ShoreTel

Can You Hear Me Now?

ShoreTel sends a clear message to the competition                                                         2/8/2012

Upon reporting Q2 financial results last week, ShoreTel may have momentary roused some in a sleepy industry.  While its overall business performance in the quarter was largely in-line with expectations, it was the announcement of its planned acquisition of M5 Networks, a hosted, business phone service provider that would have caused the awakening.  The announced acquisition marks the first, focused entrance into the fast growing but fragmented hosted telecom services business by a major PBX manufacture and may well set the stage for others to follow.  In an industry that has long eschewed the hosted-voice platform the way a king might a peasant, the announcement is sure to bring about a polarizing discussion.

Investors seemed disenchanted with the news.  The major disappointment likely came from a lowered Q3 outlook which ShoreTel blamed on short-term execution issues at certain distribution and value-added reseller (VAR) partners.  The company, which hasn’t turned a GAAP profit since 2008, also saw its margins fall to a seven quarter low, driven primarily by a decision to move a chunk of its US reseller volume through two-tier distribution last year.  Those issues, coupled with the questions and uncertainties surrounding the planned acquisition of M5, sent the value of ShoreTel’s stock price down 20% and shaved $75M of market capitalization off the company in a single day.

Was the reaction and subsequent drop in equity value justified or overdone?  Are “short-term execution issues” easily fixable or a symptom of systemic impairment to forward demand?  What are the long-term prospects for revenue growth and earnings accretion of M5 and how quickly and successfully can the company execute its integration?  These are all questions that will be answered with certainty over time but should be examined carefully today.  To better understand ShoreTel’s current business results and the logic behind the announced acquisition, it’s important to understand where the company stands today.  

Current Business Performance

ShoreTel was founded in 1996 and today is the third largest on-premise, IP-based PBX equipment manufacturer in the US with $200M in annual revenue as of last fiscal year.   In a low/no growth industry, ShoreTel has managed to grow its organic business every year by taking market share from its competitors.  Its closed-source, IP PBX is popular with medium and larger sized business and delivers well on the company’s brand promise of simplicity.  The ShoreTel has also done a good job keeping its balance sheet clean over the years by avoiding acquisitions of legacy telecom businesses that most of its peers found irresistible. 

ShoreTel’s growth is less about a rising tide of demand and more a success story derived from aggressive marketing and market share gains.  It has also benefited from a growing migration of businesses upgrading their phone systems from the dated TDM technology popular in the 1990s to the premise-based, IP platforms of today.  The company sells exclusively through its network of about 1000 VARs and has a strong presence in the western half of the US.  Its move to two-tier distribution, which has produced mixed results from the various value-added distributors (VADs), will help to both build its infrastructure for future growth and allow it to increase its penetration in key markets by taking on additional VARs.  Two-tier distribution has also pressured gross margins as middlemen now take a small cut in exchange for renting their supply chain. 

Warren Buffett once said; “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it’s the reputation of the business that remains intact.”  Unfortunately, this adage rings true for ShoreTel as well.  Although ruthlessly defended by management as an industry with strong growth potential, the on-premise PBX business could be more akin to a local TV repair shop in 1998-a business that had thrived for many years but was about to be made obsolete in short order by shifting technology.  

The shift in technology that is disrupting the traditional PBX business is a movement towards the “cloud” and the outsourcing of IT infrastructure by businesses.  Today, Gardner estimates the size of the hosted-voice market to be approximately $700M and is expected to grow to over $2B by 2016.  While some continue to view the cloud and related technologies as a passing fad, ShoreTel, by way of announcing its intention to acquire M5 Networks for $146M ($84M in cash and $62M in stock valued at $6.55/share) has told its employees, shareholders and partners that it views it much differently.  The transaction, which is expected to close in March, marks a major step forward for the company, allowing it to acquire new customer relationships and augment its current revenue immediately. 

Questions remain.  Who is M5, how does the hosted-voice model work and what are the risks?

M5 Networks

Based in New York City, NY, M5 Networks is a privately held, cloud-based, voice and unified communications provider that was founded in 2000.  The company currently has 200 employees, approximately 2000 business clients and estimated 2011 revenue of approximately $47.5M.

M5 competes in a broad segment of the business technology service provider marketplace.  Its core focus is on providing hosted phone and other telecom services for business clients, a very competitive but fast-growing niche within this market segment.  Companies like M5 allow business clients, especially smaller ones today, the option to forgo large investments in phone equipment and technical staff by having their PBX and other telecom equipment stored, updated and maintained at a remote data center in exchange for monthly payments.   Improvements in the quality and reliability of transmitting voice over the internet along with declining data storage costs and other cloud-based trends as led to a surge in demand for these services. 

One of the attractive aspects of the hosted business model is distribution efficiency and the ability to scale fixed investments quickly.   M5 utilizes three primary data centers which it manages and monitors 24x7 and has developed its own proprietary software platform that enables its virtual PBX.  These data centers “host” the software and servers which facilitate all voice and related functionality for clients.  With centralized servers /hardware and limited inventory, distribution is only limited by internet access and a few pieces of on-site telephony gear (commercial-grade QoS routing and compatible IP phones) enabling the business to be quickly scaled with aggressive marketing and sales efforts.  Because additional sales don’t require 1:1 incremental fixed investment, hosted businesses that are built out and fully utilized typically deliver a high rate of return on invested capital. 

The hosted-voice business model also delivers something else that has been elusive to PBX manufacturers in the past, recurring revenue.  Because customers pay for the service on a per month or subscription basis, revenue flows to the provider in a consistent, predictable fashion.  This type of revenue provides for much more accurate forecasts of sales/expenses and can smooth out the effects of seasonality in other parts of the business.  M5 currently has 60,000 recurring “end-points” and average revenue per user (ARPU) near $60. 

Comparison

One way to get an idea of how M5 is performing currently is to take a look at its financial results in comparison to another, pure-play, hosted business.  8x8 (EGHT) is a well run and large competitor in the hosted-voice space.  It is also, coincidentally, located in Sunnyvale, CA, near ShoreTel.

	M5	8x8
2011 Sales	$47.5M (estimated)	$79.3M (TTM)
2010 Sales	$32.2M	$70.1M
Growth Rate	47.5%	13.1%
Gross Margin Rate	50.0%	67.1%*
Current ARPU	$60	$24
Business Clients	2,000	27,600
Recurring Rev Endpoints	60,000	245,600
Profitability	CF break-even	8.7%    NPM
Employees	200	250
Rev/Employee	237k	317k
*for nine months ended 12/31/11

At first glance, one consideration for investors should be M5’s gross margin rates.  ShoreTel stated M5’s gross margin rate to be around 50%, placing it far below its publically traded peers.  Hosted businesses typically produce gross margin rates near 80% on pure hosting/voice services.  When blended with all sources of revenue such as equipment (which is typically sold below cost) and other miscellaneous telecom services such as circuit, long-distance or termination ,the total gross margin is still usually well north of 50% and both 8x8 and Cbeyond (CBEY) are currently producing total gross margins at or near 68%.  Clearly the profit is in the proprietary hosting services and not the other “middleman” offerings making a mix-related conversation around M5’s revenue an important discussion.

Valuation is another consideration.   First, M&A that represents nearly half of a business’s market cap is major by any definition of the word.  Second, when businesses overpay for acquisitions, even fantastic results will fail to produce a good return on the present value of their capital.  Because M5 is privately held, we have few financial metrics to use as comparative data points and in general, hosted businesses today sell at higher multiples based on their forward growth potential.  From the perspective of a sales multiple, $146M implies a 3x sales valuation for the business.  Based purely on historical sales growth and assuming a similar future trajectory with implied profitability, 3x appears to be a fair price when compared with 8x8 which currently trades at almost 4x its sales.

Buy or Build

To buy it or build it is age old question when entering a new market.  ShoreTel defended their decision to buy with four key points:

•         M5’s business metrics- low churn rate, competitive acquisition costs, high ARPU
•         M5’s experience in running 24x7 data centers
•         Acknowledgement that a hosted business is very different from a premise based one
•         Potential risk for distraction away from the current business

In addition, ShoreTel also named M5’s seasoned management team, account concentration (~85%) in the eastern part of the US and their proven model as additional considerations that ultimately led to the acquisition.

VAR Dilemma

The plan for now is to rebrand M5 with the ShoreTel name but keep the legacy, on-premise equipment business separate from the new hosted business, which will be run by M5’s current CEO Dan Hoffman.  Separating the old from the new will prove to be a wise decision as many VARs today are ill equipped to translate a hosted model into sales potential.  Like a tiger in the wild that kills and rests, most VARS have been fed steady diet rich in transactional sales over their business life and have adapted their businesses accordingly.  Successfully adjusting to tomorrow’s services marketplace will require these VARs to change revenue projections, cash flow  assumptions, gross margins, sales cycles, SG&A rates and as well as employee talent and skill sets- a nearly complete overhaul of their business.  Most will find the transition too daunting to make. (For additional perspective on how cloud and hosted services are causing the death of the traditional PBX VAR, click here: PBX VAR Death)

Future prospects

The hosted-voice business is fraught with risk to be sure.  Today, it very much operates as the Wild West of telecom.  It seems everyone from major cable companies to home-based “telecom businesses” have a switch in the cloud and are offering host-voice and other business services.  Pricing, standardization and quality all vary greatly and have left some potential customers confused, creating what could be, a good opportunity.  In the short-run, expect to see a wave of consolidation as some current hosted providers grow through acquisition and new ones, like ShoreTel, enter the marketplace.  As winners emerge, anticipate they’ll do it, at least partly, through price leadership.  The variable costs in the hosted business model are low and, with service margins rates currently at 75% or higher, they appear ripe to be taken down by 1/3 over the next 18 months.   As pricing falls, volume becomes critical.  Those that fail to scale, will soon find their pricing models uncompetitive and themselves out of business.

In the longer run, the biggest risk to a hosted-voice offering comes through either obsolescence or a shifting platform.  The catalyst for the obsolescence argument today would primarily be based on mobility.  As cell phones continue to get “smarter”, one could reasonably make the argument that the desk phone’s days as a productive tool in the modern business are limited.  The other great risk comes from a complete shift in the platform, one in which completely changes the entire business model.  When Google began giving away its turn-by-turn mapping program, making it available and free on a variety of devices, it completely changed every GPS manufacturer’s business model overnight.  To think PBX functionality is immune from similar outcomes is naïve at best. 

Summary and Conclusions

ShoreTel has proven it will not let past successes lull it into a false state of complacency.  Its acquisition of M5 is a bold step towards a new future for the company.  With a swoop of a pen and its checkbook, it has now officially endorsed the hosted business model as a viable competitor in telecom.  

By all accounts, hosted-voice and related services are well positioned for near-term profitable growth and will continue to take market share away from traditional PBX manufacturers for the foreseeable future.  The transaction positions ShoreTel as an immediate market leader and will create new, complementary customer relationships while helping to diversify its revenue mix. 

There is clearly risk and in a transaction of this size, much at stake.   ShoreTel must quickly integrate the business while maintaining M5’s existing customer base.  It must find a way to scale revenues while improving gross margin rates.  It must figure out a way to train, certify and then incent its current partners to bring new, hosted opportunities forward.  Failure, on a scale of this magnitude is not an option and would surely hamstring the business financially.  Success, measured not on the basis of revenue but rather long-term returns for its shareholders, would provide welcomed source of recurring revenue and healthy profitability.

The road is long and ultimately a combination of internal execution and external market forces will serve as the eventual judge of M5’s success or failure.  Regardless of future, telecom PBX manufacturers today would be wise to view the news as a shot across the bow.  Credit ShoreTel with the first move. 

References and additional sources of information:

ShoreTel Q2 12 10-Q: 10-Q

ShoreTel 8-K (acquisition): 8-K

ShoreTel Partner Presentation:  PowerPoint

ShoreTel Partner FAQ:  Partner FAQ

ShoreTel/8x8 financial comparisons:  Financial Data

8x8 Q3 12 10-Q:  10-Q

CBEY Q3 12 10-Q:  10-Q