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SHORETEL INC - 10-K - 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 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 above in the section entitled "Risk Factors." We report results on a fiscal year ending June 30. For ease of reference within this section, 2014 refers to the fiscal year ended June 30, 2014, 2013 refers to the fiscal year ended June 30, 2013, and 2012 refers to the fiscal year ended June 30, 2012. Overview ShoreTel is 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 focus on the small and medium sized businesses (less than 5,000 users), with a Unified Communications ("UC") platform so that they can communicate anytime, anyplace, and through any device that they chose. Our strategy is to provide customers with a flexible choice of deployment options: either operating our ShoreTel solution in their own premise-based data centers, subscribing to our cloud-based ShoreTel Sky communication services or a hybrid combination of both. Our solution is available for businesses to operate in their own premise-based data centers, on a hosted, cloud-based platform or a hybrid of both. Premise-based systems are comprised of our switches, IP phones and software applications which work with our unique IP distributed architecture to provide a brilliantly simple, integrated communication system. Our hosted systems are comprised of ShoreTel designed and developed software delivered to the customers as a managed service along with our phones and software applications. We anticipate that our cloud-based system sales will grow at a faster rate than our premise-based system sales. Accordingly, we will continue to invest in cloud-based infrastructure and channel development to help enable our growth. 34 -------------------------------------------------------------------------------- Table of Contents We sell our products through channel partners that market and sell our solutions to enterprises across all industry verticals, 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 also offer our hosted and related services via our direct sales organization. The number of our authorized channel partners around the world was greater than 1,100 as of June 30, 2014. Our internal sales and marketing personnel support these channel partners in their selling efforts. We are headquartered in Sunnyvale, California and have offices located throughout the United States, the United Kingdom, India, Ireland, Germany, Spain, Canada, Hong Kong, Singapore and Australia. Additionally, our ShoreTel Sky services are provided primarily from our data center in Texas. 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 9% of our total revenue for fiscal 2014 as compared with 10% and 12% in fiscal 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. In fiscal 2014, we continued to grow our market share of the IP telephony market, both in the United States and worldwide. Our total revenue increased to $339.8 million in fiscal 2014 from $313.5 million in fiscal 2013, driven by sales to new customers and add-on sales from existing customers. Our operating expenses decreased to $201.1 million in fiscal 2014 from $211.3 million in fiscal 2013, primarily due to synergies and other cost reductions. Key Business Metrics We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of our sales and marketing efforts and to measure operational effectiveness. Deferred revenue. Deferred revenue relates to the timing of revenue recognition for specific transactions based on delivery of service, support, specific commitments, product and services delivered to our value-added distributors that have not been delivered or sold through to resellers, and other factors. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from our transactions and are recognized as the revenue recognition criteria are met. Nearly all of our premise system sales include the purchase of post-contractual support contracts with terms of up to five years, and our renewal rates on these contracts have been high historically. We recognize support revenue on a ratable basis over the term of the support contract. Since we receive payment for support in advance of recognizing the related revenue, we carry a deferred revenue balance on our consolidated balance sheet. Almost all of our hosted services are billed a month in advance. Billings that are collected before the service is delivered are included in the deferred revenue balance on our consolidated balance sheet. These amounts are recognized as revenue as the services are delivered. Our deferred revenue balance at June 30, 2014 was $64.5 million, of which $46.9 million is expected to be recognized within one year. Gross margin. Our gross margins for products are primarily affected by our ability to reduce hardware costs faster than the decline in average overall system sales prices. We strive to increase our product gross margin by reducing hardware costs through product redesign and volume discount pricing from our suppliers. In general, product gross margin on our switches is greater than product gross margin on our IP phones. We consider our ability to monitor and manage these factors to be a key aspect of maintaining product gross margins and increasing our profitability. Gross margin for 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 hosted and related services is lower than the gross margins for support and services and product 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 due to synergies and other cost reductions in our service delivery platform. Operating expense. 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 as we grow, and therefore, our ability to forecast revenue is critical to managing our operating expenses. 35 -------------------------------------------------------------------------------- Table of Contents Average revenue per user. We calculate the monthly average service revenue per user ("ARPU") for our hosted and related services revenue 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 period ended June 30, 2014 was approximately $44 as compared to $49 for the three month period ended June 30, 2013. 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 internet circuits to new customers as compared to the existing customer base. Revenue churn. Revenue churn for our hosted and related services revenue is calculated by dividing the monthly recurring revenue from customers that have terminated during a period by the simple average of the total monthly recurring revenue from all customers in a given period. The effective management of the revenue churn is critical to our ability to maximize revenue growth and to maintain and improve margins. Our annualized revenue churn for customers that have terminated services for the three months ended June 30, 2014 was approximately 5% as compared to 3% for the three months ended June 30, 2013. 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. Product revenue. Product revenue consists of sales of our business communication systems. Our typical system includes a combination of IP phones, switches and software applications primarily for our premise-based solutions. We sell our products through channel partners that include resellers and value-added distributors. Prices to a given channel partner for hardware and software products depend on that channel partner's volume and other criteria, as well as our own strategic considerations. Product revenue has accounted for 55%, 59%, and 74% of our total revenue for fiscal years 2014, 2013 and 2012, respectively. The decrease from fiscal year 2013 to fiscal year 2014 in product revenue as a percent of our total revenue mainly related to the continued growth of hosted and related services revenue in addition to growth in our support and services revenues as a result of our growing installed customer base. The decrease in premise product revenue as a percent of our total revenue from fiscal year 2012 to fiscal year 2013 related to including hosted and related services revenue resulting from our acquisition of M5 Networks Inc. ("M5") on March 23, 2012 for a full twelve months in fiscal 2013 with only approximately three months of hosted and related services revenue included in the total revenue for fiscal 2012. Support and services revenue. 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. Support and services revenues accounted for 19%, 18% and 20% of our total revenue for fiscal 2014, 2013 and 2012, respectively. Hosted and related services revenue. Hosted and related 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 Unified Communication (UC) applications, internet service provisioning, training and other professional services. Our hosted and related 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 and related 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 and related services revenues accounted for 26%, 23% and 6% of our total revenues for fiscal 2014, 2013 and 2012, respectively. The increase from fiscal year 2012 to fiscal year 2013 in hosted and related services revenue as a percent of our total revenue related to including hosted revenue resulting from our acquisition of M5 on March 23, 2012 for a full twelve months in fiscal 2013 as compared to only recognizing such results for approximately three months of fiscal 2012. The increase from fiscal year 2013 to fiscal year 2014 in hosted and related services revenue as a percent of our total revenue mainly related to the continued growth of the our customer base and their greater adoption and acceptance of such hosted and related services. 36 -------------------------------------------------------------------------------- Table of Contents Cost of revenue. Cost of 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 support and services revenue consists of salary and related overhead costs of personnel engaged in support and service activities including our technical assistance center ("TAC"). Cost of hosted and related services revenue consists of personnel and related costs of the hosted services, 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. We have capitalized 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. 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 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 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, board of directors' costs, accounting, tax, compliance and information systems, travel, recruiting expense, depreciation expense and facilities expenses. Interest expense. Interest expense primarily consists of interest expense on our debt as well as other miscellaneous items affecting our operating results. Interest income and other (expense). Interest income and other (expense) primarily consists of interest earned on cash, cash equivalents and short-term investments, gains and losses on foreign currency translations and transactions as other miscellaneous items affecting our operating results. Provision for (benefit from) income taxes. Provision for (benefit from) 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. 37 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth selected consolidated statements of operations data as a percentage of total revenue for each of the periods indicated. Year Ended June 30, 2014 2013 2012 Revenue: Product 55 % 59 % 74 % Hosted and related services 26 23 6 Support and services 19 18 20 Total revenue 100 100 100 Cost of revenue: Product 19 21 25 Hosted and related services 17 14 4 Support and services 5 5 7 Total cost of revenue 41 40 36 Gross profit 59 60 64 Operating expenses: Research and development 14 17 21 Sales and marketing 33 38 38 General and administrative 12 12 11 Acquisition-related costs - - 2 Total operating expenses 59 67 72 Operating loss - (7 ) (8 ) Other income (expense): Interest expense - (1 ) - Other income (expense), net - - - Total other income (expense) - (1 ) - Loss before provision for (benefit from) income taxes - (8 ) (8 ) Provision for (benefit from) income taxes - - - Net loss - % (8 )% (8 )% Comparison of Fiscal 2014 to 2013 and Fiscal 2013 to 2012 Revenue Year Ended June 30, June 30, June 30, June 30, 2014 to June 30, 2013 June 30, 2013 to June 30, 2012 2014 2013 2012 Change $ Change % Change $ Change % (in thousands, except percentages) Product revenue $ 184,952 $ 186,190 $ 182,009 $ (1,238 ) (1 %) $ 4,181 2 % Hosted and related services revenue 89,128 70,277 15,547 18,851 27 % 54,730 352 % Support and services revenue 65,712 57,076 49,076 8,636 15 % 8,000 16 % Total revenue 339,792 313,543 246,632 26,249 8 % 66,911 27 % Total revenue increased by $26.2 million or 8% in fiscal 2014 as compared to fiscal 2013. Total revenue increased by $66.9 million or 27% in fiscal 2013 as compared to fiscal 2012. Revenue from customers in the United States accounted for approximately 91%, 90% and 88% of total revenue for years ended June 30, 2014, 2013 and 2012, respectively. 38 -------------------------------------------------------------------------------- Table of Contents Product revenue Product revenue decreased by $1.2 million or 1% in fiscal 2014 primarily due to less overall demand in the premise-based solution market. Product revenue increased by $4.2 million or 2% in fiscal 2013, primarily due to the higher sales volumes and growth of our customer base. Our higher sales volume and expanded customer base are the direct result of our investment in the sales and marketing efforts. Support and Services revenue Support and services revenue increased by $8.6 million or 15% in fiscal 2014, as compared to fiscal 2013. Support and services revenue increased by $8.0 million or 16% in fiscal 2013, as compared to fiscal 2012. The increase in support and services revenue in both fiscal 2014 and 2013 was primarily due to additional sales to existing customers resulting in higher post-contractual support revenues supported by higher renewal rates and continued expansion of our customer base resulting from sales to new customers. Hosted and Related Services revenue Hosted and related service revenue increased by $18.9 million or 27% in fiscal 2014 as compared to in fiscal 2013. The increase in hosted and related services revenue was primarily due to market growth enabling the expansion of our customer base resulting from sales to new customers and to additional sales to existing customers. As we continue to invest in the growth of our hosted and related services offering, we expect the revenue from hosted and related services to increase in future periods through greater acceptance of our hosted platform. Hosted and related service revenue increased by $54.7 million in fiscal 2013 as compared to fiscal 2012. As the acquisition of M5 occurred on March 23, 2012, only approximately three months of activity related to the newly acquired hosted and related service business were included in the results for fiscal 2012 as compared to a full twelve months of activity included in the results for the fiscal 2013 Gross margin Year Ended June 30, June 30, June 30, June 30, 2014 toJune 30, 2013 June 30, 2013 to June 30, 2012 2014 2013 2012 Change $ Change % Change $ Change % (in thousands, except percentages) Cost of revenue $ 137,871 $ 125,091 $ 88,153 $ 12,780 10 % $ 36,938 42 % Gross profit 201,921 188,452 158,479 13,469 7 % 29,973 19 % Gross margin 59 % 60 % 64 % n/a (1 %) n/a (4 %) Gross margin remained relatively consistent at 59% in fiscal 2014 as compared to 60% in fiscal 2013. Gross margin decreased to 60% in fiscal 2013 as compared to 64% in fiscal 2012. The decrease in the overall gross margins is primarily due to the change in the revenue mix resulting from the addition of the hosted and related services which had lower gross margins than the product and support and services gross margins. Product gross margin Product gross margins remained relatively consistent from fiscal 2012 to fiscal 2014 at 65% in fiscal 2014 and 66% in both fiscal 2013 and fiscal 2012. Support and Services gross margin Support and services gross margins increased to 74% in fiscal 2014 as compared to 71% in fiscal year 2013 and 66% in fiscal year 2012. These increases were driven by operation improvements which allowed lower personnel costs to support a larger customer base and generate a higher revenue amount from the same period in each prior year, coupled with an increase in related revenue from our growing customer base. 39 -------------------------------------------------------------------------------- Table of Contents Hosted and related services gross margin Hosted and related service gross margins remained relatively consistent during the period at 38% for fiscal 2014 and 37% for both fiscal 2013 and fiscal year 2012. Hosted and related service gross margins for fiscal 2013 included $1.4 million in costs related to a change in estimate of regulatory telecommunications fees. 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 and related 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 and related 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 and related service gross margin is impacted by the amortization of purchased intangible assets. The related product and support and services cost of sales reflect a much lower amount of amortization of purchased intangible assets. Upon completion of our acquisition of M5, 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 IP phones; · Integration of our customer support service 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 based solutions in the short term. Operating expenses Year Ended June 30, June 30, June 30, June 30,2014 to June 30, 2013 June 30, 2013 to June 30, 2012 2014 2013 2012 Change $ Change % Change $ Change % (in thousands, except percentages) Research and development $ 49,758 $ 52,992 $ 51,909 $ (3,234 ) (6 %) $ 1,083 2 % Sales and marketing 110,977 120,222 94,797 (9,245 ) (8 %) 25,425 27 % General and administration 40,356 38,102 27,468 2,254 6 % 10,634 39 % Acquisition-related costs - - 4,524 - - (4,524 ) (100 %) Research and development. Research and development expense decreased by $3.2 million or 6% in fiscal 2014 as compared to fiscal 2013. The decrease in research and development expenses was primarily due to a decrease of $2.5 million in personnel costs, including related benefits and bonus costs as well as a decrease of $0.4 million in facilities costs. The decrease in personnel costs was primarily due to a decrease in headcount during fiscal 2014. Research and development expenses increased by $1.1 million or 2% in fiscal 2013 as compared to fiscal 2012. The increase in research and development expenses was primarily due to an increase of $1.0 million in personnel costs, including related benefits and bonus. The increase was primarily due to an increase in average headcount during fiscal 2013. Sales and marketing. Sales and marketing expenses decreased by $9.2 million or 8% in fiscal 2014 compared to fiscal 2013. The decrease in sales and marketing expenses from the prior period is primarily due to a decrease in personnel related costs, including related benefits, bonus and commissions of $4.0 million, a decrease in demand generation and promotional activities of $3.2 million, a decrease in travel and entertainment of $1.5 million and a decrease in consulting and outside services of $1.0 million. These decreases were partially offset by an increase in of $0.5 million related to costs associated with the implementation of a new customer relationship management system. 40 -------------------------------------------------------------------------------- Table of Contents Sales and marketing expenses increased by $25.4 million or 27% in fiscal 2013 compared to fiscal 2012. 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 $11.0 million primarily attributable to an increase in headcount related to the M5 acquisition on March 23, 2012 as well as an increase in average headcount of our sales force during fiscal 2013, other increases were due to increased demand generation and promotional activities of $9.1 million, amortization expense of $2.4 million related to addition of intangible assets as part of the M5 acquisition in March 2012, consulting and outside services of $1.0 million and increased facilities and office expenses of $1.0 million. General and administrative. General and administrative expenses increased by $2.3 million or 6% in fiscal 2014 compared to fiscal 2013. The increase in general and administrative expenses from the prior period was primarily due to an increase in facilities costs of $0.7 million and to an increase in sales tax expense of $0.7 million primarily related to the increase in revenue during the period. General and administrative expenses increased by $10.6 million or 39% in fiscal 2013 compared to fiscal 2012. The increase in general and administrative expenses from the prior period was primarily due to an increase in personnel related costs including benefits and bonus of $5.2 million, an increase in professionals service fees of $4.1 million, a $1.4 million charge in fiscal 2013 related to the change in estimate of sales, use and telecommunications taxes with no corresponding charge during fiscal 2012. These increases were 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 on March 23, 2012. Acquisition-related costs. There were no acquisition related costs in fiscal 2014 or 2013. The costs incurred in fiscal 2012 reflect direct costs incurred in connection with the acquisition of M5. Other income, net Year Ended June 30, June 30, June 30, June 30, 2014 to June 30, 2013 June 30, 2013 to June 30, 2012 2014 2013 2012 Change $ Change % Change $ Change % (in thousands, except percentages) Interest expense $ (643 ) $ (1,722 ) $ (560 ) (1,079 ) (63 %) $ 1,162 208 % Interest income and other (expense), net (637 ) (690 ) (905 ) (53 ) (8 %) (215 ) (24 %) Interest expense. Interest expense decreased by $1.1 million in fiscal 2014 as compared to fiscal 2013 primarily due to lower interest expense associated with the reduction of outstanding borrowings on our line of credit in fiscal 2014 as compared to fiscal 2013 due to a lower average outstanding balance on the line of credit in fiscal 2014 as compared to fiscal 2013 as well as lower imputed interest expense recognized in connection with contingent purchase consideration liabilities in fiscal 2014 as compared to 2013 as $10.0 million of the related purchase consideration was paid in March 2013 and the remaining $3.7 million of the related purchase consideration was paid in January 2014. Interest expense increased by $1.2 million in fiscal 2013 compared to fiscal 2012 primarily due to interest expense associated with our line of credit and due to imputed interest expense recognized in connection with contingent purchase consideration liabilities in fiscal 2013 as compared to fiscal 2012. Interest income and other expense, net. Interest income and other expense, net, decreased by $0.1 million in fiscal 2014 compared to fiscal 2013 primarily as a result of a decrease in our foreign exchange loss due to the weakening of the U.S. dollar against certain foreign currencies in which we transact. Interest income and other expense, net decreased by $0.2 million in fiscal 2013 as compared to fiscal 2012 due to a decrease in our foreign exchange loss due to the weakening of the U.S. dollar against certain foreign currencies in which we transact and a decrease in interest income of $0.1 million primarily due to a lower cash and short term investment balance invested during fiscal 2013 as compared to fiscal 2012. Provision for (benefit from) income tax Year Ended June 30, June 30, June 30, June 30, 2014 to June 30, 2013 June 30, 2013 to June 30, 2012 2014 2013 2012 Change $ Change % Change $ Change % (in thousands, except percentages) Provision for (benefit from) income taxes $ 586 $ 426 $ (947 ) $ 160 38 % $ 1,373 145 % 41-------------------------------------------------------------------------------- Table of Contents Our effective tax rate differs from the statutory rate largely due to our providing a full valuation allowance on the current year net operating losses. The provision for income taxes in 2014 is primarily related to state and foreign income tax expense. In fiscal 2013, we recorded a $0.4 million income tax provision, which was primarily related to state and foreign income tax expense. In fiscal 2012, we recorded a $1.3 million income tax benefit due to the release of valuation allowance made in connection with the recording of deferred tax liabilities from our acquisition of M5, which was partially offset by state and foreign income tax expense. Liquidity and Capital Resources Cash and cash equivalents and investments The following table summarizes our cash and cash equivalents and short-term investments (in thousands): Year ended June 30, 2014 2013 2012 Cash and cash equivalents $ 53,472 $ 43,775 $ 37,120 Short-term investments 2,673 7,501 18,375 Total $ 56,145 $ 51,276 $ 55,495 As of June 30, 2014, our principal sources of liquidity consisted of cash, cash equivalents and short-term investments of $56.1 million and net accounts receivable of $33.8 million and the balance available of $50.0 million 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 and again on June 2, 2014. The Credit Facility includes a revolving loan facility for an aggregate principal amount not exceeding $50 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 can be reborrowed. The borrowings under the Credit Facility will accrue interest either (at our election) at (i) the London interbank offered rate then in effect, plus a margin of between 1.50% and 2.50%, which will be based on the our Consolidated Earnings before interest, taxes, depreciation and amortization ("EBITDA") (as defined in the Credit Agreement), or (ii) the higher of (a) Silicon Valley 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 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. No amounts were payable under the Credit Facility as of June 30, 2014. As of June 30, 2014, the Company had $50.0 million available for borrowing under the Credit Facility. Historically, our principal uses of cash have consisted of the purchase of finished goods inventory from our contract manufacturers, cost of personnel and equipment needed for data center operations, payroll and other operating expenses related to the development and marketing of our products and purchases of property and equipment and acquisitions. Our future capital requirements will depend on many factors, including our rate of revenue growth, the addition of new business initiatives, the addition of additional data center space or locations, 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. 42 -------------------------------------------------------------------------------- Table of Contents The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods: June 30, 2014 2013 2012 (In thousands) Cash provided by operating activities $ 35,878 $ 10,263 $ 10,315 Cash provided by (used in) investing activities $ (6,972 ) $ (3,183 ) $ (85,805 ) Cash provided by financing activities $ (19,209 ) $ (425 ) $ 22,915 Cash flows from operating activities Net loss during fiscal 2014, 2013 and 2012 included non-cash charges of $7.3 million, $10.6 million and $12.6 million in stock-based compensation expense, respectively, and depreciation and amortization of $18.3 million, $15.8 million and $9.0 million, respectively. Net loss during fiscal 2014, 2013 and 2012 also included non-cash charges of $0.1 million, $0.9 million and $0.2 million, respectively, in interest expense recognized related to acquisition-related consideration. Cash provided by operating activities during fiscal 2014 also reflects net changes in operating assets and liabilities, which provided $10.4 million of cash consisting primarily of an increase in deferred revenue of $9.5 million, an increase in accounts payable of $6.2 million, an increase in accrued employee compensation of $3.4 million and a decrease in accounts receivable of $3.2 million. These cash inflows were offset by an increase in inventory of $7.5 million, a decrease in accrued liabilities and other of $4.1 million and an increase in prepaid expenses and other current assets of $1.6 million. Cash provided by operating activities during fiscal 2013 also reflects net changes in operating assets and liabilities, which provided $8.4 million of cash consisting primarily of an increase in deferred revenue of $5.5 million, an increase in accrued taxes and surcharges of $3.5 million, decrease in inventory of $1.6 million, an increase in accrued liabilities of $1.4 million, an increase in accrued employee compensation of $1.0 million, an increase in accounts payable of $0.3 million and a decrease in indemnification asset of $0.3 million. These cash inflows were offset by an increase in accounts receivable of $3.1 million due to the increase in revenue partially offset by continued improved collections, an increase in prepaid expenses and other current assets of $0.9 million, an increase in other assets of $0.4 million and a decrease in purchase consideration of $0.9 million. Cash provided by operating activities during fiscal 2012 also reflects net changes in operating assets and liabilities, which provided $10.1 million of cash consisting primarily of cash inflows from an increase in accrued taxes and surcharges of $6.6 million due to the change in estimate of the sales, use and telecommunications taxes , decrease in accounts receivable of $2.2 million resulting from an improvement in customer collection efforts, an increase in deferred revenues by $10.6 million, an increase in accounts payable of $1.3 million and an increase in accrued employee compensation of $1.1 million. These amounts were partially offset by increases in the indemnification asset of $6.6 million, prepaid expenses of $1.2 million, an increase in inventories of $1.1 million, an increase in other assets of $1.1 million and a decrease in accrued liabilities of $1.8 million. 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. Because we invest only in investment securities that are highly liquid with a ready market, we believe that the purchase, maturity or sale of our investments has no material impact to our overall liquidity. Net cash flow used in investing activities in fiscal 2014 was $7.0 million and primarily consisted of $11.7 million used to purchase property, plant and equipment and $0.9 million used in purchases of investments securities, offset by maturities of short-term investments of $5.6 million. Net cash flow used in investing activities in fiscal 2013 was $3.1 million and primarily consisted of $11.5 million used to purchase property, plant and equipment, $11.2 million used in purchases of investments securities, and purchases of patents, technology and internally developed software of $2.3 million offset by maturities of short-term investments of $21.9 million. 43 -------------------------------------------------------------------------------- Table of Contents Net cash flow used in investing activities in fiscal 2012 was $85.8 million and primarily consists of $78.4 million paid, net of cash received, for our acquisition of M5, $4.2 million used to purchase property, plant and equipment, $2.6 million used in purchase of investments securities and $0.6 million used to purchase an intangible asset. Cash flows from financing activities Net cash used by financing activities was $19.2 million in fiscal 2014. In fiscal 2014, we repaid $29.3 million for borrowings made under our Credit Facility, made a payment of $3.4 million of purchase consideration in January 2014 pursuant to our acquisition of M5 and paid $0.9 million for employee tax obligations associated with the vesting of restricted stock units and paid $1.5 million in relation to our capital leases. These payments were partially offset by proceeds received of $15.8 million from the issuance of common stock under various employee benefit plans. Net cash used by financing activities was $0.4 million in fiscal 2013. In fiscal 2013, we received a net of $9.0 million from borrowings made under our Credit Facility and received proceeds of $1.9 million from the issuance of common stock under various employee benefit plans, partially offset by payment of $9.1 million of purchase consideration in March 2013 pursuant to our acquisition of M5 and $0.9 million paid for employee tax obligations associated with the vesting of restricted stock units and $1.3 million in payments in relation to our capital leases. Net cash flow provided by financing activities in fiscal 2012 was $22.9 million and primarily consisted of $19.9 million in borrowings from the Credit Facility net of repayments made during the period, $3.9 million of proceeds from issuance of common stock under various employee benefit plans, offset by $0.6 million used to pay taxes on vested and released stock awards and $0.3 million of payments made under various capital lease agreements. Contractual Obligations The following is a summary of our contractual obligations as of June 30, 2014: Payments Due by Period (In thousands) Less Than More than Total 1 Year 1-3 Years 3-5 Years 5 Years Operating lease obligations $ 31,122 $ 5,746 $ 11,616 $ 11,233 $ 2,527 Capital lease obligations 464 404 60 - - Line of credit - - - - - Non-cancellable purchase commitments (inventory and software licenses) 22,270 21,785 485 - - Outstanding letters of credit 635 635 - - - Total $ 54,491 $ 28,570 $ 12,161 $ 11,233 $ 2,527 We contract with independent sources to manufacture our products and purchase components from a variety of suppliers. During the normal course of business, in order to manage future demand for our products and to ensure adequate component supply, we enter into agreements with manufacturers and suppliers which allow us to procure inventory based upon criteria and timing that we define. Certain of these purchase commitments are non-cancelable and unconditional commitments. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Off-Balance Sheet Arrangements We do not have any material off-balance sheet arrangements (other than those disclosed above within Contractual Obligations) 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. 44 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the dates of the consolidated financial statements, the disclosure of contingencies as of the dates of the consolidated financial statements, and the reported amounts of revenue and expenses during the periods presented. Although we believe that our judgments and estimates are reasonable under the circumstances, actual results may differ from those estimates. We believe the following to be our critical accounting policies because they are important to the portrayal of our financial condition and results of operations and they require critical management judgments and estimates about matters that are uncertain: ? Revenue recognition; ? Stock-based compensation; ? Goodwill and purchased-intangible assets; ? Accounting for income and telecom taxes; and ? Indemnification asset If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected. See "Risk Factors" for certain matters that may affect our future financial condition or results of operations. Revenue Recognition We derive our revenue from the sale of premise enterprise IP telecommunications systems and ShoreTel Sky hosted services. When a sales arrangement contains multiple elements, such as hardware and software products and/or services, we allocate revenue to each element based on relative selling prices. The relative selling price is determined using vendor specific objective evidence of fair value ("VSOE") when available. When VSOE cannot be established, the Company attempts to determine the third party evidence of selling price ("TPE") for the deliverables. TPE is determined based on competitor prices for similar deliverables when sold separately by the competitors. Generally our product offerings differ from those of our competitors and comparable pricing of our competitors is often not available. Therefore, we are typically not able to determine TPE. When we are unable to establish selling price using VSOE or TPE, we use estimated selling prices ("ESP") in our allocation of arrangement fees. The ESP for a deliverable is determined as the price at which we would transact if the products or services were sold on a stand-alone basis. Product and Support and services revenues: The sale of IP telecommunication systems include hardware, primarily phones and voice switches, software components and may also include training, installation and post-contractual support for the products. Our business strategy is centered on selling to enterprise customers through channel partners rather than directly. Sales to value-added distributors allow us to leverage our existing distribution infrastructure and sales personnel. The typical system includes a combination of IP phones, switches and software applications. For sales transactions made both directly and to resellers, revenue is recognized at the time of shipment provided that all the provisions of revenue recognition have been met. For sales to value-added distributors, revenue is initially deferred and is recognized at the time of sale by the distributor to their customer, provided all the provisions of revenue recognition have been met. We refer to this distribution approach as two-tier distribution model and the recognition of revenue at the time of sale by the distributor as the sell through method. 45 -------------------------------------------------------------------------------- Table of Contents We recognize revenue when persuasive evidence of an arrangement exists, product has shipped or delivery has occurred (depending on when title passes), the sales price is fixed or determinable and free of contingencies and significant uncertainties, and collection is probable. The fee is considered fixed or determinable at the execution of an agreement, based on specific products and quantities to be delivered at specified prices. The agreements with reseller partners generally do not include rights of return or acceptance provisions. Even though substantially all of the contractual agreements do not provide return privileges, there are circumstances for which we will accept a return. We maintain a reserve for such returns based on historical experience with reseller partners. The agreements with our value-added distributors allow for limited rights of return of products generally purchased within the previous 90 days. In addition to such return rights, we generally offer price protection provisions to our distributors when there is a permanent reduction of our sales prices. In such cases, we are obligated to grant the distributor a credit for the difference between the change in the aggregate price of any amounts that have been purchased but unsold by the distributor as of the effective date of such decrease. In addition, certain of our distributors stock phones and switches and purchase licenses only upon sale to a value added reseller or end customer. Revenue is deferred for distributors until the distributor sells the hardware and license to their customer. To the extent that our agreements contain acceptance terms, we recognize revenue upon product acceptance, unless the acceptance provision is deemed to be perfunctory. Payment terms to customers generally range from net 30 to net 60 days. In the event payment terms are extended materially from the Company's standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payment becomes due. We assess the ability to collect from our customers based on a number of factors, including credit worthiness and past transaction history of the customer. If the customer is not deemed credit worthy, we defer all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue. Provisions for return allowances and product warranties are recorded at the time revenue is recognized based on our historical experience. The provision for return allowances is recorded as a reduction to revenues on the statement of operations and is included as a reduction to accounts receivable on the balance sheet. Most of the products and services included in a system qualify as separate units of accounting. Many of our products have both software and non-software components that function together to deliver the essential functionality of the integrated system product. We analyze all of our software and non-software products and services and consider the features and functionalities of the individual elements and the stand alone sales of those individual components among other factors, to determine which elements are essential or non-essential to the overall functionality of the integrated system product. We recognize revenue related to installation services and training upon delivery of the service. Our core software, which we refer to as "essential software," is integrated with hardware and is essential to the functionality of the integrated system product. We also sell additional software which provides increased features and functions, but is not essential to the overall functionality of the integrated system products, which we refer to as "non-essential software." At the initial purchase, the customer generally bundles together the hardware, essential software, non-essential software, as needed, and up to five years of post-contractual support. Thereafter, if the enterprise customer increases end users and functionality, it may add more hardware, both essential and non-essential software components, and related post-contractual support by purchasing them separately. The revenue for these multiple element arrangements is allocated to the non-essential software deliverables and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the new revenue accounting guidance. The non-essential software deliverables included in a multiple element arrangement are subject to the industry specific software revenue recognition guidance. As we have not been able to obtain VSOE for all of the non-essential software deliverables in the arrangement, revenue allocated to the delivered non-essential software elements is recognized using the residual method in accordance with industry specific software revenue recognition guidance. Under the residual method, the amount of revenue recognized for the delivered non-essential software elements equaled the total allocated consideration less the VSOE of any undelivered elements bundled with such non-essential software elements. We have been able to establish VSOE for our professional and post contractual support services mainly based on the volume and the pricing of the stand-alone sales for these services within a narrow range. We establish our ESP for products by considering factors including, but not limited to, geographies, customer segments and pricing practices. The determination of ESP is made through consultation with and formal approval by our management. We regularly review VSOE, TPE and ESP and maintain internal controls over the establishment and updates of these estimates. We have arrangements with our channel partners under which we reimburse them for cooperative marketing costs meeting specified criteria. We record the reimbursements to the channel partners meeting such specified criteria within sales and marketing expenses on the consolidated statements of operations, and maintain estimated accruals for these programs. To the extent no identifiable benefit can be provided, such amounts are recorded as a reduction of revenue. Hosted and related services revenues: Our hosted and related 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. Customers are not required to purchase phones from us directly as they can independently purchase such equipment. Our customers typically enter into a 12 month service agreement whereby they are billed for such services on a monthly basis. 46 -------------------------------------------------------------------------------- Table of Contents Monthly recurring hosted services are recognized in the period when the service is delivered. The installation fees are recognized based on customer contractual period or on a straight-line basis over the estimated customer life. We bill most of the monthly recurring hosted service revenue a month in advance. Any amounts billed and collected, but for which the service is not yet delivered, are included in deferred revenue. These amounts are recognized as revenues only when the service is delivered. We maintain a reserve for credits provided to customers for outages, quality issues, billing disputes or changes in the service levels that are included in the amounts that were billed in advance. The reserve for such credits is based on historical experiences and trends. We also maintain a reserve for amounts that are deemed as uncollectible. Stock-Based Compensation We measure all share-based payments to employees based on the grant date fair value of the awards and recognize these amounts in our consolidated statement of operations over the period during which the employee is required to perform services in exchange for the award (generally over the vesting period of the award). We amortize the fair value of share-based payments on a straight-line basis. Income tax benefits realized upon exercise or vesting of an award in excess of that previously recognized in earnings are presented in the consolidated statements of cash flows as a financing activity. Stock-based compensation expense recognized in the consolidated statements of operations has been reduced for forfeitures since it is based on awards ultimately expected to vest. If factors change and we employ different assumptions in the application of our option-pricing model in future periods or if we experience different forfeiture rates, the compensation expense that is derived may differ significantly from what we have recorded in the current year. Goodwill and Purchased-Intangible Assets Goodwill is tested for impairment on an annual basis on June 30th and when specific circumstances dictate between annual tests. When impaired, the carrying value of goodwill is written down to fair value. The goodwill impairment test involves a two-step process. The first step, identifying a potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying value of the reporting unit exceeds its fair value, the second step would need to be conducted; otherwise, no further steps are necessary as no potential impairment exists. The second step, measuring the impairment loss, compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. Any excess of the reporting unit goodwill carrying value over the respective implied fair value is recognized as an impairment loss. There was no impairment of goodwill identified in fiscal 2014, 2013, or 2012. The fair value of our single reporting unit was significantly in excess of the carrying value, which includes goodwill. Purchased-intangible assets are amortized on a straight-line basis over the periods of benefit, ranging from two to eight years. We perform a review of purchased-intangible assets whenever events or changes in circumstances indicate that the useful life is shorter than we had originally estimated or that the carrying amount of assets may not be recoverable. If such facts and circumstances exist, we assess the recoverability of purchased-intangible assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. Impairments, if any, are based on the excess of the carrying amount over the fair value of those assets. If the useful life of the asset is shorter than originally estimated, we accelerate the rate of amortization and amortize the remaining carrying value over the new shorter useful life. There was no impairment of purchased-intangible assets identified in fiscal 2014, 2013, or 2012. Accounting for Income Taxes We account for income taxes using the asset and liability method of accounting for income taxes. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefit of which future realization is uncertain. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of deferred tax assets will not be realized. The realization of deferred tax assets is based on several factors, including our past earnings and the scheduling of deferred taxes and projected income from operating activities. As of June 30, 2014, we do not believe it is more likely than not that the deferred tax assets relating to U.S. federal and state operations are realizable. We intend to maintain the valuation allowance until sufficient positive evidence exists to support reversal of some or all of the valuation allowance. Our income tax benefit recorded in the future will be reduced or increased in the event changes to the valuation allowance are required. 47 -------------------------------------------------------------------------------- Table of Contents We had federal net operating loss carryforwards of approximately $92.8 million as of June 30, 2014, which expire at various dates between 2023 and 2033. These net operating loss carryforwards include the effects of a favorable tax ruling determined under Section 382 by the Internal Revenue Service in March 2010 as well as federal net operating loss carryforwards available from the Agito and M5 acquisitions. We have not completed Section 382 studies for net operating losses incurred in the years subsequent to July 2007. Upon the completion of these studies, the amount of net operating losses available for utilization may be limited. Recent Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements in Item 8 for a discussion of the expected impact of recently issued accounting pronouncements. |