Description

I believe shares of ShoreTel (SHOR) are trading well below their intrinsic and strategic value. I think this idea is fairly simple and carries an attractive risk-reward. Ultimately, the catalyst for value realization may need to (and hopefully will) come in the form of an acquisition, and so this may not be attractive to certain investors. In this write-up, I’ll attempt to demonstrate the company’s value through a simple deconstruction of its profit streams and by looking through the eyes of an acquirer.

First, a bit about the company itself. SHOR is a $410 mm market cap company with $100 mm of cash. Despite GAAP losses, the company has nicely added to its cash balances over the past couple of years. SHOR operates in the unified communications (UC) space. I’ve recently written about this space in my write-up of MITL but it has also been covered extensively in other write-ups on this site such as Vonage (VG) and RingCentral (RNG). In a nutshell, these companies provide telephony hardware and software (IP phones, virtual PBXs, four digit dialing, etc.) mostly to SMB and small enterprise clients. The industry is in transition from premise-based deployments to cloud-based deployments. SHOR offers both, with the cloud revenue stream set to grow >20% while the premise revenue stream declines (-14% in the most recent quarter). As is often the case with these transitions, the competing forces net to create an aggregate revenue headwind. SHOR has one quarter left to go in their fiscal 2016 and will likely face a ~1% revenue decline for the full year. I believe this is a nice time to buy because despite the growth in the more valuable, recurring cloud revenue stream, the market is still disappointed in the aggregate top-line slowdown – especially as SHOR comes off two disappointing quarters in which premise based revenues declined more than expected (which was largely due to the market’s shift towards recurring cloud solutions – ultimately, a good thing). On a unit economics basis, cloud revenue is much lower in “quarter-one” but overtakes a CapEx sale within a couple of years and ultimately may have a 3-4x superior lifetime value. I wouldn’t characterize SHOR as the most dynamic company but my checks indicated that their technology is relatively well-liked and I’d particularly point out that their churn has been just 4-6% on an annualized basis, which is actually the best in the industry. Going forward, as the company actively drives the transition from premise to recurring cloud revenue, SHOR will be able to target its very large 4 mm user install base, who are already used to the feel of SHOR phone systems. Cloud users as of the most recent quarter were just 218,000 and so the large install base represents a strategic asset for driving future cloud growth, as management likes to point out.

Next, here are the company’s profit streams, using estimates for FY 2016 (one quarter left to go):

· Product sales: $150 mm of revenue @67% gross margin = $102 mm gross profit

· Services and support (contracts related to product sales and so this will also be a declining stream, albeit on a lag from product sales): $75 mm of revenue @75% gross margin = $57 mm of gross profit

· Cloud recurring revenue: $130 mm of revenue @55% gross margin (which will improve over time) = $70 mm of gross profit

· This sums to $230 mm of gross profit, of which $120 mm (34% of sales) will be spent away on sales & marketing, nearly $60 mm (16% of sales) will be spent away on R&D, and nearly $40 mm (11% of sales) will be spent away on G&A. We’re left with only about $12 mm of operating income before stock-comp and amortization.

o   What the above bullet illustrates most to me is that the company is not operationally challenged but that it is quite subscale.

o   Pure-play cloud companies (EGHT, RNG) fetch a >3x sales multiple and while SHOR’s growth has lagged, its cloud revenue stream is monthly, recurring and has mid-single digit annual churn. It’s therefore a very valuable revenue stream. At 3x, this revenue stream would well exceed SHOR’s entire enterprise value of ~$310 mm. And you’d be getting the $225 mm of product + recurring service / support revenue stream for the price of… “on-the-house.” Competitor Mitel plans to manage its product based business to a 20% ebitda margin and I believe SHOR will similarly run this business for cash.

o   While one could argue about the appropriate multiples for the various revenue streams and the fact that bottom-line profitability has been minimal over the past year, I do think sales, G&A, and R&D can all trend down from here particularly as SHOR is starting “to come out the other end” after a large amount spending in order to transition to cloud-first business.

Notwithstanding the above argument for upside – as I alluded to upfront –profitability realization likely becomes a lot easier for SHOR should a strategic or even an aggressive financial buyer emerge. On this point, two observations come to mind: (1) SHOR rejected a $8.50 offer from Mitel (without engaging them and trying to increase value) about a year-and-a-half ago. That offer is ~40% above today’s share price, while SHOR’s business hasn’t gotten any worse). (2) SHOR has a fairly concentrated list of top-holders who have given management the freedom to execute on their vision after rejecting that offer and subsequently saw the share price rise to >$10 / share in December (as consolidation chatter re-emerged) only to fall back to the $6-levels currently, brought about by a poor couple of quarters and perhaps by the sense that a Mitel deal is off the table for some period due to their acquisition of PLCM.

Finally, let me address the topic of an acquisition directly as I believe this is the ultimate end-game and upside for SHOR.

· I laid out the various expense line items for SHOR earlier. Keep in mind SHOR is essentially operating at breakeven with the mid-term goal of a 6-11% operating margin. I believe a strategic buyer could more-or less completely cut G&A (11% of sales), materially cut R&D (16% of sales), and perhaps more importantly, attain very powerful supply chain savings. It’s crystal clear that this business is worth a ton more in a consolidation scenario.

· A couple case studies to point to: When Mitel acquired Aastra, they were able to cut a full 8% of the combined companies’ operating expenses (or ~16% of Aastra’s expense base if we use the target alone as the reference – see page 20 of MITL’s 1Q earnings presentation for some more detail). Importantly, this was achieved despite the fact that those businesses had very minimal geographic overlap (Aastra was Europe focused, Mitel was N.A. focused). With two N.A. operators, the synergies could be even greater and so I think SHOR synergies could be even larger. As another example, in their latest deal, Mitel is targeting a similar 8% cost take-out for the combined MITL-PLCM entity. Vonage has also discussed the merits of consolidation synergies in this market.

· So, if we were to pro forma SHOR’s expenses for a 16% synergy, the company could offer a $55 mm synergy to a buyer (16% of $345 mm of 2016E expenses). So the synergy alone here – $55 mm based on the above pro forma, is far in excess of the company’s standalone profitability ($24 mm operating profit in FY ’15, $12 mm expected in FY ’16). And again we see that SHOR’s current enterprise value of $310 mm looks very cheap against this level of potential earnings (and leaves room for this idea to work even with a lower synergy amount and with value-sharing between the seller and buyer).

To conclude, for a $310 mm enterprise value company, I think SHOR has some very attractive profit streams (for harvesting) and a very attractive cost structure (for chopping). After a couple disappointing quarters and with the primary acquirer in the process of swallowing a bigger fish, I think the stock is very beaten up and represents an attractive risk-reward going forward at these levels. I’m willing to wait for it but I suspect, given today’s price level relative to the previous 1.5 years and the previous take-out offer of $8.50, the pressure is on SHOR management to make something happen in the near term. Similarly, for those companies that wish to make themselves known as the “consolidators” or for private equity looking to play a role, I think the pressure is on to make deals happen. For all these reasons, I find this to be quite an attractive opportunity.

Catalyst

• Cloud will transition to be the largest revenue stream over the next year and so the company is passing the hump in terms of the offsetting factors from premise-based business decline vs. cloud based business growth.
• Acquisition speculation returns and a deal ultimately gets done