UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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Form 10-Q

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(Mark one)

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

 

For the quarterly period ended December 31, 2016

 

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

 

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SHORETEL, INC.

(Exact name of registrant as specified in its charter)

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(408) 331-3300

(Registrant’s telephone number, including area code)

 

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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 January 26, 2017, 68,195,101 shares of the registrant’s common stock were outstanding.

 

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SHORETEL, INC. AND SUBSIDIARIES

 

FORM 10-Q for the Quarter Ended December 31, 2016

 

INDEX

 

PART I. FINANCIAL INFORMATION

 

ITEM 1:

FINANCIAL STATEMENTS

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

SHORETEL, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

 

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 (“the Company”) provides businesses with communication solutions, comprised of integrated voice, video, data and mobile applications based on Internet Protocol (“IP”) technologies, that make interactions simple. The Company focuses on the small and medium sized businesses seeking Unified Communications (“UC”) solutions in the cloud, onsite or a hybrid of both, giving customers the freedom to choose the best fit for their business needs now and in the future.

2. Basis of Presentation and Significant Accounting Policies

The accompanying condensed consolidated financial statements as of December 31, 2016, and for the three and six months ended December 31, 2016 and 2015 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, 2016. 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, 2016 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, 2016. The results of operations for the three and six months ended December 31, 2016 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.

Computation of Net Income (Loss) per Share

Basic net income (loss) per share is determined by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is determined by dividing net income (loss) by the weighted average number of common shares used in the basic income (loss) 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 5.9 million weighted shares and 4.9 million weighted shares were not included in the computation of diluted net loss per share for the three and six months ended December 31, 2016, respectively, because such securities were anti-dilutive. Dilutive securities of 1.9 million weighted shares and 2.2 million weighted shares were not included in the computation of diluted net income per share for the three and six months ended December 31, 2015, 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 December 31, 2016, all of the Company’s cash, cash equivalents and short-term investments were managed by multiple 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 26% of total accounts receivable at December 31, 2016. At June 30, 2016 the same value-added distributor accounted for 42% 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, 2016.

 

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. From March through December 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606):Identifying Performance Obligations and Licensing, ASU No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting, ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients and ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers. These amendments are intended to improve and clarify the implementation guidance of Topic 606. 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 continues evaluating the method of adoption and the impact that the adoption of this accounting guidance may have on its consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. Under this ASU, inventory will be measured at the “lower of cost and net realizable value” and options that currently exist for “market value” will be eliminated. The ASU defines net realizable value as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” No other changes were made to the current guidance on inventory measurement. This accounting guidance is effective for the Company in annual financial reporting periods beginning after December 15, 2016. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of this accounting guidance may have on its consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which supersedes the lease accounting requirements in Topic 840. This ASU requires a dual approach for lessee accounting under which a lessee would account for leases as finance leases or operating leases. Both finance leases and operating leases will result in the lessee recognizing a right-of use asset and a corresponding lease liability. For finance leases, the lessee would recognize interest expense and amortization of the right-of-use asset, and for operating leases, the lessee would recognize a straight-line total lease expense. The guidance also requires qualitative and specific quantitative disclosures to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities, including significant judgments and changes in judgments. This accounting guidance is effective for the Company in annual financial reporting periods beginning after December 15, 2018. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of this accounting guidance may have on its consolidated financial statements.

 

M5 Networks Australia Pty Ltd Acquisition

On November 16, 2015, the Company acquired all of the outstanding common stock of M5 Networks Australia Pty Ltd. (“M5 Australia”), a privately-held company based in Australia and a provider of hosted unified communications solutions, for a total cash consideration of $6.1 million (8.5 million Australian dollars). The acquisition accelerates the Company’s growth and expansion of providing hosted unified communications services in Australia.

In accordance with ASC 805, Business Combinations, the acquisition of M5 Australia was recorded as a purchase acquisition. Under the purchase method of accounting, the fair value of the consideration was allocated to assets and liabilities assumed at their fair values. The excess of the fair value of consideration paid over the fair values of net assets and liabilities acquired and identifiable intangible assets resulted in recognition of goodwill of approximately $5.2 million. The goodwill consists largely of expected expansion of the customer base and market share within the Australian hosted communications industry. The goodwill recorded is not deductible for income tax purposes.

 

Purchase Price Allocation

The total purchase price was allocated to M5 Australia’s net tangible and identifiable intangible assets based on their estimated fair values as of November 16, 2015 as set forth below. The following is the purchase price allocation (in thousands):

Corvisa LLC Acquisition

On January 6, 2016, the Company acquired all of the outstanding membership interest in Corvisa LLC (“Corvisa”), a provider of cloud-based communications solutions, for total cash consideration of $8.7 million. The acquisition accelerates the Company’s growth and expansion of its hosted unified communications service offering.

In accordance with ASC 805, Business Combinations, the acquisition of Corvisa was recorded as a purchase acquisition. Under the purchase method of accounting, the fair value of the consideration was allocated to assets and liabilities assumed at their fair values. The fair value of purchased identifiable intangible assets was derived from model-based valuations from significant unobservable inputs (“Level 3 inputs”) determined by management. The fair value of purchased identifiable intangible assets was determined using the Company’s discounted cash flow models from operating projections prepared by management using a market participant rate of 35.0%. The excess of the preliminary fair value of consideration paid over the preliminary fair values of net assets and liabilities acquired and identifiable intangible assets resulted in recognition of goodwill of approximately $1.5 million. The goodwill consists largely of expected expansion of the customer base and market share within hosted communications industry. The goodwill recorded is deductible for income tax purposes.

Purchase Price Allocation

The total purchase price was allocated to Corvisa’s net tangible and identifiable intangible assets based on their estimated fair values as of January 6, 2016 as set forth below. The following is the purchase price allocation (in thousands):

 

4. Balance Sheet Details

Balance sheet components consist of the following:

 

Depreciation expense for the three months ended December 31, 2016 and 2015 was $3.4 million and $2.8 million, respectively. Depreciation expense for the six months ended December 31, 2016 and 2015 was $6.6 million and $5.7 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.

 

Amortization of intangible assets for the three months ended December 31, 2016 and 2015 was $2.1 million and $2.0 million, respectively. Amortization of intangible assets for the six months ended December 31, 2016 and 2015 was $4.2 million and $3.9 million, respectively.

The estimated amortization expenses for intangible assets as of December 31, 2016 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):

 

All available-for-sale securities have been classified as current based on management’s ability to use the funds in current operations. Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.

5. 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:

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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.

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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 $53.6 million of cash balances on deposit at banks.

 

The above table excludes $58.2 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 U.S. government agency securities, corporate notes and commercial paper. The Company reviewed financial and non-financial assets and liabilities and concluded that there were no other-than-temporary impairment charges during the three and six months ended December 31, 2016 and 2015. 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 during the three and six months ended December 31, 2016 and 2015 that required a nonrecurring fair value analysis to be performed on non-financial assets.

 

6. 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 (“Credit Facility”). This Credit Facility replaces the Company’s previous credit facility. The Credit Facility includes a revolving loan facility for an aggregate principal amount not exceeding $100.0 million. The Credit Facility matures on October 22, 2019 and is payable in full upon maturity. The amounts borrowed and repaid under the Credit Facility are available for future borrowings.  The borrowings under the 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 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 Credit Facility which varies depending on the Company’s consolidated EBITDA. The Credit Facility is secured by substantially all of the Company’s assets. As of December 31, 2016, the Company had $40.1 million available for borrowing under the Credit Facility.

The Credit Facility contains customary affirmative and negative covenants, including compliance with financial ratios and metrics. The Credit Facility and the related amendment requires the Company to maintain a minimum ratio of liquidity to its indebtedness (each as defined in the Credit Facility) and varying amounts of Liquidity and Consolidated EBITDA specified in the Credit Facility throughout the term of the agreement. The Company was in compliance with all such covenants as of December 31, 2016.

As of December 31, 2016, no amounts were outstanding under the Credit Facility. The Company amortizes deferred financing costs to interest expense on a straight-line basis over the term of the Credit Facility.

7. Income Taxes

The Company recorded an income tax provision of $0.2 million and $0.4 million for the three months ended December 31, 2016 and 2015, respectively, and $0.4 million and $0.8 million for the six months ended December 31, 2016 and 2015, respectively. The income tax provision is primarily comprised of state taxes and foreign income taxes. 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’s resulting effective tax rate differs from the applicable statutory rate primarily due to the valuation allowance against its deferred tax assets in select jurisdictions.

The Company maintains liabilities for uncertain tax positions. As of December 31, 2016 and June 30, 2016, the total amount of unrecognized tax benefits was $6.7 million and $6.3 million, respectively. Of the total of $6.7 million of unrecognized tax benefit as of December 31, 2016, $0.2 million, 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 tax years 2002 through 2015 remain open and subject to tax examination by the appropriate federal or state taxing authorities.

8. Common Stock

Common Shares Reserved for Issuance

At December 31, 2016, the Company has reserved shares of common stock for issuance as follows (in thousands):

 

9. Stock-Based Compensation

The following table shows total non-cash stock-based compensation expense included in the accompanying condensed consolidated statements of operation for the three and six months ended December 31, 2016 and 2015 (in thousands):

The Company estimated the grant date fair value of stock option awards and purchase rights under the 2007 Employee Stock Purchase Plan (“2007 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 December 31, 2016, total unrecognized compensation cost related to stock-based options and awards granted to employees and non-employee directors was $11.4 million. This cost will be amortized on a ratable basis over a weighted-average vesting period of approximately 2.9 years.

 

10. Stock Option Plan

Transactions under the Company’s equity incentive plans are summarized as follows (in thousands, except per share data and contractual term):

		Options Outstanding
		Shares Subject to Options Outstanding				Weighted- Average Exercise Price			Weighted- Average Remaining Contractual Term (in years)				Aggregate Intrinsic Value
Balance at July 1, 2016			6,268			$	6.31
Options granted (weighted average fair value $3.25 per share)			1,416				7.98
Options exercised			(296	)			4.83
Options cancelled/forfeited			(309	)			6.87
Balance at December 31, 2016			7,079			$	6.69				7.05			$	6,303
Vested and expected to vest at December 31, 2016			5,962			$	6.51				6.67			$	6,177
Options exercisable at December 31, 2016			3,917			$	6.09				5.60			$	5,575

 

The total pre-tax intrinsic value for options exercised during the three months ended December 31, 2016 and 2015 was $0.1 million and $2.9 million, respectively, and $0.9 million and $3.4 million for the six months ended December 31, 2016 and 2015, 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.

11. Employee Stock Purchase Plan

On November 9, 2016, the 2016 Employee Stock Purchase Plan (“2016 ESPP”) was approved by stockholders. The 2016 ESPP is the successor to the 2007 Employee Stock Purchase Plan (“2007 ESPP”) which terminated automatically in October 2016. A total of 3.5 million shares of the Company’s common stock were reserved for issuance under the 2016 ESPP. The 2016 ESPP allows eligible employees to purchase shares of the Company’s common stock at a discount through payroll deductions. Offering periods are six-months long commencing on May 1^st and November 1^st, each year, and employees are able to purchase shares of the Company’s common stock at a purchase price of the lower of 85% of the fair market value of the Company’s common stock on the first day of an offering period or on the purchase date (the last day of the applicable offering period).

The terms of the 2007 ESPP were substantially the same as the terms of the 2016 ESPP as explained in the paragraph above.

12. Restricted Stock

Under the Company’s equity incentive plan, during the six months ended December 31, 2015 the Company issued fully vested restricted stock awards (“RSAs”) to certain non-employee directors electing to receive them in lieu of an annual cash retainer. In addition, restricted stock units (“RSUs”) can be issued to eligible employees.

 

RSA and RSU activity for the six months ended December 31, 2016 and 2015 is as follows (in thousands):

Information regarding RSAs and RSUs outstanding at December 31, 2016 is summarized below:

 

In May 2016, the board of directors authorized the repurchase of up to $20.0 million of the Company's common stock from time to time at the discretion of the Company’s management. The stock repurchase authorization has no expiration date.

 

Under this program, the Company may repurchase shares in the open market and through privately negotiated transactions. Repurchases are funded with cash and cash generated from operations. The timing and amount of specific repurchase transactions will depend upon market conditions, corporate considerations and applicable legal and regulatory requirements. The Company accounts for repurchased shares of common stock as treasury stock. Treasury shares are recorded at cost and are included as a component of stockholders’ equity in our consolidated balance sheet.

 

A summary of the approved and active share buyback program is shown in the following table (in thousands, excluding transaction costs):

There were no share repurchases in the three or six months ended December 31, 2015.

 

There were no retirements of treasury stock during the three or six months ended December 31, 2016 and 2015.

14. Litigation, Commitments, Contingencies and Leases

Litigation — As of December 31, 2016, the Company was 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 fiscal 2015 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 taxes of approximately $2.0 million, plus related penalties and estimated interest of approximately $1.3 million. In connection with the asserted NOPA, the Company accrued $1.1 million for the liability during fiscal 2015, accrued an additional $0.1 million during fiscal 2016 and released $11,000 due to final settlement of this matter for $1.2 million during the six months ended December 31, 2016.

Leases — The Company leases its facilities under noncancelable operating leases which expire at various times through fiscal 2023. The leases provide for the lessee to pay all costs of utilities, insurance, and taxes. Future minimum lease payments under the noncancelable operating leases as of December 31, 2016, are as follows (in thousands):

Minimum lease payments have not been reduced by minimum sublease rentals of $1.7 million due in the future under a noncancelable sublease.

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 December 31, 2016.

Rent expense for the three months ended December 31, 2016 and 2015 was $1.4 million and $1.3 million, respectively. Rent expense for the six months ended December 31, 2016 and 2015 was $2.9 million and $2.5 million, respectively.

Purchase commitments — The Company had purchase commitments with contract manufacturers for inventory and with technology firms for usage of software licenses totaling approximately $9.8 million as of December 31, 2016 and $15.4 million as of June 30, 2016.

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 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.

15. 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 enterprise 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 23% and 26% of the total revenue during the three months ended December 31, 2016 and 2015, respectively, and 24% and 26% of the total revenue during the six months ended December 31, 2016 and 2015, 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):

16. 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 and six months ended December 31, 2016, 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 December 31, 2016 were 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 December 31, 2016 and June 30, 2016 (in thousands):

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 provides business with communication solutions that make interactions simple. We focus on the small and medium sized businesses seeking Unified Communications (“UC”) solutions in the cloud, onsite or a hybrid of both, giving customers the freedom to choose the best fit for their business needs now and in the future.

We provide this to the market via multiple solutions: ShoreTel Connect, our UC solution, and Contact Center offering and ShoreTel Summit, our platform for developers and integrators. ShoreTel Connect delivers a feature rich UC solution and applications such as mobility, collaboration, and workgroups. ShoreTel Connect is unique in that it offers three different delivery models including cloud, onsite and hybrid. ShoreTel Connect Cloud provides a hosted voice solution to our customers. ShoreTel Connect OnSite provides our customers the ability to independently own and operate their equipment. ShoreTel Connect Hybrid enables our customers to use both our cloud and onsite offerings while still delivering the same user experience and providing our customers increased choice and flexibility. Summit, our Communications Platform as a Service (“CPaaS”) offering, delivers the option to either deeply integrate communications into any application or workflow or to create a standalone business communications application.

We believe our solutions address changes in the UC industry being driven by both technological advances and new workplace trends. We believe some of the current factors affecting the UC industry include: the shift to consuming communications from the cloud, addressing an increasingly mobile workforce, the ongoing need for collaboration, a desire for multiple forms of communication and a need to integrate communications into workflows and applications. 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 were originally incorporated in California in September 1996 and reincorporated in Delaware in 2007. ShoreTel is based in Sunnyvale, California, and has regional offices in North America, Europe, Asia and Australia. Additionally, our cloud-based services are provided from multiple data centers located in the United States, the United Kingdom and Australia. While most of our customers are located in the United States, our international sales have been relatively consistent, accounting for approximately 9% of our total revenue for both the three months ended December 31, 2016 and 2015, and 9% and 8% for the six months ended December 31, 2016 and 2015, 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 December 31, 2016 was $77.4 million, of which $56.9 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 affected primarily by the reselling of broadband circuits to customers, employee-related expense, data communication cost, data center costs, 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 model.

Gross margin for support and services is affected 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. 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 expenses. Our operating expenses are comprised primarily of compensation and benefits for our employees and related expenses such as travel. Accordingly, increases in operating expenses historically have been primarily related to increases in our headcount. Our ability to forecast revenue is critical to managing our operating expenses.

Average revenue per user. We calculate the average monthly 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 broadband 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 was approximately $48 and $52 for the three months ended December, 2016 and 2015, respectively.

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 December 31, 2016 was approximately 5% as compared to 6% for the three months ended December 31, 2015.

 

Basis of Presentation

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

Product revenue. Product revenue consists of sales of our business communication systems. Our typical system includes a combination of IP phones, switches and software applications primarily for our premise-based solutions. We sell our products through channel partners that include resellers and value-added distributors. Prices to a given channel partner for hardware and software products depend on that channel partner's volume and other criteria, as well as our own strategic considerations. Product revenue has accounted for 37% and 45% of our total revenue for the three months ended December 31, 2016 and 2015, respectively and 37% and 46% of our total revenue for the six months ended December 31, 2016 and 2015, respectively. Product revenue may continue to decline in future periods as we continue to focus a greater amount of our sales and marketing efforts to expand our hosted and related services revenue.

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.

 

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 and telecom 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 and six months ended December 31, 2016 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, 2016 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, 2016.

 

Results of Operations

The following table sets forth unaudited selected condensed consolidated statements of income (loss) data for the three and six months ended December 31, 2016 and 2015 (in thousands, except per share amounts):

 

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

 

Comparison of the three and six months ended December 31, 2016 and December 31, 2015

Revenue

Total revenue decreased by $2.4 million, or 3%, and by $6.2 million, or 3%, during the three and six months ended December 31, 2016, respectively, as compared to the same period in the prior year primarily related to a decrease in product revenue, partially offset by an increase in hosted and related services revenue. This is primarily due to a shift in our strategic focus from driving growth in product revenue to driving growth in hosted and related services revenue, which is a response to our belief in a shift in the Unified Communications industry from on premise solutions to cloud-based solutions. This shift in focus is reflected in the decrease in product revenue and increase in hosted and related services revenue during the three and six months ended December 31, 2016.

 

Product revenue

Product revenue decreased by $8.8 million, or 21%, and $18.5 million, or 22%, during the three and six months ended December 31, 2016, respectively, as compared to the same period in the prior year primarily due to the decline in sales volume resulting from our shift in strategic focus from driving growth in product revenue to driving growth in hosted and related services revenue. This shift in strategic focus has caused us to experience a decrease in sales in all product lines. During the three months ended December 31, 2016, the decrease in product revenue was primarily due to a $5.2 million decrease in software license sales, a $2.0 million decrease in switch sales and a $1.3 million decrease in phone sales. During the six months ended December 31, 2016, the decrease in product revenue was primarily due to a $10.0 million decrease in software license sales, a $4.1 million decrease in phone sales and a $3.9 million decrease in switch sales. Product revenue may continue to decline in future periods as we continue to focus a greater amount of our sales and marketing efforts to expand our hosted and related services revenue.

Hosted and related services revenue

Hosted and related services revenue increased by $6.2 million, or 20%, and by $12.4 million, or 21%, in the three and six months ended December 31, 2016, respectively, as compared to the same periods in the prior year. As a result of our shift in our strategic focus from driving growth in product revenue to driving growth in hosted and related services revenue, we have experienced both continued growth in our hosted customer base and the use of additional services by existing customers resulting in increased hosted and related services revenue in both the three and six months ended December 31, 2016. During the three months ended December 31, 2016 the increase in hosted and related services revenue was primarily due to an increase of $4.1 million in sales to existing customers as well as an increase of $2.3 million in sales to new customers. During the six months ended December 31, 2016 the increase in hosted and related services revenue was primarily due to an increase of $6.2 million in sales to existing customers as well as an increase of $5.5 million in sales to new customers.

Support and services revenue

Support and services revenue remained relatively consistent at $19.1 million for the three months ended December 31, 2016 as compared to $18.9 million for the three months ended December 31, 2015.

Support and services revenue remained relatively consistent at $37.9 million for the six months ended December 31, 2016 as compared to $38.0 million for the six months ended December 31, 2015.

 

Cost of revenue and gross profit