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Avaya Inc. (AV)

F1Q07 Earnings Call

January 23, 2007 5:00 pm ET

Executives

Matt Booher - VP of IR

Lou D'Ambrosio - President and CEO

Mike Thurk - COO

Amar Pai - Corporate Controller

Analysts

Troy Jenson - Piper Jaffray

Jiong Shao - Lehman Brothers

Tavis McCourt - Morgan Keegan

Tal Liani - Merrill Lynch

Samuel Wilson - JMP Securities

Ehud Gelblum - JP Morgan

Jason Ader - Thomas Weisel Partners

John Marchetti - Morgan Stanley

Tim Long - Banc of America

Blane Moder - Loped Partners Corporation

Presentation

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 question-and-answer session. (Operator Instructions). Please limit your questions to two per turn. Thank you.

I would now like to turn the call over to Matt Booher, Vice President of Investor Relations. Thank you sir, you may begin your conference.

Matt Booher

Thank you and welcome to Avaya's fiscal first quarter 2007 earnings conference call. I am joined on the call today by Lou D'Ambrosio, our President and Chief Executive Officer; Mike Thurk, our Chief Operating Officer; and Amar Pai, our Corporate Controller. 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 FirstCall and PRNewswire. 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. 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 2006 Form 10-K, 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'm pleased to introduce Lou D'Ambrosio.

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Lou D'Ambrosio

Great. Thanks, Matt and thank you all for joining us today. Let me start the call by reviewing our strategic priorities, actions and the quarterly results. And then I am going to ask Amar Pai -- those of you who do not know Amar, Amar is our Corporate Controller. Amar will give you a more detailed perspective on our financials. Mike Thurk, our Chief Operating Officer, will then provide an update on our execution initiatives and we will open it up for Q&A.

So let's get started. During the last call, we laid out the three critical priorities for our company -- strategy, execution and culture. And we have made progress against all three.

From a strategy standpoint, we advanced our strategic roadmap around Intelligent Communications, launching new offers, investing in our business and announcing the acquisition of two software companies that extends our technology leadership.

In terms of execution, we delivered solid bottom-line results. Non-GAAP operating income was $96 million, and our non-GAAP operating margin was 7.5%. They were however; areas where our execution should have been sharper, and in particular warehousing and staging issues, as discussed in the 10-K, impacted our product sales growth. Mike Thurk, will touch on this later in the call.

Regarding culture, we are extremely pleased with the talent we have recruited into the company. As we drive our organization, around key values of speed, achievement, accountability, integrity.

Let me spend a few minutes, on each of these three areas of strategy, execution and culture.

Let's start with strategy. I have spoken to you over the past several months about our Intelligent Communications vision. Simply, Intelligent Communications is about embedding communications solutions into the fabric of our customers' business processes. And helping them transform their business models, grow their revenues, improve their productivity, increase their profits. This strategy provides a communication platform that enables Avaya, our partners, and independent software vendors to innovate and build new communications enabled applications.

For our company, our customers, and our shareholders, this roadmap moves us up the value chain, to higher-value software and solution offers. It enables us to achieve strategic differentiation in the highest value, most profitable market segment.

As I mentioned, investing in key technologies is fundamental to our strategy, and this includes supporting internal R&D activities, as well as selectively allocating capital to acquisitions that enhance our vision.

The two transactions we recently announced are cases in point. Since our last call, Avaya acquired Traverse Networks and we launched the tender offer for Ubiquity Software. Traverse is an important element to our unified communications portfolio. Traverse develops enterprise mobility solutions, enabling enterprise workers to have their office functionality at their fingertips, supporting a broad range of mobile devices. Ubiquity, is also an important element to our strategy as we extend value in a SIP environment and SIP is a very important industry standard, and we evolve our strategy around services oriented architecture. Ubiquity is a leading SIP-based communication software developer. This platform reduces the time, cost, complexity of creating and deploying communication-enabled applications and deliver scalability, service continuity, and high performance. That provide some perspectives on the progress we've made in strategy over the past few months.

Let me spend a couple of minutes now on execution. Execution is about getting our company into fighting shape in order to both grow revenues and improve profitability. As I mentioned, we did a good job during the quarter in terms of delivering on the bottom line. Also, products and services, gross margins both increased year-over-year. The team also did a very nice job in improving discounts, and SG&A as a percentage of revenue also improved.

And let me talk about top-line performance, both for services and products. We were pleased with the performance of our services business. In fact, services revenue increased for the third consecutive quarter on a year-over-year basis with solid performance in professional services, managed services, and maintenance. Product sales, which grew 4.7%, were impacted by disruption and delays in our warehouse operations, and as I said Mike Thurk will address this in some level of detail a bit later on the call.

Finally, I want to comment on the progress we're making in transforming our culture. And important part of this process is recruiting top talent to our organization to enhance our skills and management depth. And we're very pleased with the new talent we brought on board.

Let me discuss the few of the folks. Earlier today, we announced that Caroline Dorsa will become Avaya's Chief Financial Officer, effective early February. Caroline has enjoyed an accomplished career at Merck & Company, in both finance and line operations. She has an impressive track record of developing financial strategies that enable business excellence. Most recently, Caroline was Corporate Vice President and Treasurer for Merck where she led a broad portfolio, including treasury, investor relations, tax, the controllership for manufacturing. She formally had the controllership for R&D. She recently had portfolio management for the overall corporation, an outstanding addition to our team.

In another move, we announced that Stuart Wells joined Avaya from Sun and he will lead our overall product group, that is, Global Communication Solutions. Stuart has outstanding experience with a particular specialization in software. Stuart's track record in product and software leadership, technology innovation, and delivering strong business results will be excellent assets to our company.

And just last week, we announced that Lorie Buckingham has joined Avaya as our new Chief Information Officer. Lorie will champion our IT infrastructure improvement and streamlining of our business processes. She joins our team from Visteon Corporation and brings a wealth of experience and results in leveraging IT, streamlining business processes, global software solutions, eCommerce, and just overall business leadership. These individuals join a very talented team with a relentless focus around our three priorities of strategy, execution, and culture. Our overarching goal is clear and that is to put our company in a position to generate consistent sustained performance and shareholder returns. This is not a one or two quarter activity; it's continuous process involving all aspects of the company from strategy to execution, to culture and we are prepared to take whatever actions are necessary to achieve these objectives.

Thanks. And now, Amar Pai will review our financial results.

Amar Pai

Thanks Lou, thanks very much and good afternoon to everyone. I will start by taking you through our income statement in more detail. Then, I will discuss segment performance, our restructuring actions, cash flow, and then our balance sheet. Unless indicated otherwise, I will be providing comparisons on a year-over-year basis. I want to point out that we will be discussing our results on a US GAAP basis as well as non-GAAP basis. Our Q1 '07 non-GAAP results exclude $6 million in restructuring pretax charges and $13 million in favorable income tax items. We provide a reconciliation of non-GAAP to GAAP results in our press release and the accompanying presentation that are posted on our website. I should remind you that in Q1 of last year, we had a $21 million pretax benefit from a change in our vacation policy. The positive impact to EPS of this benefit was $0.03 per diluted share in Q1 '06.

I also want to note that FEX had a positive year over impact on our revenues of about $31 million, virtually all in the Europe.

So to start, non-GAAP operating income in the first quarter of 2007 was $96 million and our non-GAAP operating margin was 7.5%. GAAP operating income was $90 million, and our GAAP operating margin was 7%. Non-GAAP net income for the first quarter of 2007 was $61 million or $0.13 per diluted share. GAAP net income and EPS was $71 million or $0.15 per diluted share. The GAAP and non-GAAP EPS numbers are both based on 459 million diluted shares.

Now, let me talk about the major drivers of our performance. Q1 revenues were $1.28 billion, a year-over-year increase of 2.5%. Sales of products were up 4.7%, as Lou mentioned, we experienced disruptions and delays in delivery due to changes made in our warehousing and distribution operations. The estimated impact to revenue in the quarter was in the range of $20 million. Services revenue rose slightly with US and EMEA contract maintenance revenues both increasing. This is the third quarter in a row in which we generated a year-over-year increase in services revenues. Professional services revenue grew 10% year-over-year. Rental and managed services revenue was relatively flat.

Now on a geographic basis, US revenues were flat year-over-year with a modest increase in sales of products, offset primarily with decline in services.

Outside the US, revenues grew 6% with product sales rising 8%. EMEA product sales increased 13%. Sales declined by $2 million in APAC, which is where we had experienced a large part of our warehouse disruption.

Looking now at revenues by channel, indirect product sales are up 11.5% and we saw particularly good growth in sales to service providers and our systems integrators. Direct sales are down 3.4% year-over-year, due to several variables. These include lower US Federal Government sales, lumpiness in financial services orders, and disruptions related to warehouse operations.

Turning now to gross margin. Gross margin was 46.8% in Q1 of '07, compared to 47.2% a year ago. However, keep in mind, that Q1 '06 margin benefited by approximately $11 million or 1 percentage point, due to the change in our vacation policy.

Gross margin on sales of products were 53.3% versus 53.1% in Q1 of '06. This reflects in part, greater pricing discipline as discount improved during the quarter versus a year ago. Services gross margin was 36.3%, up two-tenth of a percentage point over Q1 of '06, reflecting cost improvements year-over-year as well. Rental and managed services gross margin was 55.3% versus 60.4% a year ago.

Looking at our operating expenses, OpEx as a percentage of revenue was 39.8% versus 38.6% a year ago. The increase was due to higher R&D investment, which was up by $17 million year-over-year, and which rose from 7.8% of revenue to 8.9% of revenue.

SG&A as a percent of revenue improved year-over-year, to 30.4% of revenue in Q1 of '07, compared to 30.8% of revenue in the year-ago quarter.

Also I want to note that in Q1, we traditionally incurred lower level of US payroll taxes, as it is the end of the calendar year. However, we do expect that payroll tax expenses will increase by approximately $14 million in Q2, on a quarter-over-quarter basis.

Income tax expense in the quarter was $25 million resulting in effective tax rate of 26%. Our tax expense and tax rate were favorably impacted by two items, which totaled $13 million. The first was the Tax Relief and Healthcare Act of 2006, which retroactively extended the research tax credit back to January 1st of 2006. The second, was due to the timing difference in how restructuring charges are accounted for under the German GAAP and the US GAAP and their impact on our US income tax provision.

Let me now turn to restructuring. We continue to move forward with the plans we announced during the last call. We estimate that as of December 31st, we've reduced headcount by about 600 positions during Q4, as well as Q1. As part of our plan, during Q1, we incurred a restructuring charge of $10 million, to further reduce headcount in Europe, and to close or consolidate certain office facilities. This charge was partially offset by favorable adjustments, resulting from changes in estimates, related to prior restructuring actions.

As you can see, in our financial statements, the net restructuring charge in the quarter was $6 million.

During Q2, we expect to implement the rest of the restructuring activities that we previously announced. We expect to take charge of $45 million to $50 million in the quarter.

As we have discussed previously, once we have completed these additional restructuring actions, we believe that we should be able to reasonably estimate and make an addition to our reserves for post employment retirement benefits pursuant to FAS 112 for our European operations in the range of up to approximately $70 million.

I would now like to discuss in more detail, our business segment results, beginning with global communications solutions. GCS revenues rose 3%, sales of large communication systems rose 5%, sales of small communication systems were down and application sales were about flat. GCS segment operating income declined to $22 million from $43 million a year ago. About half of this decline was due to the impact of the vacation benefit in Q1 of last year. In addition, while the higher volumes had a favorable impact on the operating income, this was offset by increased R&D investment year-over-year.

Looking at Avaya Global Services, I want to point out that due to changes in the way the business is organized and managed, we have made some minor modifications to segment revenue reporting, as of the beginning of fiscal year 2007. We have reclassified prior year revenue amounts to conform the new presentation. However, please note that total segment revenues remain unchanged.

AGS revenues rose 1.7% to $598 million. Product support service revenues in Q1 was flat compared to a year ago. Contract based maintenance revenues, which are included in this category, increased year-over-year. Consulting and Systems Integration revenues increased 3.2%, driven by growth in professional services. Global Managed Services revenue also increased year-over-year.

AGS operating income was $53 million, reflecting the favorable impact of our efforts to stabilize revenues as well as to reduce costs. Excluding the impact of the vacation benefit, AGS operating income increased year-over-year and was at its highest level in eight quarters.

Before I move on to discuss cash flow and balance sheet, I want to mention two other items. The first was that we sold real estate previously associated with our business operations for a gain of $7 million pre-tax. The other, was the settlement of income tax -- non-income tax audits in various jurisdictions resulting in a gain of $8 million pre-tax. These gains did not affect GCS or AGS segment results, as they flow through our corporate segment.

Turning now to cash flow. Operating cash flow for the quarter was $17 million. A couple of items impacting the operating cash flow that I want to note. First, in Q1 we had an increase in working capital of approximately $100 million. A large part of this increase was due to payment of employee incentive compensation. As we have discussed, Q1 is when we pay up incentive compensation to employees for the previous fiscal year's performance. 2006 employee incentive compensation was approximately $70 million higher than we had paid out in fiscal year 2005. In addition, our payables decreased relative to Q4, primarily due to the timing of purchases in Q1.

Turning to our balance sheet, our cash position as of December 31, was $895 million and we remained debt fee. Major uses of cash for the quarter included the acquisition of Traverse and employee incentive compensation related to our fiscal 2006 performance. Capital expenditures and capitalized software for the quarter combined was $39 million. Depreciation and amortization during the quarter was $68 million. Inventory turns for the quarter was 9.3 and days of sales outstanding were at 60 days.

Finally, while we did not repurchase shares during the quarter, we have $65 million remaining under the current share repurchase program. So with that, I will hand it over to Mike Thurk now, our Chief Operating Officer.

Mike Thurk

Thanks Amar, as we have discussed, our operational focus is on improving both revenue growth and operating efficiency across our company. While we made good progress in execution on several fronts, there were couple of areas for us to sharpen our focus, such as the warehouse issue.

First on a positive side, our efforts to re-scale our services delivery organization and enhance our professional services capability are having a positive impact. This is reflected in the fact that services revenue increased for the third quarter in a row year-over-year. Also, we are continuing to invest to strengthen our leadership in IP-Telephony and Intelligent Communications. We shipped more than one million IP lines for the third quarter in a row. Our growth rate in a IP-line shipments was higher on a year-over-year basis than it was in Q1 '06. We also enhanced our product portfolio, launching new editions of our unified communication application. We are planning to launch exciting new offers in Q2 and Q3 across our product line. We also made progress during the quarter in managing cost and expenses. Products and services gross margin both improved year-over-year. As mentioned, we improved the level of discounting, which contributed to increased product margins. Our sales team has this as one of their focus priorities to enhance our gross margin performance in the future.

SG&A as a percentage of revenue improved compared to Q1 '06. As we continue to implement our plan to restructure and rescale our organization, this will continue to be an ongoing focus for the corporation. So to sum up here, key areas of progress for us during the quarter were IP leadership, services revenue, product and services margins, cost and expense management.

Moving on now to areas where we did not perform as planned. I would like to discuss product sales growth and the impact of distribution issues during the quarter. As we discussed, we believe there are opportunities to improve our operating efficiency by streamlining and strengthening our processes and supply chain. Product distribution is an important part of this. In Q1, we moved certain warehousing and staging operations to a different third-party logistic service at a new facility. After planning and testing, the new distribution facility was brought online during the quarter. However, during the transition to the new facility, there have been disruptions and delays in product delivery as previously discussed, and some orders were not fulfilled by quarter's end. We estimate the impact in the range of $20 million in Q1. Obviously, this impacted Q1 product revenues.

In addition because we incurred some additional cost and expense related to warehousing and transportation, gross margin was also affected in the quarter. We continue to work this issue with our warehouses. Ultimately, the benefit of moving distribution to a new vendor and a new location will result in co-locating staging of systems with our services organization, and reduce transportation costs. I want to note that the distribution issue in Q1 is not related to the supply problems we had last year. We believe those issues are largely resolved.

Let me turn now to update you on restructuring activities. We are on-track to complete our previously announced plan by the end of the 2007 first half. However, some of the initiatives we had originally planned for in Q1 will now be executed in Q2. This is primarily due to delays in EMEA relative to Works Council's negotiations. Over the course of Q1, we made progress with the Works Council and as I just mentioned, we believe we are now set to implement our plan this quarter. As Amar said with the actions we took in Q4 and Q1, we have reduced headcount by approximately 600. Some of these was achieved by further reducing headcount in EMEA and the US during the first quarter. During which time, we also closed and consolidated office facilities, again mostly in the US. So, we’re well on our way to achieving our goal and at a somewhat reduced cost to Avaya. Executing the remaining portion of the plan will be a key focus for us this quarter.

As we've discussed, the cost savings from these actions will help to offset increased expenses that we expect to incur in 2007 and the remainder will be reinvested in our business. I also want to note that as we manage the business, our restructuring actions take into account the phase of business of that time and we make adjustments as needed to maximize our performance.

Let me now turn to Q2 and outline key priorities in development. First, we're working to better capture demand in the marketplace. We are focused on resolving the warehousing issue and staging issue, and we also plan to increase our marketing spends to help us focus in the US market opportunities. In addition, we are investing in R&D as we further advance our Intelligent Communications vision and strategy.

In Q2, we also expect to complete the Ubiquity acquisition, which we had a partial quarter of their revenue and expenses, and we are completely focused on successful integration of that business.

Finally, we intend to complete remaining elements of the restructuring plan. Let me close by saying that, as Lou mentioned, our goal is to deliver sustained performance and build value for shareholders. We have recently added top talent to our management, as Lou mentioned, a new CFO, a new GPS segment head, and a new CIO. I am very happy about their experience and energy that Caroline and Stuart and Lorie will bring to our team. While we have more work to do, we are clearly heading the right direction and we made good progress over the past several months in enhancing our strategy, improving our execution and transforming our culture. We remain focused on initiatives in each of these areas as we move forward. Thanks and now we will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Troy Jenson Jensen with Piper Jaffray.

Troy Jenson - Piper Jaffray

Thanks. A quick question, Mike or Lou. Any color you can give us on guidance? I understand, you may not want to talk about the top -line, b about -- maybe some of the restructuring efforts that impact the operating expense?

Mike Thurk

As I mentioned in the comments, our restructuring actions are intended to a couple of things. They are intended to allow us to take certain elements for that hey are intended to allow us to take certain elements for that restructuring and reinvested it in key areas of our business. We are extremely focused obviously on bottom-line results and anything that we can drop to the bottom line, and in fact portion of the headcount reductions that we take will be offset by hires in critical areas, as I mentioned in last call and particularly in professional services, Asia-Pac, areas like that.

Troy Jenson - Piper Jaffray

Got it. And then, how about the tax rate guidance for '07? Are any tax credit, is that going to change what we were modeling previously? And then last question guys, if you could give us any color on product sales, how much is TDM versus IP? That would be helpful thanks.

Amar Pai

This is Amar Pai. With respect to your question on the tax rate, we are looking at right now for fiscal year 2007, approximately 36% to 38% tax rate that takes into account the two discreet items that I mentioned during our call.

Mike Thurk

It's Mike Thurk. The question was on IP and TDM, was that the question? I think it was. Let me speak to that. As we mentioned on the call, the IP growth that we achieved this quarter was higher than the growth we achieved in Q1 of '06 in IP, and TDM the actual decline in TDM, as we have historically talked about declines in the TDM business actually decline in TDM this quarter was less than it was in the prior -- in the year ago quarter. That is on a line basis as we count the lines in each quarter.

Operator

Your next question comes from Jiong Shao with Lehman Brothers.

Jiong Shao - Lehman Brothers

Thank you very much. Can you hear me okay?

Amar Pai

Yes.

Jiong Shao - Lehman Brothers

Okay great. I have two questions as well. The first question is on margins, I was hoping you can sort of provide a little bit color on your margin outlook for the next quarter, because it looks like the product gross margin declined a little bit. I think, Mike, you mentioned that that was because of warehouse you know that, do you expect that to sort of bounce back and to what level? And also the services margin jumped up quite a bit I think if my math is right is highest in two years, could you provide little bit color on what's the drivers behind that and within all those sustainable, so that’s the first question on margins. And second quarter is the housekeeping just on the $15 million to the corporate income, I was hoping that you can talk where was that number go in P&L, is that a [control] expense and which line does that go into? Thanks.

Lou D'Ambrosio

Let me start with the margins and then as Mike had commented, margins versus a year ago on the product side have improved on a year-to-year basis. The improvements were really due to a lot of focus on pricing management and discount discipline and value proposition of the offers. So there was very nice improvements in that area, which had a nice impact on margins. We also obviously continue to work hard on the cost aspect of the margins. In terms of the sequential decline that was essentially driven by volume. From a year-to-year perspective there was, as we stated in the call, margin improvement on a year-to-year basis. Mike and Amar, any additional comment you want to provide on that.

Mike Thurk

Just one last comment on the quarter-to-quarter, the Q4 to Q1 numbers. As I mentioned in the script, we were affected by the increasing transportation costs incurred as a result of the warehousing issue that did hit in the Q1 timeframe. Also working against the gross margin line.

Jiong Shao - Lehman Brothers

You also had talked about in the last call, this kind of duality of forces, where in Q4; you had some makeup from supply from last year. And in Q1 you had some impact in the warehousing this year, so that affected some of the sequentiality as well?

Amar Pai

This is a Amar Pai.

Jiong Shao - Lehman Brothers

In terms of services margins?

Lou D'Ambrosio

Services margin improved on a year-to-year basis.

Jiong Shao - Lehman Brothers

Sequentially jumped up quite a bit?

Mike Thurk

Because we had taken some cost reduction actions late last year and some early this quarter, sequentially we expected our margins to go up and they did.

Lou D'Ambrosio

As you know, the cost of goods sold in services has a lot to do with the labor delivery elements. Therefore the actions we took, that we alluded to on the call, had direct impact on the margins of services.

Operator

Your next question comes from Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Hi thanks. Just want to follow-up on the previous question; on the $15 million of corporate income in the quarter. Where was that in the consolidated income statement, (inaudible) or was that in revenues?

Amar Pai

All right. This is Amar Pai just to add to that, on the $15 million items that we talked about, neither of them affected the segment profitability, first of all, and they both remain in corporate segment. In terms of a consolidated income statement, some of them go across the P&L in our line items, some in cost of goods sold, some in R&D, some in SG&A, but a big part of that is in SG&A.

Tavis McCourt - Morgan Keegan

Got you. And then you mentioned little bit on some of the increased marketing spend in Q2 and some commentary on perhaps using discounting a little less than you have historically. Can you kind of talk big picture, what the marketing strategy is at this point? Is it this kind of more brand awareness type spend or more targeted type marketing activities?

Lou D'Ambrosio

It's overall -- it is from -- let me make a few comments to get Mike's perspective. It's going to be really from an overall go-to-market perspective from awareness to consideration and preference, and as you go through that funnel, there will be different aspects, whether it's creating continued brand awareness the preferred brand or more specifically around preference from a demand generation, all the way to go-to-market from a sales execution perspective.

Mike Thurk

We also have a bit of a pipeline of new product introductions occurring in the second and third quarter as well, with the marketing investments attached to that and as we said, additional branding works, so it's across the board.

Operator

Your next question comes from Tal Liani with Merrill Lynch.

Tal Liani - Merrill Lynch

Hi, guys. I have two questions. One, I want to go back to a question that was asked about the breakdown between IP and TDM lines, and I want to try and get a more answer in terms of revenues rather than line shipments. According to synergy numbers your -- the revenues generated by IP lines are about 18% of the total, which means IPs weigh bigger, but this doesn’t take into account location of application. And if I take this number on one hand, which is probably the lowest side of the lowest number I can think of for TDM and I am sure it's above it because of the application and then, I compare it about 50% you said on your conference call maybe a year ago. Could give us like a sense of where is TDM revenues now in terms of product sales? Is it closer to the 20% sort of the synergy numbers, or is it closer to the 50%, you said about a year ago?

Lou D'Ambrosio

Right now, you want to go on Amar?

Amar Pai

This is Amar Pai. Just -- first of all when you look at over our Global Communications Solutions revenue, our IP/TDM mix right now is, approximately 65% is IP and 35% is TDM. This has improved towards IP every consecutive quarter just about and about a year ago, it was in the range of 60/40, little bit less than 60, and other being --TDM being the lesser portion.

Tal Liani - Merrill Lynch

Okay. Second question I have is more about strategy and I am trying to take a bigger picture here on Avaya because you stock ran out as a result of expected cost savings from restructuring. And at these levels, the question is what's next. And the question now I am asking is, when you look at your product portfolio, you are dealing with the cost side and lot of this conference call dealt or we discussed here what you are going to do to the cost side of the equation, what about the revenue growth side? Is there anything you can do, for example, spin out services or anything you can do or you think of doing to improve the revenue growth? Thanks.

Lou D'Ambrosio

Sure, the revenue growth has to do with the value proposition that we are offering to our clients and the execution of bringing that value proposition to the client. So, let me separate the two. I'm not going to go into kind of different types of permutations of our business model. I'll talk about kind of the business models as we have it today and the way in which we will aim to accelerate revenue growth. What we are finding is that as we move up the value stack, we have a clear distinguishing advantage versus our competitors. Some of our competitors where their strength traditionally has been, is in what I would describe as kind of the foundational underlying dummy down type of infrastructure while our strength has been in the software layers.

As we move up the software layers very consistent with the acquisition of Traverse, very consistent with the public tender offer of Ubiquity. It plays very much to the strategy of moving up the value stack and you are now embedding these types of solution into the core processes of customer businesses.

Let me tell you why this is so important, because not only are you distinguishing yourself now in the current competitive landscape with their offers, what we are also doing is opening up new markets because you are communication enabling other types of processes and applications. As an example, we are working with a manufacturer right now who had an automatic replenishment system in place. The problem was that their automatic replenishment system wasn’t informing the end-to-end value chain when something had to be reordered. What we did was to communication enable that ERP system to inform the end-to-end supply chain to significantly increase the inventory management solution. What we just did was we went beyond what traditionally had been considered our market segment of communication and communication enabled a much broader business application. Because of the way in which we've architected our solution and advancements we've made in moving to a service-oriented architecture, we are clearly separated from our competitors in being able to operationalize the strategy. So by executing our strategy and moving up to the value state to both distinguish ourselves in the current marketplace in which we participate, but then importantly, providing ourselves an access to enabling the broader application -- business application marketplace, that become the very powerful opportunity for growth.

The second part then is from a go-to-market execution perspective and we are aligning the teams to execute on the strategy. As an example, we are putting in place a dedicated application sales team in the company, which we hadn't had in the past. That allows with us skill and solution selling to brining that value proposition to the marketplace. And those are the types of activities in which we are going to be frankly relentless on in terms of executing the strategy to accelerate revenue growth. What I am not going to comment is this something kind other broader option in terms of changing the business model more fundamentally et cetera.

Operator

Your next question comes from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon, a clarification and two questions. First, just the size of the restructuring charge you expected in Q2, I didn't quiet hear exactly. And then, secondly on the $20 million in revenue disruption, do you think that business it was lost or just slipped around in terms of timing. And, lastly, just some color on the share buyback, kind of what your thought process will be on buying that shares? You've got authorization outstanding. I know you have already gone back to the creditors to get even, do you have more room for the Board to authorize more? Just kind of what your thought process is on use of cash here? Thank you.

Lou D'Ambrosio

Yeah. Sure thanks Sam. Let me -- Amar will take the first one, Mike second, and I will take the third one.

Amar Pai

Okay. Hi, Sam. First, I think your first question was relating to the restructuring charge we expect to take in the second quarter. We gave an estimate of $45 to $50 million charge in the second quarter.

Samuel Wilson - JMP Securities

Got it, thank you.

Mike Thurk

With respect to the business and warehouse, it is also a little bit difficult to know exactly the answer to that question, although we expect that the majority of that in fact will flow in future quarter. So that business is not lost, but again it's hard to say exactly the percentage of the $20 million.

Lou D'Ambrosio

And regarding the share buyback, we currently have $65 million left in the program. Our philosophy on this has not changed. We continue to be very focused, Sam, on the usage of cash each quarter. Given the acquisition that we made, some of the other usage of cash that we described on the call, this quarter we choose not to use it to buyback stock. However, we're still very open to that as a use of cash and we still have $65 million left in the program and there is been no change in the philosophy here with the company regarding the share buyback.

Operator

Your next question comes from Ehud Gelblum with JP Morgan.

Ehud Gelblum - JP Morgan

Hi, thank you very much. I have a clarification to -- but also then two questions for you. One at a time, so you don't get confused. The quick clarification was previously someone said a question about services gross margin why that was up? And you said that cost structure flowed through that. I just wanted to make sure as a clarification whether that is sustainable. It sounds like if something else is corrected or change in the business with your employment levels and therefore there is sustainably high gross margin level that you could sustain. Is that accurate?

Mike Thurk

I think the -- obviously there is always things working on the top-line as well, but in terms of the actual restructuring charges and the improvement in the cost base, yes, that would be sustainable, in fact, we are looking to do more in that area and particularly in EMEA. So we expect, you can't sell or immediately translate that to margin as there is always price changes and things that do occur in the marketplace, but I would say that this restructuring change that we made is in fact is sustainable.

Ehud Gelblum - JP Morgan

Okay. Excellent. So my first of the two questions is going back to the $15 million in unusual items that were that seem to be embedded, $7 million in real estate for pre-tax and $8 million for legal settlements that I wrote down. You said that it is kind of scattered across the income statement. That's $15 million I'm guessing on a post-tax basis, to around $10 million, which is about $0.02. So we would be looking at this more as though the real non-GAAP numbers is closer to $0.11, if I take that 15 million out of 13, is that the right way to look at it or is there some reason that this is actually run-rate business?

Amar Pai

Hi, Ehud, this is Amar Pai. First of all the $15 million is pre-tax impact. There were two items there, the first one as you said is based on the sale of real estate relating to approximately $7 million, the other one was some settlement of non-income tax related audit that was about $8 million. They are both pre-tax items not in an after-tax. Now [we expect to] vary from the P&L, like I said before, it kind of cuts across various line items with a majority in SG&A, but however I would like to point out, that last year also, we had approximately $21 million benefit from the change in vacation policy, so when you look at year-over-year, you have got to take that into account also for proper accountability.

Ehud Gelblum - JP Morgan

I am not totally agreeing. Last year was last year, but for this year, and not really care where in the P&L it was. Just want to understand that it's correct to take that out somewhere, which is $15 million pre-tax, my guess is $10 million post tax and therefore that's a $0.02 impact to earnings and the real EPS number we should look at on an ongoing run rate is closer to $0.11 in this quarter versus $0.13 or is that incorrect. I don't care where the P&L exists?

Amar Pai

I look at that as, every quarter we have pluses and minuses, various transactions, that's why we did not take that out as a non- GAAP measure.

Ehud Gelblum - JP Morgan

Okay. I understand that, that way looking at it okay. The last thing if I could, quickly just understanding the cash flow, the decline in cash flow, I can build up most of it and just wanted to make sure I am doing it accurately. You did $17 million in cash flow, $100 million was working capital issue, most of which was the incentive bonus payments, which takes us to $117 million. The difference between that and the 191, if you can just remind me again, what the rest of the decline in cash was?.

Amar Pai

The fourth quarter, you are looking at the fourth quarter cash flow of 191.

Ehud Gelblum - JP Morgan

Right just comparing that to -- we could base it at about a 117 this quarter?

Amar Pai

That is based on the completely different kind of volume, as well as -- like I said before, typically the first quarter is very unique, because we pay out our annual employee incentive plan. I think more comparable, is the comparative is the same period of last year. So if you look at last year, our cash flow was 106 versus this year, 17, a difference about $90 million, up at 90 approximately $70 million is the difference in employee incentive compensation.

Operator

The next question comes from Jason Ader with Thomas Weisel Partners.

Jason Ader - Thomas Weisel Partners

Yes, thank you. Just two questions. First, the maintenance last year in the June quarter was down pretty sharply, the maintenance revenue, which I guess is based on your renewals. Should we expect the same type of trend from Q1 to Q2 this year and then the second question is, on the OpEx, can you just give us some sense of where you think OpEx is going to trend in Q1?

Lou D'Ambrosio

There has been over the last couple of years, a history in the second quarter where maintenance has seen the sequential erosion. We have taken several actions though, which -- we'll have to see how the quarter plays out, but we have taken several actions to do what we can do to ensure that we optimize the performance. What we are not going to do is give a projection of what the service revenue is. But we've put together a high focus around the SWAT Team, we've beefed up to Telesales environment to focus on the renewals and look very carefully in terms of why the erosion happened in previous quarters to learn from them and therefore take the appropriate actions.

Operator

Your next question comes from John Marchetti with Morgan Stanley.

John Marchetti - Morgan Stanley

Hi, thanks. Just wanted to touch base on the product side again. When I look at the operating margin this quarter relative to last, we had a pretty big sequential step down there in the operating margin, relative to even where we saw revenues go on a sequential basis within products. And the mix will looked like it was relatively stable. So just curious, I know we have talked a lot about the warehousing and staging issues, were there any sort of pricing issues or things like that on a discounting level that may have had an impact there. And then secondly, in terms of this warehousing issue, you mentioned that it wasn't related to the issue you had previously, but my question is, is it at least the same vendor, when you mention looking at a -- bringing someone new on, should be expect this to be related to the renewal that you did last March and then see that clear up within a couple of months here.

Mike Thurk

Amar, I want you to take the first one, which is pretty (inaudible).

Amar Pai

Yeah, let me talk about the product profitability as we have talked about. Let me clarify two numbers. First quarter of '06, our operating income was $43 million and first quarter of '07 it was $22 million, that's approximately $21 million reduction in operating income. About $11 million of that is relating to change in vacation policy benefit that we had in the first quarter of '06, that we are not getting the same level of benefit again this year. The other one is the increased investment in R&D. R&D year-over-year went up to close to 9% of revenue as we had stated before as our goal, and that's approximately $17 million increase -- $17 million increase year-over-year. Yeah Mike, second question.

John Marchetti - Morgan Stanley

Just if I can real quick, I was more concerned, I guess on a sequential basis, given that product revenue only came down 10% sequentially and we saw a 70% reduction in operating income here, and given at the mix stayed relatively stable, just curious if there is any kind of pricing actions or anything like that going on that's speeding into it?

Mike Thurk

Yeah, there is considerable leverage, Sam, when you go from -- sequentially from Q4 to Q1 in the volumes. So, you need to take that into account. We also, as I said earlier on the margin line, we did -- we did incur some cost that we had to bring in with respect to the warehousing issue, and if I could add and Amar has already addressed the R&D and the vacation accrual issue from a year ago. With respect to the question on the if it at the same vendor? No, it's completely separated and distinct. One is contract manufacturing and one is distribution. So, it's completely different.

Operator

Next question comes from Tim Long with Banc of America.

Tim Long - Banc of America

Thank you. Two questions, if I could. First, on go-to-market, Lou, if you could talk a little bit about just a direct versus indirect, just looking at the numbers over the least year, year and a half, I think we've seen four quarters in a row decline in year-over-year for the direct sales force, yet indirect has been growing pretty nicely. Could you talk about kind of what's causing that, is there a turnover or they have been moving accounts around, or is the indirect sales force getting bigger, and what could we do to see the direct sales force line start moving in the positive direction. And then, second, if you could just talk about the US, specifically it looks like there has been some pretty good growth there over the last two-three quarters, and it seems to flatten out on a year-over-year basis? This quarter was anything specific in the US theater that maybe was hit on the revenue side? Thanks.

Lou D'Ambrosio

Yeah, sure. Regarding the shift between direct and indirect or how that composition is playing out, a couple of things, in some of the more rapidly growing environment, we had several quarters like Asia-Pacific, et cetera, which has been very indirect-centric that obviously affects when you look at the totality. However, I would tell you that our go-to-market model with our indirect channels has done quite strong. If you remember couple of years ago, we’ve made some tough moves, which were appropriate to make at a time, but they certainly pay no dividends in terms of the type of growth that we’re seeing with the indirect channels. Among the direct channel’s side, we saw -- it’s a bit lumpy. You traditionally see a very strong direct growth, which is considerable over the last year, in the fourth quarter as they build up as people were finishing out their sales plans et cetera. We’re also doing something, ought to say, what's in our control? Like greater specialization by implementing new software on application sales force. We are redeploying skill such that we’re having more hunters in the marketplace than we have had in the past. We’re looking at when we were selling in a direct perspective to the technology what make sense to all and work with line of businesses. We recently had a major financial services sector where given the value prop of this converge technology, they asked us to work with them in sponsoring discussions with all their lines of businesses. So, there is a significant amount of work to continue to enhance the overall effectiveness of the direct sales force. And at the same time, frankly we have no intentions of doing anything to waver away from the indirect channels, which had been frankly very good success story over the past few quarters. Regarding the US, there were couple of things. And you guys have seen the same earnings announcements from other companies that we have, whether it was SAP et cetera, which point to the US as market that there are watching closely. As we talk to our sales team and our channel partners and we had our largest distributor in here last week and asked the same questions, there does not seem to be lot of panic or anxiety around US marketplace. They seem to point to a couple of aspects. One is there clearly was lower business this quarter versus a year ago in the federal sector. There were some business last year because of events like hurricane Katrina et cetera, which were not repeated obviously this year, which did had an impact on a year-on-year basis, so decline in the federal sector. There is also some lumpiness from the buying in the financial sector. And candidly, there was a fair amount of distraction from the warehousing operations that we had a wrestle with in US as well.

So I would say, those three areas were the contributing factors to the US balanced with the fact that as we speak with the teams in our go-to-market in direct channels, there is no panic or anything like that as far as the market goes, but given some announcements from other companies in technology industry, we will certainly be keeping a keen eye and paying attention to the US market place and sure that we move with whatever speed we need to in terms of making adjustments.

Matt Booher

Operator, this is Mr. Booher. I believe we have time for one more question please.

Operator

And your final question comes from [Blane Moder with Loped] Partners Corporation.

Blane Moder - Loped Partners Corporation

Hi guys. If you could just talk about your acquisition strategy, and use Ubiquity as an example, I mean, you're a paper pusher like myself, it just appears that the premium you paid in the enterprise rate of revenues, if you will, it just doesn’t seem like there is a pay off as far as shareholder value creation. But maybe you could expand on the growth you expect from Ubiquity and how you'll sell that product such that you can leverage off the price you pay? Thank you very much.

Lou D'Ambrosio

Sure. It's an excellent. I mean for sure we do not have an acquisition strategy which to pay these types of premiums on a systemic basis. I will tell you though that when there is an acquisition which is very important strategically to the organization that you're buying acquisition, frankly not just for the revenue stream or the profit stream of the acquisition, but how the technology is going to be embedded in your technology to extend the technology leadership that you have and that's core to the strategy that you laid out. You look at things to a very different length. And obviously, we did all the things in terms of fairness opinions with the bankers and so forth. And I think there was clear alignment that given where we are taking the business, given or moving up the value stack, given the importance of having a unified integrating platform, given the way in which the technology between service providers and enterprise in many ways is, is kind of blurring, given the importance of moving into a Sip-based service-oriented architecture environment, given the importance of having a leading platform that several thousand applications vendors could provide. That is at the core of where we are taking the business and at the core of our strength. So, we do not look at Ubiquity importantly only as Ubiquity in terms of as a standalone entity, we looked at that as Ubiquity in conjunction with what it could do as a technology leveraged with all set of assets and how that changes our strategic position going forward. And as a result of that analysis, which was frankly quite compelling that we made a decision to purchase Ubiquity. Okay Matt what's next, thank you very much for the question.

Matt Booher

Thank you for joining our call and we look forward to discussing our second quarter results approximately 90 days from now.

Operator

Thank you for joining today's conference call. This call will be available for replay beginning at 6 o'clock PM Eastern Time today through 11:59 PM Eastern Time on January 30, 2007. The conference ID number for the replay is 4423001 once again that's 4423001. 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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