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

Avaya Inc. (NYSE:AV)

Q1 Fiscal 2006 Earnings Conference Call

January 23rd 2006, 5:00 PM.

Executives:

Matthew Booher, Vice President, Investor Relations

Donald K. Peterson, Chairman and CEO

Garry K. McGuire, Chief Financial Officer and SVP of Corporate Development

Analysts:

Ehud Gelblum, JP Morgan

Tal Liani, Merrill Lynch

Christin Armacost, SG Cowen

Inder Singh, Prudential Securities

Troy Jensen, Piper Jaffray

John Marchetti, Morgan Stanley

Alex Anderson, Citigroup

Samuel Wilson, JMP Securities

Tim Long, Banc of America

Jiong Shao, Lehman Brothers

Tavis McCourt, Morgan Keegan.

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 speaker’s remarks there will be a question and answer session. If you would like to ask a question during this time simply press “*” then the number “1” on your telephone keypad, and questions will be taken in the order they are received. Please limit your questions to two per time. If you would like to withdraw your question, please press “*” then the number “2”. Thank you. I will now turn the call over to Mr. Matt Booher, Vice President of Investor Relations. Sir you may begin.

Matthew Booher, Vice President of Investor Relations

Thank you and welcome everyone to Avaya’s Fiscal First Quarter 2006 Earnings Conference Call. I am joined on the call today by Don Peterson, our Chairman and CEO; and Garry McGuire, our Chief Financial Officer and SVP of Corporate Development. This call is open to the media and its being webcast live with the replay available via the phone and the web. Our earnings release is on First Call and PRNewswire. Its also available on our website at www.avaya.com/investors along with slides that summarize our results. Our focus today will be on continuing operations as reported on a US GAAP basis. We will also be highlighting some significant items that are included in our GAAP results. Financial results and 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 actual outcomes and results to differ materially. Additional information regarding these risks and uncertainties may be found in our filings with the Securities and Exchange Commission and in particular our fiscal 2005 Form 10-K 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 am pleased to introduce Don Peterson.

Donald K. Peterson, Chairman and CEO

Thanks Matt, and good afternoon to everyone. I would like to start by discussing key takeaways from the quarter, both in terms of strength and challenges, and then move on to highlight initiatives and development from the last quarter, which we believe strengthened our competitive advantages and show the value of our strategy. In terms of key takeaways, first sales of products in the US, our largest market rose 5% compared to the first quarter of ’05, our first increase in 5 quarters on a year-on-year basis. It was driven by higher sales through both our direct sales force and indirect channels with direct sales increasing at a relatively higher growth rate than indirect.

During the quarter we shipped our 8 million IP line. Worldwide IP telephony lines rose 16%, and in the US IP telephony lines rose by 21%. Also services revenue in the US and in particular US maintenance revenue was flat sequentially and has been fairly steady for the past 4 quarters. As we have discussed the maintenance business has been a major area of focus for us in terms of stemming the erosion of the base and migrating to higher value-added IP services. In terms of revenue growth outside the US obviously currency had a negative impact on our growth rate here and it continues to be a concern. In EMEA the fourth quarter contribution from Tenovis had a positive impact, and we see that reflected in higher level of sales in Germany.

Revenue in the UK was down year-over-year but increased by double-digits in EMEA excluding both Germany and the UK. Rental and managed services revenue continues to be a challenge for us. It declines sequentially by 5% mostly in Europe and also in the US. One of our goals in the year is to stem the erosion in our rental base and migrate customers to our managed services offerings, and we are continuing to focus intensely on that. Another challenge we face is that we continue to operate in the competitive pricing environment, particularly in the US.

We will continue to focus on communicating the value of our offerings externally on insuring appropriate pricing discipline internally and on managing cost effectively to keep our margins on plan. Also we continue to look for ways to reduce costs to offset the decline in pricing in our industry. Our relationships with Celestica, our principal contract manufacturer has over the past several years been beneficial in that regard. That being said during the quarter, Celestica moved production of our products to plants in Mexico. This created some challenges during the quarter from a supply standpoint.

We are continuing to work with Celestica to manage this issue and to make sure that we minimize any impact going forward. Finally as we have previously outlined for you one of our challenges for 2006 is mitigating the impact of the higher level of cost and expenses we will incur this year due to FAS 123R as well as higher R&D, higher employee incentive compensation, and higher employee benefit expenses. We took a number of steps in 2005 to improve our costs in the band expense structure, and there were some additional actions that we said we will taking this year in Europe.

I would like to now move on to discuss other developments and initiatives during the quarter to strengthen our market position and competitive advantages. Let me begin by noting during the quarter several independent research firms released their latest market share report and I am very pleased to say they reconfirmed our leadership role in the enterprise market. According to Infotech, we regained the No.1 spot in US IP and US enterprise telephony based on line shipments. According to DellOro, we maintained our top position in worldwide enterprise telephony market, both IP and traditional telephony based on revenues. According to Synergy Research we are the worldwide leader in enterprise IP telephony based on revenues and port shipments. In addition, Synergy also reported that we increased our market share and rose to No.2 in EMEA enterprise IP telephony measured by ports shipped and revenues.

As we have discussed one of competitive advantages underlying our leadership position is the breadth and strength of our solutions portfolio. This was recently confirmed in a competitive review published in Business Communications Review and Miercom, an independent consulting firm of large-scale IP deployments. Avaya won the competition for the second consecutive year earning the highest score ever recorded in the seven years the test has been conducted. We were awarded special recognition for our leading edge mobility and WiFi support, advance voice process and capabilities, security features and system performance. We also received a perfect score for our endpoints, IP Hard Phones, our new all SIP softphone, wireless BlackBerry support, WiFi GSM dual mode support, off-system extension to cell and home phones, and enhanced desktop video support.

During the quarter we also took steps to further broaden and enhance our applications leadership. With Polycom, a strategic alliance partner, we introduced new capabilities that delivered integrated IP telephony with desktop, conference room and multipoint video conferencing. We also launched the new solution the embeds VPN remote capability then to our family of IP telephony telephones to enable customers to more easily and securely extend headquarters quality communications to employees working from any home/office temporary worksite or emergency location. Our clear vision and roadmap to the future of enterprise communications, a world of intelligent communications in which communication applications are embedded with business applications to drive business value is also a competitive advantage for us in the marketplace.

As part of our drive to be a leader in fixed mobile convergence, we partnered with Symbol Technologies to introduce a mobility solution that embeds our communication software and applications with Symbol’s advanced data capture mobile computing platforms and wireless infrastructure. I would like to close by offering some perspectives on where we stand as we move through 2006.

We have a few key areas of focus this year, continuing our product sales growth, and maintaining and then growing our services revenue base, and we also need to mitigate the impact of the higher costs and expenses we are incurring. I think the strengths we enjoy in terms of our vision and roadmap for intelligent communications, our global size and scale, our technology and applications leadership, the scope and breadth of our solutions and services portfolio, all position us well to benefit as enterprises around the world continue their evolution to IP telephony. As we move through the year, we hope to buildup Q1. Our focus remains on executing our plan, leveraging our strengths and maintaining financial disciplines to generate profitable growth in operating cash flow. And now let me turn the call over to Garry for more detailed view of our operations and financial performance.

Garry K. McGuire, Chief Financial Officer and SVP of Corporate Development

Thanks Don, and thank you all for joining our call this afternoon. I would like to start off today by providing you with an overview of our revenue performance in the quarter, both by type of revenue and by geography, and I will take you through the rest of the income statement, discuss our business segment performance and review our balance sheet and cash flow.

I would like to remind you that we have adopted FAS 123R beginning with this quarter, but had not restated our prior period financial results. I know there is a difference of opinion in the investment community and how FAS 123R expenses should be looked at, but I would ask of all analysts to follow our company, include stock compensation expense and their officially submitted estimates. Also unless I indicate otherwise, all other comparisons I will be giving would by on a year-over-year basis.

So to begin, revenues were $1.249 billion, an increase of 8.8%. Sales of products increased 6.7%; services revenue rose by 5%, and rental and managed services revenue increased by 34%. On a constant currency basis, the revenue growth was 10.8%. For comparison purposes, we had only a partial quarter contribution in Q1 of ’05 from our Tenovis acquisition because the transaction closed in the middle of the quarter. If we factor in revenue from the Tenovis pre-acquisition stub period last year, revenue growth was flat and in a constant currency basis was up 1.6%. As you know Q1 is seasonally our weakest quarter, and we typically expect a revenue decline on a sequential basis. In Q4 to Q1, revenue decline this year was 3.6%, and at constant currencies was 3.1%.

I would now like to provide some perspective on our geographic revenue performance. In the US, sales of products increased by 5%, offsetting a decline in traditional services and managed service revenue. Overall US revenues were flat, to extract sales of large communication systems and indirect sales of small communication system rose in the double-digits. Sales out by our channel partners increased for the fifth consecutive quarter on a year-over-year basis. Sales out of large communications rose in the double-digits and sales out of small communication systems rose in the high single-digits. Inventories in the channels were consistent with the levels that they have been running at in recent quarters.

Services revenue declined by about 1%, due primarily to lower maintenance revenues. Rental and managed services revenues declined by 20%. As we have discussed with you in the first half of last year, there were several large managed services contracts that were renegotiated, which lowered the revenue run rate. On a sequential basis, rental and managed services revenues declined by 2%. Sales of products were 8% lower, which was a significant improvement over the Q4 to Q1 sequential decline last year. Services revenues in US decline by about 1%. Overall US revenues declined by 4.4% on a sequential basis, this compares to a 10.7% sequential decline in the Q4 to Q1 periods of a year ago.

Turning now to our international markets. Revenues outside the US were 515 million or 41% of total revenues compared to 414 million or 36% of total revenues in the year ago quarter. In EMEA, revenues were 364 million, 31% increase; on a constant currency basis it would have been 40% increase. If we factor in revenues from the Tenovis pre-acquisition stub period last year, EMEA revenues declined by 4.7% and on a constant currency basis increased by 2.4%. During the quarter we saw increased revenues in Germany, a decline in the UK and a double-digit increase in the rest of EMEA. Looking at sales in EMEA by type of revenue, sales of products rose 11%; services revenues increased 29% and managed services revenue were up 80%. After adding in the Tenovis pre-acquisition stub period, revenues in Q1 ’05 sales of products rose 2%, and services revenues were essentially flat. Rental and managed services decreased about 14%, with about half of this decline due to currency and the other half to erosion of our rental base in Europe.

On a sequential basis revenues in EMEA declined by 4%, and on a constant currency basis fell by 2%. Sales of products declined by 5% and rental and managed services declined by 7%, with FX being the single biggest reason for the single biggest reason for the sequential decline. Services revenues increased by 4% sequentially. In the Asia-Pac region, revenues were 87 million, an increase of 18% and at constant currencies the growth rate was 19%.

During the quarter we saw increased revenues in India, Greater China and Japan. Looking at Asia-Pac by type of revenue, product sales, which account for most of our revenues in the region rose 15%, and services revenue, which are relatively small had a double-digit increase. On a sequential basis, Asia-Pac revenues declined by 3%, and at constant currencies, the sequential decline was 1%. Product sales fell 2%.

Our Americas non-US region, which includes Canada, Latin America and South America had revenues of 64 million in the quarter, a 3% increase. A decline in sales of products in the region was more than offset by increased services revenue. On a constant currency basis, revenues in the region declined by 4%. And on a sequential basis, revenues in the Americas non-US region rose 7%. This positive impact from currency on the sequential growth rate was 2%, and sales of products declined and services revenue increased sequentially. So that provides you with an overview of our revenues in the quarter, both by type of revenue and by geography.

I would now like to move on and take you through the rest of the income statement. Let me start by reminding you that we are incurring higher cost and expenses this year from several items. This include $80 million or $20 million per quarter in additional employee incentive expenses as a result of the lower payment for fiscal ’05. This flows through the income statement about 45% of COGS, 27% of R&D, and 28% to SG&A. It is also 16 million per year or 4 million this quarter in the stock compensation expense, and 63 million for the year or roughly 15 million for the quarter in higher employee benefit expenses. This flow through the income statement about one-half to COGS, a third to SG&A, and the remainder to R&D.

We have discussed with you items and actions we have taken that will help to offset our higher cost and expense structure. These include the cost reductions in our services businesses, restructuring activities in Europe and SG&A expense reductions, all of which we took in fiscal year ’05 and are flowing through in 2006, for our additional actions we have planned in Europe it could have an impact in the second half of this year. We have also spoken to you about the benefit we expected to receive relative to a change in our US vacation policy; we made a change primarily to eliminate quarterly fluctuations in our vacation liability accrual. The change paid off largely as expected.

During the first quarter vacation liability was reduced by a total of 21 million pre-tax. Over the course of 2005 we received the benefit from our reduction of vacation liability totaling $8 million that were spread out over the year. The net benefit on an annual basis is $13 million. For your reference the impact of the 21 million pre-tax benefit close through the income statement about one-half to COGS, a third to SG&A and the remainder to R&D. And on a secondhand basis, slightly more than half of the benefits is in the GCS segment.

With those points in mind, I would now like to discuss gross margin. Gross margin for the quarter was 47.2% compared with 47.3% a year ago. Gross margins and sales of products decline while that increased on services and rental and managed services revenues. As mentioned the vacations policy change had a positive one-time impact on gross margins. If we look at gross margin by type of revenue, gross margin on sales of products declined from 55.8 to 53.1%. The major factor behind the decline was the fourth quarter impact of Tenovis from the pre-acquisition stub period. Relatively high percentage of Tenovis’ costs are fixed and spread evenly throughout the quarter, while their product sales appeared mainly toward the back half of the quarter. As a result, with the acquisition closing in mid-quarter last year, we received a majority of our revenue, but only part of that cost in Q1 of ’05, while in Q1 of ’06 we have the full impact of both.

While the fourth quarter impact of Tenovis had a negative impact on product gross margins, it did a positive impact on rental and managed services gross margin, which increased from 55.6% to 60.5%. Gross margin also increased on services revenues from 35.4 to 35.9%. The cost reductions we have taken over the past year contributed to the increase. As we expected total gross margin declined on the sequential basis, the decline was 0.3 percentage points. Gross margin on sales of product was down by 0.3% compared to Q4 of ’05 due primarily to lower volume. Services gross margin increased sequentially by 1 percentage point, the third consecutive sequential increase. This reflects the vacation policy benefit and the full flow through a cost reduction taken in Q4.

Final, in managed services gross margin decreased sequentially to 60.5%, as you’d recall we’ve thought that the Q4 gross margin level was above what we would see in fiscal year ’06, and we expect a gross margin for this type of revenue to be between the Q3 and Q4 level, which is where it came in.

Turning now to operating expenses, beginning with R&D. R&D expense was flat in dollar terms and the 7.8% of revenue was lower as a percentage of revenue, kind of what it was in Q1 of ’05. This is partly due to the benefit resulting from the vacation policy change excluding its impact R&D would have been 8.1%. This would put us above the level we were at in Q4. As you know we expect an increase in R&D spending in 2006, some of the traditional expenses related to the Nimcat acquisition, and is already reflected in the R&D line item, and some has also did a higher employee incentive compensation expenses this year. In Q1 we did not increase our staffing as quickly as we originally planned to, but it’s still our intent to ramp R&D spending as a percentage of revenue as we move through the year.

Moving on now to SG&A. SG&A expense increased by 28 million and was 30.8% of revenue compared to 31.1% of revenue in the year ago quarter. The year-over-year change reflects several factors. We incurred higher expenses because of the full quarter impact of Tenovis, the stock compensation expense, employee incentive plan expense and the increased employee benefit expense. These items were offset by the 5 million for quarter SG&A expense reduction that we made in Q4 and I’ve told you about, and by the one-time vacation benefit.

Lets now look at operating income. Operating income for the quarter was 107 million, as mentioned this includes the 21 million benefits from the vacation policy change as well as the 4 million stock compensation expense. In the year ago period, Avaya was 88 million, we recall also that last year’s results were affected by 10 million in IP R&D and Tenovis integration costs. Other income in Q1 of ’06 was 5 million versus an expense of 38 million in Q1 of ’05, which reflected a 41 million loss related to the extinguishment of our senior notes. Interest expense in Q1 of ’06 was 1 million versus 10 million in Q1 of ’05.

Our focus next on tax expense. As you know with reversal of our portion of the evaluation allowance, on our US deferred tax asset we have started to reflect a provision for US federal income tax expense on our income statement. This is a non-cash provision. We have about 1 billion in US federal NOLs, which don’t begin expiring until 2021, and that can be used to offset future US federal taxable income. As a result we do not expect to pay US federal income taxes until the NOLs have been fully utilized. In Q1 of ’06 tax expense was $40 million and our effective tax rate was 36.4%. This is inline with our expectation of a tax rate within the range of 36 to 38% for the year. In Q1 of ’05 we had no US federal income tax provision and our tax provision was 7 million.

Net income for the quarter of 2006 was 71 million or $0.15 per share based on 478 million diluted shares. This included the vacation policy benefit, which had a positive after-tax impact of $0.03 per share. In the year ago period, GAAP net income was 31 million or $0.07 per share based on 492 million diluted shares. This included 10 million in IP R&D and integration cost and the 41 million loss from the extinguishment of the senior notes, which combined had a negative impact of $0.10 per share at last year’s lower tax rate.

So that gives you an overview of our income statement, I would now like to focus in on and briefly review our segment results. Starting with global communication systems, which consists of sales of large communication systems, small communication systems and applications. GCS revenues rose 11.7% compared to the year ago period. Sales of large communication systems grew in the double-digits in the US, EMEA and A-Pac, and sales of small communication systems also increased with double-digit growth in both the US and EMEA.

Application sales reflect with an increase in EMEA offsetting a decline in the US. Contact center application sales rose while messaging application sales declined, partly due to anticipate the grow-up of a new module in messaging release. Gross margin for the segment declined slightly compared to Q1 of ’05 and operating expenses as a percentage of revenue decreased. GCS segment operating income rose from 25 million to 43 million. So to summarize our GCS segment results we had product sales growth in the US, EMEA and Asia-Pac and an improvement in NOI.

Moving now to our Avaya global services segment, which consists of maintenance services, implementation and immigration services, and managed services. AGS grows 6% year-over-year due to the full quarter impact of Tenovis. Maintenance revenues rose by 2% with a 1% decline in the US, and then 11% in EMEA. Implementation revenues grew by 19% and managed services rose 8%.

Looking at AGS revenues on a sequential basis, revenue were flat compared to Q4 of ’05. Maintenance revenues were up 3% sequentially, with a 1% increase in US and a 2% increase in EMEA. Implementation revenues were down sequentially by 2% following the Q4 quarter, which was seasonally strong for product sales. Managed services decreased by 2 million or 2% sequentially. Gross margin for the AGS segment improved year-over-year and was flat sequentially. Operating expenses as a percent of revenue increased compared to the year ago period and declined on a sequential basis. Avaya for the segment improved by 4 million compared to Q1 of last year, and on a sequential basis, Avaya increased by 14 million.

So the summarized performance of our AGS segments, maintenance revenues up year-over-year with sequential increases in US and EMEA. Avaya improved on a sequential basis for the third quarter in a row. Cash flow from operations was 106 million versus use of cash of 36 million a year ago. Given excluding the fact that we have lower incentive compensation payments this quarter compared to Q1 of ’05. Operating cash flow for the quarter would have been positive.

Turning now to our balance sheet, which remains strong and keeps us well positioned to invest in our business and meet our cash needs. Cash on the balance sheet at quarter end stood at 726 million versus 750 million at the end of Q4, and that was 30 million. CapEx and capitalized software costs totaled 44 million. Depreciation and amortization was 68 million and both are inline with our expectations. DSOs for the quarter were 58 days compared with 60 in Q4, and inventory turnover was 9.3 versus 9.4 in Q4.

During the quarter we repurchased 7.9 million shares for an aggregate purchase price of 90 million or $11.32 per share. Since the inception of our buyback program during the later part of the 2005 second quarter we have reduced shares outstanding on a diluted basis by 3%, repurchased in a total of 19.5 million shares for an aggregate purchase price of 197 million at an average price of $10.11. So that covers our balance sheet, and I would like to close by briefly summarizing the quarter and our key areas of focus as we move through fiscal year ’06.

First, we were pleased to see the resumption in year-over-year product growth in the US and obviously we will be focused on sustaining this in the US and in our other major regions during 2006. We are also cautiously optimistic about what we are seeing in our maintenance business in the US, with revenues roughly flat over the past 4 quarters on a sequential basis. Q2 will be an important win for us as we have a large number of contract renewals this quarter. Its important that we maintain stability in our maintenance base, and that we migrate customers to our higher value-added IP offerings.

Financial and managed services continue to be a concern for us and we are focusing hard on that. We need to improve the closure rate of our managed services business in the US, and in Europe we need to address the erosion of our rental base revenues by migrating customers to managed services. Another key priority is maintaining a significant level of operating cash flow over the rest of the year. In Q1 we had a sizable negative impact from CapEx. Based on today’s spot rates we would expect to have additional head wins on a year-over-year comparables. We have also told you that we need to offset the need the impact of higher employee compensation and spending this year.

As always we will continue to manage our costs and expense structure. We are planning additional actions in Europe which we’ve discussed with you in December and which we’ll flow through mostly in the second half of the year. So to summarize some progress as well developments in OI, particularly product sales growth and stability and maintenance revenues. We have a lot more work to do in these areas as well as in managing our costs and expenses. We look forward to updating you on our progress during our next quarterly conference call, and thanks and for now Don and I would be happy to you’re your questions.

Question-and-Answer Session

Operator

At this time I would like to remind everyone if you would like to ask a question please press star “*”then the number “1” on your telephone keypad. Once again please limit your questions to two per turn. Your first question comes from the line Ehud Gelblum with JP Morgan.

Q - Ehud Gelblum

Hi thank you very much. Can you hear me?

A – Donald Peterson

Yeah, great.

Q - Ehud Gelblum

Couple of quick questions I wanted to just go over quickly. First of all, Europe, you said that the UK seems to be down, some in terms seem to be a little better, could you give a little update on how seriously the situation would be in the UK, didn’t get much seasonal and what kind of rebound some and how stable is it in the EMEA’s and do you feel more than sort of trend from managed services that you were talking about in the conversions of those of the product, give us a sense as to your comfort level with revenue out of those two region?

A – Garry McGuire

I will take it first then and I will let Don jump in as well. I think we still have the concerns around the rental and managed services in Germany, I think that will be an ongoing concern for next several quarters. You know what we are faced with there is the fact that you have got renewals on contracts that were 5, 7 or 10 year contracts and the pricing has come down substantially in that 5, 7 or 10 years. So that will be a continue issue for us for several quarters, and we will put pressure on Germany relative to you know the UK, I think some of that was a little bit seasonal, we would expect to see an up-tick in the UK in the second quarter.

A – Donald Peterson

Yeah, I would echo that, I think there is nothing that would point you to a trend in the UK that was at all negative, I am optimistic about the business, I do think there is a particular trend underlying the conversion of the rental base in Germany that we are going to have to deal with around pricing similarly as we are dealing with it in the US.

Q - Ehud Gelblum

You’ve mentioned US the competitive pricing environment, is that worse than it was before and how is that impact your gross margin trajectory you kind of look for it throughout the year?

A – Garry McGuire

We have mentioned consistently I think that we find the environment challenging and we respond to that in two ways, managing costs and then trying to sell higher value solutions. We are continuing to do that, I would say that there is a little bit more conversation about that right now then there has been in the past but I wouldn’t want to overstate that and say that it is a different trend, we are trying to push ourselves forward, you know coming out of last year, I think the eagerness for that it is highlighting the challenges that it portrays but I wouldn’t characterize that as substantially different than it has been, just needs attention and the things we have been doing I believe will be the things that we’ll continue to do and we’ll see us be able to hold our fleet do better in terms of gross margin.

Q - Ehud Gelblum

Can you comment on the linearity on the quarter then in fact to even do that geographically; was the linearity different in Asia-Pac, US or Europe?

A – Donald Peterson

Linearity was roughly the same as it has been in prior quarters; there was no significant change. I really – off top of my head do it on a regional basis for you, you know, I mean the total company wasn’t substantially different.

Operator

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

Q - Tal Liani

Hi guys, two questions I have, one is on direct versus indirect sales. Direct sales went up 5% - sorry, went down 17% and indirect went up 5% on a sequential basis, is this normal and what’s the reason for such sharp sequential decline in direct sales? Second point I have on global IP line shipment, we see recovering US and overall the number was only up 16% year-over-year, its great, its better than other sectors but we always thought that IP line shipments should grow by at least 30% or north of 30%, any concerns that some of the growth rates we’ve seen before may not be repeated in ’06 or is this something very specific to this time? Thank you.

A – Donald Peterson

Garry, let me talk about this: direct, indirect. The direct is always down in that timeframe, you know I think we indicated that was down less than it was down prior year, and on the indirect side you know that was up 4Q to 1Q, you know which is their year-end, whereas you know is our year-end from the direct side in the September quarter. So I think you got those dynamics going on between those two.

A – Garry McGuire

Okay, in terms of you know IP line shipments the percentage is going to vary depending on the base. I think a projection that this is open forever at those rates as the rates we have seen in the times when they were relatively minor amounts of shipments would not be correct. I think the ability to absorb or to pay for new telephone lines has got a limit on it, I think its going to be faster than it has been in terms of number of lines absorbed, but that percentage number is probably not going to look like 30% over the next decade, I don’t see that happening.

Q - Tal Liani

Maybe one follow-up on that is TDM lines, can you give us an update on the year-over-year trends in TDM shipments, any volatility there or any notable trend?

A – Donald Peterson

I don’t have those in my head; Garry is basically looking at a cups of pages to see if we can find a trend or a number the share of it. I think its hard to get a trend one way or the other with this but I think one thing to say about it is that the IP versus the TDM continues to grow and you know its well north of 50% of the revenue is now, gross.

Operator

Your next question comes from the line of Christin Armacost with SG Cowen.

Q - Christin Armacost

Thank you. I wanted to ask you a question about this Tenovis and the repricing of the contracts, it sounds a lot like some of the issues you did, that was in the US last year. Can you give us a sense of how different the new pricing is relative to some of the old pricing and maybe just a broad range and last year I think it is time you talked about at one point 75% of the contracts that you needed to renew, had then completed so you know where are we in that trajectory? Thank you.

A – Garry McGuire

I think the – actually little bit apples and orange, one comment last year on the 75% was more related to the US maintenance contracts, and unrelated to how much we had in the rental but I think in the rent, lot of things is going in the rental. As the German market is historically sold at a premium over the rest of Europe going back 5 or 7 years at premium sometimes 35 or 40% over the rest of Europe. So that premium alone has shrunk from that 35 to 40% to probably no more than 10% today. And that’s the biggest piece of what we are wrestling once these things come up for renewal. The older the contract in terms of years the more we have got impact as to what we are looking at, and I think that we are still in the early stages in looking at the whole rental portfolio, we probably got another couple of years before we get through it all in having this impact. And that’s why we have been focused on trying to drive managed services because we can implement additional services to offset some of that revenue decline, and you know as of yet we haven’t had enough of an impact in doing that and that’s why we have got still a lot of work to do as we move through ’06 to try to narrow that gap.

Operator

Your next question comes from the line of Inder Singh with Prudential.

Q – Inder Singh

Yeah, thanks very much, there are a few question Don on kind of the adoption rate, I mean if you exclude the seasonality that Avaya normally sees in December, this being your first fiscal quarter, and everyone else’s fourth fiscal quarter, are you seeing anything different in the IP adoption curve that would suggest that seasonality going forward from here would be any different than what we have seen in the past? You know usually this seems to be one of your weakest quarters I think from a seasonality standpoint?

A – Donald Peterson

I don’t see it, and I recognize that in the data industry they don’t have that same pattern so I am longing for the time when we flatten out that curve ourselves, and you know, I have hoped that we’ll see software turnover in telecom industry at rates that it turns over in other areas of software, but so far this is evolving in a way that looks like traditional telephony in terms of seasonality patterns and so forth for us, anyway, rather than the secular non-seasonal trend rates that exists in other part of the data industry.

Q – Inder Singh

And just very quickly on Tenovis, the i55 base, can you give us an update on where you are in terms of your ability to be in upgrading that base?

A – Donald Peterson

While we said, you know, remember Inder at the Analyst conference that we are on timeline for early spring of being able to do that, nothings changed, you know in that regard.

Operator

Your next question comes from the line of Troy Jensen with Piper Jaffray.

Q - Troy Jensen

Hi gentlemen, I’ve got two questions for Don please. Don, at the Analyst you guys talked about introducing SIP-based standards, just curious to know if you are going to be completely open and maybe what that, the potentially due to your endpoint sales?

A – Donald Peterson

Well we certainly tend to be completely open. We intend though to have a value proposition that is greater than the SIP standard, so SIP will work and we are going to implement it the way this standard is written and we will have beyond that reasons why you would prefer our SIP phone to somebody else’s as apposed to a strategy where you would implement part of the standard and then do other things around it.

Q - Troy Jensen

Okay. And speaking about the standards, IMS is an architecture that carries that kind of adopting rate now, Garry, if you know if that standard or architecture is going to make it through the enterprise or maybe what’s the revised positioning there?

A – Donald Peterson

Oh no we have a position, we are certainly aware of IMS generally and it has a number of proponents like carriers and it has a number of people who at least in the – if you get them in private moments would be critical of it as being constrictive of the market that has evolved around in the connectivity. I am not sure I know the utility of it in the – in fact I am quite sure I don’t know yet the utility of it in the corporate environment but if there is value from it we will certainly embrace it.

Operator

Your next question comes from the line of John Marchetti with Morgan Stanley.

Q - John Marchetti

Hi thank you, couple of quick questions for you. First, I was wondering if you could give us a little more color on the actions with Celestica, would it mostly on the cost side, did it relates to products that you couldn’t ship in the quarter that you expect to get out in 2Q and what’s going on there? And then secondly you mentioned some second half expense benefits that you thought you might be able to ring out up here but I was just wondering if you get some additional color there? Thanks.

A – Don Peterman

Yeah I think on the Celestica and the move that they made to Mexico, you know anytime you make a move and create some disruption, and we you know worked through the quarter with them with some of those disruptions, its very difficult because there’s always things left with any quarter to say that there was something left because of the move. And that’s why we haven’t gone there with that discussion because we really don’t know. We know that they struggled from time-to-time, day-to-day or week-to-week during the quarter but we have no idea of really whether there was, you know, if they said anything last at the end of the quarter relative to the expense reductions in the second half, you know we indicated that those would come through additional cost initiatives in EMEA region, we are you know having discussions with counsels there and I wouldn’t want to preempt anything that we are doing there with further discussion on that now.

Operator

Our next question comes from the line of Alex Anderson with Citigroup.

Q - Alex Anderson

Quick questions. First, on the rental side of it, are you getting any residual returns back on these rental equipments and if so, is there any value if it’s being captured from that? And then second, when you talk about the service and rental fees declining, can you give us the shift and the mix there, can you give us some sense of what you think the impact is when you go from an older service contract to newer service contract in terms of margin pressure? And then the second question is, can you just give us an update on what’s going on with your partnership with Extreme? And finally if you could tell us what you think the penetration of IP telephony into the enterprise is at this point in terms of the install base?

A – Donald Peterson

Okay, we will give you four questions in the north of two here.

Q - Alex Anderson

But I didn’t get any last time, so figured it.

A – Donald Peterson

Let me tell you about the rentals and the residuals, there is very little there, and let me just give you an idea of what happens, some of this, the renewals when they get renewed, some of the equipment stays in, some new equipment goes in, other times its a total replacement. So it’s more that we do use up evaluation as we write the equipment down and not having a whole left in residual, so is that, that’s a minor impact.

A – Garry McGuire

And I would just amplify that, I would say our focus now is more on transitioning the base over rather than trying to cash the residuals, so we are not trying to sell the release for you know two more years of a depreciated asset, we would rather get them into IP mode so we have the customer for the long-term.

A – Donald Peterson

And then on margin impact of services in rental declining, you know a lot of its own is just declining, it will overtime has some impact if you are not taking cost actions from that year, and that’s one of the reasons we are trying to add some of the higher value-added managed services to offset that and also doing further cost reductions. So we definitely have an impact if we don’t do either of those other things or both of them.

Q - Alex Anderson

So this, so Donald if I understand, should we view the cost reductions in Europe in the back half is offsetting this, or an opportunity to improve margins?

A – Donald Peterson

No, I would look at it as an opportunity to offset the pressure we are going to have on those renewals.

A – Garry McGuire

In terms of the Extreme, we are now moving their product I think in most parts of the world, I’d say the relationship is going well, I think it is benefiting them and us, its not going to move our numbers a lot but it doesn't give us a holistic offer for our customers where we don’t have to bring in our major competitor necessarily to offer a full solution. So, you’d have to ask them how they feel its going in terms of the impact on number, we are very happy with it.

Q - Alex Anderson

And then the install base penetration?

A – Garry McGuire

I don’t have a precise number, I would say its probably moving into the low teens.

A – Donald Peterson

I don’t think, that won’t come out, sure it will a bit yet, probably next month or so.

A – Garry McGuire

Our overall number, the number is different for obviously base versus new shipments. I would expect in 2006, we are going to see IP firmly moving past 50% of new telephony lines, which was kind of neck in neck with TV and then ’05 I haven’t seen updated numbers but I believe that trend is going to continue, I would know of no reason why it wouldn’t.

Operator

Your next question comes from the line of Samuel Wilson with JMP.

Q – Samuel Wilson

Good afternoon gentlemen, two small questions for you. One is, I haven’t gone through the numbers yet but in aggregate how much do you think currency kind of cost you on the negative side this quarter? And secondly, can you talk a little bit about channel inventory vis-à-vis the supply disruption? Did you get a sense that your channel was trying to rebuild some inventory levels or they exited roughly where they wanted to?

A – Garry McGuire

First, the impact was about 2% of revenue on the currency on the year-over-year basis.

Q – Samuel Wilson

Got it.

A – Garry McGuire

As far as the channels, it’s hard to speak for them but I think that you know we were relatively constant of where they been running you know at the lower levels for the last three quarters. So it looks like you know I go with headed. Yes but they ended about where they wanted to in the quarter because it is similar to the two prior quarters.

Operator

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

Q – Tim Long

Thank you. Two quick ones here first, I think Don you mentioned IP well about 50% of revenues, I am assuming you were talking on the product side, can you just update us on where you think that is running on the services side? And then second if you just talk a little more detail about the small business systems, we have been hearing some very positive feedback for IP office, and given that the indirect business was up sequentially, you would have expected that to be a rev line item, the small business systems to be up sequentially in the quarter as well, with Cisco getting more aggressive in that small medium business area, could you just talk about what some of the flips and takes were there was it pricing? Do you think there is competition in that businesses, you think, give me some share here? Thanks

A – Donald Peterson

Well by the time I comment about the IP mix there were kind of two. Our product mix in terms of IP move past 50% probably 18 months ago and has continued to move up since then. The industry, the market as a whole look to be about 50-50 last year and I expect the market as a whole to continue to move up and in favor of IP telephony, I really haven’t seen updated numbers for this year but I expect that that will increase and I expect that our mix will also increase. Services revenue is more a function as you would anticipate of the install base rather than the new shipment. The installation revenue, which is part of service is relatively small compared to the overall maintenance activity, so I would guess our base is still in no more than low to mid teens being IP and that’s probably a rough number, we don’t actually calculate it but a rough number at the mix that’s coming from IP in the base.

In terms of SMBS we worked through a few different issues in 2005, including a delay in new product introduction on Release 3.0 about a year ago, and a major inventory pretty adjustment in the channels, all of things that have gotten work through, we were quite there behind us the trend for that product and the most recent quarter is very good. And you know I feel positive about how the product is being received in the marketplace, how its performing the things you are hearing I think is right, we of course added a new technology platform to our effects in that space with the acquisition of Nimcat, we are doing some intense product development around that and expect to have if you will Avaya I5 version of that in the marketplace in relatively near future. This is the market that is attractive certainly from the volume standpoint, its also a very tightly competed market, its not one that is traditionally a lot of margin. We certainly recognize Cisco is going at not only SMBS but the consumer market, we are not as focused on consumers but as we meet Cisco and the other market and the SMBS market, we think we are doing the right things, we are very respectable with some of their products there, but we think the addition of Nimcat and other work that we are going on in some cases with partners is going to position us well in that market over the later and to immediate term.

A - Matthew Booher

Operator, I think we are running over our hour but we will take two more call at this point please.

Operator

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

Q - Jiong Shao

Hi thank you very much. I had couple of questions related to your OpEx. First, I want to confirm that the one-time benefit, the $21 million pre-tax benefits from the vacation policy change, was that one-time or it should be there for the next for future quarters? And with that if we do the adjustment for the OpEx, excluding that benefit, how should that trend going forward? And the second question is on the, even with that adjustment I think you said R&D was 8.1% of the revenue. I think the next day you’ve mentioned at 9%, seems to be level you are targeting for the year, and for the quarter how shall we model that going forward?

A – Garry McGuire

Well, the 21 million on vacation policy change was really one-time, so you shouldn’t be putting anything benefit-in in the future quarters. The R&D, you know, we indicated we were targeting the 9%, we’ll see that ramp-up, you know, as a percent of revenue each of several quarters, and you know I, still targeting the 95, you know, the worse and 8.5, looks like close to the 9 by 10 when we get there.

Operator

Your final question comes from the line of Tavis McCourt with Morgan Keegan.

Q - Tavis McCourt

Thanks guys, you have mentioned that product revenue in the US were up about 5% and then in some of your commentary you said small communications systems were up double-digit as were large communication systems. What was the offset there? What grew less than 5% in the US?

A – Garry McGuire

The applications revenue was down.

Q - Tavis McCourt

Okay, and that you said was related to weakness in the messaging?

A – Garry McGuire

It was weakness in the messaging, right.

Q - Tavis McCourt

Right, and then a quick follow-up. If you start being able to upgrade Germany to the IP systems, will you continue to view that as a rental market, or you’ll attempt to make that a more traditional product sale?

A – Donald Peterson

I think we have a real focus on trying to improve the product sales growth there, and the i55 piece of the market is probably better suited to product sales then it is to traditional rental, probably fits in well with many managed service offering, but there are no broad basis, we think we are probably more focused on product sales than anything with this opportunity.

A – Garry McGuire

Having said that i think we will go with the market, lets say through this that kind of a change but I have sensed is other participants in the market are seeing it the same way and it's developing that trend generally.

Operator

That concludes the Q&A portion of today's call, I will now turn the call back over to Mr. Matt Booher for any closing remarks.

Donald K. Peterson, Chairman and CEO

Operator this is Don, I just want to say a couple of things before I closes it up. First of all on balance, we are feeling pretty good about Q1. It was the growth year-over-year occurred in important segments, we are encouraged by that, the market analysis has come out, it shows us remaining in leadership positions or even regaining readership positions continues to be positive. The competitive environment certainly is very much so, but it has been and we think it is going to afford us the opportunities that we are looking for. The evolution towards IP is moving forward, we've now shipped over 8 million lines, we had a strong quarter in that regards in terms of number of lines shipment, and we see the value in the IP telephony marketplace moving to things that we do well, connectivity beyond the PBX itself other than to mobile network and to users who are away from the office side and so forth and then the integration with applications and we think that evolution is going to emphasize our strength and give us a very competitive offering, so we look forward to reporting our future results at the end of Q2 and we all thank you for joining us tonight.

Operator

Thank you for joining today's conference call. This call will be available for replay beginning at 8:00 PM Eastern Time today to 11:59 PM Eastern Time on Monday, January 30th. The conference ID number for the replay is 3975038. The phone number to access the replay is 800-642-1687 or 706-645-9291. This concludes the conference call, you may now disconnect.

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

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

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

Source: Avaya F1Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (AV)

Check out Seeking Alpha’s new Earnings Center »

This Transcript
All Transcripts