Tuesday, February 21, 2012

ShoreTel and M5 Networks - Big Bet, Big Payoff

Remember Sylantro? GoBeam? There's DNA from these long-gone companies at ShoreTel, but I think it had a lot to do with their recent move to acquire M5 Networks. If you need a primer or a refresh on the details, you can start with our podcast last week on UCStrategies and go from there. I'm not here to rehash the news, but I do want to give you my take on the deal and what I think it means for the spaces these two companies play in.

Last week I had a chance to speak with executives from both companies, and that helped me piece together the rest of the story, which I think speaks to where things are going and how you have to respond in this fast-moving business. First and foremost, kudos to ShoreTel for thinking big and thinking out of the box. I'm pretty sure they realized that organic growth and incremental moves won't cut it to stay competitive. They need to make a bigger move - and a bolder move.

Given that ShoreTel's relatively new CEO, Peter Blackmore, was ex-HP - translation, hardware - one might think they would continue on that path and try to keep growing with premise-based solutions and channel programs. Fair enough, but I'd say ShoreTel's management also knows that the upside for premise is limited and margins are getting tighter. The company may be posting solid growth, but the profits aren't there, and investors won't stick with that formula long-term. So, how best to invest and build for the right kind of growth?

As we know, cloud is the big trend, and they're betting this will be the right answer. This is where GoBeam and Sylantro come in. Both companies were pioneers in the early days of hosted/managed telephony, with the former having gone to Covad/MegaPath, and the latter folded into BroadSoft. These may not have been the most lucrative exits, but it's real nice to have that kind of experience in a company like ShoreTel.

That's where M5 enters the picture. Their roots go back to the early days of those companies, and here they are 10 years later, with over 2,000 customers. To keep things simple, what we used to call hosted/managed, is now called cloud, and I'd argue no provider understands how to make money in this business better than M5. When you look at it that way, the deal is a no-brainer and makes perfect sense.

From a business and investor point of view, the main difference between the two companies is their business models. ShoreTel's core business is premise-based phone systems - in short, a capital expense where the revenues largely come upfront. M5 is selling a service - cloud-based VoIP, where the hardware is a nominal component. This is really an annuity business that delivers recurring, predictable revenue - cashflow to fund R&D, customer support and customer acquisition. Long term, M5 has a more profitable and sustainable model, and it's a great way build both the top and bottom lines for ShoreTel.

Without a doubt, the key to this equation is customer retention, and having had a long history with M5, I can say that churn is not their problem. Customer turnover data is pretty hard to come by in this space, but I'm pretty sure M5's churn is lower than their competitors. That's another important factor to note - this is a very fragmented and regionalized business, and while M5 is a fairly small company (about 200 employees), they're probably the biggest fish in the small pond of hosted/cloud-based VoIP providers.

At first glance, you have to wonder what is a telco vendor doing buying a hosted player? It's not that long ago these were very separate businesses, but they're chasing the same customers with a lot of common technology. Remember the early days of VoIP when it seemed like a radical idea to get your home phone service from a cableco? Doesn't seem strange today, and it won't be long until the telcos concede that whole market - gladly, btw - to the MSOs. If you don't think the same thing is going to happen with business VoIP - especially among SMBs, then you're not following me closely enough (or hiring me to re-think your strategy!).

So what are both companies getting here? Well, ShoreTel buys its way into a new market with lots of upside, and gets to shake up the landscape a bit. As with a lot of tech spaces, this was a textbook make vs. buy decision, and it's just way too late in the game for ShoreTel to replicate M5 - just doesn't make sense. So, if you're entering that market, go buy the biggest and smartest player. Done. It's a bit like free agency and baseball - sometimes you have to spend big to get the best, but if you lock them in long-term, you recoup your costs via better attendance and TV revenues.

Not only that, but ShoreTel has to look both ways in their market. For the domestic market, they only lag Cisco and Avaya, and Mitel is relatively close. Below them are all kinds of players - some are big companies with small shares, and others are just too small to worry about. ShoreTel will never catch Cisco, but Avaya has question marks - even post-Skype, and neither has what M5 brings to the table. Interesting, huh? As a sidenote, M5 also gives ShoreTel a nice boost in terms of market reach, as their presence is stronger on the West coast, whereas M5 is strongest in the Northeast.

M5 gets a great exit, and it's a great validation for cloud in this space. I've been assured that their homegrown switching platform can scale to the heights ShoreTel is dreaming of, and if there is any concern, it's keeping the culture strong. M5 is renowned for being customer-centric and being a small company themselves, they understand what SMBs need. This is a pretty special quality, and if they can scale that as the business folds into ShoreTel, they should be fine. I hope Mr. Blackmore leaves them alone!

Perhaps best of all is the fact that M5 exited to a vendor - and not a service provider. If you're an SMB, this is a huge sigh of relief, as M5 could just as easily sold out for even bigger bucks to an incumbent, but that would really be selling out. Just like ShoreTel is seen as a friendly alternative to the almighty Cisco, M5 is the great white hope for SMBs who otherwise would be hostage to their incumbent telcos. You don't think that has something to do with keeping churn low?

So, kudos to ShoreTel for taking the road less travelled. It's a risk, but now they can offer customers the best of both worlds. A lot of their customers are happy with premise-based systems - they're not ready for the cloud or they don't even trust it. Same for their channels. However, they know where the market is going, and can now offer cloud when these customers are ready, which of course keeps them in-house long term.

Of course, this isn't the only path available. Just look at Alteva - another leading hosted provider I've followed for a while - and their move to Warwick Valley Telecom. Nothing wrong with that move, but the deal was much smaller, and I think the upside will be too - unless Warwick ramps up by acquiring other telcos, but that's pretty hard to do.

That brings me back to thinking bigger and bolder. I think you need to do both, certainly for what ShoreTel's current station in the market is. The deal is financially manageable for ShoreTel, and they get the benefit of immediate cashflow. Given what Alteva sold for, I really don't see many players out there who could get what M5 got. In that regard, ShoreTel has acquired a nice cache of customers, so they hit the ground running. For another vendor to counter with a me-too deal, they'll likely end up with a much smaller player - and probably overpay - which means needing to invest another whack of money to expand the customer base and make the move worthwhile. This may be an early stage market still, but that seems like a much riskier move to me. No thanks.

What's next? Well, we'll all be watching to see if this is a one-off, or if other vendors try the same thing. I also wonder how the platform vendors - namely BroadSoft and Metaswitch - will respond. This is an adjacent space, but they're all after the same customers at the end of the day. There could be a domino effect - or maybe not. Either way, I like the move - it's great for M5, and it shows savvy from ShoreTel to get to the next level. If the cloud trend holds up, they'll be a big winner, and register much higher on Avaya and Cisco's radar. Gotta like that.


Bernard Gutnick said...

Thank you for the enjoyable posting about the M5 acquisition under way. It's a really exciting time to be at ShoreTel.

With respect to your comment of "I'd say ShoreTel's management also knows that the upside for premise is limited and margins are getting tighter.", we actually view the premise business is still our greatest opportunity - as observed by our market share increases just reported by Synergy Research, our best quarter ever in our history for enterprise solutions in Oct-Dec 2012 with record licenses shipped, revenues and profitability measure above expectations, - plus maintaining our margins at the 65+% level with only a slide reduction because of the costs of leveraging distributors for wider reach to resellers and certain markets.

It's clear hosted represents a tremendous opportunity. But I believe the key as you point out is that customers will want to have the choice between private and enterprise cloud deployments. It appears enterprise deployments will continue to be the dominent segment for several years.

For now, the opportunity for us is to deliver a great solution in both markets, and leverages the common resources between, making us strong in both.

I hope we will see you on our Analyst Day where more information will be shared about our direction ahead.


Bernard Gutnick

Anonymous said...

As the founder and former CEO of Voice Print International ,now VPI,and before that I have been in the telephone industry,since the advent of the Carter Phone decree.
I have seen many pbx manufacters come and go over the last 40 plus years.
Shoretel has really impressed me greatly,and I beleve they we be around for the long hall as a major player. On the other hand stay away from Voice Print as a recording solution. E-mail me for some advice and imput. GeneSilvers@gmail.com You can also Goole me, Gene Silvers Voice Print International, to show you who I am

Anonymous said...

Where does 8x8 stand in all of this?

$100 million in current annual revnues projected to grow at least 20% annually.

M5 didnt even have close to those revenues.

Jon Arnold said...

8x8 - fair comment, thanks! Like M5, the company has a history of developing its own technology, so 8x8 is an important player. Initially, the focus was consumer VoIP - business market came much later, but still, the company is putting up great numbers and is definitely a survivor - and an innovator of course.

Anonymous said...

Shoretel is in trouble post m5 acquisition. They laid a bunch of people off and have some serious integration issues to deal with going forward with m5. Look at their stock value

Jon Arnold said...

Thanks Anonymous. Well, I don't know your sources, so can't really comment. They certainly have been hiring lately, and it would be surprising to be hearing about major integration issues at this point. I can look into this a bit further, though.

Anonymous said...

Excellent analysis of the Shoretel acquisition. I chose M5 for my company last fall and completed the implementation in November. M5has had some major stability issues this year and virtually all development and enhancements are off the table at the moment as they address their stability issue post acquisition; despite Dan Hoffman's promise to us that key issues would be addressed by this past June. For instance, we cannot get reliable, or meaningful, call center metrics from their Callfinity product. Outbound statistics, although shown to us on a previous version, are no longer available and will not be addressed before January 2013. They also can't attribute talk time to an agent if the call is transfered. As we are largely an outbound company, we do not have any meaningful stats to help with productivity or staffing. The M5 crowd still don't seem to grasp the need for this type of reporting which is mind-boggling to me. Perhaps I have too much experience with large PBX solutions like Lucent and Nortel. Strongly considering a switch to another hosted provider - thoughts?

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