Description

Based in Sunnyvale, CA, ShorTel is a provider of IP Telephony software, switches and handsets to mid/large size enterprises, universities, and local governments. SHOR sells products primarily through a network of resellers and over 90% of revenue is derived from the United States. The company recently surpassed the 10,000 customer mark and has installed more than 60,000 switches, 900,000 VoIP endpoints and over 1m user seats.

Summary

Despite what a promotional management team and would have you believe, SHOR is a tiny company competing against incumbent giants (that just got bigger) in an industry that is declining in absolute and relative terms with lower volumes and pricing pressure. SHOR's EV/S and P/S multiples are off the charts for a company that is not GAAP profitable, generates minimal cash flow and has declining revenue. Meanwhile one of the biggest players in the space just sold for a fraction of SHOR's valuation and The Company is between a rock and a hard place with respect to their growth strategy. SHOR's CFO and VP of Global Support have both made open market sales of the stock at prices 20+% lower than the shares are trading for now. Four venture funds who unloaded roughly 20% of their collective SHOR stake in the June '07 IPO continue to hold north of 60% of the outstanding shares which are re-entering the IPO price range of $9.50; a price the stock commanded at the height of the most recent equity bubble. While the sun is shining on the proverbial dog's behind due to some reshuffling of the competitive landscape, we believe that it would be very difficult for SHOR to grow into its current market value and that the business' intrinsic value implies a share price significantly lower than today's quote.

You should buy this company if you believe that SHOR can grow FCF at a 19% CAGR from calendar 2010's $7.7mm for the next 10 years discounted back to today at 11% with a 3% terminal growth rate. At that point, it's worth $9.08, or 0.9% more than where the shares are trading for today. If you believe that perfection is priced in and SHOR is going to face significant headwinds including a severely depressed and declining market, aggressive price competition from large incumbents and a potential exit by 60+% of the shareholder base you might want to secure some borrow and take the other side.

Investment Opportunity

According to Synergy Research, the pure IP telephony space has been declining in the low/mid-20s percent for the last six months.  The sales cycle for SHOR is 6-9 months and so they appeared to be gaining market share as some of their orders came in through the weak period while Nortel struggled. Sales growth at SHOR stalled and in fact is in decline as of the last quarter and management's expectations have apparently changed. They went from hiring people over the last four quarters to announcing a 9% reduction in force on their last earnings call. For a young and aggressive company that's investing in growth, an about-face from hiring to restructuring at this stage sends a clearly negative signal despite the CEO's promotional comments.

Meanwhile, we believe that Avaya has been very aggressive in pricing and Cisco is slashing the price of their systems by 50+% to get a sale. Therefore, as volumes in the industry contract so too is pricing which we believe will ultimately hurt smaller players, at least in the near-term.

The large incumbent players dwarf SHOR in terms of revenue: Nortel (now combined with Avaya), Avaya, Cisco, NEC, Siemens. Microsoft has also made a significant effort in this space. Granted many of these competitors are engaged in many areas outside of unified communications but if you take a look at overall revenue...

Avaya, the largest competitor by market share, announced on July 20^th, 2009 that it would purchase Nortel's office phone unit for $475m. The sale brings to a close months of on-and-off negotiations over the Nortel division which holds the #4 market share position in the industry. According to 2008 figures, the combination would give Avaya a 26.2% market share position and a 12.2% lead over the Cisco who has the second largest market share. The transaction significantly strengthens Avaya's competitive positioning and begins to close the window of opportunity that challengers such as SHOR have to gain market share from Nortel's customer base. What's more is that the selling price for the fourth largest company in the space was just above the market cap of SHOR - a very small challenger.

There are two ways for SHOR to get into an enterprise after the lengthy sales cycle. Either the enterprise rips out their old iron and puts SHOR in or they gradually migrate to a SHOR solution as they grow and then go back through to change out the telephone gear at the existing locations. My question is this? Who is significantly expanding to new locations at this time? Enough to sustain growth for SHOR in the near / mid-term? Also, where is this on a CIO's priority list? Budgets are being slashed, people are getting laid off and they're going to rip out a perfectly fine system to put in a new SHOR system? This doesn't seem likely, especially now.

What's more is that SHOR's target market is businesses with multiple locations and 50-500 end points. SHOR has made a strong effort to move up to larger enterprises but we believe that this is a tough sell for such a young company. There are the obvious synonymous clichés but the reality is that nobody's going to get fired for putting in a Cisco IP Telephony system and Cisco is willing to drop the price dramatically in competition with SHOR. SHOR claims a lower total cost of ownership which is great but we believe that, at the very least, the growth trajectory will look less like the share-price implied hockey-stick and more like a rubber doorstop.

The fall of Nortel, one of the largest players in the space, represents an opportunity for all players to erode Nortel's customer base. We believe however, that between Nortel's BK filing and Avaya's purchase many of Nortel's customers were more-or-less frozen. While it likely has been an opportunity for SHOR to go after Nortel's partner base we suspect that the industry's backup plan isn't to flock to SHOR; a $280m enterprise value company who shipped their first system only 10 years ago. We believe that investors may be too optimistic about SHOR's prospects for poaching Nortel's customers; especially in the near-term as competitive bake-offs and the overall sales cycle can take over half a year. These are mission critical systems to just about every vertical in every sector in the business world.

Based on Thomson Reuters estimates, SHOR is trading at 2.9x P/FY1 sales and 2.1x EV/FY1 sales. By contrast, Nortel just sold to Avaya for 0.2x sales. While Nortel's business segment was levered and unprofitable this is not good news for the industry. To their credit, SHOR has generated free cash but it's been, on average, $5-6mm per annum vs. a $390mm market cap and they're now going through one of the worst periods for their industry during which they've already announced a 9% reduction in headcount. SHOR has generated $5mm free cash so far this fiscal year but they've also drawn down working capital by $5.3m.

Four venture funds own more than 60% of SHOR: Crosspoint, Foundation, Lehman and JP Morgan.  These four sold nearly 20% of their respective stakes in the IPO at $9.50. Lehman, who owns almost 20% of the stock, will have to get out of these shares at some point in the near future. The other three have not had the opportunity to realize their gain and we believe that, at the very least, they will want to monetize a portion of their investment in the recent price runup putting a potential cap on the shares as we enter the $9 range.

SHOR came out of the box near the height of the last equity bubble in '07 at $9.50. In the subsequent months the stock spiked north of $18. The share lockup expired on 12/29/07 (Saturday) and the first day to trade was Monday, 12/31/07.  Tuesday, New Year's Day, was a holiday. By Monday, January 7^th, SHOR preannounced negatively and the stock plunged 54.0% to $6.02 trading 6mm shares in the open market. The shares haven't traded back into the IPO range until now. The venture firms with large ownership stakes had a window of only four days to sell out of any shares at or above the IPO price before the precipitous plunge.

Insiders have taken advantage of the recent runup in price, however. SHOR's VP of Global Support and CFO have both sold shares in $6 range over the past 10 weeks. The stock now trades at $9. While the share sales weren't significant, neither are the executives' total holdings so recent sales represent a large percentage of their skin in the game.

Of Course There Are Risks To Selling SHOR here. The biggest risk is that the industry bottoms, SHOR gains market share and shows solid growth. The industry data however, do not look good and SHOR, who touts their vast investment in growth has recently announced a restructuring.

There's also the risk that SHOR will use their cash for a large repurchase, a large acquisition or some other capital structure improvement. We don't believe this will be the case however. We believe there is a reason that SHOR went public and put $80mm in the bank yielding virtually nothing. They want to be able to show large customers that they're a viable player that will be around for the long-term. Having that cash balance is likely important to the sales and marketing efforts of SHOR and their partners and likely will not be reduced in any significant way in the foreseeable future. Further, the management team is very promotional which could result in headline risk.

SHOR's CEO, John Combs, has been on the media soundbite offensive when it comes to other players in the space. He declared Nortel, one of the largest players, "weakened or dead" just before their Enterprise Solutions business that did 17.5x more revenue than SHOR in 2008 sold for almost twice SHOR's enterprise value to Avaya which is another very large incumbent. He also "suspected" Avaya of having shaky financials despite having >$1bn in cash and no long-term debt as of the date they were taken private. Further, Combs espouses a $16bn market opportunity though we believe that it's closer to $1.5bn. Simply look down the list of SHOR generated press releases or read their conference call transcripts:

-ShoreTel Surpasses 10,000 Enterprise Customers (07/27/2009). SHOR's management states the number of customers on each conference call. In fact, on their 3Q09 earnings call in May 2009 Combs announced that they now sell to 10,000 customers. Two months later and only a couple weeks before their full year call they release a statement saying they now sell to "10,000 Enterprise Customers."

-The Sports World is Abuzz Over ShoreTel Unified Communications Systems (05/11/2009). SHOR had won a couple of high profile deployments including the Giants and the Wizards. This press release however includes the Sacramento River Cats (AAA Baseball) and the Frisco RoughRiders??? (AA Baseball).  Seems like a weak and shameless excuse for a press release.

-Q3 2009 ShoreTel Earnings Conference Call (05/07/2009):

*John Combs (CEO): "Wow, Troy, you sound really good today, buddy. Anything New?"

*Troy Jensen (Piper Analyst): "Must be my new ShoreTel phone."

-ShoreTel Helps Compassion Improve Children's Lives (01/22/2008). Because of a new phone system, the lives of children have been improved. You get the picture...

You should buy this company if you believe that SHOR can grow FCF at a 19% CAGR from calendar 2010's $7.7mm for the next 10 years discounted back to today at 11% with a 3% terminal growth rate. At that point, it's worth $9.08, or 0.9% more than where the shares are trading for today. If you believe that perfection is priced in and SHOR is going to face significant headwinds including a severely depressed and declining market, aggressive price competition from large incumbents and a potential exit by 60+% of the shareholder base you might want to secure some borrow and take the other side.

What Does It Take to Get to SHOR's Current Share Price?

Catalyst

We believe that 4Q and FY09 earnings will be a catalyst for share price decline. We just don't believe the growth will be there and it will become apparent that a lengthy and bumpy road lies ahead as SHOR struggles to grow into its current valuation.

F3Q09 was stronger by $700k due to the release of deferred revenue; a balance sheet account that once was growing but is now on the decline. This $700k additional revenue masked significant weakness in their business and will not be there in future quarters.  For instance, rather than sales declining 11.6% sequentially in F3Q09 they would've declined 13.6%.

If product sales remain flat sequentially in F4Q09 and you lop off the $700k one-time impact, sales will decline over 10% y/y. A business experiencing a 10% top-line decline and operating losses often commands a forward sales multiple of less than 2.0x which is where SHOR is trading at now based on very aggressive forward calendar-year 2009 assumptions (much higher than sell-side expectations).