MRR, our monthly recurring revenue customer installations.

In fact, we saw a 34% increase in our monthly recurring revenue net gain this quarter versus the previous quarter. We added 159 new customers and continue to track larger businesses. Our monthly average revenue per user or ARPU was $61 and our average number of seats per customer increased to 35.

Our gross margins in the cloud business improved to 46.7%, driven by the increase in revenue, coupled with relatively stable costs in the operations area. Our Q1 combined non-GAAP gross margin was 62.9%. Non-GAAP product gross margin were 66.2% and support and service, non-GAAP gross margin was up nicely to 70.5%, driven by 7% sequential reduction in our premise support costs and increased revenue.

Q1 non-GAAP operating expenses were $49 million, slightly above the top end of the guided range of $47.5 million to $48.5 million due to higher incentive compensation on over achievement in revenue. Operating expenses increased by $500,000 over the last quarter, mostly driven by increases in sales, labor and other costs.

Due to our actions in engineering areas in Q1, our R&D expense line actually dropped by $1 million, or 7% sequentially and for the quarter came in at 17% of revenue. Therefore, we had a non-GAAP loss of $2.1 million or $0.04 per share in terms of earnings.

Now, let me review some of the balance sheet highlights. Cash and short-term investments were $55.1 million. For the quarter, we generated approximately $3.1 million in cash flow from operations, mostly related to the reduction in inventory and an improvement in accounts receivable.

Accounts receivable of $30.3 million were down $3.9 million on the sequential decrease in revenue in the quarter. On a combined basis, our day sales outstanding were once again fantastic at 37 days and help drive our cash flow.

Inventory decreased by $1.2 million to $19.1 million due to better than expected revenue achievements. Deferred revenue was up $700,000 to $50.2 million, primarily due to an increase in our support and maintenance contracts. Capital expenditures were approximately $2.3 million including the capitalization of R&D activities, our certain R&D activities.

Depreciation and amortization was approximately $3.7 million. We ended the quarter with 942 employees, up nine from the previous quarter.

Next, I’ll discuss our outlook for the December 2012 quarter. Based on our backlog, billings and business book-to-date, we expect revenue to be in the range of $75 million to $80 million. 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 for the amortization of acquisition-related intangibles and stock-based compensation charges.

We expect non-GAAP operating expenses to be in the range of $49.5 million to $50.5 million, including further investment in our cloud business and over $1 million in expenses related to our annual partner conference in November. We expect GAAP operating expenses to be in the range of $53.5 million to $54.5 million including approximately $4 million in stock-based compensation and other expenses.

Before, I turn it back to Peter for some closing remarks. I just wanted to say congratulations to one of our customers to my hometown team, the San Francisco Giants for the most recent successes of winning the 2012 World Series on Sunday night. We’re all very proud to be the UC provider to this world-class organization. Peter, back to you.

Peter Blackmore

Thanks, Mike. Let me take a minute reinforce our perspective. As I said earlier, the unified communication industry is changing and I expect that rate of change to accelerate over the coming months. We’re clearly at an inflection point and we believe that ShoreTel is extremely well-positioned.

It is not just the movement to cloud that is making the UC industry excited. It is new options of a customized approach, which allows the choice of a full premise, only full cloud or a hybrid solution that perfectly fits a customer’s need. This is really exciting for our customers. End users will also be able to use the device of their choice as it would be a world-class desk phone, a smartphone or a tablet docked directly into their phone system.

We have the resources, the technology and the market capability to take full advantage of these trends. We look forward to keep you up-to-date with our progress over the coming quarters. And with that, I will now turn the call over to the operator. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

Thanks so much. Just a couple of questions. So, curious about the pricing environment, we’ve heard some aggressive pricing via Mytel just curious to see what you are seeing out there. Obviously, it didn’t seem as if it backed it your premise space margins that much just wanted to see what you are seeing out there? And then just a couple of follow-up after that.

Peter Blackmore

Thanks, Sanjiv. And you hit the point on volume ahead. Our margins have stayed very solid, so yeah, the pricing environment continues to be competitive. I don’t think it’s increased particularly but it’s always been very competitive. And we continue to be able to weigh on our total cost of ownership and therefore our margins are very solid.

Sanjiv Wadhwani - Stifel, Nicolaus

Got it. Okay. Thanks. That’s helpful. And then Mike for you, I just wanted to confirm two things with the cloud business you obviously hit the mid-40s growth margin goal higher than what you have June quarter because of some one-time items, I just wanted to confirm that going forward we should be thinking about consistently sort of hitting that mid-40s range and then on the booking to the cloud business if I remember correctly I think it was 43% last quarter, came in at 22% this quarter just wondering should be sort of expect that level of volatility going forward over the some other items that might have had a favorable impact on the June quarter?

Peter Blackmore

Yeah. I will start. I’m sure Mike will add, Sanjiv.

Mike Healy

On bookings, yeah.

Peter Blackmore

On bookings yeah, it was 43%. Your memory is good and now 22% together that gives us the average we are looking forward for the year of 30% and also remind you we increased a backlog bookings waiting to be installed and that’s improving our infrastructure including our operations time to install. So, we are not seeing any weakness in pipeline. It’s just managing the input of bookings. So, Mike on the margin.

Mike Healy

Yeah. On margin on a cloud business, non-GAAP gross margins all the numbers were quoted. For the quarter, it was $46.7 million. So that was little bit higher than I guided to -- I do stick that guidance of mid-40s for the rest of the fiscal year. We do have some investments to make on the operation side. We actually -- we didn’t hire as fast as we wanted to this quarter in the operation side. So that helped their gross margins a little bit. We didn’t grow expenses too much in revenue. It did its usual climb up which is good.

So, we have a little fluctuating gross margins but I think continuing the model the mid-40s is way to go.

Sanjiv Wadhwani - Stifel, Nicolaus

Got it. And then one last question, profitable that you still set up one target if I remember correctly by the June quarter, some where around there in terms of getting to profitability?

Peter Blackmore

That’s actually correct, Sanjiv. And we are committed to that. So mike…

Mike Healy

Yeah. For do you mean cloud, Sanjiv, our overall company.

Sanjiv Wadhwani - Stifel, Nicolaus

Just the overall business?

Mike Healy

Yeah. So, the -- I think what we said last quarter is we’re striving for a small overall -- small operating profit for the entire company with premise being a profitable and continuing investment in the cloud side, together those too move into a small operating profit which lot would come into the second half of the year certainly given the guidance you gave for Q2.

Sanjiv Wadhwani - Stifel, Nicolaus

Got it. All right. Appreciate it. Thanks so much and good job guys.

Peter Blackmore

Thank you, Sanjiv.

Mike Healy

Thank you.

Operator

Our next question comes from Rohit Chopra with Wedbush.

Rohit Chopra - Wedbush

Wondering when you are going to mention the Giants, Mike.

Mike Healy

Didn’t say far and good overall.

Peter Blackmore

How did they get back?

Rohit Chopra - Wedbush

Could hear it in his voice. A couple of questions. Just want to get a sense of what’s happening to the service provider partners. It’s a very volatile channel but I just want to get a sense of what’s happening this quarter?

And the second question, the re-organ EMEA with the distributors and partners, is that -- is the potential momentum in front of us? Have they been brought up to speed on the product or is that part of the -- partner conference things we can. Then we see the ramp up with those partners, where are we in that?

Peter Blackmore

So, let me do the last one first. We’ve -- Mark Arman is now engaged full-time as Vice President of International. He is doing good job. And one of the challenges is being to simplify distribution because as we built up international, we ended up with just too many partners, some of them too small, sub-critical mass and as you know in North America, we signed up ScanSource and Ingram but that was for North America only and I’m delighted they’ve now said yeah, we will be your partner in Europe, Middle East and Africa.

That’s only just happened so clearly to your point. There is some training, on boarding to enable them to ramp. But it’s a big win for us and we’ve got some real heavy weights behind us now in Europe and East Africa.

And on the services providers that was the one type of partner in our business in North America this last quarter, which didn’t quite meet our expectations. The Gold, Silver partners exceeded our expectations but service providers were a bit weaker on the CP sale through.

I’d remind you that in May we put it in inside sales team on AT&T. We really haven’t seen the full impact of that yet. So, working it -- but its clearly that is a softer part of the market but it did not affect us hitting our numbers. We’ve got our numbers the right way.

Mike Healy

Yeah. Anything else I would add Rohit is, in Europe -- I wouldn’t characterize that as a reorganization of any kind. It’s just a natural evolution of our channel strategy. Years ago, we had smaller partner both resellers and VADs and this is just a natural revolution as you get bigger to get more established VADs in the region.

Rohit Chopra - Wedbush

Can I ask the quick follow-up? Should we assume any changes in gross margin as we go forward for the CP business with the addition of these partners?

Mike Healy

Now, the VADs in Europe, I mean obviously, it takes a few points to go through distribution than it does through resellers. But I think that business is still relatively small as a percentage of our overall business. I think extra volume we’ll get will out ways any small negative impact we’ll have on discount a little bit more through the VAD. So, I’m not modeling any significant impact in gross margins because of that.

Rohit Chopra - Wedbush

Thanks, guys. I appreciate it very much.

Peter Blackmore

Thanks, Rohit.

Mike Healy

Thanks.

Operator

Your next question comes from Mike Latimore with Northland Capital.

Mike Latimore - Northland Capital

Hi. Thanks a lot. Nice quarter.

Peter Blackmore

Hi, Mike.

Mike Healy

Thank you.

Mike Latimore - Northland Capital

Can you talk a little bit more about the -- hearing the channel to sell your cloud business, how many channel partners do you expect? How long do you think it will take for them to become meaningful?

Peter Blackmore

Yeah. It’s a good question, Mike. We’ll launch it next week at the partner conference in Florida. We’ve had a handful of partners in a pilot already, because we wanted to check their ability to learn, the type of terms, conditions that make more sense. So, we -- but on a handful I made seven or eight partners.

We planned so that once we launched it, there is different qualification process and for premise. So, they’re going to undergo some training. They’re going to certify their sales people. They are going to certify us their support people, get all the demonstrations lined up. So, we don’t expect a ramp in business until late quarter for this financial year and probably you will see more impact if I’m honest in quarter one.

Because its gong to take a while, because remember most of our premise partners have never had any experience of a services of sale model. And we need to just keep -- help them and hold their hand, but the potentially is clearly very exciting. But it will take it few quarters to ramp.

Mike Latimore - Northland Capital

All right. And then the -- you mentioned a couple of large customers for your on-premise business. Is there any way to quantify the average size of your on-premise customers that are getting bigger?

Mike Healy

This quarter the average size, the new deals was down a little bit, which did a higher percentage of business coming from the existing customer base than we did new customers. But in general, it’s trickling up, we’ve got hundreds of hundreds of customers over 500 seats, I think that’s about one-third of our overall seats something like that. I don’t have an exact step for you, Mike, but in general yeah, it’s continuing to move upwards, both on the cloud side and the premise side for that matter.

Mike Latimore - Northland Capital

I assume that sort of behind the guidance you talked about sort of years that you expect to be cash flow positive this year, is that right or not?

Mike Healy

Cash flow from operations, yeah.

Mike Latimore - Northland Capital

Yeah. Okay. Got it. All right. Thank you.

Peter Blackmore

Thank you.

Mike Healy

Thanks, Mike.

Operator

Our next question comes from Greg Burns with Sidoti and Company.

Greg Burns - Sidoti and Company

Afternoon.

Mike Healy

Hi Greg.

Greg Burns - Sidoti and Company

Hi. I noticed on your website you were having some service outages due to the hurricane on the Sky business. Can you just give us, maybe a little -- a quick update on that and is that going to anyway impact your ability to put on some of this backlog of customers that you have? And then looking forward, what do you need to do to invest to put in the redundancies in place, so you don’t have these types of issues going forward?

Peter Blackmore

Yeah. Thanks, Greg. It’s a good question and very important one. We did experienced outages, starting at about 11 o’clock last night when the storm surge, the water came into the city and it affected a number of -- we got two data centers in it. First of all, it affected one then it affected the other and given that there was a flooding, it’s very hard to do all the fail overs.

But the good news is we were able to get those data centers up and running by daylight. Subsequently, we still had some lingering problems with one data center. So the moment we got about 70% of our customers live and up and running, but the balance will probably be up and running by this evening.

We kept our customers fully up to date, obviously very difficult situation in Manhattan, New York area anyway. And I think they are understanding that our job is notwithstanding a hurricane, to get them back up to date. And then we do have back up within New York. We had two data centers in New York, and we can technically move customs between the two. We have a third data center in Chicago and when we acquired cloud, we got them to put in a complete project to make that fail over backup system in a different geographic location.

Unfortunately, the timing for completion of that project is March. So we missed the window but our intent and it’s already budgeted and funded. But our intent is to have complete back-to-back resilience for the whole of North America in the future.

Greg Burns - Sidoti and Company

Okay. And I jumped on a bit late, but I guess in the prepared remarks, in the release you talked about some deals in the cloud size and the 10,000 seat range. Was that two separate deals of 10,000 seats and more, or was that in total?

Peter Blackmore

There is two large -- we’ve got one installed two large 10,000 seaters as we call them, that are installing over time, two separate deals and just trying to demonstrate. We were not getting the 20-sized seat customers, right. There is a number of larger customers moving to cloud all the time. That big we are going to install over time.

Greg Burns - Sidoti and Company

Okay. Okay. Multi-years or is there something like a Lumberg over the course….?

Peter Blackmore

No. I wouldn’t -- Yeah. The 10,000 -- guys, I wouldn’t say multi-years but it would say multi-quarters.

Mike Healy

The gate is in our ability to install and the gate is when they are ready and often they have offices that go at their pace. So it will be ongoing as they emerge and acquire and grow, we continue to grow with them.

Greg Burns - Sidoti and Company

Okay. Great. And just maybe a little update on some of the synergies in terms of what the Sky business -- looks like you have a little benefit of R&D that build once or twice kind of thing and then you brought on mobile. But can you give us any update on some of the other synergies in terms of the IP phones or any other initiatives you are having moving forward?

Peter Blackmore

And on the engineering, it’s not yet complete but the cloud engineers and the Sunnyvale engineers got together and could see enormous benefits in combined engineering team, a combined roadmap. And as we move to these hybrid solutions, I talked about it. It’s very logical to that, because as we got the build once deliver twice type of approach.

And then the -- if you remember, one of the other synergies which you pointed out was enabling the cloud services to have a ShoreTel phone as well as the relative phone use at the moment and that is the P-series phone because we want to do it on the SIP-enabled phone, which is our next generation of phones, that is available next calendar year. We haven’t given the date yet, but they’re on track to have that and that will be increased revenue because of the competitive phone, we get zero revenue, zero margin. So that will be increased revenue and margin plus better branding experience, because it’s a ShoreTel branded phone.

Greg Burns - Sidoti and Company

Okay. And when you -- going forward, you think about hybrid deployments, when someone has our premise system and then in the remote side, they are using the cloud. Will they be -- will the systems, the images that they are seeing, the systems they are using be identical or will the branch office have a different M5 system and the home office ShoreTel traditional system. How is that going to evolve going forward or will it be just a single image one system across the enterprise?

Peter Blackmore

That’s what we’d like to do, because otherwise, it’s a clutch and it’s harder to operate to the administrators to help you out. So we’ve got a team of engineers dedicated in the development of this architecture. Obviously, just because is to get that complete and they started work a quarter ago.

And then we’ve got a team of engineers agreeing which applications report to hybrid, we know we can pull it to cloud fast, we did that in 90 days, we’ve got a list of applications, I won’t name them today, but the idea despite we are -- April timeframe we’ll be naming which applications and how they rollout and we are very excited about this. But we wanted to be a seamless experience for our users as you pointed out.

Greg Burns - Sidoti and Company

Okay. Thank you very much.

Mike Healy

Thanks Greg.

Operator

(Operator instruction) Our next question comes from Trevor Bacon with Lazard Capital Markets.

Trevor Bacon - Lazard Capital Markets

Hey, guys. Just couple of questions, one on each business, first, how fast you think the on premise market is growing currently and how much above this do you think ShoreTel can grow?

And then secondly, any thing in particularly that you are seeing in the market that’s driving larger customer consider adopting your cloud solutions?

Kevin Gavin

Well, this is Kevin. The premise business had been growing in the high single-digit range. Recently, we’ve seen a drop down to the low single-digit range but it continues to grow. We continue to outpace the market and capture share.

So our growth is to some extent a combination of the market growth plus our ability to capture share. We’re highly confident of our ability to capture share and we’re anxious for the market to continue growing and hopefully rebound and continue to grow at higher rate, but that remain to be same.

Peter Blackmore

And larger customers.

Trevor Bacon - Lazard Capital Markets

In terms of our larger customers.

Kevin Gavin

We are certainly seeing, I mean, at the initial wave of customers, we’re focus on the cloud, tended to be smaller customers, but we been having good success now, it actual appears almost bimodal. It seems like smaller customers are embracing the cloud and then, there are some larger customers, some CIOs who are sophisticated in buying the whole idea of cloud, and we’ve been successful in attracting some of those larger customers as well as odd. So the mid market the one that hasn’t move yet, but we have seen some significant and some nice uptick on the larger customers.

Mike Healy

And I would say the reason for that the larger customers is just the stickiness that we provide our cloud service like Peter mentioned some of the apps coordinating with Salesforce.com or Netsuite, at the most sticky you can make your UC offering, the compelling is for large customer, a 10% company is not going to care about Salesforce.com how to integrate with them, right.

So that’s why we are getting larger customers. Its all -- its not all about the apps, but certainly about a lot of apps that we provide and that provide better revenue streams, more stickiness to customer. So, I think that’s where the trends we are seeing and that’s why we are having success.

Trevor Bacon - Lazard Capital Markets

Okay. Great. Thank you.

Peter Blackmore

Thank you.

Mike Healy

Thanks, Trevor.

Operator

Our next question comes from Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Yeah. Good afternoon. As we look at your operating expenses, at which point do they stop kind of creeping up, we begin to see some more meaningful operating leverage?

Mike Healy

Well, yeah, so for this quarter Christian, certainly we’ve got an increase for our Partner Conference in the marketing line. So you’ll certainly see that one trick a lot, its $1 million this quarter of expense.

And then we are hiring, certainly we hire around the cloud side and premise side, and sales and a little bit in marketing. And that you saw this quarter the action we took in Q1 has helped the R&D line.

So overall, for fiscal ‘13, I think we’ve been very specific in that. We are going to have a small operating profit. So expenses will more move up in conjunction with revenue. Our revenue expectations, and then for fiscal year ‘14, that’s when we’ll start putting that more in the leverage. We obviously have some infrastructure areas to focus on cloud as you’ve heard in the operations there. So we’ve got to spend some money there to get some things solidified.

So our plan is op expense continues to move up assuming we’ll hit our revenue goals that we trade off of that the premise growth is not fast as we expected, then we’ll take appropriate action to manage small amount of profitability for fiscal year ‘13.

Christian Schwab - Craig-Hallum Capital Group

It looks like the fiscal year ‘14, which is not too far away now. Do you see a path 5% to 6% operating margins on double-digit or modestly better revenue growth over that, or would revenues have to grow materially more than that?

Peter Blackmore

It’s a fair question Christian, we are not able to give you a number yet, but let me just endorse the principal that you are stating, we want to have a reasonable profit next year, that’s not and this year it simply investing cloud, getting to mission critical high growth capability, because I think that’s produces enormous shareholder value because of the recurring revenue stream, and then manage premise tightly and we are doing that, we’ll have very cautious recruitment of sales in the next quarter for example.

And then I really want to be able to deliver to the shareholders a good operating margin and financial year ‘14. But we aren’t prepared yet, just to give you number but that’s the intend, I want to make that very clear.

Christian Schwab - Craig-Hallum Capital Group

Great. Thank you. No other question.

Peter Blackmore

Thank you.

Mike Healy

Thanks, Christian.

Operator

It appears there are no further questions at this time. I’d like to turn the conference back to our speakers for any additional or closing remarks.

Peter Blackmore

Well, thank you all for listening, more questions I expected with the challenges in the east of the country, but wish you well and talk to you next quarter. Thank you.

Operator

That concludes today’s conference. Thank you for your participation.

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