---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

---

Form 10-Q

---

 

(Mark one)

☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2015

 

OR

 

☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to

 

Commission File Number 001-33506

 

---

SHORETEL, INC.

(Exact name of registrant as specified in its charter)

 

(408) 331-3300

(Registrant’s telephone number, including area code)

---

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

 

As of October 23, 2015, 65,592,401 shares of the registrant’s common stock were outstanding.

 

---

SHORETEL, INC. AND SUBSIDIARIES

 

FORM 10-Q for the Quarter Ended September 30, 2015

 

INDEX

 

PART I. FINANCIAL INFORMATION

 

ITEM 1:

FINANCIAL STATEMENTS

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

 

 

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

SHORETEL, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.	Description of Business

ShoreTel, Inc. was incorporated in California on September 17, 1996 and reincorporated in Delaware on June 22, 2007. ShoreTel, Inc. and its subsidiaries (referred herein as “ShoreTel” or “the Company”) is a leading provider of brilliantly simple business communication solutions, comprised of integrated voice, video, data and mobile applications based on Internet Protocol (“IP”) technologies. The Company focuses on the small and medium sized businesses (less than 5,000 users), with a Unified Communications (“UC”) platform so that they can communicate anytime, anyplace, and through any device that they chose. The Company’s strategy is to provide customers with a flexible choice of deployment options: subscribing to our cloud-based communication services, operating our ShoreTel solution in their own premise-based data centers or a hybrid combination of both.

2.	Basis of Presentation and Significant Accounting Policies

The accompanying condensed consolidated financial statements as of September 30, 2015, and for the three months ended September 30, 2015 and 2014 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2015. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement have been included.

The condensed consolidated balance sheet as of June 30, 2015 has been derived from the audited consolidated financial statements as of that date but does not include all of the information and footnotes included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2015. The results of operations for the three months ended September 30, 2015 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.

Computation of Net Income per Share

Basic net income per share is determined by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the weighted average number of common shares used in the basic income per share calculation plus the number of common shares that would be issued assuming conversion of all potentially dilutive securities outstanding under the treasury stock method. Dilutive securities of 3.0 million weighted shares and 2.6 million weighted shares were not included in the computation of diluted net income per share for the three months ended September 30, 2015 and 2014, respectively because such securities were anti-dilutive.

Concentration of Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents, short-term investments and accounts receivable. As of September 30, 2015, all of the Company’s cash, cash equivalents and short-term investments were managed by several financial institutions. Accounts receivable are typically unsecured and are derived from revenue earned from customers. The Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses. Accounts receivable from one value-added distributor accounted for 37% of total accounts receivable at September 30, 2015. At June 30, 2015 the same value-added distributor accounted for 33% of the total accounts receivable.

Significant Accounting Policies

The Company’s significant accounting policies are included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2015.

 

Recent Accounting Pronouncements

Recent Accounting Standards or Updates Not Yet Effective

In May 2014, the FASB issued ASU No. 2014-9 Revenue from Contracts with Customers (Topic 606) - an accounting standard that supersedes the revenue recognition requirements in Topic 605, Revenue Recognition.  The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. New disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers are also required. The effective date of the new standard was deferred by one year by ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) Deferral of Effective Date. This accounting guidance is effective for the Company in annual financial reporting periods beginning after December 15, 2017; early adoption is permitted for periods beginning after December 15, 2016. ASU No. 2014-9 may be applied retrospectively (a) to each reporting period presented or (b) with the cumulative effect in retained earnings at the beginning of the adoption period. The Company is currently evaluating the method of adoption and the impact that the adoption of this accounting guidance may have on its Consolidated Financial Statements.

In September 2015, the FASB issued ASU 2015-16, Simplifying the Accounting for Measurement-Period Adjustments (Topic 805). The guidance requires that adjustments to provisional amounts recognized in a business combination be recorded during the measurement period in the period in which the adjustment amounts are determined. This also applies to the effect on earnings of changes in depreciation, amortization or other income effects, if any; as a result to the change in the provisional amounts as if the accounting had been completed at the acquisition date. This accounting guidance is effective for the Company in the annual financial reporting periods beginning after December 15, 2015 and for interim periods within those fiscal years, with early adoption permitted. The Company does not anticipate adoption of this guidance to have a material effect on its Consolidated Financial Statements.

 

3.	Balance Sheet Details

Balance sheet components consist of the following:

Depreciation expense for the three months ended September 30, 2015 and 2014 was $2.9 million and $2.6 million, respectively.

Intangible Assets:

 

Intangible assets consist of the following (in thousands):

 

The intangible assets that are amortizable have estimated useful lives of two to eight years.

Research and development costs are expensed as incurred. In accordance with ASC 985-20, Costs of Computer Software to be Sold, Leased, or Marketed, development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established; therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant. Such costs are amortized using the straight-line method over the estimated economic life of the product. The Company will evaluate the realizability of the assets and the related periods of amortization on a regular basis. Judgment is required in determining when technological feasibility of a product is established as well as its economic life.

 

Certain internally developed software became available for general release to customers during the three months ended September 30, 2015; at which time, an aggregate of $1.4 million in software development costs were transferred from intangible assets in process and other to technology in the table above, and the amortization expense is being recognized related to these capitalized software costs.

Amortization of intangible assets for the three months ended September 30, 2015 and 2014 was $1.9 million and $2.2 million, respectively.

 

The estimated amortization expenses for intangible assets as of September 30, 2015 for the next five years and thereafter are as follows (in thousands):

 

Short-Term Investments:

 

The following tables summarize the Company’s short-term investments (in thousands):

 

The following table summarizes the maturities of the Company’s fixed income securities (in thousands):

Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.

4.	Fair Value Disclosure

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal market (or most advantageous market, in the absence of a principal market) for the asset or liability in an orderly transaction between market participants at the measurement date. Further, entities are required to maximize the use of observable inputs and minimize the use of unobservable inputs in measuring fair value, and to utilize a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of inputs used to measure fair value are as follows:

 

•

Level 1 — Quoted prices in active markets for identical assets or liabilities.

 

•

Level 2 — Observable inputs other than quoted prices included within Level 1, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and inputs other than quoted prices that are observable or are derived principally from, or corroborated by, observable market data by correlation or other means.

 

•

Level 3 — Unobservable inputs that are supported by little or no market activity, are significant to the fair value of the assets or liabilities, and reflect the Company’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

 

The tables below set forth the Company’s financial instruments and liabilities measured at fair value on a recurring basis (in thousands):

 

The above table excludes $94.1 million of cash balances on deposit at banks. 

 

 

The above table excludes $78.1 million of cash balances on deposit at banks.

Money market funds are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices in active markets. Short-term investments are classified within Level 2 of the fair value hierarchy because they are valued based on other observable inputs, including broker or dealer quotations, or alternative pricing sources. When quoted prices in active markets for identical assets or liabilities are not available, the Company relies on non-binding quotes from independent pricing services. Non-binding quotes are based on proprietary valuation models prepared by independent pricing services. These models use algorithms based on inputs such as observable market data, quoted market prices for similar instruments, historical pricing trends of a security as relative to its peers, internal assumptions of the independent pricing service and statistically supported models. The Company corroborates the reasonableness of non-binding quotes received from the independent pricing service by comparing them to the (a) actual experience gained from the purchases and redemption of investment securities, (b) quotes received on similar securities obtained when purchasing securities and (c) monitoring changes in ratings of similar securities and the related impact on the fair value. The types of instruments valued based on other observable inputs include corporate notes and commercial paper and U.S. Government agency securities. The Company reviewed financial and non-financial assets and liabilities and concluded that there were no other-than-temporary impairment charges during the three months ended September 30, 2015 and 2014, respectively. The Company reviews the fair value hierarchy on a quarterly basis. Changes in the ability to observe valuation inputs may result in a reclassification of levels of certain securities within the fair value hierarchy. The Company recognizes transfers into and out of levels within the fair value hierarchy as of the date in which the actual event or change in circumstances that caused the transfer occurs. There were no transfers between Level 1 and Level 2 of the fair value hierarchy for any of the periods presented.

Assets and Liabilities That Are Measured at Fair Value on a Nonrecurring Basis

Non-financial assets such as goodwill, intangible assets, and property, plant, and equipment are evaluated for impairment and adjusted to fair value using Level 3 inputs, only when impairment is recognized. Fair values are considered Level 3 when management makes significant assumptions in developing a discounted cash flow model based upon a number of considerations including projections of revenues, earnings and a discount rate. In addition, in evaluating the fair value of goodwill impairment, further corroboration is obtained using the Company’s market capitalization. There were no indicators of impairment in the three months ended September 30, 2015 that required a nonrecurring fair value analysis to be performed on non-financial assets.

5.	Line of Credit

 

On October 22, 2014 the Company entered into an Amended and Restated Credit Agreement which was further amended on December 1, 2014 and again on August 5, 2015 (“New Credit Facility”). This New Credit Facility replaces the Company’s previous credit facility. The New Credit Facility includes a revolving loan facility for an aggregate principal amount not exceeding $100.0 million. The New Credit Facility matures on the fifth anniversary of its closing (October 22, 2019) and is payable in full upon maturity. The amounts borrowed and repaid under the New Credit Facility are available for future borrowings.  The borrowings under the New Credit Facility accrue interest (at the election of the Company) either at (i) the London interbank offered rate then in effect, plus a margin of between 1.50% and 2.25%, which is based on the Company’s consolidated EBITDA (as defined in the New Credit Facility), or (ii) the higher of (a) the bank’s publicly-announced prime rate then in effect and (b) the federal funds rate plus 0.50%, in each case of (a) or (b), plus a margin of between 0.00% and 0.50%, which will be based upon the Company’s consolidated EBITDA. The Company also pays annual commitment fees during the term of the New Credit Facility which varies depending on the Company’s consolidated EBITDA. The New Credit Facility is secured by substantially all of the Company’s assets. As of September 30, 2015, the Company had $99.4 million available for borrowing under the New Credit Facility.

 

The New Credit Facility contains customary affirmative and negative covenants, including compliance with financial ratios and metrics. The New Credit Facility and the related amendment requires the Company to maintain a minimum ratio of liquidity to its indebtedness (each as defined in the New Credit Facility) and varying amounts of Liquidity and Consolidated EBITDA specified in the New Credit Facility throughout the term of the agreement. The Company was in compliance with all such covenants as of September 30, 2015.

 

As of September 30, 2015, no amounts were outstanding under the New Credit Facility. The Company amortizes deferred financing costs to interest expense on a straight-line basis over the term of the New Credit Facility.

6.	Income Taxes

The Company recorded an income tax provision of $0.4 million for both the three months ended September 30, 2015 and 2014. The tax provision primarily consists of income tax provisions for federal alternative minimum tax, tax provisions for profitable foreign jurisdictions based upon income earned during the period and state tax provisions, including certain states that are determined on a basis other than income earned. No income tax benefit was accrued for jurisdictions where the Company anticipates incurring a loss during the full fiscal year as the related deferred tax assets were fully offset by a valuation allowance.

The Company maintains liabilities for uncertain tax positions. As of both September 30, 2015 and June 30, 2015, the Company’s total amount of unrecognized tax benefit was $5.1 million. Of the total of $5.1 million of unrecognized tax benefit as of September 30, 2015, none, if recognized, would impact the effective tax rate. The Company does not expect its unrecognized tax benefits to change materially over the next 12 months.

While management believes that the Company has adequately provided for all tax positions, amounts asserted by tax authorities could be greater or less than the Company’s current position. Accordingly, the Company’s provisions for federal, state and foreign tax related matters to be recorded in the future may change as revised estimates are made or as the underlying matters are settled or otherwise resolved.

The Company’s primary tax jurisdiction is in the United States. For federal and state tax purposes, the years 2002 through 2014 remain open and subject to tax examination by the appropriate federal or state taxing authorities.

7.	Common Stock

Common Shares Reserved for Issuance

At September 30, 2015, the Company has reserved shares of common stock for issuance as follows (in thousands):

 

8.	Stock-Based Compensation

The following table shows total non-cash stock-based compensation expense included in the accompanying Condensed Consolidated Statements Income for the three months ended September 30, 2015 and 2014 (in thousands):

The Company estimated the grant date fair value of stock option awards and Employee Stock Purchase Plan (“ESPP”) rights using the Black-Scholes option valuation model with the following assumptions:

Compensation expense is recognized only for the portion of stock options that are expected to vest, assuming an expected forfeiture rate in determining stock-based compensation expense, which could affect the stock-based compensation expense recorded if there is a significant difference between actual and estimated forfeiture rates. As of September 30, 2015, total unrecognized compensation cost related to stock-based options and awards granted to employees and non-employee directors was $9.9 million. This cost will be amortized on a ratable basis over a weighted-average vesting period of approximately 3.0 years.

 

9.	Stock Option Plan

Transactions under the 1997 and 2007 option plans are summarized as follows (in thousands, except per share data and contractual term):

 

The total pre-tax intrinsic value for options exercised during the three months ended September 30, 2015 and 2014 was $0.5 million and $0.1 million, respectively, representing the difference between the fair values of the Company’s common stock underlying these options at the dates of exercise and the exercise prices paid.

10.	Employee Stock Purchase Plan

The ESPP allows eligible employees to purchase shares of the Company’s common stock at a discount through payroll deductions. The ESPP consists of six-month offering periods commencing on May 1^st and November 1^st, each year. Under the ESPP, employees purchase shares of the Company's common stock at 85% of the market value at either the beginning of the offering period or the end of the offering period, whichever price is lower.

11.	Restricted Stock

Under the 2007 Plan, during the three months ended September 30, 2015 and 2014 the Company issued fully vested restricted stock awards to non-employee directors electing to receive them in lieu of an annual cash retainer. In addition, restricted stock units can be issued under the 2007 Plan to eligible employees.

Restricted stock award and restricted stock unit activity for the three months ended September 30, 2015 and 2014 is as follows (in thousands):

 

Information regarding restricted stock awards and restricted stock units outstanding at September 30, 2015 is summarized below:

12.	Litigation, Commitments, Contingencies and Leases

Litigation — As of September 30, 2015, the Company is involved in litigation relating to claims arising out of the ordinary course of business or otherwise. Any litigation, regardless of outcome, is costly and time-consuming, can divert the attention of management and key personnel from business operations, deter distributors from selling the Company’s products and dissuade potential customers from purchasing the Company’s products. The Company defends itself vigorously against any such claims. Due to the uncertainty surrounding the litigation process, the Company is unable to estimate a range of loss, if any, at this time, however the Company does not believe a material loss is probable.

Contingencies — During the three months ended December 31, 2014 the Internal Revenue Service (“IRS”) issued a Notice of Proposed Adjustment (“NOPA”) resulting from a withholding tax audit of payments made to non-U.S. vendors during calendar years 2008 through 2012.  The NOPA asserts a liability for under-withheld tax of approximately $2.0 million, plus related penalties and estimated interest of approximately $1.3 million. While the Company disagrees with a majority of the IRS’ assertions and proposed liability, the Company accrued $1.1 million for the probable liability during fiscal 2015.

Leases — The Company leases its facilities under noncancelable operating leases which expire at various times through 2023. The leases provide for the lessee to pay all costs of utilities, insurance, and taxes. Future minimum lease payments under the noncancelable capital and operating leases as of September 30, 2015, are as follows (in thousands):

 

 

The current portion of the capital leases is included in accrued liabilities and other on the condensed consolidated balance sheet. The non-current portion of the capital leases is included in the other long-term liabilities on the consolidated balance sheet. Lease obligations for the Company’s foreign offices are denominated in foreign currencies, which were converted in the above table to U.S. dollars at the interbank exchange rate on September 30, 2015.

Rent expense for the three months September 30, 2015 and 2014 was $1.2 million and $1.1 million, respectively.

Purchase commitments — The Company had purchase commitments with contract manufacturers for inventory totaling approximately $17.7 million as of September 30, 2015 and $14.9 million as of June 30, 2015.

 

Indemnification — Under the indemnification provisions of the Company’s customer agreements, the Company agrees to indemnify and defend its customers against infringement of any patent, trademark, or copyright of any country or the misappropriation of any trade secret, arising from the customers’ legal use of the Company’s services. The exposure to the Company under these indemnification provisions is generally limited to the total amount paid by the customers under pertinent agreements. However, certain indemnification provisions potentially expose the Company to losses in excess of the aggregate amount received from the customer.

The Company also has entered into customary indemnification agreements with each of its officers and directors.

13.	Segment Information

ASC Topic 280, Segment Reporting, establishes standards for reporting information about operating segments, products and services, geographic areas of operations and major customers. Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision maker or decision making group in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision-maker is its Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. On this basis, the Company is organized and operates in a single segment: the design, development, marketing, and sale of business communication solutions.

Revenue by geographic region is based on the ship to address on the customer order. The following presents total revenue by geographic region (in thousands):

 

 

Revenue from one value-added distributor accounted for approximately 26% and 28% of the total revenue during the three months ended September 30, 2015 and 2014, respectively.

The Company’s assets are primarily located in the United States of America and not allocated to any specific region; furthermore, the Company does not measure the performance of its geographic regions based upon asset-based metrics.

The following presents a summary of long-lived assets, excluding deferred tax assets, other assets, goodwill and intangible assets (in thousands):

 

14.	Derivative Instruments and Hedging Activities

In the normal course of business, the Company is exposed to fluctuations in interest rates and the exchange rates associated with foreign currencies. During the three months ended September 30, 2015, the Company used derivative instruments to reduce the volatility of earnings associated with changes in foreign currency exchange rates. The Company used foreign exchange forward contracts to mitigate the gains and losses generated from the re-measurement of certain foreign monetary assets and liabilities, primarily including cash balances, third party accounts receivable and intercompany transactions recorded on the balance sheet. These derivatives are not designated and do not qualify as hedge instruments. Accordingly, changes in the fair value of these instruments are recognized in other income and expenses during the period of change. These derivatives have maturities of approximately one month. The foreign exchange forward contracts outstanding as of September 30, 2015 are entered into by the Company on the last business day of the period. Given the relatively short duration such contracts are outstanding in relation to changes in potential market rates, the change in the fair value is not material and is not reflected either as an asset or a liability.

 

The following table presents the gross notional value of all of the Company’s foreign exchange forward contracts outstanding as of September 30, 2015 and June 30, 2015 (in thousands):

 

		September 30, 2015
		Local Currency Amount				Notional Contract Amount (USD)
Australian dollar		$	2,270			$	1,578
British pound		£	1,270				1,905
Canadian dollar		$	560				417
Euro		£	1,450				1,610
Total						$	5,510

		June 30, 2015
		Local Currency Amount				Notional Contract Amount (USD)
Australian dollar		$	2,420			$	1,840
British pound		£	910				1,429
Canadian dollar		$	750				596
Euro		£	1,550				1,708
Total						$	5,573

 

15.	Subsequent Event

 

On November 1, 2015, the Company entered into a Share Purchase Agreement for the acquisition of M5 Networks Australia Pty., a provider of hosted unified communication systems. The aggregate consideration for the acquisition consists of 8.5 million Australian dollars (approximately $6.1 million). The acquisition is anticipated to close during the three months ended December 31, 2015.

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this document. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled “Risk Factors.”

Overview

ShoreTel is a leading provider of brilliantly simple business communication solutions, comprised of integrated voice, video, data and mobile applications based on Internet Protocol (“IP”) technologies. We focus on the small and medium sized businesses (less than 5,000 users), with a Unified Communications (“UC”) platform so that they can communicate anytime, anyplace, and through any device that they chose. Our strategy is to provide customers with a flexible choice of deployment options: subscribing to our cloud-based communication services, operating our ShoreTel solution in their own premise-based data centers or a hybrid combination of both.

We believe our solution addresses changes in the UC market being driven by both technological advances and new workplace trends. We believe some of the current factors affecting the UC market include:  addressing an increasingly mobile workforce, the increased adoption of a Bring Your Own Device (“BYOD”) philosophy, the ongoing need for electronic collaboration and a desire for multiple forms of communication. Our solutions are sold through our extensive network of over 1,100 authorized resellers and value-added distributors throughout the world served either by national distributors or by ShoreTel directly.

We are headquartered in Sunnyvale, California and have offices located throughout North America, Europe, Asia and Australia. Additionally, our cloud-based services are provided from multiple data centers in the United States and the United Kingdom. While most of our customers are located in the United States, we have remained consistent in revenue from international sales, which accounted for approximately 8% of our total revenue for both the three months ended September 30, 2015 and 2014, respectively. We expect sales to customers in the United States will continue to comprise the majority of our sales in the foreseeable future.

Key Business Metrics

We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of sales and marketing efforts and measure operational effectiveness.

Deferred revenue. Deferred revenue relates to the timing of revenue recognition for specific transactions based on delivery of service, support, specific commitments, product and services delivered to our value-added distributors that have not been delivered or sold through to resellers, and other factors. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from our transactions and are recognized as the revenue recognition criteria are met. Nearly all of our premise system sales include the purchase of post-contractual support contracts with terms of up to five years, and our renewal rates on these contracts have been high historically. We recognize support revenue on a ratable basis over the term of the support contract. Since we receive payment for support in advance of recognizing the related revenue, we carry a deferred revenue balance on our consolidated balance sheet. Almost all of our hosted services are billed a month in advance. Billings that are collected before the service is delivered are included in the deferred revenue balance on our consolidated balance sheet. These amounts are recognized as revenue as the services are delivered. Our deferred revenue balance at September 30, 2015 was $69.9 million, of which $52.1 million is expected to be recognized within one year.

Gross margin. Our gross margins for products are primarily affected by our ability to reduce hardware costs faster than the decline in average overall system sales prices. We strive to increase our product gross margin by reducing hardware costs through product redesign and volume discount pricing from our suppliers. In general, product gross margin on our switches is greater than product gross margin on our IP phones. We consider our ability to monitor and manage these factors to be a key aspect of maintaining product gross margins and increasing our profitability.

Gross margin for hosted and related services is lower than the gross margins for support and services and product and is impacted primarily by the reselling of broadband circuits to customers, employee-related expense, data communication cost, carrier cost, telecom taxes, and intangible asset amortization expense. We expect that with the growth in hosted and related services revenue, the gross margins may reflect improvement due to economies of scale, synergies and other cost reductions in our service delivery platform.

Gross margin for support and services is impacted primarily by labor-related expenses. The primary goal of our support and services function is to ensure a high level of customer satisfaction and our investments in support personnel and infrastructure are made with this goal in mind. We expect that as our installed enterprise customer base grows, we may be able to slightly improve gross margin for support and services through economies of scale. However, the timing of additional investments in our support and services infrastructure could materially affect our cost of support and services revenue, both in absolute dollars and as a percentage of support and services revenue and total revenue, in any particular period.

Operating expense. Our operating expenses are comprised primarily of compensation and benefits for our employees. Accordingly, increases in operating expenses historically have been primarily related to increases in our headcount. We intend to expand our workforce as we grow, and therefore, our ability to forecast revenue is critical to managing our operating expenses.

Average revenue per user. We calculate the monthly average service revenue per user (“ARPU”) for our hosted and related services revenue as the average monthly revenue per customer divided by the average number of seats per customer. The average monthly revenue per customer is calculated as the monthly service revenue from customers in the period, divided by the simple average number of business customers during the period. Our ARPU includes telecommunication internet circuits 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 likely to have their own networks already established. Our monthly ARPU for the three months ended September 30, 2015 was approximately $54 as compared to $53 for the three months ended September 30, 2014.

 

Revenue churn. Revenue churn for our hosted and related services revenue is calculated by dividing the monthly recurring revenue from customers that have terminated during a period by the simple average of the total monthly recurring revenue from all customers in a given period. The effective management of the revenue churn is critical to our ability to maximize revenue growth and to maintain and improve margins. Our annualized revenue churn for customers that have terminated services for the three months ended September 30, 2015 was approximately 5% as compared to 2% for the three months ended September 30, 2014.

Basis of Presentation

Revenue. We derive our revenue from sales of our premise IP telecommunications systems and related support and services as well as hosted services.

General and administrative expenses. General and administrative expenses primarily relate to our executive, finance, human resources, legal and information technology organizations. General and administrative expenses primarily consist of personnel costs, professional fees for legal, board of directors' costs, accounting, tax, compliance and information systems, travel, recruiting expense, depreciation expense and facilities expenses.

 

Interest expense. Interest expense primarily consists of interest expense on our debt as well as other miscellaneous items affecting our operating results.

Interest income and other (expense). Interest income and other (expense) primarily consists of interest earned on cash, cash equivalents and short-term investments, gains and losses on foreign currency translations and transactions as other miscellaneous items affecting our operating results.

Critical Accounting Policies and Estimates

The preparation of our financial statements and related disclosures in conformity with generally accepted accounting principles in the United States of America (“GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are based on historical experience and various other factors that we believe are reasonable under the circumstances. We consider our accounting policies related to revenue recognition, stock-based compensation, goodwill and purchased-intangible assets and accounting for income taxes to be critical accounting policies. A number of significant estimates, assumptions, and judgments are inherent in our determination of when to recognize revenue, how to estimate the best evidence of selling price for revenue recognition, the calculation of stock-based compensation expense, evaluation of the potential impairment of goodwill and purchased-intangible assets and the accounting for income and telecom taxes. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates. Management believes there have been no significant changes during the three months ended September 30, 2015 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended June 30, 2015 filed with the Securities and Exchange Commission. For a description of those accounting policies, please refer to our Annual Report on Form 10-K for the fiscal year ended June 30, 2015.

 

Results of Operations

The following table sets forth unaudited selected condensed consolidated statements of income data for the three months ended September 30, 2015 and 2014 (in thousands, except per share amounts):

 

The following table sets forth selected condensed consolidated statements of income data as a percentage of total revenue for each of the periods indicated.

Comparison of the three months ended September 30, 2015 and September 30, 2014

Revenue

 

Total revenue remained relatively consistent at $90.2 million in the three months ended September 30, 2015 as compared to $90.4 million in the three months ended September 30, 2014.

 

Product revenue

Product revenue decreased by $6.2 million or 13% during the three months ended September 30, 2015 as compared to the same period in the prior year primarily due to the decline in volume from new customers.

Hosted and related services revenue

Hosted and related services revenue increased by $4.7 million or 19% in the three months ended September 30, 2015as compared to the same period in the prior year. The increase in hosted and related services revenue was primarily due to continued growth in our hosted customer base, increase in our non-recurring revenue such as installation fees and usage based telecommunications charges as well as additional increases in the use of our services from existing customers.

Support and services revenue

Support and services revenue increased by $1.3 million or 7% in the three months ended September 30, 2015,as compared to the same period in the prior year. The increase in support and services revenue was primarily due to our ability to maintain high renewal rates on maintenance contracts as well as the continued expansion of our customer base resulting from sales to new customers who entered into post-contractual support agreements.

Cost of revenue and gross profit

The overall gross margin was 64% for the three months ended September 30, 2015 compared to 59% for the same period in the prior year.

Product gross margin

Product gross margins increased to 68% for the three months ended September 30, 2015 as compared to 65% in the same period in the prior year. The increase from the prior period was primary related to a change in product mix with greater sales of higher margin products during the three months ended September 30, 2015 as compared to the same period in the prior year.

 

Hosted and related services gross margin

Hosted and related service gross margin increased to 53% in the three months ended September 30, 2015 as compared to 37% in the same period in the prior year. The increase from the prior period was primarily due to operating efficiencies gained in our hosted deployment model as we have continued to serve our expanding hosted customer base with a consistent level of staff and due to the release of certain previously accrued surcharges as a result of reaching the statute of limitations in those jurisdictions.

Support and services gross margin

Support and services gross margins remained relatively consistent at 75% in the three months ended September 30, 2015 as compared to 76% in the same period in the prior year.

Operating expenses

Research and development

Research and development expenses remained relatively consistent at $13.8 million for the three months ended September 30, 2015 as compared to $13.7 million for the same period in the prior year.

Sales and marketing

Sales and marketing expenses increased by $1.8 million, or 6%, in the three months ended September 30, 2015 as compared to the same period in the prior year. This increase in sales and marketing expenses was due to an increase in marketing expenses of $0.9 million primarily due to partner commissions as well as an increase in personnel related costs including, benefits, bonus and commissions of $0.9 million primarily related to an increase in headcount.

General and administrative

 General and administrative expenses remained relatively consistent at $10.1 million for the three months ended September 30, 2015 as compared to $10.0 million for the same period in the prior year.

Other income (expense), net

Interest expense

Interest expense remained relatively consistent at $0.1 million for the three months ended September 30, 2015 as compared to $0.2 million for the same period in the prior year.

Interest income and other (expense), net

Interest income and other (expense), net remained relatively consistent at $0.6 million for the three months ended September 30, 2015 as compared to the $0.2 million for the same period in the prior year.

 

Provision for income tax

Provision for income tax

The provision for income taxes for the three months ended September 30, 2015 and 2014 was primarily related to federal Alternative Minimum Tax, state and foreign income tax expense.

Liquidity and Capital Resources

Balance Sheet and Cash Flows

The following table summarizes our cash, cash equivalents and short-term investments (in thousands):

As of September 30, 2015, our principal sources of liquidity consisted of cash, cash equivalents and short-term investments of $106.1 million, accounts receivable of $28.5 million and the balance of $99.4 million available for borrowing under our New Credit Facility.

The borrowings under the New Credit Facility accrue interest (at our election) either at (i) the London interbank offered rate then in effect, plus a margin of between 1.50% and 2.25%, which is based on our consolidated EBITDA (as defined in the New Credit Facility), or (ii) the higher of (a) the bank’s publicly-announced prime rate then in effect and (b) the federal funds rate plus 0.50%, in each case of (a) or (b), plus a margin of between 0.00% and 0.50%, which will be based upon our consolidated EBITDA. We also pay annual commitment fees during the term of the New Credit Facility which varies depending on our consolidated EBITDA. The New Credit Facility is secured by substantially all of our assets.

The New Credit Facility contains customary affirmative and negative covenants, including compliance with financial ratios and metrics. The New Credit Facility and the related amendment requires the Company to maintain a minimum ratio of liquidity to its indebtedness (each as defined in the New Credit Facility) and varying amounts of Liquidity and Consolidated EBITDA specified in the New Credit Facility throughout the term of the agreement. As of September 30, 2015, the Company was in compliance with all such covenants and no amounts were outstanding under the New Credit Facility.

Historically, our principal uses of cash have consisted of the purchase of finished goods inventory from our contract manufacturers, payroll and other operating expenses related to the development and marketing of our new products, purchases of property and equipment and acquisitions.

 

Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the addition of new business initiatives, the timing and extent of our expansion into new territories, the timing of introductions of new products and enhancements to existing products, the continuing market acceptance of our products and acquisition and licensing activities. We may enter into agreements relating to potential investments in, or acquisitions of, complementary businesses or technologies in the future, which could also require us to seek additional equity or debt financing. If needed, additional funds may not be available on terms favorable to us or at all. We believe that the available amounts under the line of credit together with our cash flows from our operations will be sufficient to fund our operating requirements for at least the next twelve months.

 

The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods (in thousands):

Cash flows from operating activities

Net income during the three months ended September 30, 2015 and 2014 included non-cash charges of $2.8 million and $2.5 million in stock-based compensation expense, respectively, depreciation and amortization of $4.8 million and $5.0 million, respectively.

Cash provided by operating activities of $19.6 million during the three months ended September 30, 2015 reflects net changes in operating assets and liabilities, which provided $9.7 million of cash consisting primarily of a decrease in accounts receivable of $7.9 million due to improved collections, a decrease in inventory of $1.7 million, an increase in deferred revenue of $2.7 million and an increase in accrued liabilities and other of $0.7 million. These cash inflows were partially offset by a decrease in accrued taxes and surcharges of $1.4 million, a decrease in accounts payable of $1.1 million and a decrease in accrued employee compensation of $0.7 million.

 Cash provided by operating activities of $11.1 million during the three months ended September 30, 2014 reflects net changes in operating assets and liabilities, which provided $3.2 million of cash consisting primarily of a decrease in accounts receivable of $6.1 million due to improved collections, a decrease in inventories of $2.3 million, an increase in deferred revenue of $2.7 million and an increase in accrue and other liabilities of $1.7 million. These cash inflows were partially offset by an increase in prepaid expenses and other current assets of $2.8 million, a decrease in accounts payable of $3.2 million, a decrease in accrued employee compensation of $2.8 million and a decrease in accrued and taxes and surcharges of $0.8 million.

Cash flows from investing activities

We have classified our investment portfolio as “available for sale,” and our investments are made with a policy of capital preservation and liquidity as the primary objectives. We may hold investments to maturity; however, we may sell an investment at any time if the quality rating of the investment declines, the yield on the investment is no longer attractive or we are in need of cash.

Net cash used in investing activities was $5.1 million during the three months ended September 30, 2015 primarily related to the purchase of short-term investments of $4.2 million, the purchase of property and equipment of $3.5 million, offset by $2.6 million in proceeds from maturities of our short-term investments.

Net cash used in investing activities was $6.6 million during the three months ended September 30, 2014 primarily related to the purchase of short-term investments of $4.2 million, the purchase of property and equipment of $3.3 million and the purchases of patents, technology and internally developed software of $0.6 million, offset by $1.5 million in proceeds from maturities of our short-term investments.

Cash flows from financing activities

Net cash used in financing activities was $0.1 million for the three months ended September 30, 2015. During the three months ended September 30, 2015, we received $0.9 million from the issuance of common stock under various employee benefit plans offset by the payment of $1.0 million associated with employee tax obligations on the vesting of restricted stock units.

 

Net cash used in financing activities was $0.7 million for the three months ended September 30, 2014. In the three months ended September 30, 2014, we paid $0.8 million associated with employee tax obligations on the vesting of restricted stock units and paid $0.2 million in relation to our capital leases, offset by the receipt of $0.3 million from the exercise of stock options.

Off-Balance Sheet Arrangements

We do not have any material off-balance sheet arrangements (other than those disclosed below within the Contractual obligations and commitments section) nor do we have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Contractual obligations and commitments

The following table summarizes our contractual obligations as of September 30, 2015 and the effect that such obligations are expected to have on our liquidity and cash flows in future periods:

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the normal course of our business, we are exposed to foreign currency exchange rate risk inherent in conducting business globally in foreign currencies. We are primarily exposed to foreign currency fluctuations related to collections from accounts receivable balances and cash in banks that are denominated in the Australian dollar, British pound, Canadian dollar and the Euro. We use relatively short-term foreign currency forward contracts to minimize the risk associated with the foreign exchange effects of the losses and gains of the related foreign currency denominated exposures. We recognize the gains and losses on foreign currency forward contracts in the same period as the losses and gains of the related foreign currency denominated exposures. The gains and losses on foreign exchange contracts mitigate the effect of currency movements on our cash and accounts receivable balances. As of September 30, 2015, a 10% change in the applicable foreign exchange rates would result in an increase or decrease in our pretax earnings of approximately $0.7 million.

We do not have any material changes in the market risk and the interest rate risk disclosure included in the “Quantitative and Qualitative Disclosures About Market Risk” in Item 7A of Part II of our Annual Report on Form 10-K for the fiscal year ended June 30, 2015.

 

ITEM 4.

CONTROLS AND PROCEDURES

Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures were effective.

Internal Control Over Financial Reporting. There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

 

ITEM  1.

LEGAL PROCEEDINGS

 

See Note 12 to the Condensed Consolidated Financial Statements.

 

ITEM 1A.

RISK FACTORS

 

There were no material changes in our risk factors as described in “Part I, Item 1A. Risk Factors” of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2015.

 

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.

MINE SAFETY DISCLOSURES

 

Not applicable.

 

ITEM 5.

OTHER INFORMATION

 

Not applicable.

 

ITEM 6.

EXHIBITS

 

See Index to Exhibits following the signature page to this Form 10-Q, which is incorporated by reference herein.

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date: November 6, 2015

 

EXHIBIT INDEX

 

(1)

This certification accompanying this report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether made before or after the date of the Report), irrespective of any general incorporation language contained in such filing.

 

 

---