A Closer Look at Quarterly Results in UC

In this Industry Buzz podcast, the UCStrategies Experts try to make sense of recently announced quarterly results, in particular the positive results announced by ShoreTel. The podcast is moderated by Blair Pleasant; she is joined by Jon Arnold, Marty Parker, Dave Michels, Don Van Doren, and Steve Leaden.

Blair Pleasant: Hi, this is Blair Pleasant. I am here with my fellow UCStrategies UC experts. Today we are going to talk about some of the vendors' financial results in the UC market. Last week ShoreTel announced positive results, while others like Cisco, Avaya, and Mitel didn't have such great quarters. We are going to talk a little bit about these different financial results and why we think things are the way they are.

I know one of the reasons Cisco and Avaya had some losses was because the government sector wasn't as strong as in the past or as they had hoped. ShoreTel actually seemed to have done well in that area, so it will be interesting to see why some people think that ShoreTel did well or did not do as well as they could have, or why Cisco, Avaya and Mitel did as well or didn't do as well as they could have.
So Jon Arnold why don't we start with you?

Jon Arnold (0:53): Thanks, Blair. I think we all agree there is kind of a mixed bag of results out there. There is less good news than we think we'd all like to expect. ShoreTel has been putting up reasonably good numbers for a while. The growth metrics have been strong. I know there are ups and downs there, but I believe this is the first update they have had in some time, since the M5 acquisition, and I think we're all kind of interested to see how that is going to impact their performance because they are betting big on having both offerings. But it's pretty clear from their numbers that premise is still carrying the day for them.

So they talk about good numbers for adoption of cloud, but it's still small. The base is pretty small, so I don't think cloud is having a huge impact on their business yet. I think we will need some more time to gauge if that's really going to pay off for them or not. I think it speaks to the bigger picture with so much emphasis on the cloud right now with all the vendors, I think it's going to be a while until that shows positive outcomes for all the players. Because I think a lot of the channels and the decision-makers of the businesses are having reservations. They are confused and they are having a hard time figuring out which way to go; where UC fits in to that value proposition. That's another conversation, but I think it is speaking to probably some slowness of take-up. ShoreTel is showing okay numbers and yes, you can point to the metrics in their report, and you can look at the standings of their competitive standing. They're certainly holding their own against the competitors, and that's all well and good. So those numbers can all look great, you cannot deny them; but they are still not making money. I think that, to me, is the thing I point to and say okay well, despite all this good momentum if they're not making money that may be the best of a bad loss. And we will hear more about that from how others are viewing some of the other vendors who are doing relatively poorly. They are probably posting the strongest story right now. Mitel, I know, is on a good roll to. This is a good indicator I think of how real the cloud story is right now. The numbers just aren't that impressive. So we have to kind of watch that and see if this is really going to happen, or is this going to slow down the market for everybody.

The other comment I would just have is that again, without profits to show for all these changes we are putting the industry through, it really creates a lot of a ripple effect through the industry. Because if they are not making money the channels probably are not going to make money, and then their incentive to sell these new solutions is particularly relevant to UC because it really depends on channels educating the marketplace and getting it to see that.

I think all the vendors are up against this. You mentioned earlier I think the slowdown in government sector, for example; that's a bigger thing that affects some of the other companies more. I just look at ShoreTel as kind of a key indicator of a company that has a lot of things going right for it, but still aren't making money. That, to me, is the bottom line for how real this market really is. So I will move on now to others.

Blair Pleasant (3:48): Thanks, Jon. Marty, I think you have some things that you wanted to add about ShoreTel and about some of the other vendors in the industry.

Marty Parker: Yes, I would like to, and first, ShoreTel deserves compliments for their great revenue growth this quarter. It's really a significant jump over the prior three quarters, which were flat at around $56 million a quarter. So hopefully this is sustainable. Hopefully it's not just a year-end quarter sales thrust that tends to fall back. The investment community, I think, is still making up their mind because the ShoreTel stock has not moved significantly as a result of all of this.

I agree with Jon quite a bit that there are a number of companies in this industry, ShoreTel, Avaya, Mitel, who are operating at break even or slightly less than that, but still creating positive cash flow. That's good, that means that they are paying their way. But by not creating a profitable marketplace, it just puts stress on everybody in the value chain, as Jon suggested. Cisco, on the other hand, who did say that they had a decline in revenue, not a loss in profits but a decline in revenue year-over-year in collaboration category, still is running a $4 billion business in collaboration and still is reporting 17% pre-tax earnings on a gap basis and higher than that on a non-gap basis. I think it is an important metric to watch. Avaya is also cash positive, their cash balance declined $150 million but $250 million was spent buying Radvision out of their own pocket, not out of debt or other financing. So again, cash-positive operations seems to be the norm, but Cisco stands out as a profitable model.

The last thing I'd bring out in this question of the industry, is that there is a major shift going on and who knows, I think it could be a couple, three more years as it shakes out. But I think demand for pure telephony is really declining more than most people think. ShoreTel seems to be successful in filling against that, probably because of their good channel and their good appliance model. But still, I think that there is a major shift going on. We are seeing growth in companies like 8X8 and others who major in the cloud. Interactive intelligence is really making a point of that. The interesting thing is it will look like revenues are soft in this industry as they convert to the cloud, because the cloud is a multi-month if not multi-year amortization of the initial purchase revenue that we normally have seen in this industry. And Interactive intelligence, Dr. Brown's press releases, have been very clear about that migration. I used to work for IBM that had an equipment rental model, and it was tough to convert off the rental model to a purchase model. Well, we are seeing the same thing happening the other way now in telecom. I think we're in a major transition time, and the results will be highly variable, I think, over the next few years with some revenue declines reflecting both the shift in the type of demand and a shift in the delivery model. So that's really what I wanted to comment on, Blair, just that there is uncertainty yet, and it will take a few more quarters before I am going to believe anybody's particular claim to a trend.

Blair Pleasant (7:05): Okay, good points, thank you. Dave Michels, I think you had some things to add.

Dave Michels: Thanks, Blair. I wanted to talk a little bit about the overall climate and how hard it is to really pull it all together. You have so many things that are difficult to compare that we're trying to compare together. Clearly, the business conditions are not great, but these vendors are all kind of doing different kinds of business models, different segments in different parts of the world so it makes it very tricky. Also, the fact that these quarterly results are different quarters for most of these companies... so, for Cisco and ShoreTel, you have quarter 4, which are their stronger quarters. You have Quarter 1 for Mitel, for which they have not actually posted the results yet. They have only posted that they have revised their guidance. And Q3 for Avaya. And so, all these quarters have their own cycles within their companies and it is somewhat hard to compare the quarters-to-quarters between companies.

The second point I wanted to make is, the cloud is actually really changing everything, as well. And some companies like Siemens and Mitel are a little further along on their cloud evolution. ShoreTel, this is their first full quarter since they have acquired M5. They still have integration costs, R&D costs, and acquisition costs that are clouding the issue, if you will. We have Cisco getting fairly aggressive in their HCS, which sells cloud services to service providers. You have Avaya just launching their collaborative cloud service.

And the point is that the cloud model is a very different business model. You have recurring revenue instead of one-time revenue. You have different expectations around margin, different expectations around profit, and different expectations around sales cycles. They are doing different things about whether they are selling phones or renting phones, and it makes it very difficult to compare all that. But clearly, the cloud is the area that is growing and getting a lot of attention. And I think that is going to make it even more interesting moving forward.

The next point I want make is about international business, which in particular seems to be pretty tough and the companies are having a tough time with European sales. That is particularly hard for Alcatel-Lucent and Aastra, which are predominately in Europe. You have foreign exchange rates, which have been brutal, and causing problems. ShoreTel pulled out on their results a $450 million loss in foreign exchange conversions and they are predominately U.S.-focused. Avaya mentioned the foreign exchange rates were causing a significant change in their balance sheet. And so, you have a very difficult international climate. And depending where your market focus is, that can be significantly impactful.

It is nice to see, going through some of the individual reports, that Avaya is increasing their R&D spend and it is pretty significant -- up to $461 million. That is noteworthy and interesting in many ways. I think that it's very hard for companies to continue their R&D spend in tough times, so it is nice to see that taking place at Avaya.

I also wanted to point out that on the ShoreTel one, that the headcount was very interesting. With their acquisition, they cited a 47 percent increase in headcount. If you take out the acquisition, they still grew some 16 percent in headcount. And they're actually saying they are going to keep on growing their headcount, which is somewhat mind-boggling since almost everyone else in the industry seems to be reducing their headcount. And the other point there is that usually with an acquisition, you reduce headcount because you have natural redundancies or overlaps as you acquire a company. And we did not see that ShoreTel went through that process.

On acquisitions, I think that's also very interesting that Avaya has acquired five companies now in the recent past few months. Radvision is a pretty significant company; $200 million purchase price, I think it was. So very interesting there.

Cisco, Avaya, and Mitel all specifically cited poor macro-economic conditions. Avaya cited that government transactions were, in particular, down here in the U.S. And that's all fairly consistent with each other. The interesting point is that ShoreTel is actually saying they are seeing an increase in government spending. Now ShoreTel is targeting smaller accounts and is a much smaller player, so I am wondering if that is the size of the installations that are changing? So smaller branches of the government are able to keep on spending and bigger ones are not...? I don't know if that's what it is or if it's an upgrade versus replacement. I am not sure what the angle is there, but ShoreTel definitely stands out from the herd there with a different story.

And then, I'm going kind of back to what Jon was talking about -- I think that's very interesting right now that the companies seem to be managing either revenue - or profit. And it seems to be a choose-one scenario. And it isn't clear which is more important right now. In the cloud space, I think that potentially revenue might be more important. And in the premises space I think that profit might be more important. But there are arguments to both sides of that and I think it deserves some interesting conversation. I think it could be a whole other conference call on its own: revenue or profit... So those are my thoughts.

Blair Pleasant (12:17): Okay thank you. I'm also glad you pointed out the fact that ShoreTel is primarily in the U.S. I know they are international, but the bulk of their sales are in the U.S. When I spoke with Avaya and Cisco last week when they had their quarterly announcements it seemed that the international market, particularly Europe, was part of what was really dragging down their revenues and sales because of what is going on in Europe. All these things that have to be taken into account - it's very interesting. Don, do you have anything you would like to add to this discussion?

Don Van Doren (12:49): Yes Blair, I do. I don't find any of these results to be surprising, frankly. As Marty pointed out, we are in the middle of a massive structural change in the traditional telecom equipment industry. And it's really, in my opinion, a three-pronged issue. First of course is we are siphoning off PBX traffic into peer-to-peer, or mobility, or other UC applications. Second, we are seeing that the sourcing model is clearly under attack as we move to the cloud. And third, it is just a change in consumer patterns of how people want to do communications. We are going to be still having voice conversations, that's pretty clear. But it's also clear that the traditional models for providing these kinds of capabilities are really crumbling. And as we work through these changes, let's just keep in mind that there is absolutely no requirement that existing companies will survive, let alone thrive. A lot of change is coming and it will be interesting to see how all this plays out.

Blair Pleasant (13:57): Okay, thank you. Does anyone else have anything they would like to add to this?

Steve Leaden: Thanks, it is an interesting time, I think, for ShoreTel, very specifically, while we're seeing other manufacturers with major changes on, there were layoffs a little bit earlier this year with Cisco, there is some attrition going on. Avaya recently changed their CFO out, and other activities that are showing slowness in the market... Here you have ShoreTel really killing the market, especially from their vantage point.

There are a couple of things I am seeing out there. Number one is they've had, as they are stating, 17 percent sequential revenue growth from the third fiscal quarter. They have quarterly revenues of $78 million with 39 percent growth. They have recently organized a consultant relations program within the last 12 months, and that seems to be holding its own, going very strong, if not even gaining more momentum. And I can tell you that I've been to many corporate public websites, especially on the publication side, and ShoreTel is out there pushing a lot of banner ads, offering reports...(of) which I've downloaded a couple myself, actually. They are very, very diligent on following up on any of these reports for download. They have consistently followed up with me even though I am in their database. But I find that interesting.

I think there are also a couple of other things in ShoreTel's favor. Number one is, their product really is, from what we have seen compared with competitors, there is a very strong ease-of-use factor within the world of ShoreTel. And they have purchased, now, five networks within the last year, so they are primed for the cloud, and they have seen a lot of growth in that area and internally. They bought Agito Networks just less than two years ago and they have a vendor-neutral mobile solution, a wireless solution to adapt to the smartphone arena, if you will. So there is a lot going on there as well.

So, I think really all-in-all, ShoreTel is obviously showing that they can succeed, despite general market trends. And they are primed now for the number three slot in the U.S. in terms of annual sales. They are even claiming that they are out-doing Avaya in the user space in the over-500 line size, which I find quite interesting. They are also very, very anal about customer satisfaction. We have seen that they are very strong in terms of "is the customer pleased?" point of view. And according to Gartner, they are in the very, very positive segment - one out of five, with five being the highest.

So, I think, again, there is a lot going on in the world of ShoreTel in their favor. And it's nice to see and despite, again a sluggish market, it is refreshing to see one of our manufactures out there really hitting it hard and really making some major inroads into the market share segment.

Blair Pleasant (16:54): Okay well thank you everybody for great insights. I think the consensus is that one quarter does not say very much and there is a lot of dynamics going on in the industry. Some ups and downs and things are going to be that way for a while so it will be interesting, as industry watchers, to see what is going on and see what the future holds. Thanks everybody, and talk to you next week.