Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Avaya Inc. (NYSE:AV)

Q3 2006 Earnings Conference Call

July 24, 2006, 5:00 pm EST

Executives

Matt Booher - Vice President of Investor Relations

Don Peterson, Chairman

Louis D’Ambrosio, President and Chief Executive Officer

Mike Thurk, Chief Operating Officer

Garry McGuire, Chief Financial Officer and SVP of Corporate Development

Analysts

Inder Singh - Prudential

Jeff - Banc of America Securities

Manuel Recarey - Kaufman Brothers

Tal Liani - Merrill Lynch

Tavis McCourt - Morgan Keegan

Samuel Wilson - JMP Securities

Ehud Gelblum - JP Morgan

Troy Jensen - Piper Jaffray

Operator

Good afternoon, my name is Ian and I will be your conference operator today. At this time I will like to welcome everyone to the Avaya Earnings Conference Call. [Operator Instructions]. I would now like to turn the call over to Matt Booher, Vice President of Investor Relations. Mr. Booher you may begin your conference.

Matt Booher - Vice President of Investor Relations

Thank you and welcome to Avaya's Fiscal Q3 2006 Earnings Conference Call. I am joined on the call today by Don Peterson, our Chairman, Louis D’Ambrosio, our President and Chief Executive Officer, Mike Thurk, our Chief Operating Officer, and Garry McGuire, our Chief Financial Officer and SVP of Corporate Development. This call is open to the media and is being web cast live with the replay available via the phone and the web. Our earnings release is on First Call and PR Newswire. It's also available on our website at www.avaya.com/investors, along with slides that summarize our results.

Our focus today will be on continuing operations as reported on a US GAAP basis. We will also be highlighting some significant items that are included in our GAAP results. Financial results in the press release and slides are unaudited.

Our remarks may contain forward-looking statements regarding the company's outlook and the company's expected performance. Forward-looking statements represent our judgment as to what may occur in the future and are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.

Additional information regarding these risks and uncertainties may be found in our filings with the Securities and Exchange Commission, and in particular, our fiscal 2005 Form 10-K and our Q1 and Q2 2006 Form 10-Q, as well as in our earnings release, which we filed on Form 8-K earlier today.

Avaya disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Unauthorized recording of this conference call is not permitted. Now, at this time, I would like to introduce Don Peterson.

Don Peterson - Chairman, CEO

Thanks Matt, and good afternoon to everyone. Earlier today we announced key management changes. Louis D’Ambrosio was appointed Chief Executive Officer and Mike Thurk, Chief Operating Officer. I will remain Chairman until September 30th at which time I will be stepping down from the board. It’s been a great privilege for me to lead our company since we became independent nearly six years ago. Over the course of those six years, our industry and our company have changed substantially. We have endured the bursting of the technology bubble, the market meltdown and the uncertainties following 9/11. We have seen our customers begin the transition to IP telephony and all the potential this new technology offers.

At Avaya, the last six years have been a time of profound transformation and improvement. We have become the market leader in the IP Telephony business. We have radically reengineered our solutions portfolio developing and acquiring new technologies. We have strengthened our geographic footprint and we have imposed the financial discipline that has turned us from an over leveraged, under capitalized company to one that is financially strong and debt free.

As we look at our market we see significant opportunities ahead. We have made progress in capturing them as evidenced by our solid product sales growth. But there is more potential ahead. The board and I believe that Lou and Mike are the best people to help us capture that potential. Lou is an industry veteran with over two decades of experiences in sales, services, software and marketing. Prior to his appointment as CEO he was Senior Vice President and President of Global Sales and Marketing. He previously headed our Global Services business unit. Before joining Avaya in 2002, Lou spent 16 years at IBM in key domestic and international roles. He knows our company and our industry well.

Michael Thurk, our new COO was formally Senior Vice President and President of Global Communications Solutions. He has more than 30 years of industry experience including management positions at Ericsson Digital Equipment and several US data communications companies. Those of you who know Lou and Mike and have met them at our Investor Conferences will appreciate their energy, talent, integrity and enthusiasm, and I would like to take this opportunity to congratulate them introduce Lou and have him share his initial thoughts with you, Lou?

Lou D'Ambrosio

Thanks. Thank you very much. Let me first start by saying how excited I am to lead our company as we continue to drive our industry transformation. Today I would like to briefly discuss with you the opportunities we see ahead in our market, the strengths and competitive advantages that we bring to bear, and I would also like to talk about the recent customer successes and then a bit of our strategic focus going forward.

To begin, IP telephony and intelligent communications are opening up new possibilities for our customers. It offers new opportunities for customers to profoundly transform their business processes, how employees interact with each other internally, how they interact with customers, suppliers, partners, externally, how they access news information wherever it is. We are in a strong position in our market today and we continue to earn recognition as the industry leader, and you all read the same reports we do, which rank the different companies. We see that Infotech has ranked us number one in US Enterprise Telephony. Dell'Oro ranked us number one Global Enterprise Telephony, Synergy ranked us number one in Global Enterprise IP Telephony Line Shipments and IP Telephony Revenue for the tenth consecutive quarter.

It’s important to recognize the advantages of our leadership at this stage of the market and at this stage of the transition to IP telephony. It indicates our initial success in maintaining and converting our installed base as well as winning green field opportunities. It also importantly positioned us for additional sales down the road at enterprise and deploying intelligent communication solutions and applications on top of our IP telephony platform.

We continue to drive forward and capture opportunities in the market, we generated solid growth in IP sales, IP line shipments were up over 20% worldwide, with 20% plus growth in the US, and we shipped our 10 millionth IP line during the quarter, a major milestone for the company. Product sales overall has grown to double digits. But these growths have not been just in some vacuum but to real customers, delivering real values. Now let me talk about some of them.

Kimberly Clarke selected us for a suite of IP telephony contact center messaging and mobility applications for 57,000-plus employees worldwide. While Vanguard, the second largest US mutual funds firm chose our solutions for IP telephony networking and applications for 18,000 endpoints around the world. One of the world largest mutual fund and investment management companies has chosen us to install our voice applications for its 40,000 employees and use our global services for their IPT and telephony infrastructure solutions.

It’s not just the US; in fact in Germany a leading OEM auto parts supplier implemented a wide range of products and services including telephony, contact center solutions and network management for voice and data. And finally one of the world’s largest financial services firms (inaudible) solutions in services as it rolls out IP telephony in up to 2,200 branches throughout North America. What I would also like to talk about just quickly now is that we just don’t announce these wins, they get installed, they get deployed, they deliver value to customers. At our last investor conference we talked about the Home Depot deal, since hat time we’ve deployed over 1,000 branches at Home depot.

Now let me take a minute to highlight another event that underscores the strength of our offerings. And that’s the sponsorship and partnership of the FIFA World Cup. This partnership was valuable on many levels; it gave us exposure to worldwide audience, helped build our brand in key markets and demonstrated the strength of our solutions and services capabilities on a real time basis. Let me talk a little bit about this partnership and what we did. We designed, built, install and serviced the largest converged communications network ever for a sporting event. The network connected FIFA headquarters, stadiums and meeting centers and included 45,000 network connections and 30,000 network devices that was used to issue accreditations for players and journalists, report results, tracking payrolls and inventory, confirm accommodation at FIFA’s official hotels, and importantly maintain security systems.

Between May 15 when the network became operational and July 10 the day of the championship match, we estimated that a total of 21 terabytes of voice and data traffic was transferred over the network. During that time people have logged in to converged network over 600,000 times and made over 300,000 phone calls. Through it all, the network delivered 99.999% of availability. We are very proud of our partnership with the FIFA World Cup, our services people did a terrific job as did our solutions team and I also want to take this opportunity to thank the FIFA executives for helping to make this partnership a true win-win.

As we look to build a momentum into the future we need to understand and leverage our significant strengths and the market that we are in is an attractive market, one that’s large and growing. We have the size, skill and footprint to compete and win in all regions around the world. We have the broadest range of solutions and services in the industry. Our solutions are known for their quality and reliability built on open standards, and we’re continuing to develop and acquire new capabilities that will further enhance our portfolio. And finally as Don alluded to, we are financially strong, you will see Garry talk about the strong cash flow, debt free balance sheet, etc.

We have a talented and energetic management team, a team that’s focused and committed, and a team that I’m very much looking forward to work with. At the same time, however, the scope and pace of change within our industry is increasing. So what does that mean for us? The bottom line is that we need to accelerate our own transformation if we are going to strengthen our market leadership position. Let’s talk about what this means strategically? Strategically, this means sharpening our focus on our customers and accelerating our movement into the value layers. It also means accelerating the pace of helping customers transform and improve their business processes to intelligent communication. To be clear, customers are not looking for dummy down communications infrastructure. In fact, they are looking to leverage communication solutions, to improve their competitions in the marketplace.

This transformation is all about imbedding communications into customer processes and providing the services that’s important to this integration. This means accelerating our momentum into communications applications and services that integrate into these processes. And it means extending our leadership position in IP telephony solutions and extending our IP telephony platform. It means sharpening our focus in the communications applications space and leveraging our global services as a unique competitor advantage in delivering value to our customers. It means leveraging existing partnerships, but also forming new partnerships and new strategic alliances. And finally it means allocating our intellectual and financial capital in these critical areas. We strongly believe that this makes sense for all constituencies.

For share holders, this is where the (inaudible) reside. For customers, this is where the leverage points are to innovate their business processes. For Avaya this builds on the very core competencies of our organization, open standards, software differentiation, IP telephony leadership and a comprehensive services portfolio. Importantly, and in addition to sharpening our strategic focus, we will have an equal emphasis on fierce execution and urgency and speeding up the pace of change within our company. And this will enable us to stay ahead of the changes occurring within our industry, which will enable us to further build value for our shareholders.

I very much look forward to meeting you and speaking with all of you in the future. Thank you for your time today and now Garry will provide you a detailed operational and financial review.

Garry K. McGuire

Thanks Lou. I would like to start of by giving our overall view as reported and then discuss where we did well and where we need to improve. In terms of positives we made solid progress in several key areas. We grow revenues by 5% year-over-year, and we delivered double digit product sales growth with particularly strong growth in the US at 15%. It was our second quarter in a row of double digit increases in US product sales. In addition, services revenue were stable. Operating cash flow was strong and we now have a debt free balance sheet. There were also some areas of our business that we have been focusing on and still needs to see further progress. Increased cost and expenses resulted in lower operating income. A portion of this was due to restructuring charges in the quarter as well as some items that will not impact us in future periods. Net of these items there are still work that needs to be done. We need to continue to improve our cost and expense profile particularly in Europe. Toward that end we took a restructuring charge in Q3 and we expect to take additional actions in Q4 throughout Europe as well as the US to reduce cost and expenses. So that’s the snapshot of the quarter.

Now I would like to take you through several key items that impacted our Q3 operating results. I will begin with the product supply issue. As you remember from our last call we estimated that net impact on Q2 revenues was $30 million to $35 million. Since that time we have made substantial progress on this issue. Even with the increase in revenues in the quarter we improved order fulfillment and significantly reduced backlog. Assuming there are no further supply disruptions and assuming we can continue to build on last quarter’s progress we should be at a point at the end of Q4 where any impact would not be significant.

There were three items that impacted the operating income line. First, let me discuss the restructuring charge. The Q3 charge was $22 million and is reflected in the restructuring line on our income statement. I will provide more detail on this in a few minutes. During Q3 we also had a non-cash asset impairment charge of $29 million which impacted SG&A and which was mostly related to the write down of internal use software assets. You may recall that at our Investor Day last year, we talked about our plan to adopt and implement a unified SAP ERP system globally. We said then that there might be charges during the course of this implementation and the Q3 impairment as part of this. More specifically the charge relates to capitalized cost incurred in prior years for the development and design of internal use software. After evaluating whether it was possible to use the software as part of the new system that we are implementing we decided this quarter that we could not which resulted in the impairment. Just to remind you, we said last December that we expected significant expense savings beginning in fiscal 2008 when the SAP system is fully deployed and functional.

Finally, we also had a positive impact of $22 million in Q3 related to favorable non-income tax settlements that we reached with several jurisdictions. This benefit partially offset the charges we took and it also flowed through in the SG&A area. So if we look at the three items together, the net negative impact on operating income was $29 million. In addition to these items, in Q3 we incurred cost and expense related to the FIFA World Cup. As part of our sponsorship of the event we supplied products and services at substantially discounted prices, which adversely impacted gross margin. We also incurred $9 million in related sales and marketing expenses. We’re looking now at how much of this if any will be redeployed into other marketing and branding opportunities in subsequent quarters but we don’t expect in any case it will be the whole amount.

Now that I have covered all of these items let me quickly put them in context for you as we do not expect to see much if any impact from them going forward. Revenues in Q3 were positively impacted from the pick up of some of the previous quarter’s delayed shipments. Operating income was negatively impacted by $29 million, which was a net effect of the two charges and the benefit from the non income tax settlements. There were also other items, FIFA related cost and expenses that impacted margins and opex in the period.

Let me now move on to the income statement beginning with revenues. As usual, unless I note otherwise, I will be disgusting our performance on a year-over-year basis. Revenues in the quarter were 1.297 billion, which was a 5% increase year-over-year. Capex had a positive impact of $4 million or 0.3%%, mostly in the Americas non-US region. Looking at revenues by geography, the US was up 5% and EMEA rose 3%, Asia Pacific was up 4% and Americas non-US increased 18% percent. In terms of revenue by type, sales of products were strong; they were up 12% compared to the same period last year. The US was up 15%, Americas non-US was up in the mid teens, EMEA was up in the high single digits and APAC was up about 7%.

Services revenue were up 1.4% year-over-year due to higher implementation and integration services revenue. Sequentially services revenue was up 3.5% due to increases in maintenance revenues and implementation revenues as well as favorable currency impact. US services revenue overall and US maintenance revenues were down slightly year-over-year and flat sequentially. Rental and managed services revenue declined about 9% year-over-year and was down by less than 1% on a sequential basis. As we have discussed there are have been a couple of factors affecting rental and managed services revenue in AMEA, specifically in Germany. Our rental contracts that are relatively long-term -- four or five years, and prices have fallen over that period of time, so contracts being renewed today produced lower revenue. This is not a new issue and while we are continuing to address it we have not yet been able to achieve enough net new revenue growth to offset the impact of price erosion or contract cancellation.

In addition, we have recently begun to shift away from the traditional rental business model to what used in Germany, which I discussed on our last quarter. While this shift will adversely impact the rental and managed services line item, it should generate higher product sales and incremental maintenance revenue. We are now beginning to see some impact from this shift but we need to intensify efforts to maintain and grow the overall base of business in the region. Looking at revenue by channel, direct sales were flat year-over-year, but up 11% sequentially. Indirect sales were up 25% year-over-year and up 5% sequentially. In terms of mix, sales from the direct channel was 44% of product revenue in Q3 2006 which was a declines of 5 percentage points from a year ago, but an increase of 2 percentage points from Q2. Indirect was 56% in Q3 2006, 51% a year ago and 58% in the Q2 of 2006

Days of inventory on hand in the channel were down significantly compared to last year and up slightly compared to Q2. We saw solid improvement in both sales in to and sales out by our channel partners. Let me shift to a discussion on gross margins. Gross margins were 45.3% down 1.2 percentage points from a year ago. Rental and managed services margins had the biggest impact accounting for nearly half or 0.6 percentage points of the decline. The rest of the decline was split fairly evenly between product sales and services. Looking at each of these areas in more detail, the client in rental and managed services gross margins was primarily due to two factors. The first was the impact of lower revenues in our rental business in Germany which I discussed earlier. We need to do more work here to align cost with revenues. The second factor has to do with our managed services business.

A large contract that was signed in a previous quarter is now ramping and is at relatively lower margins than historical contracts. Some of this is caused by a ramp up in expenses faster than revenue early in the contract deployment but is some also due to expected lower overall margins than what is in the base. We are working to achieve scale in this business and are also monitoring carefully the scope of new contracts to ensure appropriate margins and level of profitability. In terms of gross margins and sale of products, we benefited from higher volumes and manufacturing cost improvements, but these were more than offset by market pricing pressure as well as channel mix.

Gross margins for our service business were affected primarily by FIFA related cost in Europe. To put this discussion in perspective, gross margins are a key area where we need to improve our performance. Some of the decline is volume related in the service business, some reflects higher cost, and some is a result of market pricing pressure. We are attacking these issues in a couple of different ways. We’re reducing cost across the business and geographies to get the appropriate leverage in growth areas, such as product sales. We are working to grow revenues and manage cost in the business like managed services where we need additional scale and we are aligning cost with revenue in our rental and in maintenance businesses.

Based on this, in Q4 we would expect to see margins improving directionally back to their level that we had in Q2. The actions we expect to take in Q4 should enable us to make additional progress. Let me now address our operating expenses, SG&A increased by $17 million year-over-year. As I discussed earlier there was a net negative impact of $7 million this year which was the difference between the internal use software impairment charge in the non-income tax settlements benefit. We also had higher FIFA sales and marketing expenses during the period that I discussed earlier. R&D increased in Q3 by $22 million and was roughly 9% of revenue in line with our claim.

I would now like to discuss operating income which was $28 million in the quarter. As mentioned, this includes a net negative impact of $29 million from the three items I previously discussed, higher costs and expenses related to the FIFA sponsorship and the gross margin issues discussed earlier.

Let me now move on to taxes. During the quarter we had an income tax benefit of $11 million. It is worth noting that two tax matters were finalized in the quarter and are included in this amount.

The first is an $18 million favorable tax benefit associated with transfer pricing adjustments reflected on the company’s fiscal year '05 corporate income tax returns filed during the quarter. The second is a small favorable non-US audit settlement. Excluding these items are effective tax rate for the Q3 '06 period would have been approximately 30%. We believe that our annual fiscal '06 effective tax rate excluding non-recurring tax items will be in line with our previous estimate of 36% to 38%.

Net income for the quarter was $44 million or $0.10 per diluted share based on 465 million shares outstanding. Net income for Q3 last year was $194 million or $0.40 per diluted share based on 487 million shares outstanding.

Just to remind you, this included a non-recurring tax benefit of $123 million or $0.26 per diluted share. I'd now like to focus on restructuring activities. As we have discussed with you, one of our challenges is to improve our operational and financial matrix in EMEA and bring them closer in line with the rest of the company. We have taken a number of actions since the beginning of fiscal year 2005 toward that goal. In Q2 of this year for example, we took $20 million charge to reduce EMEA headcount by about a 130 people. This part quarter we took two additional action, which in the aggregate resulted within a charge of 22 million. Approximately 4 million of the charge relates to further headcount reductions in EMEA and the remaining 18 million is a non-cash charge related to consolidating European office space facilities.

During Q4, we plan to drive further improvements in costs and expenses. We expect to reduce headcount in Europe and in the US. We are working now to finalize our plan and as you know, these restructurings often require Board's counsels and other referables. But at this point, we expect that its scope and the resulting savings could be larger than the combined impact of what we announced in Q2 and Q3 of '06. The majority of these actions should be completed by the end of the quarter with a partial flow through of savings in Q1 and the full flow through by the end of Q2.

Now I'd like to review the performance of our business segments beginning with global communication solutions. On a year-over-year basis, GCS revenues increased by 9% and operating income increased by 35 million from $1 million of OI last year to $36 million in Q3 of this year. The revenue increase was driven by higher sales of large communication systems which rose 16% overall. LCS sales grew by double digits in the US, APAC and the Americas non-US, and in the high single digits in EMEA. Small and medium communication system sales were basically flat with high-teens growth in US offset by a decline in Europe. Converge voice application sales declined by about 5% with increased application sales in the US offset in declines in other regions. GCS segment gross margins increased by 0.4 year-over-year but declined by a percentage point on a sequential basis. OPEX as a percentage of revenue improved both year-over-year and sequentially.

Turning now to Avaya Global Services, AGS segment revenues increased by 0.9% year-over-year and by 2.7% sequentially. The increase over both periods was driven primarily by higher implementation and integration services revenue, which is tied to product sales and which rose in both the US and EMEA. The sequential increase in Europe was also as the result of a positive apex impact.

Maintenance revenues in the quarter were down 2% year-over-year mostly by decline in the US. Sequentially maintenance revenues were flat in the US and up modestly in EMEA partially due to favorable currency impact. As you recall, most US maintenance contracts renew in our second fiscal quarter. As a result, that is when we see the most impact in terms of scope and price changes. Our experience last year was that US maintenance revenues dipped slightly in Q2 and that we are relatively stable over the following three quarters. So far in 2006, we have seen a similar dip in Q2 and then in Q3 revenues were stable which may indicate that we are seeing similar trends this year that we had last year.

Global managed services revenue was about flat year-over-year with EMEA flat in a modest decline in the US. Sequentially, the US declined slightly and EMEA also declined. AGS segment margins declined year-over-year and sequentially, but OPEX as a percentage of revenue improved over both periods.

Moving now to the corporate segment in Q3, we recorded $42 million loss in the corporate segment, which reflects the restructuring in asset impairment charges as well as the tax settlement benefit. So that gives you an overview of the segment results, let me now move on to cash flow and the balance sheet.

Operating cash flow for the quarter was $181 million, an increase of 55 million over Q3 of last year. For the first nine months of 2006, operating cash flow totaled $456 million, that’s up $270 million over the first nine months of last year. And so far in 2006, we have generated a higher level of operating cash flow than we did in all of 2005 and nearly as much as we had in 2004, which was a record year with 479 million in operating cash flow.

Cash on the balance sheet was 822 million, up 77 million from 745 million in Q2 of '06. We ended the quarter debt-free having retired the remaining 13 million in senior notes outstanding. Depreciation and amortization during the quarter was 76 million consistent with previous quarters this year. This included about 7 million in amortization related to stock options and restricted stock units. CapEx and capitalized software were 45 million during the quarter and year-to-date they were 136 million and we still expect to spend about 200 million for the full year.

DSOs in the quarter improved slightly to 57 days, their lowest level in seven quarters and inventory turns also increased about seven times compared with nine in Q2 and 8.1 in the year-ago quarter. During the quarter, we repurchased and retired 5.1 million shares at an average purchase price of $12.32 per share for a total of $63 million.

Since the inception of the buyback program last year, we have purchased about 34 million shares for an aggregate price of $363 million. We have approximately 137 million available through April of 2007 for further share repurchases under the current plan. So that covers our income statement, segment results, cash, liquidity and balance sheet. Let me end by providing our view as to where we stand as we enter the final quarter of our 2006 fiscal year.

In the first nine months of 2006, our total revenues are up 5%. Sales of products are up 9%. Sales of large communication systems are up 13%, and sales of small communication systems are up 14%. In addition, the growth rate in sales of products has increased as we have moved through the year. On a year-over-year basis, it was 6.7% in Q1, 9.2% in Q2, and 12.4% in Q3. This is a similar trend to what we had experienced in fiscal 2004.

Keep in mind that these are as reported numbers and have not been adjusted to reflect constant currencies this year or to include this last year. If we make these adjustments, total revenues increased by 3.3% and sales of products rose by nearly 10%. We are generating a solid level of organic growth especially on the product side.

In addition to our top line results, we are also generating strong operating cash flow and we have a healthy debt free balance sheet. While these are all positives, we know we have more work to do on a few key areas. Cost and expense management remain our biggest priorities particularly in Europe. As discussed, we are continuing to take actions there to improve our operational and financial metrics and bring them in line with the rest of the company.

Having said that, let me provide our current perspective on Q4. As you know, Q4 is traditionally our strongest quarter of the year. Our Q3 to Q4 revenue growth has averaged between four and five percent in each of the last three years. Based on what we see today and assuming that currencies and economic conditions remain stable, we expect that Q4 will also we be our strongest quarter this year from our revenue perspective. However, due to the strong growth in revenue in Q3, we may not see the same level of historical sequential growth that we had in previous years.

Additionally, we expect to see improvements in other areas with gross margin moving directionally back to where it was in Q2 in OpEx as a percentage of revenue divining. As a result of all of these factors, we should see a solid improvement in OI for the quarter, compared to Q3 excluding any charges that we might take.

With that I’d like to turn it over to Q&A section and Lou and I would be glad to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Inder Singh with Prudential.

Inder Singh - Prudential

Yeah, thank you very much. First, congratulations to Lou and Mike for your new roles at the company.

Lou D'Ambrosio

Thanks, Inder.

Inder Singh - Prudential

Just wanted to ask you Lou, sort of the acceleration in Avaya’s leadership in IP that you were talking about before, you obviously had some very solid sales, upside this quarter, can you talk about the end market strength as you see at right now, even in sort of a lackluster economic climate?

And then also, in terms of the competition there has been some talk of some of your competitors; Siemens perhaps, looking to exit the market, can you calm on your market strategy and whether you expect to count more on organic growth or inorganic growth, or what?

Lou D'Ambrosio

Yeah, let me try to answer a few of those questions that you outlined. You are right, I mean the general economic situation is not particularly robust. However, our segment is clearly showing a migration to IP telephony as customers are looking at ways to fundamentally transform their business processes.

I would describe it as us being essentially past year, earl adopter stage, and move now into a much broader adoption phase of IP telephony and we are seeing customers using it in much broader set of ways. It’s you know … at first it was essentially you know, let’s go to IP telephony to save some money on toll charges, or to integrate networks et cetera, and now it’s a much more fundamental discussion about how they can use it to change the very competitiveness of the organization.

I think that in fact was the trigger point to move from what I would describe as the earlier adopter to the mass adoption stage, and as you described about product sale, which in many ways are proof point to that, suggests that also. In terms of competition you know obviously you know, most attractive markets you know, people look to enter. We feel very strongly positioned with our current strengths particularly as it relates to the technology, to the customer franchise, to the Linux based solution that we have been developing for five years, to the focus on applications et cetera.

They are obviously traditional competitors that we think about, there are new competitors in the marketplace, there are new alliances that have been established e.g. the Nortel Microsoft alliance, and we are very mindfully watching one of them and as we pursue our growth strategies, it will be execution, it will be delivering on a plan, it will be instructing focused on applications, it will be leveraging our services as a differentiator. In fact we would be moving up to value layers, with that will come partnerships that we have, that we'll build on, and probably some additional partnerships and strategic alliances.

Inder Singh - Prudential

Thank you.

Operator

And your next question comes from Tim Long with Banc of America Securities.

Jeff - Banc of America Securities

Good afternoon. This is Jeff calling in for Tim, a couple of questions, the first on the direct revenues up nicely on a sequential basis relative to the March quarter. Is this purely a result of improvements in the supply chain or is this more a result of end market strength and more sustainable trends and then on the application side of the business, when should we expect to see some better trends especially now that you have a fair number of IP customers? I would think that your application business would start to pick up.

Garry McGuire

Yeah, relative to the first part, it is not just the -- having to do with the supply, the market strength as well as the execution on the supply issue. Relative to the applications; we had good growth in application sales in the US, I think it was up approximately 7% in the quarter.

The execution there has been outside of the US and it’s primarily in where we are missing is in the modular messaging area, which you know, was late to market, and I think it’s just taking a little longer to get some traction there. So we are hoping that as we move forward into Q4 and Q1 of next year, it will begin to get that traction outside the US like we had in the US in the quarter.

Jeff - Banc of America Securities

Thank you.

Operator

And your next question comes from the line of Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

That would be Samuel Wilson from JMP Securities, thank you though. Two questions for you. One is, first on the cost savings deal that you took in Q2 and in fiscal Q3, can you just give us some sense now that those are kind of complete what you expect in terms of cost savings or restructuring on a flow through basis, over time? And second, Lou, can you give us some sense on just pricing pressure, is there anything abnormal going on or is it just kind of a normal stuff you play it all the time?

Lou D'Ambrosio

Let me take the second question first and then Garry will come back to first. I mean as you know, there always has been and there will always be you know, a fierce competitive market in this space.

We have seen pricing pressures. It’s hard to gauge whether or not they are materially different than what we’ve seen in the past, but it’s a competitive battle out there. I believe that the way we are positioned in terms of moving up the value stack and leveraging our software as a differentiator positions us well to get much more into the value sell than some of our competitors.

That being said, we are very mindful of the pricing tension in the marketplace and we’ll continue to develop the plans both to differentiate ourselves, to mitigate against debt, as well as take the appropriate cost actions to address it directly.

Garry McGuire

Sam, just to go back to your first question, make sure I understand specifically what you are looking for there.

Samuel Wilson - JMP Securities

On the restructuring that you took in Q2 and Q3, what you are expecting cost savings to be over time?

Garry McGuire

I think we are looking at annualized -- between the two, we are looking at annualized cost savings, they’re probably $9-$12 million.

Samuel Wilson - JMP Securities

Perfect, and congratulations on being debt free, thank you.

Garry McGuire

Thanks, Sam.

Operator

And your next question comes from the line of Ehud Gelblum with JP Morgan.

Ehud Gelblum - JP Morgan

Hi thank you, can you hear me, okay?

Lou D'Ambrosio

Yes, we can.

Ehud Gelblum - JP Morgan

Okay, thanks so much. First of all Mike, congratulations for moving back into the US, I guess. You were brought back from Germany, I guess. And Lou, congratulations to you as well.

First, a couple of clarifications and a question. I may have missed the beginning, did you give the IP line growth and what percent of your product was IP this quarter related to last quarter?

Lou D'Ambrosio

We said that it was up approximately 20%, we didn’t give the mix, but it improved some over the last quarter.

Ehud Gelblum - JP Morgan

So it was up as a percent versus the last quarter?

Lou D'Ambrosio

Yes.

Ehud Gelblum - JP Morgan

Okay, great. You said that out of the $30-$35 million in revenue from last quarter that slipped from Celestica your supplier, how much of -- some of that was captured this quarter, do you know roughly how much of that was captured -- we kind of do a little bit of a normalization, maybe you can give -- was it about 50% of it?

Lou D'Ambrosio

We didn’t size it because it’s a bit of an art trying to get your arms around the exact number with number of accounts moving, and we attempted to do it last part because of the size and the impact.

I think… I believe that it’s a substantial improvement. You know, you can draw your own conclusion to that, but it is substantial improvement this quarter and we would you know, as I said we would expect that by the end of next quarter if nothing changes, they are pretty much behind us.

Ehud Gelblum - JP Morgan

Okay, and that is what brought you backlog down because of that. How did your book to bill look this quarter, I'm sorry if you mentioned that already as well.

Garry McGuire

No, we have never talked book to bill.

Ehud Gelblum - JP Morgan

Okay, but I assume your backlog is down lower because of the backlog from the prior quarter of the fiscal…?

Garry McGuire

Yeah, the way to think of it is the past two backlog is down.

Garry McGuire

Okay.

Garry McGuire

Mike, do you want to clarify your…?

Matt Booher

Yeah, I am not sure whether you identified my living in Germany, but I’ve been here for a very long time.

Ehud Gelblum - JP Morgan

Okay. A couple of other things; on the Germany, the way you are now dealing with the rental agreements in Germany that you are -- for a lack of a better term, it sounds like (inaudible) taking the rental agreements and turning that into products, are you recognizing right upfront and how much to that of those rental agreements did you turn into upfront products agreement, how much does that conversion of rental to upfront products did you recognize this quarter and how would have that looked -- how would your revenue look if you had not done that, continued to recognize under the prior rental agreement?

Matt Booher

Well, let me make sure that it’s not a securitization. This is where TIT buys the assets from us, they enter into the rental agreement directly with the customer. So it is a rental from the financing source to the customer and yes, we do recognize the revenue upfront.

It was a small amount last quarter and they'd increase just marginally this quarter. And the reason for that is that we are only doing it with new customers that are installing new equipment. If you are an existing customer and you’re rolling it over or you’re an existing customer and you’re adding equipment to it, we are leaving that on our balance sheet. So it’s going to take a lot while for this to ramp and to have a significant impact on results.

Ehud Gelblum - JP Morgan

Can you give us a sense as to if you had not started this arrangement, what the revenue would have looked like this quarter? Would it have been 10-15 million below where it was?

Matt Booher

You are talking about the rental revenue?

Ehud Gelblum - JP Morgan

Well, the combination of your entire rental revenue, you took rental revenue, you’re moving the product, but the amount that your product is higher is more than the rental is lower. On that basis, it was improvement in revenue by doing this arrangement.

Matt Booher

Yeah, it’s single digits.

Operator

And the next question comes from the line of Manuel Recarey with Kaufman Brothers.

Manuel Recarey - Kaufman Brothers

Good afternoon, congratulations Lou and Mike. One question for Lou, one question for Garry.

Garry, just to get an idea of what the base SG&A would be in this quarter? If you take the 423 million you kind of net out 7 million of that and then there’s another I think you said 9 million due to for the World Cup. So if you take out another 16, the way to look at that would be, be by what… 407 million or so comes as a base rate?

Garry McGuire

I'd go back to what I said, during the script and see if we can get there. It increased 17 million over a year ago period, so let’s use the year-ago period as the basis to get there.

Manuel Recarey - Kaufman Brothers

Okay.

Garry McGuire

And we had a net negative impact of 7 million this year, which was that difference between the internal used software impairment and the income tax settlements.

Manuel Recarey - Kaufman Brothers

Right.

Garry McGuire

And then we had the FIFA sales and marketing expenses that we didn’t identify completely. So there is, you know, you guys you can take a rough guess there as to what that would be, we didn’t outline it specifically, but I think if you can take that $7 million negative and can plug in some number for the FIFA sales and marketing expenses you will get close to where it is.

Lou D'Ambrosio

Some of which of that last number may have been deployed to other sales and marketing.

Garry K. McGuire

And some maybe, you know, as I said some may go forward so we may redeploy some of those dollars in the future.

Manuel Recarey - Kaufman Brothers

Okay, Lou a comment you made during your opening remarks, you may want to increase the speed of change in the company, Avaya is a fairly large company so -- I mean, can you expand a little bit more about that, how you’d plan on trying to accomplish that?

Lou D'Ambrosio

Well one of the way we are going to start is we have the top hundred leaders in company together for the next few days and one of the ways I think you get speed is to have priority and to have everybody moving in the same direction. So without getting in to all the specific details Mike and I are going to take the top hundred leaders in the company over the next couple of days through a discussion around our strategic focus and essentially the way in which we are going to execute the business and get clarity top to bottom and as you point out when you change something this large it’s not trivial and at the same time it’s very doable and with clarity, with a sense of urgency, with people thinking about the customer first and always having in their mind shareholder value and having an objective to support those areas I think the objective is very well within our reach.

Manuel Recarey - Kaufman Brothers

The impact to the company, is it -- would you expect to be the same magnitude as when -- towards the beginning of fiscal ‘05 when you changed your go to market strategy that had a bit of an impact on the company and its results?

Lou D'Ambrosio

Yeah, we are not going to get into that and quantify that, I mean as Garry talked to you earlier, we’ve seen the type of product sales results that we wanted to over the past few quarters and some that meant that we had to make some changes you know year and half ago or so to get that longer term benefits. Where that’s the case in this situation we will also take the appropriate adjustment, but we are not going to try to quantify you know, the degree of what the impact that will be.

Garry K. McGuire

I think this is really about speed of execution and not, you know, fundamental changes like we are heading -- go to the market.

Manuel Recarey - Kaufman Brothers

All right.

Operator

And your next question comes from the line of Tal Liani with Merrill Lynch.

Tal Liani - Merrill Lynch

Hi guys, I have a few questions. First clarification you gave the impact, pre-taxes of your one off charges and income. I calculated it on the net income basis after tax implications you actually had almost no change to the reported net income. Is this correct or if not can you give us the net impact of all the charges and income?

Garry K. McGuire

No, that’s essentially correct.

Tal Liani - Merrill Lynch

Okay. Second, expenses grew about 8% year-over-year and revenues despite the fact you had some revenue -- some strength this quarter related to the weakness, last quarter revenues only grew 5%. What are you intending to do on this? I mean it’s not only that revenue growth is low, expense growth is higher than revenue growth, how this is going to change to create some shareholder value over the next two years?

Lou D'Ambrosio

I think that what we’re going to about it is what we have already done and talked about doing. We’re going to get the full flow through of what we did in the previous quarters of those restructuring charges and we’re going to take a restructuring charge in Q4 as I said could be as large as the two of them combined and all three of them are designed to get after the cost and expense. I guess we realize we’ve got that issue. So, I think this is not like we’re sitting here not doing anything about it. I think we’ve been very aggressive and we’re getting more aggressive in Q4 in dealing with that issue.

Operator

[Operator Instructions]. Your next question comes from the line of Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Hi guys, this is Travis. I understand you talked a little bit about the SG&A impact of FIFA, I just wanted you to give us a little more detail on the gross margin impact, you mentioned that there was some impact, any kind of quantification about that would be nice.

Garry K. McGuire

Well, we really can’t give you any more than what we had in the prepared remarks.

Tavis McCourt - Morgan Keegan

And then my other one would be more of a strategic question, obviously there is a Microsoft-Nortel deal was just announced a couple of weeks ago and Lou talked a little bit about strategy in your prepared remarks, but in terms of some IT players -- now Microsoft getting into this stage, I mean what does Avaya -- I mean what do you bring to the table? Is this a type of deal that you had an opportunity to do and turned down?

Lou D'Ambrosio

Obviously, we’re not going to comment on you know what deals we had or didn’t have or what we decided to pursue or turn down but in terms of where do we fit? Your suggestion is exactly right; the complexion of the marketplace is changing significantly. Those who were not competitors a couple of years ago are now competitors, also those who were competitors in some way now we have the opportunity to have partnerships with. We spent a lot of time analyzing the Nortel-Microsoft deal and we think we understand it, we deeply understand how we would compete against it. If you look at the core of that partnership, it has to do with essentially layer on applications to the foundation of IT telephony. Fortunately when you look at our core strengths, what we have is the very nature of applications and open based, Linux based software as frankly the competencies of our organization, so I think while strengths don’t get you at the end of the day results, they certainly provide the foundation and give us the advantage of now delivering on the strategy having that as our foundation of Avaya, so the environment is changing, there is new competitors, software is becoming more important, plays well to our strengths, we are carefully evaluating both organic as well as partnership type of alliances to continue see growth of our company.

Matt Booher

Operator, I think we have time for about one more question please.

Operator

Yes sir, your next question comes from the line of Troy Jensen with Piper Jaffray.

Troy Jensen - Piper Jaffray

Hey, I think guys, two quick questions. Garry, on the May 9 10-Q filing, you guys reported that you had already bought back 5.1 million shares for $63 million, so it looks like there wasn’t any repurchases during the second half of the year. So I was just wondering if you can give us some color if and why Avaya can stop the buyback?

Garry McGuire

We will buy opportunistically as we see fit in the marketplace. I don’t think it would serve or develop to give our thinking as to when it’s right and when it’s not right, it would be back in the market at different point in time, so I think it suffices to say that we bought 63 million back consistent with what we had done in some other quarters and we still have an opportunity to do another 136 million out there, which we will do at opportunistic times.

Troy Jensen - Piper Jaffray

So I guess Garry, what I was asking was, were you restricted at all from buying back in the back half of the year?

Garry McGuire

I think I'm going to leave it at the comments that I made.

Troy Jensen - Piper Jaffray

Guys, understood, then the next question would be, if the channeling would have been up slightly in the quarter, could you maybe quantify and remind us if you recognize on sales into the channel?

Garry McGuire

We recognize on sales into the channel, and I should also remind you that the channel inventory is down substantially from where it has been in prior years even though it’s up in the quarter.

Operator

Thank you for participating in today's Avaya conference call. This call will be available for replay beginning at 08:00 p.m. Eastern Standard Time through 11:59 p.m. Eastern Standard Time on Monday July 31st 2006. The conference ID number for the replay is 2009-163.

That concludes today's Avaya conference call; you may now disconnect your line.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Avaya Inc. Q3 2006 Earnings Conference Call Transcript (AV)
This Transcript
All Transcripts