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Avaya Inc. (NYSE:AV)

F2Q07 Earnings Call

April 25, 2007 5:00 pm ET

Executives

Matt Booher - VP of IR

Lou D'Ambrosio - President and CEO

Caroline Dorsa - CFO

Mike Thurk - COO

Analysts

Samuel Wilson - JMP Securities

Ian Conn - J.P. Morgan

Inder Singh - Prudential

Michael Genovese - Citigroup

John Marchetti - Morgan Stanley

Tavis McCourt - Morgan Keegan

Manny Recarey - Kaufman Brothers

Rob Goldman - Jefferies

Persil Lal - Merrill Lynch

Presentation

Operator

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

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

Matt Booher

Thank you and welcome to Avaya's Fiscal Second 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 Caroline Dorsa, our Chief Financial Officer.

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 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, and our first quarter 2007 Form 10-Q as well as in our earnings release which we filed on Form 8-K earlier today.

Avaya disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Unauthorized recording of this conference call is not permitted.

Now, at this time, I'm pleased to introduce Lou D'Ambrosio.

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Lou D'Ambrosio

Great. Thanks, Matt and thanks to all of you for joining us today. As Matt mentioned with me are Caroline Dorsa, our CFO; and Mike Thurk, our Chief Operating Officer.

I want to welcome Caroline to our first earnings call with Avaya. As most of you know Caroline joined us in February from Merck and Company and she has just been a great addition to our leadership team. As a side note, that's a great day for Caroline to be having our first earnings call with Avaya as today is Caroline's birthday, so happy birthday Caroline.

Let's get started and get running to the numbers. We made good progress this quarter. Non-GAAP operating income was up 25%. Non-GAAP EPS was $0.14 versus $0.11 a year ago, and our non-GAAP operating margin rose to 7%. Also importantly, we had a good top line performance in key strategic areas, and importantly it is the areas that we have targeted for growth and investment. Let me give you a couple of examples.

IP product revenues grew 28%. In fact our revenue composition this quarter was 68% IP versus 32% TDM. This compares to a year ago when the IP to TDM ratio was 56% to 44%. So, we have had a 12 point growth in IP revenue composition in one year. Also in the quarter our application sales growth was up 15%. Our overall product revenues were up 8%. US direct product sales and Asia Pacific were up double digit, professional services revenues grew by over 20%.

We also improved across an expense profile. SG&A expense declined and OpEx as a percentage of revenue improved. And in building value, bottom-line growth had to translate to strong cash flow. I am pleased to say then in Q2 we generated $205 million in operating cash flow.

Now, there are also a couple of areas that need further improvement. Like supply chain and our operations in Germany. And we're working to bring the speed, the focus, the intensity to them that we have demonstrated and achieved in other parts of the business.

In our supply chain, as an example, while we have made improvements to our supply and warehousing situation, it is still not where it needs to be and it has impacted sales force productivity. But we are taking actions. One of them includes appointing a new leader Francis Scricco, previously the leader of our services business to lead our end-to-end supply chain and procurement for the corporation. Fran has responsibility and accountability to take these processes and make them world class.

As you may know, prior to joining Avaya three years ago, Fran was the Chief Executive Officer of Arrow Electronics, a multi-billion dollar technology distributor, whose business model was determined by the success of its value chain. Fran also spent many years at GE running businesses with supply chain leadership responsibilities.

Like wise in Germany, we have brought a new leadership, and announced Juergen Gallmann as President of Avaya Germany. Prior to joining Avaya, Juergen was President of Microsoft Deutschland. And before Microsoft he led IBM's software business for Central Europe. Juergen is quickly moving to assess the situation and make the changes to invigorate growth in Germany. This won't be an overnight fix, but we are confident it will get on the right track.

So, in net, it was a solid quarter. We demonstrated strong performance in key strategic areas, double-digit growth in applications, 28% growth in IP telephony, 20% growth in professional services, effective costs and expense management and very strong cash flow. Likewise we have continued our intense focus on the areas we need to improve.

During the past couple of calls, we have discussed our three priorities for our company; strategy, execution and culture. What I would like to do now is just wrap up this section with a few sentences about each.

In terms of strategy, we are making very good progress in moving up the value stack and delivering communications applications. We closed on our Ubiquity acquisition and announced a core set of differentiating software capabilities in the area of communication enabled business processes. This both expands our addressable market and enables customers to dramatically improve the cycle time of their core business processes.

As a case in point, one of our customers is using our software to condense cycle time for part of its inventory management process from two hours to two minutes. Regarding execution Mike Thurk and his team are taking action to get our company into fighting shape, aligning the organization, accelerating decision-making and driving accountability. This is not a one or two quarter process, it's ongoing, but clearly we are going in the right direction.

And then culture, as we have discussed in previous calls we have brought in some great talent and have a very strong team now. And importantly, we have the right team to execute the right strategy. Our team will be measured on a clear set of metrics; metrics that drives shareholder value; a case in point. This year we changed our long-term compensation plan, so that a significant component of the leadership team's compensation is tied directly to shareholder return versus a peer group of technology companies.

With that section, let me now turn it over to Caroline to review our financial results in more detail. Caroline.

Caroline Dorsa

Thanks Lou, and thanks for those good wishes and good afternoon to everyone. As Lou noted, this is my first earnings call at Avaya and I am very pleased to be here. I want to add that I look forward to speaking and meeting with many of you in this and future quarters.

I'll start today by taking you through our income statement in more detail. Then I'll discuss segment performance, our restructuring actions, cash flow, and our balance sheet. Unless indicated otherwise, I'll be providing comparisons on a year-over-year basis. I will be discussing our results on a US GAAP basis as well as on a non-GAAP basis.

Our Q2 2007 non-GAAP results exclude restructuring charges of $10 million. Our Q2 '06 non-GAAP results exclude restructuring charges of $20 million. We provide reconciliation of non-GAAP to GAAP results in our press release and accompanying presentation, both of which as Matt mentioned are posted on our website.

So to start, let me echo Lou's comment that we had a good quarter and demonstrated strong growth in key areas and effective cost management to deliver solid bottom-line results. Non-GAAP operating income rose 25% in the second quarter of 2007 to $91 million from $73 million a year ago. Our non-GAAP operating margin was 7% versus 5.9% last year. You can see that on the last page of our financial disclosure detached to the release where we reconcile GAAP and non-GAAP measures.

Non-GAAP net income was $64 million or $0.14 per diluted share. This compares to $50 million or $0.11 per share in Q2 last year. GAAP operating income was $81 million, and GAAP operating margin was 6.3%. GAAP net income and EPS were $57 million or $0.13 per diluted share. The Q2 '07 GAAP and non-GAAP EPS numbers are both based on 457 million diluted shares.

Now let me talk about the major drivers of our performance, turning to the first page of our financial disclosures. Q2 revenues were $1.294 billion, an increase of $56 million or 4.5%. On page 10, we show the supplemental revenue table, so let me point out a few things from them. Sales of products rose 8%. We had mid-teens growth in applications revenues and about 6% growth in sales of large communication systems. Services revenue was up year-on-year as well by 3.5%.

Professional services part of that category grew by 20%. We also had continued good performance in our contract maintenance space, which was up modestly year-over-year on both the US and the global basis. Rental and managed services revenue decline by 4.6%. Relatively high percentages of rental contracts in Germany come up for renewal during our fiscal Q2. So, there was pressure on revenues from both the pricing and the renewal rate perceptive.

Almost all of this impact is in our small business line in Germany, so you will see the negative impact of the German rental business renewal carried through to both the Germany region line on page 10 as well as the small business product line in our Global Communication Solution business.

Looking at revenues on a geographic basis, US sales were up 4%. We had good performance from our direct sales team which generated a mid-teens increase in products sales. Application sales were particularly strong, up in the mid-teens. On the services side we are very pleased with growth in professional services in the US which drove professional services growth globally and we encouraged by the modest growth we achieved in contract maintenance versus the year ago period.

While we are encouraged by our Q2 results in the US, we are watchful of what the second half of the year will be like as other technology companies have signaled some softness in the IT spending environment. We do of course expect the year to end with a seasonally strong Q4 in terms of the US product sales.

Outside the US, revenues grew 6% with products sales rising 10%. Asia Pacific had a good quarter with revenues up 12% reflecting in part the warehouse catch up from Q1.

Sales in America's, x-US were up 8%. Revenues in the EMEA region increased by 3%, with EMEA revenues excluding Germany growing 9%. Overall EMEA product sales were up 9%. FX had a positive impact on revenues of about $32 million in the quarter, virtually all in Europe and had a negligible impact on earnings.

Let's now turn to revenue by channels. Direct products sales were up 11% driven by a mid teens increases in the US as well as strong performance in Asia-Pacific. Indirect product sales were up in the mid-single digits with EMEA largely driving the increase. And I'd note that US channel inventories are down one day compared to last quarter.

So that covers revenues, I'll now move on to gross margins. Gross margin was 46.2% in Q2 of '07 compared to 46.7% a year ago. Gross margin on sales of products was 52.9% versus 53.6% in the year ago period.

Discounts, in fact, were relatively flat with the prior quarter and were slightly better than the year ago period. Product mix had a favorable impact. There were, however, cost and expenses associated with the warehouse issue that Lou mentioned earlier that negatively impacted product gross margin.

Services gross margin was up about 1 percentage point, increasing to 36.3%. This reflects the cost improvements we had implemented over the past year. Rental and managed services gross margin declined to 51.4%. As mentioned this reflects revenue pressure in the rental business and delay in achieving cost reductions, both of which are primarily in Germany.

Looking at our operating expenses, operating expenses as a percentage of revenue was 40% versus 42.4% a year ago. This includes restructuring related expenses. If we exclude those items, operating expense as a percentage of revenue was 39.2% this quarter versus 40.8% a year ago. The improvement here was driven by higher volumes and also by lower SG&A spending. As pointed out, that SG&A expense $393 million in Q2 '07 compared to $399 million a year ago.

R&D spending was a $114 million or 8.8% of revenue, compared with a $106 million or 8.6% in the year ago period. I should point here that we completed the Ubiquity transaction late in Q2 and had only about one month of their financial results in our P&L.

In Q3, with the full quarter of Ubiquity, we expect R&D to be at or slightly above 9% inline with our long term target. The integration of Ubiquity does however provide us with potential cost synergies and we continue to look for cost reduction opportunity within our existing organization.

Income tax expense in the quarter was $31 million resulting in an effective tax rate of 34.7%. We recall that we had some one time favorable items that caused the Q1 tax rate to be lower than a normal run rate.

I'll now move on to discuss restructuring. During the quarter, we incurred a net charge of about $10 million related to headcount reductions and office closures and consolidations in the EMEA region. About 75 positions were eliminated across various business functions.

These actions are part of our previously disclosed plan to optimize our cost structure and improve our skill base. As of March 31, we have reduced headcount by approximately 800 positions over the past three quarters.

I'd now like to discuss in more detail our business segment results; beginning with Global Communications Solutions or GCS. GCS revenues increased 6% and segment operating income rose by $6 million to $38 million. The increase in revenues was driven by higher application sales which were up 15% and a 6% increase in sales of large communications systems. Partially offsetting this growth was an 11% decline in sales of small communication systems, which as we've said reflects primarily the situation in Germany.

For those of you who track the hardware-software mix metric that we've talked about in GCS before, the mix this quarter was software as 38% of product sales compared to 36% last quarter and 34% in Q2 '06.

The segment's gross margin decreased. Increased product sales volumes and favorable mixture were offset by cost related to the warehousing issue and lower margins on the product portion of the German rental contracts. As mentioned, discounts were relatively flat with the prior quarter and were slightly better than the year ago period.

SG&A spending was relatively flat year-over-year and R&D spending increased. As I mentioned there is only one month of Ubiquity's SG&A and R&D in our second quarter results. We are managing the cost impact of Ubiquity while maintaining funding of our priorities to ensure the success of this acquisition.

Looking at Avaya Global Services or AGS; AGS revenues rose by 3.3% and segment operating income rose 37% to $56 million. Product support service revenue was up 3%, contract based maintenance revenues, which are included in this category increased year-over-year, and we are encouraged by the more consistent performance and improvement we are achieving in our maintenance business. This is the key focus area, an important driver of cash flow for the company.

Consulting and systems integration revenues increased 9%, driven by a 20% growth in professional services demonstrating good performance in this strategic growth business for Avaya. Global Managed Services revenue increased 1% year-over-year. The AGS segment gross margin improved, reflecting headcount reductions over the past year. Expense management also improved significantly, as AGS operating expenses declined on an absolute dollar basis and as a percent of revenue. So that covers our business segments. I'd like now to turn briefly to cash flow.

Operating cash flow for the quarter was a strong $205 million. That's compared with $169 million in Q2 of last year and $17 million in Q1 of this year. The increase in operating cash flow in Q2 over Q1 reflects in part an improvement in working capital and the same is true when you look at year-over-year performance. But also keep in mind that the company made its annual employee incentive payment in Q1 of this year, as we discussed in last quarter's call.

Moving on to our balance sheet, which remained strong, our cash position at March 31 was $829 million with no debt. Major uses of cash for the quarter included the repurchase of 7.3 million shares for total of $94 million. We've now completed our prior share buyback authorization and have begun to buy under the new repurchase plan that was approved by the Broad in February of this year.

We also of course completed the Ubiquity transaction for a net cash cost of $146 million. I think it's worth noting here that with our strong cash position demonstrated cash generating ability. We have the ability to build value by returning cash to shareholders through repurchases and to build value by investing in our business.

Capital expenditures and capitalized software for the quarter combined with $48 million. Depreciation and amortization during the quarter was $73 million. Inventory turns for the quarter were at 9.8 times, up from 9.3 times last quarter. Days of sales outstanding were at 62 days versus 60 days last quarter. So, that's our Q2 financial review. All in all, a solid quarter, growth in key areas, good cost management, improved profitability.

Before I hand it over to Mike, I want to say again that it's great to here at Avaya and to partner with Lou and Mike and our leadership teams as we work together to drive profitable growth.

Avaya has tremendous assets, and a very strong balance sheet, and we clearly have the opportunity to further build value for shareholders. Mike.

Mike Thurk

Thanks Caroline and welcome aboard. I would like to briefly update you on the major transformational initiatives underway as we drive for revenue growth and operating efficiency.

Let's start with restructuring. Our primary goals here are to more effectively allocate resources to improve returns, and to reinvest the cost savings to enhance our skill base and support our growth initiatives. We've come a long way in our overall restructuring plan, optimizing resources, streamlining processes and reducing headcount by 800 over the past three quarters. We can see this progress reflected in our results. With a $56 million increase in revenues year-over-year, SG&A expense was lower by $6 million.

For the first half, SG&A is about flat, and revenues are about $87 million higher. We are generally pleased with the pace and scale of our progress. However we are facing challenging environments in Germany. Our restructuring effort there has been delayed, and our rental business is under pressure from price and renewal rate perspectives.

Our new leader in Germany, Juergen has developed a plan for putting the business back on track for the long-term. This includes driving for growth and improving our cost structure. This requires close cooperation of course with the works council's. Juergen and his team are moving quickly, but we may continue to see softness in Germany until the new management initiatives are fully in place.

Let's move next to the supply chain issue. We do not have any significant customer impacting shortages this quarter. However, we did continue to incur higher costs with our warehouser with whom we all only recently began doing business. These costs impacted gross margin that was mentioned this quarter. And as Lou mentioned we have new leadership now in place for our supplied chain efforts. We believe there is still much opportunity for streamlining this part of our value chain over the coming year.

So far, I've basically talked about what we are doing on the cost and expense side. Let me now shift briefly to discuss our growth initiatives. We continue to build on our leadership position in IP telephony. During the quarter, IP revenues rose 28%. We shipped over 1 million IP lines for the fourth consecutive quarter. IP based offers now account for 68% of product sales while TDM is the remainder at 32%. With a strong focus on applications, application sales were up 15% this quarter compared to Q2 '06. In fact a new sales focus is now in place with a specialized team and a new leader to drive application sales.

I would like to touch now on some advances we are making in our product portfolio. With a good success in hitting our delivery dates for new products on schedule. This quarter we released our new Communications Manager Platform version 4 as well as a new highly competitive IP Office platform. We are investing in these solutions to drive growth today for evolving our platform into new areas.

As Lou noted, we launched an important new solutions portfolio, Communication Enabled Business Process or CEBP solutions. It includes our new Avaya Communications Process Manager Software that orchestrates activities across multiple modes and applications when a business event occurs. Many other exciting new offers will emerge on the CEBP solutions set as we integrate Ubiquity and work with our many ISP's on new applications. We'll move quickly over the coming quarters to fill out this portfolio.

Ubiquity is an example of how we are driving for growth by selectively allocating capital to accusations that leverage our technology leadership.

Organic growth is also a priority, for example professional services, software and applications consulting and integration is essential to our growth strategy. We continue to be pleased with the solid growth trends we are achieving in this area. The Asia-Pac region is another higher growth opportunity. Sales were up 12% year-over-year and we are devoting more resources to increase our presence there.

In addition, we are actively exploring ways to leverage and expand our presence in India, particularly in the sales, support, services, and R&D areas. We seeing opportunity to extend our platform work, improve time to market, and increase efficiency by leveraging more offshore sites and combing those efforts with our global and US centers.

So, in summary, nice progress in key strategic areas of growth, effective cost management and intense focus on the areas that warrants improvement.

In addition, we are looking forward to seeing all of you at our upcoming Analyst Day meeting which will be held on May 31.

Let me now turn it back over to Matt

Matt Booher

Operator, we are now ready for the question-and-answer session please.

Question-and-Answer Session

Operator

(Operator Instruction). Your first question comes from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

I hate to set this precedence, but I'm going to ask two questions right of the batter, one question in two parts. Just real quickly, first, product accelerated it was 8% year-over-year growth versus 5% last quarter. Do you think you are sort of at the beginning point of a trend here on a re-acceleration on the product side? And second, can you just give us a sense, it sounded like discount levels didn't go up. Was the pricing environment any more or different than it has been in the previous quarters? Thank you.

Lou D'Ambrosio

Let me start and then let Mike and Caroline to begin. The discounting part of your question to start Sam, I think the team did a very nice job here in effective discount management throughout the quarter. But fairly it's a competitive environment out there. The set of disciplines and metrics that we put in place to effectively manage discipline I think is clearly paying dividends and I would say that we're pleased with the discount management which was essentially flat versus previous quarter. So, we are pleased with where we are in that result.

In terms of the growth, we are not going to comment in terms of forward-looking and where we are, etcetera and Mike or Caroline any additional comments you want to add on that.

Mike Thurk

Just a comment, we've talked about the strong applications growth this quarter and we've made some changes in the sales force, kind of focused in that area. So clearly we are trying to set ourselves up for an appropriate investment in that area to help the applications grow. I think on a balance, we look at Germany as one of the areas of concern, but all-in-all the trends that we've just seen, they were hopeful. They are hopeful.

Lou D'Ambrosio

The other thing I would say is while we look at product growth for sure we actually spend more time in looking at the sub components of it. So, we'll look at IP telephony applications etcetera, as you really kind of partition the business into its relevant parts, given the scope of the portfolio. As we set the area, areas like applications, areas like TDM, areas like professional services that we have been very explicit in terms of our growth areas. Frankly we are very encouraged by those signs.

Matt Booher

Next question please.

Operator

Your next question comes from Ehud Gelblum with J.P. Morgan.

Ian Conn - J.P. Morgan

Hi, this is [Ian Conn] for Ehud. Maybe I could also get two questions.

Matt Booher

One question, two parts.

Ian Conn - J.P. Morgan

One question two parts, that's right. A question and a clarification, actually is traditional from this office. On growth, I just want to clarify, you had 1238 in revenue in Q2 '06 but you had 30 to 35 kind of revenue, so should you select, some what like a 1270 number. You are just closed to 1294 and you said there is no disruption from warehousing. But I think you had a 30 plus million positive impact from Forex. So, I mean the question is is revenue really up for the year in an apples-to-apple sense. And then also on the OpEx performance, which was just fantastic. How were you be able to retch down OpEx almost, in what appears to be the middle of the quarter, given that on the Ubiquity announcement, you said for instance R&D in a range of 9.4% of revenue and I think everybody, at least certainly us expected, given FICA renewals this quarter and Ubiquity SG&A would have come in a slightly higher than you posted as well?

Mike Thurk

I'll take the second one first and circle back. On the R&D item, we have across the board throughout the quarter targeted very, very aggressive cost actions. And particularly the cost actions that we have gone after have been ones that have been not related to sales or revenue generation or in fact even R&D deliveries. We have gone after a lot of associated cost that would be considered for example, indirect spending a lot of good cost management and a lot of lines that are unrelated to specific headcount. And frankly, we are very pleased with where we ended up at the end of the quarter on our spend. As you saw however as we go forward into the next couple of quarters, we expect the full allocation of Ubiquity to come online and to get back into roughly the range that we discussed.

With that said, we will continue to go after all cost opportunities that we can find in Q3 and of course in Q4, these are not one quarter actions. We look for efficiencies where we can find them. If we went back to the prior question, maybe on the revenue from last year, we have very, very different issues occurring between the two years. One was the issue of actually not having a supply in one quarter and the other, which was last year, we did not have the equipment to actually ship. And it's hard to assess as we said in that call, try to assess the exact nature of what the business would do after that quarter. This quarter we had a different issues, which was or in the last couple quarters, we had a different issue, which has been the warehousing issue. It was not a shortage of product, we had equipment in houses. It's really not apples-to-apples comparison year-over-year, in the sense of those two issues the way you described it.

Caroline Dorsa

We did mention that Asia-Pacific benefited from some of that in Q2.

Mike Thurk

Yes, and Asia-Pacific did benefit in Q2 from the warehouse issue in Q1.

Matt Booher

Next question please.

Operator

Your next question comes from Inder Singh with Prudential.

Inder Singh - Prudential

Yes. Thanks very much. I wanted to just look beyond sort of the current quarter or the next quarter Lou and just to ask you for an update and may be direction on where you are going with the software strategy? How far along you think you are? Where do you think you need to go? Whether organic growth is really the main part of that strategy or whether you see a few more acquisitions here and there, and if you could comment on your philosophy in terms of the size of the deals if there are any that you could foresee? Just may be enlighten us on where you are in the software strategy because that seems to be a key part of your future growth and profit growth as well?

Lou D'Ambrosio

Sure Inder, I'd be glad to. If you would speak with our customers and you really get into how they are valuing technology today and going forward. What's clear is that as communications becomes fully embedded into your business processes, the attribution of value to communications becomes that much stronger. As it turn out, that also plays extremely well to our strengths around software, and what we're basically doing Inder is our strategy is very clearly to go from the IP telephony stack and above. As we speak today, never say never, but we do not have intentions of going deeper down into other layers. But it's the IP telephony stack and above into the applications. Let me give you some examples.

So, if you think about it right now, you have IP telephony, on top of that you have contact center, messaging, mobility, conferencing, all as software layers. What Ubiquity did was Ubiquity in many ways provides, in this industry we would call kind of a container, to kind of hub integrate those sets of application and to accelerate the decomposition of them into a server based architecture.

As we are with customers all the time, they are deriving frankly significant value from this and as we look at our differentiated strengths versus our competitors, I think it would be a very fair assessment to say that we are much further along in software architecture of our business than are others and we are going to continue to fill that portfolio with given our open API strategy or Linux based solution with different software layers. That will be done, Inder both organically and frankly we are very open to inorganic place as well where appropriate. As evidenced by what we did with Ubiquity, which is I would describe as the platform and what we did with Traverse, and what I would describe as an application.

We are feeling actually pretty good and have a nice roadmap set out in terms of the next set of steps to continue to execute on that strategy organically, and frankly where the opportunity presents itself inorganically as well. So, last point I would bring out on that would be our [data] connect partnership. We unlike many of our competitors have over 4000 independent software vendors that are part of our community, that are writing their software to our software platform. So, the combination of having the platform, having kind of core part of the application and then having this very large eco system writing applications to it is truly at the epicenter of our strategy, an area that it will be reasonable for you to look at us to continue to invest in both our organically and inorganically.

Unfortunately I can't comment on the apatite or the size of the deals. We will certainly have that as kind of an important part of our decisions here, shareholder value and that's all I would like to comment in terms of sizing up the apatite for inorganic place.

Matt Booher

Next question please?

Operator

Your next question comes from Michael Genovese with Citigroup.

Michael Genovese - Citigroup

Great, thanks a lot. So Lou, you gave us the metrics that IP revenues grew to 68% from 56% a year ago. Your IPT systems are up 28%. But still the overall revenue growth is only about 5%. So, how far do we have to look out to see a meaningful change do you think in 5% growth rate and, to ask in other way, what is dragging on the business, for the time being?

Lou D'Ambrosio

Well the TDM, yes, it's a fair question, when you look at the split between IP and TDM that is the product composition split. So, when you have the 28%, it's the 28% growth of IP revenue year-over-year. The TDM business is declining and that is kind of both, as there were some substitutions happening as well as the decline in Germany. So, those are the areas of the decline. So, you have IP product growing at 28%, you have a slower growth in that in services and then you have the decline in TDM. And that's when you kind of add up all the maths and proportion them to the size of the business, you get to the total growth of the company.

Matt Booher

Next question please.

Operator

Your next question comes from John Marchetti with Morgan Stanley.

John Marchetti - Morgan Stanley

Hi thanks, just a quick question if I can. I'd like to follow-up on when your were talking about the applications being sort of where are you going forward and you mentioned a numbers of developers you have. As we look out, over, say the next 12, 24 months how do you stack up if this becomes a developer war as Microsoft and Nortel's alliance comes together and we see them sort of approaching the voice side more from the Desktop front?

Lou D'Ambrosio

Two of our larger partners happen to be companies who have very strong relationship on the desktop enterprise and those would Microsoft and IBM. In fact if you would look at our delivery schedule in terms of products with Microsoft its quite good, its quite aggressive and I think if you were to talk to Microsoft they would also talk very highly about the Avaya partnership and the way in which teams are working to deliver offers to the market place. So, there is significant interoperability between our solution and Microsoft solution and we are very pleased with frankly how that partnership continues to expand. And likewise we have a very strong partnership with IBM. So, as the two dominant players in the desktop arena of Microsoft and IBM continue to expand the Unified Communication, Avaya is very well positioned in the alliances it has established with both.

So for example; today from either Microsoft desktop or from IBM desktop you could click to get into the feature functionality set of the Avaya Communication Manager. So that interoperability is some thing that's very important to us and I think we plan to continue to expand partnerships with both organizations.

Matt Booher

Next question please.

Operator

Your next question comes from Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Good afternoon. Want to delve a little bit into the direct-indirect mix in the quarter. I think this is the first quarter that direct sales growth outgrew indirect in quite a while. Is that simply because you are seeing a little stronger demand trends from some of your larger customers than the smaller customers or is that something proactively that you guys have done?

Mike Thurk

I would say it's not a proactive action on our part but there has been a bit of a lumpiness in particular on the direct side due to our supply chain issues, actually if you look at it kind of over the last year or so in particular our direct sales force depends highly on that chain to be very, very effective where as the indirect, it's a little bit buffered from it.

So you get the opportunity really to, when we get this thing sorted out I would expect you would start to see the lumpiness go out of the equation.

Lou D'Ambrosio

Yeah, I just think this is larger than to that, there is no express metric to try to increase one as a greater composition versus the other. Obviously our full intention is to have both direct and indirect show strong growth rates.

Mike Thurk

Just one last point on that as well as you noticed its where the Asia-Pac region has been showing good growth for a while and that is heavily in direct for us, not exclusively but heavily. So that helps pull that number a little bit higher than that might be obvious to the naked eye.

Matt Booher

Next question please.

Operator

Your next question comes from Manny Recarey with Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Thanks. It is a follow-up on the direct sales and your focus on some of the applications. As you move forward and you are selling more and more of the applications is the direct sales going to grow in importance? How important is the indirect channel going to be? You got to do a lot more training for the indirect?

Lou D'Ambrosio

It's a combination. We have software application specialist whose role is to work, partnering cooperatively with our partners in bringing solutions to the marketplace as well as specialized application teams selling directly to end-users. There will be for sure, continued partner enabled, and in fact we have one of our partner's conferences coming up and a large part of that will be around continued education and skill building and enablement in bringing application sales to the marketplace. And in addition, we are working very closely with our distributors. We are recruiting new types of resellers as well as it moves more to an application focus. So, direct, indirect both training and expansion of the distribution channels to achieve the key strategic trust of the company of moving more and more into the communications applications business.

Matt Booher

Next question please?

Operator

You next question comes from Bill Choi with Jefferies.

Rob Goldman - Jefferies

Hi, good afternoon. This is Rob Goldman in for Bill.

Mike Thurk

Hi Rob.

Rob Goldman - Jefferies

I had a few quick questions. First of all, regarding the employee, the headcount reduction, I know you mentioned 800 additions over the last three quarters. Just to clarify, is that only 500 remaining out of the 1300. And my second would be, you also mentioned that, you are going to continue to see some softness in Germany until the new initiatives are in place? Is that more of a 2008 thing, we should expect?

Matt Booher

Could you repeat the last part of your second question, please?

Mike Thurk

We lost him. We were just trying to get the last question, sorry for the quick delay. On the reductions, yes, the 800 is a subset of the 1300 target that we discussed earlier. We have and as you might guess a focus for that reduction and working through that has been in Germany, and it was important to get our new German head, Juergen in place, so that we could get that plan exactly right. So, there is still work to do on the 1300 that was discussed on our prior calls. With respect to the softness in Germany, it's very hard to predict the future of the German market at this point. We have seen softness there and we reflected that in our comments today. But, we are going to work very hard to mitigate any future softness of course, but, the state of the German market is hard to predict of course.

Matt Booher

Next question please.

Operator

Your next question comes from Tal Liani with Merrill Lynch.

Persil Lal - Merrill Lynch

Hi. This is [Persil Lal] calling for Tal Liani. My question is on service revenue. On a year-over-year basis service revenue grew around 5%, but pretty flat over last few quarters and margin came down this quarter? What does Avaya plan to do to grow service revenues? Or what does the Avaya think they would need to monetize that business if their growth continues to be flat? And how high is the priority to work on that segment over the overall restriction plan?

Lou D'Ambrosio

Well, I mean the services is a core element to our overall business strategy. I mean it represents a large portion of revenue, a large piece of the profit, a large piece of the cash flow. So, make no mistake about it. We are intentionally focused on the services business. The way we see the services business play out is continued accelerated growth in the professional services business. Professional services business fits very closely in line with the broader strategy that we laid out on moving up the application stack. As you move up the application stack, customers are looking for trusted buyers to help sthem implement the applications as they embed it into the processes. The track record that we put on over last few quarters in terms of growth and professional services, I think is a proof point through that.

Likewise we are going to continue to work to continue to reinvent the maintenance offerings that we bring to that marketplace. And I think the stabilization that you've seen maintenance is a result of that work also. So, services overall is very high on the priority list for the company. And frankly in our segment, we are one the few companies which do offer a fully integrated solution to the customers. Customers do not have the kind of piece part to solution from different providers but at the single point of accountability in the Avaya offer.

Caroline Dorsa

And I'd just add that in terms of overall and cash flow generation as Lou mentioned, as I mentioned earlier we have done a lot relative to the cost management and services business and actually that segment gross margin actually improved on a year-over-year basis again because of our tight focus on expenses in running that business.

Matt Booher

Next question please.

Operator

Your next question comes from Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Hey, just a follow-up, wondered if you could quantify at all, how much the warehouse issues impacted gross margin if not exactly, at least some range?

Caroline Dorsa

No we are not quantifying the gross margin impact specifically to the warehouse issues. I pointed that out just to help you understand why we didn't see on gross margin move in a positive direction but as Mike mentioned we are working on those issues going forward but no specific quantification I think is needed relative to letting the gross margin sort of speak for themselves where they are right now.

Operator

At this time there are no further questions.

Lou D'Ambrosio

I would like to thank everyone for joining our fiscal second quarter 2007 call and we'll look forward to updating you on our third quarter progress in 90 days. Thank you.

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 May 2nd, 2007. The conference ID for the replay is 1950002. 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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