Focus Article: ShoreTel (SHOR)

ShoreTel (SHOR) $5.74

The Company:

Businesses often use phone systems called Private Branch Exchange (PBX) systems to facilitate call handling and use a certain number of phone lines across a large number of extensions in an office. For example a business may choose to get 10 lines and use them across 20 extensions. With reliable and cheap broadband access, businesses started switching from traditional PBX systems to IP-based PBX systems that used a voice-prioritized internet connection to route calls instead of regular land lines. While considering the IT infrastructure needs of a San Francisco based sustainable seafood start-up called CleanFish in 2007, I looked at an IP based PBX system by Avaya that would essentially pay for itself in about 3 to 4 years when compared to the cost of using regular phone lines by AT&T. That system is about to complete its 5th year of service.

As is usually the case with technology, costs come down and system capabilities tend to increase. When looking at a recent quote for an IP-based PBX system a few weeks ago for another start-up client, I noticed that the cost was almost half what we paid for that Avaya system 5 years ago. This quote, which was provided by AT&T, was for a ShoreTel system.

Founded in 1996 and based in Sunnyvale, California, ShoreTel provides Unified Communications (UC) solutions based on its IP business phone system. With $200M in annual revenue in the last fiscal year and 19,000  customers, the company is the third largest, IP-based PBX equipment manufacturer in the U.S. ShoreTel provides its solutions through a group of channel partners instead of using a direct sales force. It has a network of around 1,000 value-added resellers (VARs) and a strong presence in the western coast of the U.S. The company has also been growing its international operations and saw a 27% year-over-year increase in international revenue last quarter.

At the Barclays Capital Technology Conference in December last year, ShoreTel’s CEO, Peter Blackmore said that 45% of the company’s business every quarter is from new customers. This number jumped in fiscal Q2 ended December 31, 2011, with 52% of its business coming from new customers. This implies the company has to rely on increasing market share instead of recurring revenue streams.

With widespread acceptance and adoption of hosted or “cloud” services, a number of companies have cropped up to provide hosted PBX solutions to companies that do not want to purchase, install and maintain a phone system. A notable public hosted PBX provider is 8×8 (EGHT) and two of the largest private cloud telephony companies are RingCentral (a Sequoia Capital portfolio company) and M5 Networks.

On February 1, 2012, ShoreTel acquired M5 Networks. With this acquisition, the company expects to expand its solutions into the cloud and reach a larger customer base that is looking to deploy IP communications through a hosted model. ShoreTel agreed to pay approximately 3 times estimated 2011 revenue of $47.5 million for M5 Networks in a cash plus stock deal. M5 shareholders will receive $84.1 million in cash and 9.5 million shares of ShoreTel stock valued at $62.2 million, bringing the total consideration to $146.3 million.

New York based M5 Networks has about 2,000 business clients and generates $60 in Average Revenue Per User (ARPU). The deal is geographically complimentary for ShoreTel as the company has a strong presence in the western U.S., while M5 is concentrated in the eastern U.S. According to Gartner, the hosted PBX market is approximately $700 million today and is expected to grow at a 36% compounded annual growth rate to $2.2 billion in 2015. M5 is currently growing at 50% a year.

Business Statistics and Financials:

ShoreTel managed to post revenue growth of 30+% for five consecutive quarters in fiscal 2010 and 2011 by increasing its sales force by 40% and investing in R&D. ShoreTel considers itself a software company with 220 of its 700 employees engaged in R&D and less than 10 engaged in hardware design. The company has been posting a string of losses as it invests in growth. While net income was negative in fiscal Q2 ended December 2011, cash from operations was $4.1 million and the company generated $3.6 million in free cash flow. The company generated $10 million in cash flow from operations in the first half of fiscal 2012. Gross margins of 66.1% were down slightly from last year.

The stock plunged 19% from $6.81 to $5.50 following Q2 results because revenue of $58 million was “only” up 22% year-over-year and 8% on a sequential quarter basis. The M5 acquisition also had a part to play in the plunge as the company is utilizing a majority of the cash it had on its balance sheet. As of Q2, ShoreTel had $116 million in cash and no debt. The company also has $45 million in deferred revenue related to sales and maintenance contracts. ShoreTel is using a line of credit to finance part of the M5 acquisition and should have $50 in cash on the balance sheet following the transaction.

Assuming the company manages to generate an additional $10 million in operating cash flow in the second half of fiscal 2012 without taking the M5 acquisition into account and an enterprise value of $160 million (once again before the M5 acquisition), the company is trading for 8 times 2012 operating cash flow. Obviously once we include the M5 acquisition, the numbers are going to change. The company also expects $4 million in additional expenses related to the closing of this acquisition. ShoreTel expects the acquisition to be “modestly dilutive” to earnings in 2012 and “slightly accretive” in 2013.

Competitors:

Insider Buying:

Given below is a list of purchases by the insiders of ShoreTel over the last six months.

Conclusion:

ShoreTel appears to be a very interesting company that has been executing well to increase its market share and in my opinion has made the right acquisition. Partly on account of this acquisition and partly because of the company’s focus on revenue, ShoreTel appears to be a fiscal 2013 story and may see some weakness over the next two quarters.