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SHORETEL INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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 brilliantly simple business communication solutions, comprised of integrated voice, video, data and mobile applications based on Internet Protocol ("IP") technologies. We provide customers with a choice to operate our solution in their own premise-based data centers, or to subscribe to our cloud-based hosted communication service which we refer to as ShoreTel Sky. Our distributed IP architecture enables multi-site enterprises to be served by a single integrated communication system. These solutions enable a single point of management, easy installation and a high degree of scalability and reliability. They also provide end-users with a consistent, full suite of features across the enterprise, regardless of location, which helps IT management meet growing demands for powerful communication capabilities. As a result, we believe our solutions enable enhanced end-user productivity and provide lower total cost of ownership and higher customer satisfaction than alternative systems. 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 leader in providing 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 leader in 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, or computer, at any location using any cellular or Wi-Fi network simply and cost effectively. We sell our solutions through our extensive network of over 1,000 authorized resellers served either by national distributors or by ShoreTel directly. ShoreTel solutions are also sold by strategic partners under their brand names, such as AT&T and HP for our mobility services. 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 application which work with our unique IP architecture to provide a brilliantly integrated communication system. The hosted solutions business acquired from M5 is now a part of our hosted segment which we also refer to as the Cloud division. The products and services of the hosted segment are now branded and sold as 'ShoreTel Sky'. Our ShoreTel Sky solutions are comprised of our unique software delivered to the customer using our routers and IP phones. 19-------------------------------------------------------------------------------- Index We sell our premise products primarily through channel partners that market and sell our systems to enterprises across all industries, including small, medium and large 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 enterprise customers more effectively than if we were to sell directly. As of September 30, 2012, we worked with over 1,000 channel partners to sell our products. 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. Most channel partners perform installation and implementation services for the enterprises that use our systems. Generally, our channel partners provide the post-contractual support to the enterprise customer by providing first-level support services and purchasing additional services from us under a post-contractual support contract. For channel partners without support capabilities or that do not desire to provide support, we offer full support contracts to provide all of the support to enterprise customers. Our channel partners may provide managed services offerings to the enterprise customer under which the channel partner may purchase our products and services and, in turn, charge the enterprise customer a monthly subscription fee to access those products and services. 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 products using single-tier or two-tier distribution channels to enterprises across all industries, including small, medium and large companies and public institutions. Our single-tier distribution channel consists of resellers that usually sell our products to end customers. Resellers usually do not stock our products and do not have rights of return. During the second quarter of fiscal 2011, we entered into arrangements with two major value-added distributors to distribute our comprehensive line of premise business communication solutions to resellers within the United States in what we refer to as a "two-tier" distribution model. During fiscal 2012, we expanded our two-tier network and added more value-added distributors to the network. We believe that the two-tier distribution model allows us to better serve our existing channel partners, to reach a larger number of prospective enterprise customers more effectively and to position us to continue to build momentum and capture increased market share in the IP telephony, mobility and UC markets. Furthermore, the two-tier distribution model allows us to scale our business operations without making significant investments in product distribution facilities, thus allowing us to manage our cost structure. Our two-tier distribution channel consists of value-added distributors that stock and sell our products to other resellers or to end customers. The value-added distributors have limited rights of return. We refer to our resellers and value-added distributors collectively as "channel partners". Although we have historically sold our systems primarily to small and medium sized enterprises, in recent years, we have been expanding our sales and marketing activities to increase our focus on larger enterprise customers, including the creation of a major accounts program whereby our sales personnel assist our channel partners to sell to large enterprise customers. As of September 30, 2012, we had sold our products to approximately 26,000 enterprise customers. To the extent we continue to successfully acquire larger enterprise customers in the United States and worldwide, we expect our sales cycle to increase, and the demands on our sales and support infrastructure to increase. We are headquartered in Sunnyvale, California and have sales, customer support, general and administrative and engineering functions in Texas. After the acquisition of M5, our ShoreTel Sky services are primarily provided 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. While most of our customers are located in the United States, we have remained fairly consistent in revenue from international sales, which accounted for approximately 11% of our total revenue for the three months ended September 30, 2012 as compared with 12% in the three months ended September 30, 2011. We expect sales to customers in the United States will continue to comprise the majority of our sales in the foreseeable future. Key Business Metrics We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of sales and marketing efforts and measure operational effectiveness. Initial and repeat sales orders. Our goal is to attract a significant number of new enterprise customers and to encourage existing enterprise customers to purchase additional products and support. Many enterprise customers make an initial purchase and deploy additional sites at a later date, and also buy additional products and support as their businesses expand. As our installed enterprise customer base has grown we have experienced an increase in revenue attributable to existing enterprise customers, which currently represents a significant portion of our premise revenue. 20-------------------------------------------------------------------------------- Index Deferred revenue. Deferred revenue relates to the timing of revenue recognition for specific transactions based on delivery of service, support, specific commitments, product and services delivered to our value-added distributors that have not been delivered or sold through to resellers, and other factors. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from our transactions and are recognized as the revenue recognition criteria are met. Nearly all of our premise system sales include the purchase of post-contractual support contracts with terms of up to five years, and our renewal rates on these contracts have been high historically. We recognize support revenue on a ratable basis over the term of the support contract. Since we receive payment for support in advance of recognizing the related revenue, we carry a deferred revenue balance on our consolidated balance sheet. 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, 2012 was $50.2 million, of which $36.0 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 segment 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 costs to customers, employee-related expense, data communication cost, carrier cost, telecom taxes, and intangible asset amortization expense. We expect that with the growth in customer base, the gross margins may reflect improvement. Operating expenses. Our operating expenses are comprised primarily of compensation and benefits for our employees. Accordingly, increases in operating expenses historically have been primarily related to increases in our headcount. We intend to expand our workforce 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 telco 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 period ended September 30, 2012 was $61. 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 simple average of the total monthly recurring revenue from all customers in a given period. The effective management of the revenue churn is critical to our ability to maximize revenue growth and to maintain and improve margins. Our annualized revenue churn as of September 30, 2012 was 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. 21-------------------------------------------------------------------------------- Index Premise Revenue. 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. Product revenue has accounted for 61% and 78% of our total revenue for the three months ended September 30, 2012 and 2011, 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 18% and 22% of our total revenue for the three months ended September 30, 2012 and 2011, 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, internet service provisioning, training and other professional services. Additionally, we offer our customers the ability to purchase phone systems 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 21% of our total revenues for the three months ended September 30, 2012. There was no hosted or related services revenue in any of the fiscal years prior to 2012. 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 significant 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 to invest in development of our distribution channel by increasing the size of our field sales force to enable us to expand into new geographies and further increase our sales to large enterprise customers. 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 increase in absolute dollars and remain 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, 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. 22-------------------------------------------------------------------------------- Index 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, 2012 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 2012 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those accounting policies, please refer to our 2012 Annual Report on Form 10-K. 23-------------------------------------------------------------------------------- Index Results of Operations The following table sets forth unaudited selected condensed consolidated statements of operations data for three months ended September 30, 2012 and 2011 (Amounts in thousands, except per share amounts). Three Months Ended September 30, 2012 2011 Revenue: Product $ 45,834 $ 42,184 Hosted and related services 15,662 - Support and services 13,488 11,674 Total revenue 74,984 53,858 Cost of revenue: Product (1) 15,787 14,455 Hosted and related services (1) 9,142 - Support and services (1) 4,189 3,915 Total cost of revenue 29,118 18,370 Gross profit 45,866 35,488 Gross profit % 61.2 % 65.9 % Operating expenses: Research and development (1) 13,953 11,813 Sales and marketing (1) 30,756 21,222 General and administrative (1) 8,595 6,629 Total operating expenses 53,304 39,664 Loss from operations (7,438 ) (4,176 ) Other income (expense), net (402 ) (399 ) Loss before provision for tax (7,840 ) (4,575 ) Provision for income tax 197 67 Net loss $ (8,037 ) $ (4,642 ) Net loss per share - basic and diluted (2) $ (0.14 ) $ (0.10 ) Shares used in computing net loss per share - basic and diluted (2) 58,186 47,528 (1) Includes stock-based compensation expense as follows: Cost of product revenue $ 50 $ 41 Cost of hosted and related service revenue 38 - Cost of support and services revenue 207 199 Research and development 1,059 1,012 Sales and marketing 862 1,014 General and administrative 1,137 984 Total stock-based compensation expense $ 3,353 $ 3,250 (2) Potentially dilutive securities were not included in the compilation of diluited net loss per share for the periods which had a net loss because to do so would have been anti-dilutive. 24-------------------------------------------------------------------------------- Index 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, 2012 2011 Revenue: Product 61 % 78 % Hosted and related services 21 % - Support and services 18 % 22 % Total revenue 100 % 100 % Cost of revenue: Product 21 % 27 % Hosted and related services 12 % - Support and services 6 % 7 % Total cost of revenue 39 % 34 % Gross profit 61 % 66 % Operating expenses: Research and development 19 % 22 % Sales and marketing 41 % 40 % General and administrative 11 % 12 % Total operating expenses 71 % 74 % Loss from operations (10 %) (8 %) Other income (expense), net (1 %) (1 %) Loss before provision for income tax (11 %) (9 %) Provision for income tax - - Net loss (11 %) (9 %) Use of Non-GAAP Financial Measures We believe that evaluating our ongoing operating results may limit the reader's understanding if limited to reviewing only generally accepted accounting principles (GAAP) financial measures. Many investors and analysts have requested that, in addition to reporting financial information in accordance with GAAP that we also disclose certain non-GAAP information because it is useful in understanding our performance as it excludes non-cash and other non-recurring charges or credits that many investors and management feel may obscure our true operating performance. Likewise, we use these non-GAAP financial measures to manage and assess the profitability of the business and determine a portion of our employee compensation. We do not consider stock-based compensation charges, amortization of purchased intangibles, severance charges, interest charge from change in fair value of contingent consideration and related tax adjustments (non-GAAP adjustments) in managing the core operations. These measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies. Non-GAAP net income (loss) is calculated by adjusting GAAP net income (loss) for non-GAAP adjustments. Non-GAAP net income (loss) per share is calculated by dividing Non-GAAP net income (loss) by the weighted average number of basic and diluted shares outstanding for the period. These measures should not be considered in isolation or as a substitute for measures prepared in accordance with GAAP, and because these amounts are not determined in accordance with GAAP, they should not be used exclusively in evaluating our business and operations. We have provided a reconciliation of non-GAAP financial measures in the following tables: 25-------------------------------------------------------------------------------- Index RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES (Amounts in thousands, except per share amounts) (Unaudited) Three Months Ended September 30, 2012 GAAP Excludes Non-GAAP Revenue: Product $ 45,834 $ - $ 45,834 Hosted and related services 15,662 - 15,662 Support and services 13,488 - 13,488 Total revenues 74,984 - 74,984 Cost of revenue Product 15,787 (310 ) (a),(b) $ 15,477 Hosted and related services 9,142 (795 ) (a),(b),(c) 8,347 Support and services 4,189 (209 ) (a),(c) 3,980 Total cost of revenue 29,118 (1,314 ) 27,804 Gross profit 45,866 1,314 47,180 Gross profit % 61.2 % 62.9 % Operating expenses: Research and development 13,953 (1,158 ) (a),(c) $ 12,795 Sales and marketing 30,756 (1,948 ) (a),(b),(c) 28,808 General and administrative 8,595 (1,213 ) (a),(b),(c) 7,382 Total operating expenses 53,304 (4,319 ) 48,985 Loss from operations (7,438 ) 5,633 (1,805 ) Other income (expense) - net (402 ) 188 (d) (214 ) Loss before provision for income tax (7,840 ) 5,821 (2,019 ) Provision for income tax 197 (143 ) (e) 54 Net loss $ (8,037 ) $ 5,964 $ (2,073 ) Net loss per share: Basic and diluted (f) $ (0.14 ) $ 0.10 $ (0.04 ) Shares used in computing net loss per share: Basic and diluted (f) 58,186 58,186 (a) Excludes stock-based compensation included in: Cost of product revenue $ 50 Cost of hosted and related service revenue 38 Cost of support and services revenue 207 Research and development 1,059 Sales and marketing 862 General and administrative 1,137 $ 3,353 (b) Excludes amortization of acquisition-related intangibles included in: Cost of product revenue $ 260 Cost of hosted and related services 749 Sales and marketing 851 General and administrative 38 $ 1,898 (c) Excludes severance included in: Cost of hosted and related service revenue $ 8 Cost of support and services revenue 2 Research and development 99 Sales and marketing 235 General and administrative 38 $ 382(d) Excludes interest charge from change in fair value of contingent consideration included in: Other expense $ 188 (e) Excludes the deferred tax benefit arising from acquisition and tax impact of the items which are excluded in (a) to (d) above. (f) Potentially dilutive securities were not included in the calculation of diluted net loss per share for the periods which had a net loss because to do so would have been anti-dilutive. 26 -------------------------------------------------------------------------------- Index RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES (Amounts in thousands, except per share amounts) (Unaudited) Three Months Ended September 30, 2011 GAAP Excludes Non-GAAP Revenue: Product $ 42,184 $ - $ 42,184 Support and services 11,674 - 11,674 Total revenues 53,858 - 53,858 Cost of revenue Product 14,455 (226 ) (a), (b) 14,229 Support and services 3,915 (199 ) (a) 3,716 Total cost of revenue 18,370 (425 ) 17,945 Gross profit 35,488 425 35,913 Gross profit % 65.9 % 66.7 % Operating expenses: Research and development 11,813 (1,012 ) (a) 10,801 Sales and marketing 21,222 (1,044 ) (a), (b) 20,178 General and administrative 6,629 (984 ) (a) 5,645 Total operating expenses 39,664 (3,040 ) 36,624 Loss from operations (4,176 ) 3,465 (711 ) Other income (expense), net (399 ) - (399 ) Loss before provision for income tax (4,575 ) 3,465 (1,110 ) Provision for income tax 67 - (c) 67 Net loss $ (4,642 ) $ 3,465 $ (1,177 ) Net loss per share: Basic and diluted (d) $ (0.10 ) $ 0.08 $ (0.02 ) Shares used in computing net loss per share: Basic and diluted (d) 47,528 47,528 (a) Excludes stock-based compensation as follows: Cost of product revenue $ 41 Cost of support and services revenue 199 Research and development 1,012 Sales and marketing 1,014 General and administrative 984 $ 3,250 (b) Excludes amortization of acquisition-related intangibles: Cost of product revenue $ 185 Sales and marketing 30 $ 215(c) Excludes the tax impact of the items which are excluded in (a) and (b) above. (d) Potentially dilutive securities were not included in the calculation of diluted net loss per share for the periods which had a net loss because to do so would have been anti-dilutive. 27 -------------------------------------------------------------------------------- Index Comparison of the three months ended September 30, 2012 and September 30, 2011 Revenue. Three Months Ended September 30, 2012 2011 Change $ Change % (in thousands, except percentages) Revenue $ 74,984 $ 53,858 $ 21,126 39 % Total revenue increased by $21.1 million or 39% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. The increase in the overall revenue is due primarily to the continued growth and expansion of our premise solution business as a result of greater market acceptance of our products and services and due to the additional revenue associated with our hosted business following our acquisition of M5 on March 23, 2012. Premise Revenue Premise product revenue increased by $3.6 million or 9% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, primarily due to the higher sales volumes. Our international revenue was 14% of our premise revenue in the three months ended September 30, 2012 as compared to 12% in three months ended September 30, 2011. Our higher sales volume and expanded customer base are the result of our investment in the sales and marketing efforts to expand our brand awareness. Premise support and services revenue increased by $1.8 million or 16% in three months ended September 30, 2012 as compared to three months ended September 30, 2011. The increase in support and services revenue was primarily due to the growth is in sales to new customers as well as additional sales to the existing customers resulting in higher post-contractual support revenues. Hosted Revenue Hosted and related service revenue contributed $15.7 million of revenue for the three months ended September 30, 2012 as a result of our acquisition of M5 during March 2012. There were no such revenues in the three months ended September 30, 2011. As we continue to invest in the growth of our hosted segment, we expect the revenue from hosted and related services to increase in future periods. Cost of revenue and gross profit. Three Months Ended September 30, 2012 2011 Change $ Change % (in thousands, except percentages) Cost of revenue $ 29,118 $ 18,370 $ 10,748 59 % Gross profit 45,866 35,488 10,378 29 % Gross margin 61 % 66 % n/a (5 %) Gross margin decreased to 61% in the three months ended September 30, 2012 as compared to 66% in the three months ended September 30, 2011. The decrease in the overall gross margins is mostly due to the change in the revenue mix resulting from the addition of the hosted business which has lower margins. Premise Gross Margin Premise product gross margins remained consistent during the period as it remained at 66% for both the three months ended September 30, 2012 and 2011. Premise support and services gross margins increased to 69% in the three months ended September 30, 2012 as compared to 66% in the three months ended September 30, 2011. 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 compared to the same period in the prior year. Hosted Gross Margin Hosted and related service gross margins were 42% for the three months ended September 30, 2012. There were no related costs in the three months ended September 30, 2011. 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. 28-------------------------------------------------------------------------------- Index Operating expenses. Three Months Ended September 30, 2012 2011 Change $ Change % (in thousands, except percentages) Research and development $ 13,953 $ 11,813 $ 2,140 18 % Sales and marketing 30,756 21,222 9,534 45 % General and administration 8,595 6,629 1,966 30 % Research and development. Research and development expenses increased by $2.1 million or 18% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. The increase in research and development expenses from the prior period is primarily due to higher personnel costs, including benefits and bonus, of $1.6 million due to an increase in headcount primarily attributable to the M5 acquisition in March 2012 and due to an increase in consulting fees of $0.4 million to further support our product development efforts. Sales and marketing. Sales and marketing expenses increased by $9.5 million or 45% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. The increase in sales and marketing expenses from the prior period is primarily due to an increase in personnel related costs, including benefits, bonus and commissions, of $5.6 million due to an increase in headcount related to the M5 acquisition in March 2012 as well as the expansion of our sales force associated with our premise business, advertising and promotional activities of $1.8 million, amortization expense of $0.8 million related to addition of intangible assets as part of the M5 acquisition in March 2012, consulting and outside services of $0.5 million and increased facilities and office expenses of $0.4 million. General and administrative. General and administrative expenses increased by $1.9 million or 30% in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. The increase in general and administrative expenses from the prior period is primarily due to an increase in personnel related costs, including benefits and bonus, of $1.4 million as well as an increase in audit and tax service fees of $0.4 million. These increases are due to the increase in overall expenses to support a growing business including the addition of facilities and headcount resulting from the acquisition of M5 in March 2012. Other income (expense), net. Three Months Ended September 30, 2012 2011 Change $ Change % (in thousands, except percentages) Other income (expense), net $ (402 ) $ (399 ) $ (3 ) 1 % Other income (expense), net. Other income remained steady quarter over quarter due to an increase in interest expense by $0.4 million as a result of additional interest expense associated with our Credit Facility and due to interest expense recognized in connection with contingent consideration liabilities in the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, and a decrease in foreign exchange loss of $0.4 million due to the strengthening of foreign currencies against the U.S. dollar. Provision for income tax. Three Months Ended September 30, 2012 2011 Change $ Change % (in thousands, except percentages) Provision for income tax $ 197 $ 67 $ 130 194 % Provision for income tax. The provision from income taxes increased by $0.1 million in three months ended September 30, 2012 as compared to three months ended September 30, 2011. 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. The valuation allowance was increased based on the adjustments recorded for M5 acquisition. 29-------------------------------------------------------------------------------- Index |