ShoreTel, Inc.
ShoreTel Inc (Form: 10-Q, Received: 11/08/2013 14:32:26)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

(Mark one)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2013
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)

 
Delaware
77-0443568
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
960 Stewart Drive, Sunnyvale, California
94085-3913
(Address of principal executive offices)
(Zip Code)
 
(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   x     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   x     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.
 
Large accelerated filer
¨
Accelerated filer
x
 
 
 
 
Non-accelerated filer
¨   (Do not check if a smaller reporting company)
Smaller reporting company
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x
 
As of October 25, 2013, 60,366,531 shares of the registrant’s common stock were outstanding.


SHORETEL, INC. AND SUBSIDIARIES
 
FORM 10-Q for the Quarter Ended September 30, 2013
 
INDEX
 
 
 
Page
PART I: Financial Information
 
 
 
 
Item 1
3
 
3
 
4
 
5
 
6
 
7
Item 2
18
Item 3
28
Item 4
28
 
 
PART II: Other information
 
 
 
 
Item 1
29
Item 1A
29
Item 2
29
Item 3
29
Item 4
29
Item 5
29
Item 6
29
 
30
 
31
 
PART I. FINANCIAL INFORMATION
 
ITEM 1: FINANCIAL STATEMENTS
 
SHORETEL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
(Unaudited)
 
 
 
September 30,
2013
   
June 30,
2013
 
ASSETS
 
   
 
Current assets:
 
   
 
Cash and cash equivalents
 
$
49,855
   
$
43,775
 
Short-term investments
   
6,118
     
7,501
 
Accounts receivable, net of allowances of $643 as of September 30, 2013 and $639 as of June 30, 2013
   
31,003
     
37,118
 
Inventories
   
17,634
     
18,891
 
Indemnification asset
   
6,600
     
6,277
 
Prepaid expenses and other current assets
   
6,506
     
6,417
 
Total current assets
   
117,716
     
119,979
 
Property and equipment - net
   
15,623
     
15,625
 
Goodwill
   
122,750
     
122,750
 
Intangible assets - net
   
35,646
     
38,138
 
Other assets
   
3,313
     
3,295
 
Total assets
 
$
295,048
   
$
299,787
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
13,823
   
$
9,790
 
Accrued liabilities and other
   
15,703
     
17,766
 
Accrued employee compensation
   
11,984
     
13,159
 
Accrued taxes and surcharges
   
10,623
     
11,312
 
Purchase consideration
   
3,630
     
3,577
 
Deferred revenue
   
40,835
     
39,692
 
Total current liabilities
   
96,598
     
95,296
 
 
               
Line of credit, net of debt issuance costs
   
18,026
     
29,004
 
Long-term deferred revenue
   
16,540
     
15,294
 
Other long-term liabilities
   
3,783
     
4,053
 
Total liabilities
   
134,947
     
143,647
 
Commitments and contingencies (Note 12)
               
Stockholders' equity:
               
Preferred stock, par value $.001 per share, authorized 5,000 shares; no shares issued and outstanding
   
     
 
Common stock and additional paid-in capital, par value $.001 per share, authorized 500,000; issued and outstanding, 60,297 and 59,168 shares as of September 30, 2013 and June 30, 2013, respectively
   
327,249
     
322,260
 
Accumulated other comprehensive income (loss)
   
5
     
(2
)
Accumulated deficit
   
(167,153
)
   
(166,118
)
Total stockholders’ equity
   
160,101
     
156,140
 
Total liabilities and stockholders’ equity
 
$
295,048
   
$
299,787
 
 
See Notes to Condensed Consolidated Financial Statements
SHORETEL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 
 
 
Three Months Ended
 September 30,
 
 
 
2013
   
2012
 
Revenue:
 
   
 
Product
 
$
47,682
   
$
45,834
 
Hosted and related services
   
20,739
     
15,662
 
Support and services
   
15,866
     
13,488
 
Total revenue
   
84,287
     
74,984
 
Cost of revenue:
               
Product  (1)
   
16,296
     
15,787
 
Hosted and related services  (1)
   
12,533
     
9,142
 
Support and services  (1)
   
4,282
     
4,189
 
Total cost of revenue
   
33,111
     
29,118
 
Gross profit
   
51,176
     
45,866
 
Operating expenses:
               
Research and development  (1)
   
13,280
     
13,953
 
Sales and marketing  (1)
   
27,666
     
30,756
 
General and administrative  (1)
   
10,629
     
8,595
 
Total operating expenses
   
51,575
     
53,304
 
Loss from operations
   
(399
)
   
(7,438
)
Other income (expense):
               
Interest income
   
28
     
41
 
Interest expense
   
(287
)
   
(413
)
Other income (expense), net
   
(168
)
   
(30
)
Total other expense
   
(427
)
   
(402
)
Loss before provision for income tax
   
(826
)
   
(7,840
)
Provision for income tax
   
209
     
197
 
Net loss
 
$
(1,035
)
 
$
(8,037
)
Net loss per share - basic and diluted
 
$
(0.02
)
 
$
(0.14
)
Shares used in computing net loss per share - basic and diluted (2)
   
59,543
     
58,186
 
 
               
(1) Includes stock-based compensation expense as follows:
               
Cost of product revenue
 
$
29
   
$
50
 
Cost of hosted and related services revenue
   
49
     
38
 
Cost of support and services revenue
   
247
     
207
 
Research and development
   
564
     
1,059
 
Sales and marketing
   
544
     
862
 
General and administrative
   
681
     
1,137
 
Total stock-based compensation expense
 
$
2,114
   
$
3,353
 
 
(2) Potentially dilutive securities were not included in the computation of diluted net loss per share for the periods which had a net loss because to do so would have been anti-dilutive.
 
See Notes to Condensed Consolidated Financial Statements

SHORETEL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)

 
 
Three Months Ended September 30,
 
 
 
2013
   
2012
 
 
 
(In thousands)
 
Net loss
 
$
(1,035
)
 
$
(8,037
)
Other comprehensive income, net of tax:
               
Unrealized gains on short-term investments
   
7
     
7
 
Other comprehensive income
   
7
     
7
 
 
               
Comprehensive loss
 
$
(1,028
)
 
$
(8,030
)
 
See Notes to Condensed Consolidated Financial Statements
SHORETEL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
   
 
Net loss
 
$
(1,035
)
 
$
(8,037
)
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
   
4,345
     
3,677
 
Stock-based compensation expense
   
2,114
     
3,353
 
Amortization of premium on investments
   
40
     
51
 
Loss on disposal of property and equipment
   
278
     
-
 
Provision for doubtful accounts receivable
   
75
     
-
 
Change in fair value of purchase consideration
   
53
     
188
 
Changes in assets and liabilities, net of effect of acquisition:
               
Accounts receivable
   
6,040
     
3,896
 
Inventories
   
1,141
     
1,140
 
Indemnification asset
   
(323
)
   
-
 
Prepaid expenses and other current assets
   
(89
)
   
(741
)
Other assets
   
(18
)
   
361
 
Accounts payable
   
3,201
     
(419
)
Accrued liabilities and other
   
(2,109
)
   
(866
)
Accrued employee compensation
   
(1,175
)
   
(499
)
Accrued taxes and surcharges
   
(689
)
   
318
 
Deferred revenue
   
2,389
     
694
 
Net cash provided by operating activities
   
14,238
     
3,116
 
 
               
CASH FLOWS FROM INVESTING ACTIVITES:
               
Purchases of property and equipment
   
(1,036
)
   
(1,774
)
Purchases of investments
   
-
     
(3,552
)
Proceeds from sale/maturities of investments
   
1,350
     
7,950
 
Purchases of patents, technology and other intangible assets
   
-
     
(750
)
Net cash provided by investing activities
   
314
     
1,874
 
 
               
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from issuance of common stock
   
3,315
     
27
 
Taxes paid on vested and released stock awards
   
(440
)
   
(618
)
Payments made under line of credit
   
(11,000
)
   
-
 
Payments made under capital leases
   
(347
)
   
(304
)
Net cash used in financing activities
   
(8,472
)
   
(895
)
 
               
NET INCREASE IN CASH AND CASH EQUIVALENTS
   
6,080
     
4,095
 
CASH AND CASH EQUIVALENTS - Beginning of period
   
43,775
     
37,120
 
CASH AND CASH EQUIVALENTS - End of period
 
$
49,855
   
$
41,215
 
 
               
SUPPLEMENTAL CASH FLOW DISCLOSURE:
               
Cash paid for interest
 
$
215
   
$
220
 
Cash paid for taxes
 
$
63
   
$
60
 
 
               
NONCASH INVESTING AND FINANCING ACTIVITIES:
               
 
               
Property, plant and equipment acquired on capital lease
 
$
123
   
$
41
 
Unpaid portion of property and equipment purchases included in period-end accruals
 
$
888
   
$
893
 
 
See Notes to Condensed Consolidated Financial Statements
SHORETEL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
1. Description of Business
 
ShoreTel, Inc. and its subsidiaries (referred herein as “the Company”) are a leading provider of pure Internet Protocol, or IP, Unified Communications (“UC”) systems for enterprises while offering both premise-based and hosted business solutions. The Company’s premise systems are based on its distributed software architecture and switch-based hardware platforms which enable multi-site enterprises to be served by a single telecommunications system. The Company’s premise systems enable a single point of management, easy installation and a high degree of scalability and reliability, and provide end users with a consistent, full suite of features across the enterprise, regardless of location. The Company also offers a hosted solution based on the Company’s proprietary UC platform. The hosted solution offers a secure and managed business communications solution to enterprises with minimal capital investment required. The Company’s hosted architecture offers a wide variety of applications and services which provide a full user experience along with the capability to scale based on a customer’s evolving needs.
 
2. Basis of Presentation and Significant Accounting Policies
 
The accompanying condensed consolidated financial statements as of September 30, 2013, and for the three months ended September 30, 2013 and 2012 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, 2013. In the opinion of management, all adjustments (primarily consisting of normal recurring adjustments) considered necessary for a fair statement have been included.
 
The condensed consolidated balance sheet at June 30, 2013 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, 2013. The results of operations for the three months ended September 30, 2013 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.
 
Reclassifications
 
In connection with the acquisition of M5 Networks, Inc. (“M5”) in March 2012, the consolidated statement of cash flow for the three months ended September 30, 2012 has been recast to include retrospective purchase accounting adjustments. These adjustments were retrospectively applied to the March 23, 2012 acquisition date balance sheet. These adjustments pertain to measurement period adjustments during the nine months ended March 31, 2013, which coincides with the one year anniversary date of the acquisition, based on the valuation of assets acquired and liabilities assumed in the M5 acquisition. The effect on the consolidated statement of cash flow for the three months ended September 30, 2012, as a result of the recast, is a change to the addition of the deferred tax valuation allowance of $0.1 million, a decrease in the other assets of $1.0 million, a decrease in accrued and other liabilities of $1.2 million and an increase in accrued taxes and surcharges of $0.3 million.
 
Computation of Net Loss per Share
 
Basic net loss per share is determined by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is determined by dividing net loss by the weighted average number of common shares used in the basic 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 10.8 million and 11.8 million shares were not included in the computation of diluted net loss per share for the three months ended September 30, 2013 and 2012, 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, 2013, 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 31% of total accounts receivable at September 30, 2013. At June 30, 2013 one value-added distributor accounted for 27% of the total accounts receivable .
Revenue Recognition
 
The Company’s revenue recognition policy from products and services of its premise and hosted segments is included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2013.
 
Recent Accounting Pronouncements
 
In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (ASU) No. 2011-11, Balance Sheet (Topic 210) -   Disclosures about Offsetting Assets and Liabilities (ASU 2011-11) , that requires an entity to disclose additional information about offsetting and related arrangements to enable users of the financial statements to understand the effect of those arrangements on the financial position. ASU 2011-11 was adopted by the Company beginning July 1, 2013. The adoption of ASU 2011-11 did not impact disclosures or the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-5, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income , which requires companies to present the total of comprehensive income (loss), the components of net income (loss), and the components of other comprehensive income (loss) either as a single continuous statement of comprehensive income (loss) or in two separate but consecutive statements. This update eliminates the option to present the components of other comprehensive income (loss) as part of the statement of changes in stockholders’ equity. In December 2011, the FASB deferred the effective date of the specific requirement to present items that are reclassified out of accumulated other comprehensive income (loss) to net income (loss) alongside their respective components of net income (loss) and other comprehensive income (loss). The deferred provision was adopted in the three months ended September 30, 2013 and did not have an impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued ASU No. 2012-2, Intangibles - Goodwill and Other (Topic 350) - Testing Goodwill for Impairment (ASU 2012-2) , an accounting standard update intended to simplify how an entity tests indefinite-lived intangible assets other than goodwill for impairment by providing entities with an option to perform a qualitative assessment to determine whether further impairment testing is necessary. This accounting standard update was adopted in the three months ended September 30, 2013 and did not have an impact on the Company's consolidated financial statements.

3. Balance Sheet Details
 
Balance Sheet Components Consist of the Following:
 
 
 
September 30,
2013
   
June 30,
2013
 
 
 
(Amounts in thousands)
 
Inventories:
 
   
 
Raw materials
 
$
128
   
$
128
 
Distributor inventory
   
1,450
     
1,687
 
Finished goods
   
16,056
     
17,076
 
Total inventories
 
$
17,634
   
$
18,891
 
 
               
Property and equipment:
               
Computer equipment and tooling
 
$
25,027
   
$
23,172
 
Software
   
3,108
     
3,080
 
Furniture and fixtures
   
3,207
     
3,072
 
Leasehold improvements & others
   
6,029
     
6,330
 
Total property and equipment
   
37,371
     
35,654
 
Less accumulated depreciation and amortization
   
(21,748
)
   
(20,029
)
Property and equipment – net
 
$
15,623
   
$
15,625
 
 
               
Deferred revenue:
               
Product
 
$
4,074
   
$
4,893
 
Support and services
   
49,867
     
47,074
 
Hosted and related services
   
3,434
     
3,019
 
Total deferred revenue
 
$
57,375
   
$
54,986
 
 
Intangible Assets:
 
The following is a summary of the Company’s intangible assets as of the following dates (in thousands):
 
 
 
September 30, 2013
   
June 30, 2013
 
 
 
Gross
Carrying
Amount
   
Accumulated‎
 Amortization
   
Net Carrying
‎ Amount
   
Gross
  Carrying
Amount
   
Accumulated‎
Amortization
   
Net Carrying‎
Amount
 
Patents
 
$
3,810
   
$
(2,643
)
 
$
1,167
   
$
3,810
   
$
(2,446
)
 
$
1,364
 
Technology
   
24,944
     
(10,238
)
   
14,706
     
22,948
     
(8,832
)
   
14,116
 
Customer relationships
   
23,300
     
(5,299
)
   
18,001
     
23,300
     
(4,448
)
   
18,852
 
Non-compete agreements
   
300
     
(228
)
   
72
     
300
     
(191
)
   
109
 
Intangible assets in process and other
   
1,700
     
-
     
1,700
     
3,697
     
-
     
3,697
 
Intangible assets
 
$
54,054
   
$
(18,408
)
 
$
35,646
   
$
54,055
   
$
(15,917
)
 
$
38,138
 

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. Such costs are amortized using the straight-line method over the estimated economic life of the product. The Company evaluates 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. 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.
During the three months ended September 30, 2012, the Company capitalized $0.5 million of software development costs related to new products. The software became available for general release to customers during the three months ended September 30, 2013; therefore, a total of $2.0 million in software development costs were transferred from intangible assets in process and other to technology in the table above and amortization expense is being recognized related to these capitalized software costs.  The Company did not capitalize any software development costs for the three months ended September 30, 2013.
 
Amortization of intangible assets for the three months ended September 30, 2013 and 2012 was $2.5 million and $2.4 million, respectively.
 
The estimated amortization expenses for intangible assets as of September 30, 2013 for the next five years and thereafter are as follows (in thousands):
 
Years Ending June 30,
 
 
 
2014 (remaining nine months)
 
$
7,093
 
2015
   
7,745
 
2016
   
7,064
 
2017
   
5,574
 
2018
   
3,579
 
Thereafter
   
2,891
 
Total
 
$
33,946
 

Short-Term Investments:
 
The following tables summarize the Company’s short-term investments (in thousands):
 
 
 
Amortized
 Cost
   
Gross Unrealized
Gains
   
Gross Unrealized
 Losses
   
 
Fair Value
 
As of September 30, 2013
 
   
   
   
 
Corporate notes and commercial paper
 
$
5,524
   
$
5
   
$
-
   
$
5,529
 
U.S. Government agency securities
   
589
     
-
     
-
     
589
 
Total short-term investments
 
$
6,113
   
$
5
   
$
-
   
$
6,118
 
 
                               
As of June 30, 2013
                               
Corporate notes and commercial paper
 
$
6,107
   
$
1
   
$
(3
)
 
$
6,105
 
U.S. Government agency securities
   
1,396
     
-
     
-
     
1,396
 
Total short-term investments
 
$
7,503
   
$
1
   
$
(3
)
 
$
7,501
 
 
The following table summarizes the maturities of the Company’s fixed income securities (in thousands):  

 
 
Amortized
Cost
   
 
Fair Value
 
As of September 30, 2013
 
   
 
Less than 1 year
 
$
5,609
   
$
5,613
 
Due in 1 to 3 years
   
504
     
505
 
Total
 
$
6,113
   
$
6,118
 

 
Amortized
Cost
 
Fair Value
As of June 30, 2013
Less than 1 year
 
$
4,912
   
$
4,912
 
Due in 1 to 3 years
   
2,591
     
2,589
 
Total
 
$
7,503
   
$
7,501
 
 
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):
 
 
 
September 30, 2013
 
 
 
Fair Value
   
Level 1
   
Level 2
   
Level 3
 
Assets:
 
   
   
   
 
Cash and cash equivalents:
 
   
   
   
 
Money market funds
 
$
7,679
   
$
7,679
   
$
-
   
$
-
 
Short-term investments:
                               
Corporate notes and commercial paper
   
5,529
     
-
     
5,529
     
-
 
U.S. Government agency securities
   
589
     
-
     
589
     
-
 
Total assets measured and recorded at fair value
 
$
13,797
   
$
7,679
   
$
6,118
   
$
-
 
Liabilities:
                               
Acquisition-related consideration
 
$
3,630
   
$
-
   
$
3,630
   
$
-
 

The above table excludes $42.2 million of cash balances on deposit at banks.

  June 30,2013
 
 
Fair Value
   
Level 1
   
Level 2
   
Level 3
 
Assets:
 
   
   
   
 
Cash and cash equivalents:
 
   
   
   
 
Money market funds
 
$
6,280
   
$
6,280
   
$
-
   
$
-
 
Short-term investments:
                               
Corporate notes and commercial paper
   
6,105
     
-
     
6,105
     
-
 
U.S. Government agency securities
   
1,396
     
-
     
1,396
     
-
 
Total assets measured and recorded at fair value
 
$
13,781
   
$
6,280
   
$
7,501
   
$
-
 
Liabilities:
                               
Acquisition-related consideration
 
$
3,577
   
$
-
   
$
3,577
   
$
-
 
 
The above table excludes $37.5 million of cash balances on deposit at banks.
 
The foreign exchange forward contracts outstanding as of September 30, 2013 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.
 
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 material impairment charges during the three months ended September 30, 2013 and 2012, 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.
 
The Company measures the fair value of outstanding debts for disclosure purposes on a recurring basis. As of September 30, 2013 and June 30, 2013, long-term debt of $18.0 million and $29.0 million, respectively, is reported at amortized cost. This outstanding debt is classified at Level 2 as it is not actively traded and is valued using a discounted cash flow model that uses observable market inputs. Based on the discounted cash flow model, the fair value of the outstanding debt approximates amortized cost.
 
The purchase consideration for the Company’s acquisition of M5 included a contingent portion ranging from zero to $13.7 million and was subject to the achievement of certain revenue targets. These revenue targets were met in full on December 31, 2012, and as such, $10.0 million was paid in March 2013 and the full remaining $3.7 million will be paid in January 2014. Additionally, due to the achievement of these revenue targets, the fair value of the remaining $3.7 million was determined as of September 30, 2013 by taking the present value of these future cash payments using a present value discount rate of 6.0%. The purchase consideration is classified within Level 2 of the fair value hierarchy since it is based on observable inputs.
 
The change in the fair value of the Company’s purchase consideration liability is as follows (in thousands):
 
 
 
Fair Value
 
As of June 30, 2013
 
$
3,577
 
Add: Change in fair value of purchase consideration
   
53
 
As of September 30, 2013
 
$
3,630
 

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 an 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, 2013 that required a nonrecurring fair value analysis to be performed on non-financial assets.
5. Line of credit
 
On March 15, 2012, the Company entered into a secured credit agreement (the “Credit Facility”).  The Credit Facility was amended on December 4, 2012. The Credit Facility includes a revolving loan facility for an aggregate principal amount not exceeding $50.0 million. The Credit Facility matures on the fifth anniversary of its closing (March 15, 2017) 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 either (at the election of the Company) at (i) the London interbank offered rate then in effect, plus a margin of between 2.00% and 2.50%, 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. The amounts borrowed are recorded as long-term debt, net of the financing costs, in the Company’s consolidated financial statements. As of September 30, 2013, the Company had an additional $31.7 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 September 30, 2013.
 
For the three months ended September 30, 2013, the Company paid interest at an approximate rate of 2.4% per annum. As of September 30, 2013, the Company had $18.3 million outstanding under the Credit Facility. The Company amortizes deferred financing costs to interest expense on a straight-line basis over the term of the debt.
 
6. Income Taxes
 
The Company recorded an income tax provision of $0.2 million for both the three months ended September 30, 2013 and 2012.
 
The tax provision of $0.2 million determined for the three months ended September 30, 2013 is primarily the result of income tax provisions for federal alternative minimum tax, tax provisions for profitable foreign jurisdictions based upon income earned during this period and tax provisions for 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 tax provision determined for the three months ended September 30, 2012 is primarily the result of income tax provisions for profitable jurisdictions based upon income earned during this period, tax provisions for certain states that are determined on a basis other than income earned and an increase in the valuation allowance recorded against deferred tax assets established upon the acquisition of M5 Networks.
 
The Company maintains liabilities for uncertain tax positions. As of September 30, 2013 and June 30, 2013, the Company’s total amounts of unrecognized tax benefits were $4.1 million and $4.1 million, respectively. Of the total of $4.1 million of unrecognized tax benefit as of September 30, 2013, only $0.1 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.
 
The “American Taxpayer Relief Act of 2012” (the “2012 Tax Act”) was enacted in January 2013. The 2012 Tax Act extended certain tax provisions that had previously expired under the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010”. The 2012 Tax Act extended the Research and Development credit for qualifying activities through December 31, 2013 and also extended the 50% bonus depreciation provisions on property acquired through December 31, 2013.
 
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 2001 through 2013 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, 2013, the Company has reserved shares of common stock for issuance as follows (in thousands):

Reserved under stock option plans
   
16,676
 
Reserved under employee stock purchase plan
   
510
 
Total
   
17,186
 
 
  8. Stock-Based Compensation
 
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:

 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Expected life from grant date of option (in years)
   
5.44
     
5.32
 
Expected life from grant date of ESPP (in years)
   
0.50
     
0.50
 
Risk free interest rate for options
   
1.51
%
   
0.67 - 1.68
%
Risk free interest rate for ESPP
   
0.07
%
   
0.15
%
Expected volatility  for options
   
66
%
   
69 - 73
%
Expected volatility  for ESPP
   
42
%
   
57
%
Expected dividend yield
   
0
%
   
0
%

During the three months ended September 30, 2013 and 2012, the Company recorded non-cash stock-based compensation expense of $2.1 million and $3.4 million, respectively.
 
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, 2013, total unrecognized compensation cost related to stock-based options and awards granted to employees and non-employee directors was $10.4 million. This cost will be amortized on a ratable basis over a weighted-average vesting period of approximately 2.9 years.
 
9. Stock Option Plan
 
In January 1997, the Board of Directors and stockholders adopted the 1997 stock option plan (the “1997 Plan”) which, as amended, provided for granting incentive stock options (“ISOs”) and nonqualified stock options (“NSOs”) for shares of common stock to employees, directors, and consultants of the Company. This plan was terminated in January 2007 for new issuances.
 
In February 2007, the Company adopted the 2007 Equity Incentive Plan (the “2007 Plan”) which, as amended, provides for grants of ISOs, NSOs, restricted stock units (“RSUs”) and restricted stock awards (“RSAs”) to employees, directors and consultants of the Company. Options granted generally vest ratably over four years from the date of grant. The 2007 Plan provides that the options shall be exercisable over a period not to exceed ten years. Five million shares of common stock were initially reserved for future issuance in the form of stock options, restricted stock awards or units, stock appreciation rights and stock bonuses. Pursuant to the provisions under the 2007 Plan, each year, the number of shares in the reserve shall be increased by the provisions set forth in the 2007 Plan, subject to approval by the Company’s Board of Directors. The Company’s Board of Directors increased the number of shares authorized and reserved for issuance under the 2007 Plan during the years ended June 30, 2013 and 2012, by 2.9 million shares and 2.4 million shares, respectively.
Transactions under the 1997 and 2007 option 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, 2013
   
8,898
   
$
5.45
   
   
 
Options granted (weighted average fair value $2.67 per share)
   
1,476
     
4.63
   
   
 
Options exercised
   
(947
)
   
3.57
   
   
 
Options cancelled/forfeited
   
(257
)
   
6.07
   
   
 
Balance at September 30, 2013
   
9,170
   
$
5.49
     
6.61
   
$
10,557
 
Vested and expected to vest at September 30, 2013
   
7,939
   
$
5.58
     
6.05
   
$
8,853
 
Options exercisable at September 30, 2013
   
5,216
   
$
5.73
     
4.82
   
$
5,528
 

The total pre-tax intrinsic value for options exercised in the three months ended September 30, 2013 and 2012 was $1.7 million and $36,000, 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
 
On September 18, 2007, the Board of Directors approved the commencement of offering periods under a previously-approved employee stock purchase plan (the “ESPP”). 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 purchased 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.
 
In February of fiscal 2013 and 2012, pursuant to the automatic increase provisions of the ESPP, the Company’s Board of Directors approved increases to the number of shares authorized and reserved for issuance under the ESPP by 587,188 and 481,433 shares, respectively .
 
As of September 30, 2013, 509,924 shares are reserved for future issuance under the ESPP.
 
11. Restricted Stock
 
Under the 2007 Plan, during the three months ended September 30, 2013 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, and generally vest 25% at each one year anniversary from the date of grant.
 
Restricted stock award and restricted stock unit activity for the three months ended September 30, 2013 and 2012 is as follows (in thousands):
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Beginning outstanding
   
1,310
     
1,641
 
Awarded
   
619
     
468
 
Released
   
(294
)
   
(431
)
Forfeited
   
(53
)
   
(55
)
Ending outstanding
   
1,582
     
1,623
 

Information regarding restricted stock awards and restricted stock units outstanding at September 30, 2013 is summarized below:
 
 
 
Number of Shares
(thousands)
   
Weighted Average
Remaining
 Contractual Lives
   
Aggregate Intrinsic
 Value
(thousands)
 
Shares outstanding
   
1,582
     
1.77
   
$
9,557
 
Shares vested and expected to vest
   
1,026
     
1.48
   
$
6,195
 

  12. Litigation, Commitments, Contingencies and Leases
 
Litigation — At September 30, 2013, 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 and 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.
 
In addition, on March 21, 2013, the Company provided Fortis Advisors LLC, as representative of the former shareholders of M5 Networks, with a Claim Certificate disclosing certain claims for indemnification under the January 31, 2012 Agreement and Plan of Reorganization between M5 and the Company (the “Purchase Agreement”).  Thereafter, the Company and Fortis engaged in negotiations in an attempt to resolve the indemnification claims asserted by the Company.  In September 2013, the Company received notice of commencement of an arbitration proceeding by Fortis on behalf of the former shareholders of M5.  Through the arbitration, Fortis seeks a declaration that the Company’s claims for indemnification are precluded.  On October 11, 2013, the Company served its response, denying all of Fortis’ allegations and asserting counterclaims for breach of the Purchase Agreement and declaratory relief.  An arbitration hearing has not yet been set.
 
Indemnification asset — At September 30, 2013, the Company had recorded a $6.6 million indemnification asset. The indemnification asset represents reimbursement the Company reasonably expects to receive from the escrow funds, currently held by a financial institution, pursuant to the M5 acquisition agreement.
 
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, 2013, are as follows (in thousands):

Years Ending June 30,
 
Operating
 Leases
   
Capital
 Leases
 
2014 (remaining nine months)
 
$
3,262
   
$
1,087
 
2015
   
3,420
     
413
 
2016
   
3,188
     
41
 
2017
   
3,013
     
14
 
2018
   
2,279
     
-
 
Therafter
   
4,230
     
-
 
Total minimum lease payments
 
$
19,392
     
1,555
 
 
               
Less: amount representing interest
           
(78
)
Present value of total minimum lease payments
           
1,477
 
Less: current portion liability
           
(1,258
)
Capital lease obligation, net of current portion
         
$
219
 

The operating lease obligations noted in the table above have not been reduced by non-cancellable sublease rentals of $0.6 million.
 
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, 2013.
 
Rent expense for the three months ended September 30, 2013 and 2012 was $1.1 million and $0.9 million, respectively.
Purchase commitments — The Company had purchase commitments with contract manufacturers for inventory totaling approximately $32.1 million as of September 30, 2013 and $24.0 million as of June 30, 2013.
 
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. The Company also has indemnification obligations to the underwriters of its initial public offering pursuant to the underwriting agreement executed in connection with that offering.
 
13. Segment Information
 
The Company provides UC systems for enterprises through offering both premise and hosted business solutions. Due to the uniqueness of these platforms, the Company considers each of these offerings a separate segment. The Company’s chief operating decision-maker (“CODM”) is its Chief Executive Officer (“CEO”). The Company’s CEO reviews revenue and gross profit for these two distinct segments to evaluate financial performance and allocate resources. The financial information by the two reportable segments is also accompanied by information about revenue by geographic regions.

The following presents total revenue and gross profit by reportable segments (in thousands):

 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Total revenues:
 
   
 
Premise
 
$
63,548
   
$
59,322
 
Hosted
   
20,739
     
15,662
 
Total
 
$
84,287
   
$
74,984
 
 
               
Gross profit:
               
Premise
 
$
42,970
   
$
39,346
 
Hosted
   
8,206
     
6,520
 
Total
 
$
51,176
   
$
45,866
 

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):
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
United States of America
 
$
76,531
   
$
66,965
 
International
   
7,756
     
8,019
 
Total
 
$
84,287
   
$
74,984
 

Revenue from one value-added distributor accounted for approximately 25% and 22% of the total revenue during the three months ended September 30, 2013 and 2012, respectively.
 
The Company’s assets are primarily located in the United States of America and not allocated to any specific region and it 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, and intangible assets (in thousands):
 
 
 
September 30,
2013
   
June 30,
2013
 
United States of America
 
$
14,971
   
$
14,929
 
International
   
652
     
696
 
Total
 
$
15,623
   
$
15,625
 

The following presents the carrying value of goodwill for the Company’s reportable segments (in thousands):
 
 
 
Premise
Segment
   
Hosted
Segment
   
Total
 
As of June 30, 2013
 
$
7,415
   
$
115,335
   
$
122,750
 
 
                       
As of September 30, 2013
 
$
7,415
   
$
115,335
   
$
122,750
 

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, 2013, 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. The fair values recorded during the three months ended September 30, 2013 and 2012 were not material since these contracts were entered into on the last day of the period. These derivatives have maturities of approximately one month.
 
The following table presents the gross notional value of all of the Company’s foreign exchange forward contracts outstanding as of September 30, 2013 (in thousands):

 
 
September 30, 2013
 
 
 
Local Currency
 Amount
   
Notional Contract
 Amount (USD)
 
Australian dollar
 
$
2,350
   
$
2,165
 
British pound
 
£
2,710
     
4,355
 
Euro
 
420
     
564
 
Total
         
$
7,084
 

No such contracts were outstanding as of June 30, 2013.
 
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
 
We are a leading provider of Internet Protocol (“IP”) telecommunications solutions for enterprises. We were founded in September 1996 and shipped our first system in 1998. Since that time, we have continued to develop and enhance our product line. Our acquisition of M5 Networks, Inc. (“M5”), a provider of hosted unified communication solutions, in the third quarter of fiscal 2012, expanded our products and service offerings to now include hosted solutions. Our acquisition of Agito Networks, Inc. (“Agito”), a provider of platform-agnostic enterprise mobility, in the second quarter of fiscal 2011, expanded our existing mobile solution with the vision of allowing users to communicate on any device, such as a desk phone, mobile phone, tablet or computer, at any location using any cellular or Wi-Fi network simply and cost effectively.
Our solutions are available for businesses to operate in their own premise data centers or on a hosted, cloud-based platform. Solutions within our premise segment are comprised of our switches, IP phones and software applications which work with our unique IP architecture to provide a brilliantly simple integrated communication system. Our ShoreTel Sky solutions are sold within our hosted segment and are comprised of M5’s software and services delivered to the customer using our routers and IP phones. We anticipate that our cloud business will grow at a faster rate than our premise business. Accordingly, we will continue to invest more in cloud-based infrastructure to help enable our growth.
 
Our phone and switch products are manufactured by contract manufacturers located in the United States and in China. Our contract manufacturers provide us with a range of operational and manufacturing services, including component procurement, final testing and assembly of our products, which allows us to scale our business without the significant capital investment and on-going expenses required to establish and maintain a manufacturing operation.
 
We sell our premise and hosted products primarily through channel partners that market and sell our systems to customers across all industry verticals, focusing on small and medium companies and public institutions. Our channel partners include resellers as well as value-added distributors who in turn sell to the resellers. We believe our channel strategy allows us to reach a larger number of prospective small and medium business customers more effectively than if we were to sell directly. The number of our authorized channel partners was approximately 1,000 as of September 30, 2013. Our internal sales and marketing personnel support these channel partners in their selling efforts. In some circumstances, the enterprise customer will purchase products directly from us, but in these situations we typically compensate the channel partner for its sales efforts. At the request of the channel partner, we often ship our products directly to the enterprise customer.
 
We are headquartered in Sunnyvale, California and have sales, customer support, general and administrative and engineering functions in Texas. Following the acquisition of M5, our ShoreTel Sky related functions are performed from our offices in New York and Illinois. The majority of our personnel work at these locations. Sales, engineering, and support personnel are also located throughout the United States and, to a lesser extent, in Canada, the United Kingdom, Ireland, Germany, Spain, Hong Kong, Singapore, Philippines, India and Australia. Since the vast majority of our new hosted revenue comes from the United States, we have experienced a decrease in the percentage of total revenue represented by international sales, which accounted for approximately 9% and 11% of our total revenue for the three months ended September 30, 2013 and 2012, respectively. We expect sales to customers in the United States will continue to comprise the majority of our sales in the foreseeable future.

As of September 30, 2013, our solutions have been installed by more than 31,000 business customers. We serve a wide range of vertical markets, including professional services, financial services, government, education, health care, manufacturing, non-profit organizations and technology industries.
 
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 made 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. This deferred revenue helps provide predictability to our future support and services revenue. 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. Deferred revenue for our hosted segment represents amounts paid by customers for future services to be provided. Our deferred revenue balance at September 30, 2013 was $57.3 million, of which $40.8 million is expected to be recognized within one year.
 
Gross margin. Our gross margin for premise segment products is 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. As the prices and costs of our hardware components have decreased over time, our software components, which have lower costs than our hardware components, have represented a greater percentage of our overall margin on system sales. 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 premise 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.
 
Gross margin for the hosted segment services is lower than the gross margins for the premise segment 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 the hosted customer base, the gross margins for our hosted business may improve over time.
 
Operating expenses. Our operating expenses are comprised primarily of compensation and benefits for our employees as well as marketing expenses. Accordingly, increases in operating expenses historically have been primarily related to increases in our headcount. We intend to expand our workforce in the hosted business to support our anticipated growth, 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 segment as the average monthly recurring revenue per customer divided by the average number of seats per customer. The average monthly recurring revenue per customer is calculated as the monthly recurring 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 month periods ended September 30, 2013 and 2012 were approximately $47 and $55, respectively. The decrease in ARPU was primarily due to a greater number of volume discounts related to increased sales to larger enterprise customers and a decrease in the resale of telecommunication internet circuits to new customers as compared to the existing customer base.
 
Revenue churn . Revenue churn for our hosted segment is calculated by dividing the monthly recurring revenue from customers that have terminated during a period by the total monthly recurring revenue from all customers in a given period and then annualizing the calculation. 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 as of both September 30, 2013 and 2012 was approximately 4%.

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.

Premise Revenue . Premise product revenue consists of sales of our business communications systems. Our typical system includes a combination of IP phones, switches and software applications primarily for our premise business. 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 customer satisfaction levels, as well as our own strategic considerations. In circumstances where we sell directly to the enterprise customer in transactions that have been assisted by channel partners, we report our revenue net of any associated payment to the channel partners that assisted in such sales. This results in recognized revenue from a direct sale approximating the revenue that would have been recognized from a sale of a comparable system through a channel partner. Premise product revenue accounted for 56% and 61% of our total revenue for the three months ended September 30, 2013 and 2012, respectively.
 
Premise support and services revenue primarily consists of post-contractual support, and to a lesser extent revenue from training services, professional services and installations that we perform. Post-contractual support includes software updates which grant rights to unspecified software license upgrades and maintenance releases issued during the support period. Post-contractual support also includes both Internet- and phone-based technical support. Revenue from post-contractual support is recognized ratably over the contractual service period. Premise support and services revenues accounted for 19% and 18% of our total revenue for the three months ended September 30, 2013 and 2012, respectively.

Hosted Revenue. Hosted services and solutions consist primarily of our proprietary hosted VoIP Unified Communications system as well as other services such as foreign and domestic calling plans, certain UC applications like mobility, internet service provisioning, training, installation and other professional services. Additionally, we offer our customers the ability to purchase IP phones from us directly or rent such systems as part of their service agreements. Our hosted services are sold through indirect channel resellers and a direct sales force. Our customers typically enter into 12 month service agreements whereby they are billed for such services on a monthly basis. Revenue from our hosted services is recognized on a monthly basis as services are delivered. Revenue associated with various calling plans and internet services are recognized as such services are provided. Hosted revenues accounted for 25% and 21% of our total revenues for the three months ended September 30, 2013 and 2012, respectively.

Cost of revenue. Cost of premise product revenue consists primarily of hardware costs, royalties and license fees for third-party software included in our systems, salary and related overhead costs of operations personnel, freight, warranty costs and provision for excess inventory. The majority of these costs vary with the unit volumes of products sold. Cost of premise support and services revenue consists of salary and related overhead costs of personnel engaged in support and service activities. Cost of hosted services revenue consists of personnel and related costs of the hosted operation, data center costs, data communication cost, carrier cost and amortization of intangible assets.

Research and development expenses. Research and development expenses primarily include personnel costs, outside engineering costs, professional services, prototype costs, test equipment, software usage fees and facilities expenses. Research and development expenses are recognized when incurred on a project basis. We capitalize development costs incurred from determination of technological feasibility through general release of the product to customers. We are devoting substantial resources to the development of additional functionality for existing products and the development of new products and related software applications. We intend to continue to make investments in our research and development efforts because we believe they are essential to maintaining and improving our competitive position. Accordingly, we expect research and development expenses to continue to increase in absolute dollars.

Sales and marketing expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, travel, marketing promotional and lead generation programs, branding and advertising, trade shows, sales demonstration equipment, professional services fees, amortization of intangible assets, and facilities expenses. We plan to continue investing in our domestic and international marketing activities to help build brand awareness and create sales leads for our channel partners.  We expect that sales and marketing expenses will be our largest operating expense category.

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, accounting, tax, compliance and information systems, travel, recruiting expense, software amortization costs, sales and telecom taxes, depreciation expense and facilities expenses. As we expand our business, we expect general and administrative expenses to increase in absolute dollars.

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

Provision from income taxes. Provision for income taxes includes federal, state and foreign tax on our income as well as any adjustments made to our valuation allowance for deferred tax assets. Since our inception, we have accumulated substantial net operating loss and tax credit carryforwards. We account for income taxes under an asset and liability approach.  Deferred income taxes reflect the impact of temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for income tax reporting purposes, net operating loss carryforwards and other tax credits measured by applying current enacted tax laws.  Valuation allowances are provided when necessary to reduce deferred tax assets to an amount that is more likely than not to be realized.
 
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, or 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 income tax related balances. 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, 2013 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 2013 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those accounting policies, please refer to our 2013 Annual Report on Form 10-K.
Results of Operations
 
The following table sets forth unaudited selected condensed consolidated statements of operations data for the three months ended September 30, 2013 and 2012 (in thousands, except per share amounts).

 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Revenue:
 
   
 
Product
 
$
47,682
   
$
45,834
 
Hosted and related services
   
20,739
     
15,662
 
Support and services
   
15,866
     
13,488
 
Total revenue
   
84,287
     
74,984
 
Cost of revenue:
               
Product  (1)
   
16,296
     
15,787
 
Hosted and related services  (1)
   
12,533
     
9,142
 
Support and services  (1)
   
4,282
     
4,189
 
Total cost of revenue
   
33,111
     
29,118
 
Gross profit
   
51,176
     
45,866
 
Gross profit %
   
60.7
%
   
61.2
%
 
               
Operating expenses:
               
Research and development  (1)
   
13,280
     
13,953
 
Sales and marketing  (1)
   
27,666
     
30,756
 
General and administrative  (1)
   
10,629
     
8,595
 
Total operating expenses
   
51,575
     
53,304
 
Loss from operations
   
(399
)
   
(7,438
)
Other income (expense):
               
Interest income
   
28
     
41
 
Interest expense
   
(287
)
   
(413
)
Other income (expense), net
   
(168
)
   
(30
)
Total other expense
   
(427
)
   
(402
)
Loss before provision for income tax
   
(826
)
   
(7,840
)
Provision for income tax
   
209
     
197
 
Net loss
 
$
(1,035
)
 
$
(8,037
)
Net loss per share - basic and diluted  (2)
 
$
(0.02
)
 
$
(0.14
)
Shares used in computing net loss per share - basic and diluted (2)
   
59,543
     
58,186
 
 
               
(1) Includes stock-based compensation expense as follows:
               
Cost of product revenue
 
$
29
   
$
50
 
Cost of hosted and related services revenue
   
49
     
38
 
Cost of support and services revenue
   
247
     
207
 
Research and development
   
564
     
1,059
 
Sales and marketing
   
544
     
862
 
General and administrative
   
681
     
1,137
 
Total stock-based compensation expense
 
$
2,114
   
$
3,353
 
 
(2) Potentially dilutive securities were not included in the computation of diluted net loss per share for the periods which had a net loss because to do so would have been anti-dilutive.

The following table sets forth selected condensed consolidated statements of operations data as a percentage of total revenue for each of the periods indicated.
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Revenue:
 
   
 
Product
   
56
%
   
61
%
Hosted and related services
   
25
%
   
21
%
Support and services
   
19
%
   
18
%
Total revenue
   
100
%
   
100
%
Cost of revenue:
               
Product
   
19
%
   
21
%
Hosted and related services
   
15
%
   
12
%
Support and services
   
5
%
   
6
%
Total cost of revenue
   
39
%
   
39
%
Gross profit
   
61
%
   
61
%
Operating expenses:
               
Research and development
   
16
%
   
19
%
Sales and marketing
   
33
%
   
41
%
General and administrative
   
12
%
   
11
%
Total operating expenses
   
61
%
   
71
%
Loss from operations
   
-
     
(10
%)
Interest income
   
-
     
-
 
Interest expense
   
(1
%)
   
(1
%)
Other income (expense), net
   
-
     
-
 
Total other expense
   
(1
%)
   
(1
%)
Loss before provision for income tax
   
(1
%)
   
(11
%)
Provision for income tax
   
-
     
-
 
Net loss
   
(1
%)
   
(11
%)
 
Comparison of the three months ended September 30, 2013 and September 30, 2012
 
Revenue.
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
   
Change $
   
Change %
 
(in thousands, except percentages)
 
   
   
   
 
Revenue
 
$
84,287
   
$
74,984
   
$
9,303
     
12
%
 
Total revenue increased by $9.3 million or 12% in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012.  The increase in the overall revenue was primarily due to a $5.1 million increase in revenue associated with our hosted business as well as a $4.2 million increase in premise revenue during the same period.

Premise Revenue

Premise product revenue increased by $1.8 million, or 4%, in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012, primarily due to higher sales volumes of our solutions. Our international premise revenue represented 12% and 14% of our premise revenue in the three months ended September 30, 2013 and 2012, respectively. Premise support and services revenue increased by $2.4 million or 18% in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012. The increase in support and services revenue was primarily due to increased sales to existing customers resulting in higher post-contractual support revenues due to high renewal rates on maintenance contracts as well as the continued expansion of our customer base resulting from sales to new customers.

Hosted Revenue

Hosted and related service revenue increased by $5.1 million or 32% in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012, respectively. The increase in hosted and related service revenue was primarily due to continual growth in our customer base as a result of additional sales personnel within our hosted segment, our expanded branding and product marketing efforts as well as additional increases in the use of our services from existing customers.
 
Cost of revenue and gross profit.

 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
   
Change $
   
Change %
 
(in thousands, except percentages)
 
   
   
   
 
Cost of revenue
 
$
33,111
   
$
29,118
   
$
3,993
     
14
%
Gross profit
   
51,176
     
45,866
     
5,310
     
12
%
Gross margin
   
61
%
   
61
%
   
n/
a
   
-
 
 
Overall gross margin remained consistent at 61% for both the three months ended September 30, 2013 and 2012.

Premise Gross Margin

Premise product gross margins were 66% in both the three months ended September, 2013 and 2012. Premise support and services gross margins increased to 73% in the three months ended September 30, 2013 as compared to 69% in the three months ended September 30, 2012. This increase was driven by synergies achieved by existing headcount which allowed lower personnel costs to support a larger customer base and generate a higher revenue amount from the same period in the prior year.

Hosted Gross Margin

Hosted and related service gross margin remained relatively consistent at 40% for the three months ended September 30, 2013 as compared to 42% for the three months ended September 30, 2012. As the related hosted business continues to expand and grow, we anticipate that we will realize improvements in our gross margins as we achieve synergies and other cost reductions in our service delivery platform.
 
Our hosted business service offering includes cost elements that are unique to the hosted service offering which in turn, impacts the overall hosted service gross margins. Specifically, as part of our hosted service offering, we provide our customers unlimited domestic calling plans and internet service plans. To provide calling services, we purchase and resell minutes and calling plans from various national and regional telecommunication carriers. Additionally, we purchase and resell telecommunications circuits from various local and national internet service providers as a service to customers. As a result of reselling calling plans and providing internet data plans to customers, we incur various regulatory charges. In addition, the hosted gross margin is impacted by the amortization of intangible assets related to the acquisition of M5 Networks.
 
Upon completion of our acquisition of M5 Networks, we have undertaken and plan to undertake several initiatives to create greater efficiencies in the delivery of our hosted services.  These initiatives include:
 
· Consolidation of data centers;
 
· Integration to common hardware platforms;
 
· Integration of our customer support services teams;
 
· Review of our telecommunication costs;
 
· Development of our next generation product.
 
While we believe that through the execution of these initiatives we will improve our gross margins, due to the nature of the unique costs identified above and the overall timing to execute our gross margin improvement initiatives, we do not anticipate that gross margins for our hosted and related services will be commensurate with that of premise business in the short term.

Operating expenses .

 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
   
Change $
   
Change %
 
(in thousands, except percentages)
 
   
   
   
 
Research and development
 
$
13,280
   
$
13,953
   
$
(673
)
   
(5
%)
Sales and marketing
   
27,666
     
30,756
     
(3,090
)
   
(10
%)
General and administration
   
10,629
     
8,595
     
2,034
     
24
%

Research and development. Research and development expenses decreased by $0.7 million, or 5%, during the three months ended September 30, 2013 as compared to the three months ended September 30, 2012 The decrease in research and development expenses from the prior period is due to a decrease in personnel related costs including benefits, bonus and commissions of $0.7 million due to a decrease in headcount.
 
Sales and marketing. Sales and marketing expenses decreased by $3.1 million, or 10%, in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012.  The decrease in sales and marketing expenses from the prior period is primarily due to a decrease in personnel related costs including benefits, bonus and commissions of $2.8 million and a decrease in travel and entertainment expenses of $0.7 million , both due to a decrease in headcount.
 
General and administrative.  General and administrative expenses increased by $2.0 million, or 24%, in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012. The increase in general and administrative expenses from the prior period is primarily due to an increase in personnel related costs including benefits and variable compensation of $0.9 million, an increase in consulting and outside service fees of $0.4 million, an increase in facilities costs of $0.3 million and an increase in sales tax expense of $0.3 million. These increases are due to the increase in overall expenses to support the addition of facilities and headcount.
 
Other income (expense), net.
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
   
Change $
   
Change %
 
(in thousands, except percentages)
 
   
   
   
 
Interest income
 
$
28
   
$
41
   
$
(13
)
   
(32
%)
Interest expense
   
(287
)
   
(413
)
   
(126
)    
(31
%)
Other income (expense), net
   
(168
)
   
(30
)
   
138
 
   
460
%

Interest income. Interest income decreased by $13,000 primarily due to a lower cash and short term investment balance invested during fiscal 2013 as compared to fiscal 2012.

Interest expense. Interest expense decreased by $0.1 million in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012 primarily due to a lower base of purchase consideration  liabilities in which imputed interest expense is recognized in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012.

Other income (expense), net. Other income (expense), net, increased by $0.1 million in the three months ended September 30, 2013 compared to the three months ended September 30, 2012 primarily as a result of an increase in our foreign exchange loss due to the stregthening of the U.S. dollar against certain foreign currencies in which we transact.
Provision for income tax.
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
   
Change $
   
Change %
 
(in thousands, except percentages)
 
   
   
   
 
Provision for income tax
 
$
209
   
$
197
   
$
12
     
6
%

Provision for income tax. The Company’s effective tax rate differs from the statutory rate largely due to the Company providing a full valuation allowance on the current year net operating losses. The provision for income taxes for the three months ended September 30, 2013 is primarily related to federal Alternative Minimum Tax, state and foreign income tax expense.  The income tax provision for the three months ended September 30, 2012 includes a charge of approximately $135,000 relating to the increase in valuation allowance for deferred tax assets associated with subsequent purchase price adjustments recorded for the M5 acquisition.
 
Liquidity and Capital Resources
 
Balance Sheet and Cash Flows
 
The following table summarizes our cash, cash equivalents and short-term investments (in thousands):
 
 
 
September 30,
2013
   
June 30,
2013
   
Increase/
(Decrease)
 
Cash and cash equivalents
 
$
49,855
   
$
43,775
   
$
6,080
 
Short-term investments
   
6,118
     
7,501
     
(1,383
)
Total
 
$
55,973
   
$
51,276
   
$
4,697
 

As of September 30, 2013, our principal sources of liquidity consisted of cash, cash equivalents and short-term investments of $56.0 million, accounts receivable of $31.0 million and the balance of $31.7 million available for borrowing under our Credit Facility.
 
On March 15, 2012, we entered into a secured credit agreement (the “Credit Facility”) with Silicon Valley Bank to finance a portion of the M5 acquisition including paying related fees and expenses and for general corporate purposes.  The Credit Facility was amended on December 4, 2012. The Credit Facility includes a revolving loan facility for an aggregate principal amount not exceeding $50.0 million. The Credit Facility matures on the fifth anniversary of its closing (March 15, 2017) 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 either (at our election) at (i) the London interbank offered rate then in effect, plus a margin of between 2.00% and 2.50%, which is based on the our Consolidated EBITDA (as defined in the Credit Agreement), 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 an annual commitment fee during the term of the Credit Agreement which varies depending on our Consolidated EBITDA. The Credit Facility is secured by substantially all of our assets. For the three months ended September 30, 2013, we paid interest at an approximate rate of 2.4% per annum. The amount outstanding under the Credit Facility was $18.3 million as of September 30, 2013.
 
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):
 
 
 
Three Months Ended
September 30,
 
 
 
2013
   
2012
 
Cash provided by operating activities
 
$
14,238
   
$
3,116
 
Cash provided by investing activities
   
314
     
1,874
 
Cash used in financing activities
   
(8,472
)
   
(895
)
Net increase in cash and cash equivalents
 
$
6,080
   
$
4,095
 

  Cash flows from operating activities
 
Our cash flows from operating activities are significantly influenced by our cash expenditures to support the growth of our business in all areas of operating expense. Our operating cash flows are also influenced by our working capital needs to support growth and fluctuations in inventory, accounts receivable, vendor accounts payable and other current assets and liabilities. We procure finished goods inventory from our contract manufacturers and typically pay them in 30 days. We extend credit to our channel partners and value added distributors on collection terms of 30 to 60 days. In some cases we also prepay for license rights to third-party products in advance of sales.
 
Net loss during the three months ended September 30, 2013 and 2012 included non-cash charges of $2.1 million and $3.4 million in stock-based compensation expense, respectively, and depreciation and amortization of $4.3 million and $3.7 million, respectively. Net loss during the three months ended September 30, 2013 also included a non-cash charge of $0.3 million related to the loss on disposal of property and equipment.
 
Cash provided by operating activities during the three months ended September 30, 2013 also reflects net changes in operating assets and liabilities, which provided $8.4 million of cash consisting primarily of a decrease in accounts receivable of $6.0 million due to improved collections, a decrease in inventory of $1.1 million, an increase in accounts payable of $3.2 million and an increase in deferred revenue of $2.4 million. These cash inflows were offset by an increase in indemnification asset of $0.3 million, a decrease in accrued and other liabilities of $2.1 million, a decrease in accrued employee compensation of $1.2 million and a decrease in accrued taxes and surcharges of $0.7 million.
 
Cash provided by operating activities during the three months ended September 30, 2012 also reflects net changes in operating assets and liabilities, which provided $3.9 million of cash consisting primarily of a decrease in accounts receivable of $3.9 million due to improved collections coupled with lower revenue recognized, decrease in inventory of $1.1 million due to the reduction in the volume of production, increase in deferred revenue of $0.7 million due to higher support contracts and increased volume through our value-added distributors, decrease in other assets of $0.4 million and an increase in accrued taxes and surcharges of $0.3 million. These cash inflows were offset by an increase in prepaid expenses and other current assets of $0.7 million, an decrease in accrued liabilities and other of $0.9 million and decreases in accounts payable and accrued employee compensation of $0.4 million and $0.5 million, respectively.
 
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 provided by investing activities was $0.3 million during the three months ended September 30, 2013 primarily related to the maturities of short-term investments of $1.4 million, offset by purchase of property and equipment of $1.0 million.
 
Net cash provided by investing activities was $1.9 million during the three months ended September 30, 2012 primarily related to maturities of short-term investments of $8.0 million offset by the purchase of short-term investments of $3.6 million, purchases of property and equipment of $1.8 million and purchases of patents, technology and other intangible assets of $0.8 million.
 
Cash flows from financing activities
 
Net cash used in financing activities was $8.5 million and $0.9 million for the three months ended September 30, 2013 and 2012, respectively. In the three months ended September 30, 2013, we made repayments of $11.0 million under our Credit Facility, paid $0.4 million associated with employee tax obligations on the vesting of restricted stock units, paid $0.4 million in relation to our capital leases, offset by the receipt of $3.3 million from the exercise of stock options. In the three months ended September 30, 2012, we paid $0.6 million associated with employee tax obligations on the vesting of restricted stock units and made $0.3 million in payments in relation to our capital leases.
Off-Balance Sheet Arrangements
 
We do not have any material off-balance sheet arrangements (other than those disclosed below within 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, 2013 and the effect that such obligations are expected to have on our liquidity and cash flows in future periods:
 
 
 
Payments Due by Period
 
 
 
Total
   
Less Than
   
1-3 Years
   
3-5 Years
   
Thereafter
 
(In thousands)
 
   
   
1 Year
       
   
       
  
        
  
 
Operating lease obligations
 
$
19,392
   
$
4,326
   
$
6,342
   
$
5,669
   
$
3,055
 
Capital lease obligations
   
1,555
     
1,333
     
222
     
-
     
-
 
Line of credit
   
18,332
     
-
     
-
     
18,332
     
-
 
Non-cancellable purchase commitments (inventory and software licenses)
   
33,500
     
32,769
     
731
     
-
     
-
 
Purchase consideration
   
3,630
     
3,630
     
-
     
-
     
-
 
Total
 
$
76,409
   
$
42,058
   
$
7,295
   
$
24,001
   
$
3,055
 
 
The operating lease obligations noted in the table above have not been reduced by non-cancellable sublease rentals of $0.6 million.
 
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 Australian dollar, British pound 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, 2013, 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, 2013.
 
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 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, 2013.
 
ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
Unregistered Sales of Equity Securities
 
None.
 
ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
 
None.
 
ITEM 4.
MINE SAFETY DISCLOSURES
 
Not applicable.
 
ITEM 5.
OTHER INFORMATION
 
Not applicable.
 
ITEM 6.
E XHIBITS
 
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 8, 2013
 
 
 
 
 
 
ShoreTel, Inc.
 
 
By:
/s/    M ICHAEL E. H EALY
 
 
Michael E. Healy
 
 
Chief Financial Officer
EXHIBIT INDEX
 
Exhibit
Number
Exhibit Title
 
10.1+
Executive Employment Agreement dated August 12, 2013, by the Company and Donald Joos (incorporated by reference to Exhibit 10.5 of the Company’s Annual Report on Form 10-K for the year ended June 30, 2013 filed on September 12, 2013).
 
 
10.2+
Transitional Offer letter dated August 7, 2013, by the Company and Peter Blackmore (incorporated by reference to Exhibit 10.6 of the Company’s Annual Report on Form 10-K for the year ended June 30, 2013 filed on September 12, 2013).
 
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.
 
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.
 
 
Section 1350 Certification of Chief Executive Officer.
 
 
Section 1350 Certification of Chief Financial Officer.
 
101.INS
XBRL Instance Document
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
 
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
 
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
 
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
 
+
Management Compensatory Plan or Arrangement

(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.
 
 
31


Exhibit 31.1
 
CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER
PURSUANT TO EXCHANGE ACT RULES 13a-14(a) AND 15(d)-14(a), AS ADOPTED
PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
 
I, Don Joos, certify that:
 
1.
I have reviewed this quarterly report on Form 10-Q of ShoreTel, Inc.;
 
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
 
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
 
4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
 
a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
 
c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
 
d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
 
5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
 
a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
Date: November 8, 2013
 
 
 
 
/s/ Don H. Joos
 
Don H. Joos
 
Chief Executive Officer
 
(Principal Executive Officer)
 
 


Exhibit 31.2
 
CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER
PURSUANT TO EXCHANGE ACT RULES 13a-14(a) AND 15(d)-14(a), AS ADOPTED
PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
 
I, Michael E. Healy, certify that:
 
1. I have reviewed this quarterly report on Form 10-Q of ShoreTel, Inc.;
 
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
 
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
 
4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
 
a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
 
c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
 
d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
 
5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
 
a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
Date: November 8, 2013
 
 
 
 
/s/ Michael E. Healy
 
Michael E. Healy
 
Chief Financial Officer
 
(Principal Accounting and Financial Officer)
 
 


Exhibit 32.1
 
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
 
I, Don Joos, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report on Form 10-Q of ShoreTel, Inc. for the quarter ended September 30, 2013 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of ShoreTel, Inc.
 
Date: November 8, 2013
 
 
 
 
By:
/s/ Don H. Joos
Name:
Don H. Joos
Title:
Chief Executive Officer
 
(Principal Executive Officer)
 
This certification accompanies this Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by referenced into any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether made on or before or after the date of this Report), irrespective at any general incorporation language contained in such filing.
 
 


Exhibit 32.2
 
CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
 
I, Michael E. Healy, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report on Form 10-Q of ShoreTel, Inc. for the quarter ended September 30, 2013 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of ShoreTel, Inc.
 
Date: November 8, 2013
 
 
 
 
By:
/s/ Michael E. Healy
Name:
Michael E. Healy
Title:
Chief Financial Officer
 
(Principal Accounting and Financial Officer)
 
This certification accompanies this Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by referenced into any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether made on or before or after the date of this Report), irrespective at any general incorporation language contained in such filing.