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Avaya Inc. (NYSE:AV)

F4Q06 Earnings Call

October 24, 2006 5:00 pm ET

Executives

Matt Booher - VP of IR

Louis D’Ambrosio - President and CEO

Mike Thurk - Chief Operating Officer

Garry McGuire - CFO and SVP of Corporate Development

Analysts

Inder Singh - Prudential

Samuel Wilson - JMP Securities

Tim Long - Banc of America

Tal Liani - Merrill Lynch

Ehud Gelblum - JP Morgan

Tavis McCourt - Morgan Keegan

Jiong Shao - Lehman Brothers

Manny Recarey - Kaufman Brothers

Operator

Good afternoon. I would like to welcome everyone to the Avaya Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

I will now turn the call over to Mr. Matt Booher, Vice President of Investor Relations. Mr. Booher, you may begin.

Matt Booher

Thank you, and welcome to Avaya's fiscal fourth quarter 2006 earnings conference call. I am joined on the call today by 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 webcast 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 U.S. GAAP basis. We will also be highlighting some significant items that are included in our GAAP results. Certain of these measures are non-GAAP financial measures, which have been provided in an effort to provide investors with additional information. All non-GAAP financial measures have been reconciled to their most directly comparable GAAP measure in accordance with SEC rules. The reconciliation of these adjustments are available in today's slides, which are currently available on our website and will be filed with the SEC after this call. 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 first, second, and third quarter 2006 Form 10-Qs, as well as in our earnings release which we filed on Form 8-K earlier. 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'm pleased to introduce Lou D'Ambrosio.

Louis D'Ambrosio

Great. Thanks, Matt, and thank you all for joining us today. I'm going to start our call by providing an overview of our priorities and the results for the quarter, which were strong. Garry will then provide a detailed financial review; Mike Thurk, our Chief Operating Officer, will provide an update on our execution initiatives; and then I will wrap up with a discussion of the future direction of our company. Since I spoke to you on our last conference call, we spent a considerable amount of time on three key priorities that are critical to our success. First, strategy, a strategy around playing to win. A strategy that leverages our strengths, differentiates our offerings, and enhances our leadership position. Second, execution, tenacious execution and getting our company into fighting shape, improving execution to perform better and more consistently every year, every quarter, every month, every day. And third, culture, building a culture around winning, urgency, and excellence in serving our customers and, of course, unwavering integrity. We've made progress on each, which we will discuss in our call today.

But first, I want to provide some financial highlights for the quarter. Overall, we are pleased with our fourth quarter performance. Revenues were $1.364 billion, up 5% with a 9% increase in sales of products. IP line shipments were up in the high 20% range, and on the bottom line, we captured operating leverage from our revenue growth with higher gross margins on the product side and lower SG&A.

Operating income improved significantly to $137 million, and we had a double-digit operating margin, both before restructuring charges. Operating cash flow for the quarter was $191 million, an increase of $43 million compared to Q4 last year. In fact, for 2006 as a whole, cash flow was $647 million, almost double 2005. So all in all, a solid end to our 2006 fiscal year. As we move into 2007, our goal is to generate consistent, sustained improvements in performance. Toward this end, we're implementing a number of actions to realign our resources to better support profitable growth. We announced several of these actions earlier in the quarter and we intend to take additional actions in the first half of 2007. These actions enable us to shift resources away from lower performing and less productive areas of our business and reallocate them to higher value opportunities. They also help us to improve our cost structure, increase the efficiency, streamline processes, and importantly, deliver sustained value creation to our constituencies.

Mike Thurk will discuss our operational initiatives in more detail in a few minutes, but first, Garry McGuire will review in more detail our Q4 financial performance. As you know, Garry is retiring at the end of December and he will stay on as a Senior Adviser until the end of March to ensure a smooth transition as we bring on our new CFO. Let me just say that Garry has been instrumental to Avaya since we became an independent company. We really appreciate his hard work and integrity and the Board and I thank Garry for his contributions.

So Garry, over to you.

Garry McGuire

Thanks, Lou, and good afternoon to everyone. As usual, I will start by taking you through our Q4 income statement in more detail. Then I will discuss segment performance, our restructuring actions, cash flow, and our balance sheet. Unless indicated otherwise, I will be providing comparisons on a year-over-year basis. Also, I want to point out that FX had a positive impact on our revenues by about 1% year-over-year.

So starting with revenues, Q4 revenues increased year-over-year by 5%. The increase was driven primarily by sales of products which were up 9% and which rose in all regions. Q4 growth in sales of products is pretty much consistent with recent trends. In the past three quarters, we have generated product sales growth of 9% or better on a year-over-year basis. Services revenue also rose by about 2%. This was mainly due to 10% growth in implementation and integration services and, in particular, professional services. Q4 maintenance revenues were flat overall with a modest decline in the U.S. offset by an increase in EMEA. Rental and managed services revenues were about flat year-over-year.

On a geographic basis, revenues rose year-over-year in all regions led by growth of over 20% in Asia Pacific and Americas non-U.S.

Looking now at revenues by channel; indirect sales were up 20% and direct sales were down slightly year-over-year. Sales into and sales out by our channel partners both increased year-over-year.

Taking a look now at gross margin; gross margin was 46.6% and as we expected, gross margin was back to the level it was in Q2 of 2006. Product gross margin was 54.8% which is up year-over-year. The improvement was due to higher volumes, manufacturing cost improvements, and favorable product mix. Services gross margin declined year-over-year. This largely reflects the additional cost incurred as we continue to reskill our services delivery organization, which Mike will discuss in more detail in a few minutes.

Rental and managed service gross margin was 57.9%, a decline from the year ago period.

Looking at operating expenses; in Q4, operating expenses as a percentage of revenue were 41% compared to 41.2% in the year ago period. Excluding the restructuring charges and other items, OpEx as a percentage of revenue was about 36.5% compared to 39.3% in Q4 of '05. R&D expense was $110 million or 8.1% of revenue and SG&A was $388 million or 28.4% of revenue.

Turning now to operating income; OI for the quarter was $75 million. Excluding the $62 million in restructuring charges, it was $137 million. Our operating margin for the quarter was 5.5% as reported, and excluding restructuring, it was 10%. In the year ago quarter, OI as reported was $82 million for an operating margin of 6.3%. OI in Q4 of last year included restructuring charges and IP R&D write-offs totaling $25 million. OI adjusted for these items was $107 million and our adjusted operating margin was 8.3%.

Looking now at other income; during Q4 of '06 it was about $8 million. Income tax expense in the quarter was $35 million and our effective tax rate was 42%. This includes net favorable income tax items totaling $11 million during the quarter. The company's fiscal 2006 effective tax rate was 29%; excluding the net favorable tax items and the net impact of the restructuring charge, our effective tax rate would have been in the range we previously gave you. Net income for the fourth quarter of 2006 was $48 million or $0.10 per diluted share based on 459 million diluted shares. Excluding the net impact of the restructuring charges and the tax benefits I discussed earlier, net income was $80 million or $0.17 per share.

That covers our income statement and now I'd like to discuss in more detail our business segment results, beginning with Global Communications Solutions. GCS revenues rose 7% and operating income doubled from $43 million to $86 million. Large communications systems were up 9% overall with double-digit growth in the U.S., APAC and CALA. Sales of small communications systems were up 5% with the U.S. and Asia Pacific growing in the double digits. Application sales were up 3% year-over-year.

At Avaya Global Services, revenues were $604 million, an increase of $15 million or 3% year-over-year. OI was $36 million, a decrease of $10 million compared to Q4 of '05. AGS revenue growth was driven primarily by a 10% growth in implementation and integration services which totaled $137 million in Q4. Global Managed Services revenue during the quarter was $93 million, which was an increase of 7% year-over-year. Maintenance revenues in Q4 were $374 million, which was about flat overall.

So that covers the business segments. I'd like to now turn to a review of our restructuring actions and plans. First, actions we took in Q4. During the quarter, we incurred restructuring charges of $62 million pre-tax, and $43 million after-tax. These charges were mostly related to our plan to further reduce headcount in the U.S. and EMEA as we optimize resources, and to improve our skill base and increase efficiency. In the U.S., we reduced headcount in our services business and this action was completed prior to the end of the quarter. In EMEA, the workforce reductions were spread across various functions and countries, with the majority in Germany. Most of this was completed in Q4, with the remainder scheduled to be completed in the first half of fiscal 2007.

As Lou mentioned, we also intend to take further actions in the fiscal 2007 first half. The charge will be about $68 million to $75 million pre-tax to be primarily incurred in Q1. Once we have completed these additional restructuring actions, we believe that we should be able to reasonably estimate and make an addition to our reserve for future post-employment retirement benefits pursuant to FAS 112 for our European operations in the range of up to approximately $70 million.

I'd now like to move on to cash flow and the balance sheet. Lou already mentioned cash flow, so just to summarize, operating cash flow for Q4 was $191 million and for all of fiscal 2006, it was $247 million. Our cash position remained strong, increasing to $899 million and we continue to have a debt-free balance sheet. Major uses of cash for the quarter included a $42 million contribution to our U.S. pension program. This was a voluntary contribution and by making it prior to September 15, we reduced our required funding obligation in 2007 from approximately $67 million to about $2 million.

During the quarter, we continued to repurchase shares. We repurchased 7.4 million shares at an average price of $9.76 with total cash usage amounting to $72 million. During 2006, we repurchased a total of 29.9 million shares for total cash usage of $328 million, and reduced our diluted share count by 20 million shares or 4.1%. We have 65 million remaining under our current share repurchase program.

CapEx and capitalized software for the quarter was $52 million and for the year, was $188 million. Depreciation and amortization during the quarter was $71 million, consistent with previous quarters. For the year, it was $284 million versus $282 million in fiscal 2005.

Inventory turns for the quarter improved to 10.2 compared to 9.4 in the year ago period and DSOs were at 57 days, down 3 days from the year ago period.

So that covers our financial performance for the quarter. I would like to add a brief personal note to end what is my 25 and last earnings call. As you know, I am staying on officially until the end of this calendar year and will also work to ensure a smooth transition as Lou brings on a new CFO. I have greatly enjoyed my time at Avaya and I enjoy our management -- and I joined our management team in feeling very proud about what we have accomplished. I also want to say that it has been my pleasure to have met and worked with you, our investors and analysts, over the last six years.

So with that, I'll hand it over to Mike Thurk, our Chief Operating Officer.

Mike Thurk

Thanks very much, Garry. I'd just like to add my thanks to you for your contributions to Avaya over the past six years. We all appreciate your efforts. I would like to start by discussing my role as COO, which is a new position at Avaya and then outline my priorities and approach to achieving them. First, the role of the COO. We have organized the company to achieve rapid decision making, minimize complexity and cost, and create investment alignment. This will improve our ability to execute our strategies more effectively and respond to market opportunities. The role of a COO has brought our product and services business segments, sales, and the key support functions of IT, procurement, and supply chain under one roof. We believe that there are revenue opportunities and efficiencies that are yet unrealized by Avaya. I approach this role with an eye to both revenue growth and operational efficiency. In terms of revenue growth, many untapped opportunities to grow can be found in IP telephony infrastructure, intelligent communications and applications, and professional services and others. It will be by focusing our investments and critically by skilling the organization to go after them. We will be able to further enhance our leadership positions. For example, in 2006 alone, we enhanced the skilling of our services delivery organization by hiring skilled engineers in three centers globally. We expect to continue our training and workforce development over the coming year. As we have continued to provide more value on top of our IP telephony infrastructure with applications, we have initiated a custom software development capability in our German, Brazilian, and U.S. centers with a new center in Dalian, China. This will be an important area of differentiation for us. Another example of how skill enhancement can drive revenues is in the professional services market. We have organized our professional services organization into five global practices and added staff. We achieved nearly 40% growth as well as improved margins during 2006. We believe this continues to be an attractive and supportive of closing product businesses in our future. Networks are becoming multi-vendor, applications-driven, and the ability of professional services to lead these engagements is being well received by our customers.

I just want to reiterate my point about focused investments. Our approach to operational excellence will depend on our focusing on the investments that matter to our customers and yield shareholder value. I will bring focus to our team on these two items.

Turning now to operational efficiency; some areas that are on the agenda this year include first, improving our supply network. While our supply issues of Q2 and Q3 are behind us, we still believe we can make improvements from raw material buys, inventory management and distribution. We will be working with our contract manufacturers during '07 to address these opportunities. Second, we are balancing skill requirements, cost, and regional support by investing in lower cost regions as appropriate. We are a global company and utilizing skills globally is an imperative. An example is our organization in India, where we have already established a solid base that serves not only India, but the Asia PAC region. Third, we are also undertaking an intensive review of our portfolio of solutions and services to determine the appropriate level of investment. This analysis will be guided by Lou's strategic direction for Avaya. And lastly, we see opportunities to increase general efficiency and improve our processes globally.

So that gives you some context for the opportunities set on both the revenue and the expense side. Let me now provide more detail on our restructuring actions. A few minutes ago, I mentioned that to support our revenue growth objectives, we must have the right skilled employees in the right places. This means both workforce reductions and additions. The Q4 actions and those we intend to take in fiscal 2007 will in the aggregate result in a gross reduction in headcount of approximately 1,300 employees or 7% of our workforce, and gross cost savings of about $120 million. A portion of the $120 million in cost savings will help to offset increased employee compensation and benefit expenses that we expect to incur in 2007. These expenses include three major items; first, post-retirement health benefits for union employees will increase by $20 million year-over-year. It's important to note here that the contract we negotiated earlier in 2006 with our unions caps this benefit expense at the 2007 level.

Second, share-based compensation expense, which is non-cash, will also increase by approximately $15 million year-over-year. This reflects the ramp up in implementation of FAS 123R.

Third, in 2007, we intend to fully accrue for incentive compensation. Because of our performance in 2006, incentive compensation accruals were less than the levels set in our original plan. If we meet our plan for 2007, the incremental expense that would be incurred would be roughly $21 million more than it was in 2006. The remainder of the cost savings, about $50 million, will, as I mentioned, be reinvested in our business to support our growth strategy. This includes adding people in areas where new skills are required, such as R&D and professional services and in high growth market opportunities such as Asia PAC and Eastern Europe.

Now, as you know, we usually hold our Investor Day during our first quarter. As we bring on a new CFO, we have decided to host it in Q2. Naturally, we will keep you updated on the timing of this meeting.

With that said, we thought it would be important to give you perspective on our first fiscal quarter. Please keep in mind that this view is based on what we see now, assumes no major changes in economic conditions, IT spending patterns or currency with everything else being equal.

Turning to Q1 revenues, we're targeting product sales growth at a level that's consistent with the year-over-year growth rate that we've achieved in the past several quarters. We expect services revenue to be essentially flat year-over-year. Rental and managed services should decline year-over-year due to the loss of a couple of Managed Services contracts and erosion in our rental base. In terms of operating expenses, R&D should remain at about 9% of revenue. SG&A expense in Q1 will increase from Q4, primarily reflecting two items -- first, the increased compensation and benefit expense we see in a new year, and second, the cost of our Global Sales conference which we traditionally hold in Q1.

So that gives you an idea as how we view our 2007 first quarter. Our goal during the quarter and the remainder of the year is to continue our momentum and enhance our market leadership by capturing both revenue growth opportunities and operating efficiencies. I look forward to reporting on the progress of these initiatives over the course of the year, and with that let me turn it back to Lou for some comments on future direction of the company.

Louis D'Ambrosio

Great. Thanks, Mike. As I mentioned at the outset, strategy, execution, and culture are our top priorities. I would like to just take a few minutes to discuss each of these with you briefly. In terms of strategy, we have a compelling vision for our future and the future of our industry. It's a future around intelligent communications.

Intelligent communications is about embedding communication solutions into our customers' business processes to help them transform their business and innovate their business models. It's about enabling customers to increase revenues, improve productivity, and grow profits. As the evolution toward intelligent communications continues, software becomes a much larger part of the IP telephony platform, and this plays well to our advantage. For the past five years, we've been committed to Linux, open standards, and the leadership in our software based platform. We're well ahead of our competitors here and we plan to press this advantage in a couple of different ways. First, by extending the value of our communication management software as we move into a SIP environment and a services-oriented architecture framework. We also plan to build on our clear leadership position in contact center applications by extending the core attributes and functionality of the contact center across the entire enterprise creating in many ways a virtual contact center throughout the enterprise, and also by deepening and strengthening our technology solutions in this area. In unified communications, we plan to build off of our leadership position in messaging and conferencing and move into multimedia conferencing, portal, and video.

We're also integrating more closely with our alliance partners such as IBM and Microsoft. In fact, overall partnerships and new strategic alliances are critical to our strategy going forward. And for sure, our services business is an important differentiator in this strategy. Our services business will focus on closer alignment with and support of our intelligent communications solutions. And as Mike said, transforming our services skill set and increasing our codified assets, I think our strong growth in professional services shows our ability to execute against this. These are some of the major tenets of our strategy to drive leadership in intelligent communications. But an equally important part is all-around execution. Mike discussed execution in detail, so I'm not going to spend a lot of time on this, but let me briefly say that this is all about getting our company into fighting shape and consistency of performance; to become more competitive, to improve our cost and expense structure such that we can continue to both win market share and increase profitability.

And then finally, to do this, we also need to build a powerful culture around success. This is not something that is soft or to be taken lightly. A culture transcends every part of a company. Since I became CEO a few months ago, in addition to meeting with many, many customers and partners and analysts, I spent a lot of time with our employees; technology people, marketing, R&D, services, finances, right down to the line. In fact, two weeks ago, I was in New Orleans with 4,000 of our sales associates and business partners. And in all of these meetings, I've articulated and will be holding people accountable to a set of core cultural values that will drive and transform our company. Integrity tops the list, putting the customer first, urgency, speed, simplicity, destroying complexity, solving problems, getting results. Our goal here is to reinvigorate our culture. Yes, build off of and be proud of our 100-year heritage, but at the same time, capture that entrepreneurial spirit at a new company, one that is only six years old, with the speed and agility to go along with that. So that's it in a nutshell. Strategy, execution, culture. It's how we're going to enhance our leadership, get our company into a better position to win consistently in our market, and build value for our shareholders. Q4 was a good start.

I now will be happy to take your questions.

Question-and-Answer Session

Operator

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

Inder Singh - Prudential

Yes. Thanks very much. Congratulations on a very solid quarter there.

Louis D'Ambrosio

Thanks Inder.

Inder Singh - Prudential

Product sales, geographic strengths. And then sort of laying out your strategy, Lou, as you take from here, you describe that competitive environment, I think Microsoft and Nortel in the past and Cisco and others, and then you're framing your initiative as the intelligent communications initiative. Can you help contrast how you differentiate the intelligent communications initiative from other things we've seen in the press recently? For example, Cisco's telepresence offer or the Microsoft Nortel combination? How are you differentiating your strategy for 2007 and aiming to take share?

Louis D'Ambrosio

Sure. It's a good question Inder. If you look at the way some of our competitors are defining this space, they're using words like unified communications and certainly, as I've described that we will have a strong presence in unified communications. But frankly, that's one small slice to the much broader communications solutions as we embed them into our customers' business processes. As an example, if you look at what we're doing with contact centers, not only focus on the agents in the center, but virtualizing the entire enterprise. How we are embedding our communications applets into, say, customers' ERP systems to create a closed-loop, more efficient process by taking the human latency out of the cycle time and out of the process. Those speak much more towards this broader thought around intelligent communications versus a much more narrow definition around unified communications. And frankly, played very well to our strengths and, as I've mentioned, we plan to fully take advantage of our strengths in rolling out our strategy.

Inder Singh - Prudential

Your gross margins also bounced back nicely this quarter. Obviously you're not going to rest on the laurels of that happening. You outlined a bit of a restructuring initiative that might continue here. How much of a focus do you intend to put on continuing sort of the improvement scenario especially on the services and the rental side where we're fighting, I guess, some declining prices over time?

Louis D'Ambrosio

Significant. I mean, for sure, it's an intense marketplace out there. One of the major actions we've taken this year, Inder, is we've put a greater profit component into our team which interacts with customers so that as we are bringing solutions to the marketplace, we have much more alignment in terms of the metrics, not only from the executives, but all the way down throughout kind of the sales leadership teams. In addition, as you say, we're looking very seriously at the different cost elements and while, yes, we are pleased with the rebound this quarter, we're certainly not being complacent and we'll continue to go after both from a cost perspective, a priority focus, e.g. with our sales teams, but also importantly, from a portfolio perspective. As you know, as you get more and more into the application space and move up the value layer, the margins do get richer. So this combination between going up the value stack, focused on cost and have it as a priority for our team interacting with customers, are three of the specific actions we're taking to address that issue.

Operator

Next question comes from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

So for my two questions, Lou and Michael and Garry, first, can you give us just sense of what the market environment was out there and the competitive environment and just how that's changed in the last 90 days? And secondly, as part of that, can you talk a little bit or separate from that, can you talk a little bit about the share buyback? At the rate you're going, it's about to run out. You're building cash on the balance sheet. Just what are your thoughts in terms of asking the Board to renew the buyback?

Louis D'Ambrosio

Let me take it -- I'll address the market environment and I'll ask Garry to talk about the share buyback. The market environment, Sam, I would say in terms of relative in these past 90 days to prior quarters, I haven't seen any market change. It's an intense competitive environment out there. It's an environment that if you try to compete only at the infrastructural layer without having a differentiating value prop, you're going to get caught up into a pricing discussion. And if you have value creation, you have much greater opportunities to protect your gross margins. The major competitors in the landscape are, as you outlined, it's kind of -- we haven't seen any kind of new entrants. We're certainly focused on some of the new alliances that have been formed, but I would say we have not seen any market changes in the pricing environment or intensity in the marketplace over the past 90 days than we have seen in the past. Let me ask Garry to comment, if you would, on the -- where we are with share buyback program.

Garry McGuire

Yeah. As you have observed, Sam, we've got a strong balance sheet and we have been doing the buyback and just have a little bit left under the original program. And I think the way we are thinking about things, as Lou goes through the strategy development with the management team and with the Board, an aspect of that could be more acquisitions in the future than we've done in the last 12 to 18 months. So, acquisitions could be part of what we're looking at cash for. Restructuring, obviously, of what we've done in Q4 and what we've announced we're going to do in the future we'll use cash in 2007. So I think once we get all of that formulated, we will sit down with the Board and explore whether we wanted to propose another share buyback or not. So I think that's something that is probably going to come in the next quarter or so as we dialogue with the Board on what we ought to use the cash for.

Operator

Your next question comes from Tim Long with Banc of America.

Tim Long - Banc of America

Thank you. Just, if I could, a question on the channel side and then on the margins. It seems like there's been a very nice recovery in the last few quarters on the direct channel. Could you make some comments there? Has there been any changes in the way that that organization has been doing their business? And also do you think the kind of success there that's really mirroring the indirect channel is that sustainable? And then second, on the gross margin side, I'm assuming from the splits you gave for the different growths of businesses into the first quarter of next fiscal year, it sounds like gross margins should probably be down sequentially on mix. Is that correct? And maybe if you can just give us an update, Mike, on the timing where we might see some of these initiatives start to manifest themselves in better gross margins, talking about raw materials, inventory, et cetera. Thank you.

Louis D'Ambrosio

Now let me address the go-to-market model and then Mike and Garry will respond to the gross margin discussion. I think we're very pleased with kind of where we are right now from a go-to-market model and our channel mix. As you point out, we've seen growth in the past multiple quarters in both direct and indirect, you know, vary some quarters, one is higher than the other, et cetera. We don't have any arbitrary target in terms of direct should be x percent of the business and indirect should be y percent of the business. If you remember, a couple of years ago, we redesigned our go-to-market model to have much greater segmentation between us and our partners in terms of going after the very large accounts, the midsize accounts and the small accounts. While a couple of years ago, we had a quarter or so in which we had to kind of work through that transition, it's clearly paying its dividends now and we're pleased with the composition and the mix of our channels.

Mike Thurk

Yes. If I just address the issue of margin cost improvements. One of the things that as I'd mentioned in my opening remarks was that looking at our supply chain is one of our highest priorities. And so focusing a team on how we take cost out of that top line is something that I want to address when we get to our earnings meeting in the Q2 timeframe on some of the items that we think are going to be opportunities there. I would say with respect to your assumptions on -- or your statements with respect to gross margin, the inferences you drew were not intended from the comments that I made. So we have given the outline with respect to margins from this quarter and discussed what we see as the outlook in Q1.

Garry McGuire

The only other thing I think I would add is that we -- going back to what Mike's comments were on the three different segments, the product gross margins obviously are a positive for us in any quarter that they're growing. The services, we've continued to have a mix change there, and in rental and managed services, we mentioned we lost a couple of existing accounts. Now those accounts had been in the revenue base, good margin. So that is margin that we will have to offset in the future that will impact us in Q1.

Operator

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

Tal Liani - Merrill Lynch

Hi, guys. Question about seasonality and another question about expenses. If I look at this quarter out performance, revenues, and most of the lines were relatively in line with expectations, your operating expenses were well below expectation. So the question is, was there anything seasonal -- and I think this question was asked in a different way -- but was there anything seasonal this quarter that led the expenses down? Or should we simply model lower operating expenses going forward for the next four quarters and beyond? So that's about expenses. And the first question was about, can you discuss seasonality going into the next year typically in -- you do have strong 4Q. The question is whether first quarter is expected to be -- now with all the changes -- first quarter is expected to be of normal seasonality or not, and if you don't want to give a specific first quarter, maybe you can speak about seasonality throughout the year. Thanks.

Louis D'Ambrosio

Let me take the first part here on the expense reduction. It was about $35 million of SG&A reduction sequentially. About half of that came from some one-time changes quarter-over-quarter. And if you remember, we had an asset impairment in Q3. We didn't have FIFA expenses in Q4 that we had in Q3. We had a slight pickup in real estate and some [VAT] recoveries that we had in the quarter that won't repeat in Q1. So about half of that -- of the change that you saw was one-time in nature. Relative to the seasonality, there's nothing at this point that we would see that would cause us to say we're going to have anything different seasonally in the core quarters next year from the past.

Operator

Your next question comes from the line of Ehud Gelblum, JP Morgan.

Ehud Gelblum - JP Morgan

Hi. Thank you very much. First, a clarification and then my two questions. Clarification is just, Mike, in giving your thoughts on Q1, you didn't say anything about gross margin, I'm just assuming that gross margin stays relatively the same as it was this quarter, but I just wanted to make sure that there weren't any moving parts that we needed to know about. And my questions, on the revenue side, you said that the issue that you had with one of your key EMEA suppliers that seems to have been an issue in Q2 and Q3 were now cleared up. I'm wondering how much of the revenue upside that you had over -- your revenue this quarter came from some of the backlog that have been kind of kept up because that supplier could not supply enough equipment to you in past quarters, and so it was kind of like a catch-up from that problem being relieved. And then, on the rental and managed services, the guidance seems to say that it will come down next quarter for those two reasons Garry that you mentioned and I'm wondering, why was it even up this quarter and can you give us a magnitude of how much it comes down next quarter?

Garry McGuire

If I counted correctly, Ehud, that was three questions.

Ehud Gelblum - JP Morgan

It was kind of really a clarification.

Louis D'Ambrosio

One clarification in there. Relative to the gross margin, let me take that first. We didn't give specific gross margin guidance, but we did talk about some of the moving parts. And we talked about the product sales being up, they have good gross margins. So, take that for what it's worth. Rental and managed service, the loss of those contracts will have an impact on gross margin going ahead. So we look for that to be down. And the services piece has been under pressure and it will be our objective to continue to work that, some of the restructuring that we have done and are doing is focused on that. One of the things that I should also point out that with the loss of those contracts in the rental and managed service, there was some cancellation penalties that we got that improved the rental and managed services margin in the quarter. So they will go away, obviously, in Q1 along with just the loss of the gross margin on that business itself that was lost.

On the supply question, the supply impact in the quarter is extremely hard to assess, but our best assessment right now is it was in the $7 million to $10 million range. Again, it's very, very hard to assess that in the quarter, but that would be our assessment.

Operator

The next question comes from the line of Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Thanks guys. First, a question on the benefit obligation on the balance sheet. It was down about $250 million sequentially. Is there any income statement impact to that? And then, second, and I guess with that question, the $40 million of contribution this quarter that you took, where in the cash flow statement does that go? And then my other question was for Mike. The professional services organization, how big is that now and what would your goal be there over the next couple of years to grow that too? It sounds like it's a business that is probably not to support higher levels.

Louis D'Ambrosio

Let me take the pension stuff here. The change sequentially there is really related to two things. One is the increase in the discount rate, and the performance of the plan better than the planned rate. As far as where that falls -- the cash contribution falls, it has no P&L impact. And I think that was your question, right? Where in the cash flow statement? Let me -- that's a non-cash, so -- no, I'm sorry -- you're talking about the pension contribution, not the change, right? We made $42 million. So that's in the cash flow statement.

Mike Thurk

If we just jump to the professional services area, we have today -- we have hundreds of professionals today doing the very high-end professional services work today and what we are going to do is, as we did in this past year, we added a large number of folks to grow that business and to grow that business commensurate with the demands that we see. So it really is tied directly to the demands associated with the professional services business, and we saw that grow 40% this year. So we had a commensurate investment to go with that. We'll continue to do that in the future.

Louis D'Ambrosio

Now a couple other points on the professional services business. It's an important business unto itself. It's also an important business as we drive more license software into the marketplace and also it's an important business as we move from what I will call customized integration to codified assets. So for all three reasons there will be a focus there.

Operator

Your next question comes from the line of Jiong Shao with Lehman Brothers.

Jiong Shao - Lehman Brothers

Thank you very much. Can you hear me okay?

Louis D'Ambrosio

Yes.

Jiong Shao - Lehman Brothers

Great. I have two questions as well. The first question is on the operating margin. I think you described the cost savings from a restructuring -- you're doing the $120 million would be sort of how that's going to be split. It sounded like you either reinvest back into the business or sort of increase some of the company's Asian stock. So is that fair to assume the normalized operating expenses for next fiscal year, so broadly speaking, kind of flat from the current level and are the operating margin variations is going to be driven mostly by revenue? So that's question number one. My second question is the sort of a specific focus for Lou and Mike. I know both of you have had the benefit for working at Avaya for the last several years at a key positions going forward at elevated positions, what you are to be focusing more going forward than you have in the past? What's going to be the most different you're going to be doing going forward? Thank you.

Louis D'Ambrosio

Let me address the second one first to get us started. As you've said, we had the advantage of, both Mike and I, coming from the outside where we both spent many years in outside companies but then four years at Avaya, so we had the blend of both. And we have been in senior level roles here and we have had a good view of the company. I would say there are a couple things that we're going to be focusing on differently now than you've seen in the past are those specific areas which we talked about today. One has to do with much greater prioritization. Divesting cash count on certain items while we double down in certain businesses and we described, kind of, some of the key priorities around that today. Secondly, you're going to see much greater emphasis around execution and accountability. And thirdly, you're going to see a reinvigoration of a company culture, frankly which is built around winning and is built around agility and speed. I think those three areas together will have a -- creates one exciting company. Mike, do you want to comment on that?

Mike Thurk

Yes. I had a couple of points from my vantage point as well. There is -- if you went back a few years, in fact, when I joined the company about five years ago, we made a decision at that time to double down and prepare for the transition to IP telephony from TDM. As you may recall, the products business was not only declining, it was losing a significant amount of money. We made the strategic bet to double down on the investments needed to position the company for IP telephony and that at the short term looked risky at the time, but certainly paid off handsomely for the company. Think about it this way, as we move into Lou's vision of the future with respect to software and the importance of moving up the value stack, we need to make the same types of double-down decisions that we are -- in both product and frankly in service. So one of the real important areas where my focus is, as I mentioned in my opening remarks, is around that services reskilling and investment decisions with respect to that future state we want services in. And secondly, as I've said, I think the importance of a supply chain change that also reflects that future.

So those are items that we think are going to set us up well for top line growth, which is obviously a very important element along with the operating income.

Louis D'Ambrosio

To your other question, one thing to keep in mind is that the actions that we're taking affect both OpEx and COGS, so it's not all going to benefit SG&A. And the other thing to keep in mind is we talked about earlier that we have this 20 plus million increase in our management incentive program year-over-year if we hit all of the targets at 100%, and then we've got the comp and benefit increase that we talked about. So, and one last thing to remind you of is a big part of the restructuring is in the services organization that's up in the COGS area. So I think you need to keep all of those factors in mind as you begin to model the changes.

Matt Booher

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

Operator

And your final question comes from the line of Manny Recarey with Coffman Brothers.

Manny Recarey - Kaufman Brothers

Thank you. Sneak in right at the wire. In the Avaya Global Services, you said it was driven by the implementation and integration. What was the -- can you give a little bit more color on why that -- what was going on there and how kind of sustainable that is? And then my second question is on the 7% employee reduction. If you can just go over again where is -- from a geographic perspective, is that going to be focused on any particular area or any particular product area?

Louis D'Ambrosio

Well, relative to the implementation and integration, that's got a direct correlation to product sales, particularly on the direct product sales side. So as you get a ramp up in that sequentially, you're going to see an increase in the implementation and integration revenue.

Garry McGuire

You're seeing there -- if you take the services business, there's the annuity components to it on things like the maintenance and the managed services, and then there's the transaction element to it. The transaction element to it really plays into the implementation and integration line, and has a correlation to product sales and given the strength of the product sales, that was a major cause for the benefits there.

Mike Thurk

And on the restructuring question, well, we have already taken actions in the fourth quarter, but if I looked at the combined actions in total for the 1,300 people discussed, it's pretty balanced between EMEA and the U.S. And as I've said earlier, with investments in a high growth area such as Asia PAC and Eastern Europe.

Louis D'Ambrosio

With that, this is Lou. Let me just thank everybody for joining and we look forward to continuing the discussion later on. Thank you very much.

Operator

Thank you for joining today's conference call. This call will be available for replay beginning at 8 o'clock PM Eastern Time today through 11:59 PM Eastern Time October 31, 2006. The conference ID number for the replay is 6104929. The phone number to access the replay is 800-642-1687 or 706-645-9291. This concludes the conference call. You may now disconnect.

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