Avaya Inc. (NYSE:AV)
F2Q06 Earnings Conference Call
April 26, 2006, 5:00 p.m. EST
Matt Booher - VP, IR
Don Peterson - Chairman, CEO
Garry McGuire - CFO, SVP, Corporate Development
Inder Singh - Prudential Financial
Troy Jensen - Piper Jaffray
Tim Long - Banc of America
Samuel Wilson - JMP Securities
Stanley Coaler - Merrill Lynch
Manuel Recarey - Kaufman Brothers
Jiong Shao - Lehman Brothers
John Marchetti - Morgan Stanley
Eric Buck - Brean Murray
Good afternoon. I would like to welcome everyone to the Avaya earnings conference call. (Operator Instructions). I will now turn the call over to Mr. Booher, Vice President of Investor Relations.
Thank you and welcome to Avaya's fiscal second quarter 2006 earnings conference call. I'm 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 is being webcast live with the replay available via the phone and the web. Our earnings release is on First Call and PR Newswire. It's also available on our web site at www.Avaya.com/investors, along with slides that summarize our results.
Our focus today will be on continuing operations as reported on a US GAAP basis. We will also be highlighting some significant items that are included in our GAAP results. Financial results in the press release and slides are unaudited.
Our remarks may contain forward-looking statements regarding the Company's outlook and the Company's expected performance. Forward-looking statements represent our judgment as to what may occur in the future and are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.
Additional information regarding these risks and uncertainties may be found in our filings with the Securities and Exchange Commission, and in particular, our fiscal 2005 Form 10-K and our first-quarter 2006 Form 10-Q, as well as in our earnings release, which we filed on Form 8-K earlier today.
Avaya disclaims any intention or obligation to update or revise any forward-looking statements, rather 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.
Thanks Matt, and good afternoon to everyone. Our overall performance this quarter was mixed. There were several areas where we had encouraging results and trends, and there were others where we were not satisfied. Some of the more positive or encouraging results included IP shipments and product sales being up. Sales of products in the US grew 14%. IP line shipments overall were up over 30%.
Gross margins improved and cash flow was strong. Operating income and EPS, excluding the restructuring charge, were up year over year. We launched new solutions and announced new partnerships that enhance our market and technology leadership.
Revenues, as reported, rose 1.3% year over year, but the constant currency rose 3.4%. The year-over-year overall FX impact was $25 million, including $28 million in EMEA. Product sales rose 9% as reported, and 11% on a constant currency basis. As part of our ongoing efforts to bring EMEA's profitability more in line with the rest of the business, there were additional cost reductions in all categories to improve that region's operational performance. This resulted in the restructuring charge.
There were also some negatives, which clearly need additional attention going forward. Product supply issues that first appeared in Q1 continued to impact us. While progress is being made here, it's not fast enough and we need to accelerate resolution. Also, we continue to see erosion in our rental base in Europe. We saw a sequential decline in our maintenance business for the first time in several quarters. So, overall, our performance in some areas improved in Q2. In others, we need to do better and are taking action to drive those improvements.
Strategically, we liked our positioning. The enterprise telephony market is large, dynamic, and global, and it's in the beginning of a significant technology transition to IP telephony. We believe this transition creates opportunities for growth. With our size, scale, technology, experience and intent portfolio of solutions and services, we are well-positioned to capture them.
Our market leadership is a case in point. According to Dell'Oro Group, we rank first in the global enterprise telephony market for products and services, measured by IP and traditional telephony revenues, finishing ahead of competitors in the fourth calendar quarter of 2005 and capturing market leadership for the full year.
According to InfoTech, we were also the leaders in US enterprise telephony for the fourth quarter of 2005, based on line shipments. According to Synergy, we ranked first in IP port shipments for the fourth quarter and for the full year.
During the second quarter, we continued to press forward to identify and capture opportunities in our markets. We grew IP line shipments across market segments and geographic regions. IP line shipments overall rose in the mid 30% range year over year, and we shipped our 9 millionth IP line. IP product revenue represents in the mid 50% range of total GCS product revenue and is now back up to its pre-Tenovis level as a percent of total revenue. We saw increases in both the large and small enterprise markets and in the US, EMEA, Asia-Pacific, and Americas territories.
Including the impact of TDM, line shipments grew in the low 20% range year over year. With the increase in line shipments, sales of products in the second quarter were up by about 9% versus Q205. The US, Asia Pacific and Americas non-US all grew in the double digits. Sales of products in the US were up 14%, while EMEA was essentially flat. At constant currency, sales of products were up 11% with all regions showing growth, including EMEA, which was up 6.5%.
So, while product sales trends were positive, we have some challenges. Product supply issues impacted sales in Q2 this year. Year-over-year comparisons are off a weak 2005 second quarter. We're continuing to focus intensely on the supply issue, and Gary will update you on it in just a few minutes.
Over the last 90 days, our global scope, innovative offerings, and services capabilities have enabled us to win a number of key customers around the world as they migrate to IP telephony. A few examples -- Ping An Insurance, China's second-largest life insurer, will implement IP telephony solutions, including our enterprise conferencing and collaboration capabilities. Avaya Global Services will provide both network assessment and project management services during the rollout.
A large banking cooperative in Europe, with more than $500 billion in assets, will implement Avaya IP Telephony in their headquarters operations. The bank will also package our IP offerings as a managed service to its member banks.
Also, in Europe, we won a large IP assignment for Santa Lucia, one of Spain's leading private insurance groups. We will help them migrate to IP and add new functionality to their call centers.
To further strengthen our competitive positioning, we brought to market several new offerings that extend our technology and applications leadership. These are our new Avaya 1X solutions, short for 'one user experience'. They provide consistent access to applications across devices and interfaces. The new 1X Quick Edition is based on software for Nimcat Networks, which we acquired last year. It is a plug-and-play, easy-to-use IP solution, delivering core functionality in a SIP-based peer-to-peer system.
We think it offers an attractive value proposition for very small businesses and branch offices. It is part of our plan to more effectively penetrate this market segment. Initial industry reviews have been very positive. It won the Best VoiceCon Award at the VoiceCon Industry Conference.
The 1x Desktop Edition is for workers who travel and rely on their laptop computers. The 1X Mobile Edition is for Nokia Series 60 Enterprise Smart Phones, enabling users to be accessible via one business number and use a single voicemail system, whether they are in the office or mobile.
Another way in which we are strengthening our competitive positioning is by driving the integration of IP communications applications with business applications, which enables to enterprises to transform and improve their business. So, at that end, we extended our strategic relationship with Microsoft with the goal of delivering a unified communication solution by extending the rich capabilities of Microsoft applications to include our voice capabilities.
We also launched new support tools for software developers to help them write Avaya-compatible software applications. Our ecosystem of software developers and partners continues to grow. The Avaya DeveloperConnection program recently added its 2,500th company.
Enhancing our presence in key geographic markets is an important part of our strategy. Under our new strategic alliance with Samsung, we will collaborate on the joint development and marketing of IP communications solutions to businesses globally. At the initial stage, Samsung will market and resell Avaya's contact center and IP telephony solutions in Korea. The alliance will also drive the co-development of technologies that will enhance our IP-based mobility and convergence solutions.
So far, I've talked mainly about the product side of our business. Our service offerings are also an important part of the value proposition we offer to customers, and I want to spend a few minutes discussing our strategy and our recent results. As you know, there are three components to our services business: maintenance, professional services, and managed services. The dynamics of each business are different, but our basic strategy for them shares some common themes.
First, the transition to IP can be complex. This creates opportunities for us to grow the business over time by offering value-added services, services to help customers through the transition and to more effectively manage their infrastructure once they have migrated.
At the same time, enterprises are more disciplined in how they currently use and purchase technology products and services. As you know, this is an industry-wide trend. Decisions that used to be made regionally are now looked at company-wide by CIOs and CFOs. Purchases and investments need to meet strict ROI criteria. Outsourcing is an increasingly viable option. This means staying out in front of the customers, communicating the value of our services offer and proactively developing offerings that enable customers to operate more efficiently.
Now, in terms of what this means for each of our services businesses, in the maintenance business, which is in the midst of a transition, our key challenge is managing and maintaining the value of our traditional base and gaining traction with our new IP offerings.
With regard to professional services, we are expanding our offerings in this space to more effectively focus on key market areas. We form several new dedicated practice centers, software and custom applications, contract center, and enterprise communications to help us achieve that.
As for managed services, over the last year, we have strengthened our offerings and capabilities in the US and EMEA and in other international markets. This business has gotten off to a slower start than we expected. But, with a few large wins in recent quarters, we are beginning to gain some traction.
In the second quarter, for example, we signed two multi-million dollar, multi-year managed services contracts. Managed services revenues overall was up sequentially, and it rose sequentially in the US for the first time in the past five quarters. We do however need to accelerate our growth, and it remains a key area of focus for us.
So, let me sum up here. As we move into the second half of our fiscal year, our major priority is getting the product supply issue resolved. We usually see higher product sales in the third and fourth quarters, and we are driving to capture this potential increased customer demand.
Another priority is to improve execution in our services business, continue to gain traction in managed services and stem the decline in our maintenance business. I want to add here that negotiations with our unions on a new contract are beginning in May. Cost and expense management remain an area of focus, and there are opportunities for further reductions.
Improving our business in Europe is also important. We have recently strengthened our management team there, appointing Carlos Medina as our new President of EMEA. Carlos reports to Dave Johnson, President of Avaya International, and he will bring added focus to our efforts to grow our business and increase our efficiency in the region.
We are generating strong cash flow and continuing to enhance value through our share repurchase program. We are continuing to move forward in our strategy to further strengthen our competitive advantages, enhance our technology and applications leadership, transform our service offerings, and capture the opportunities ahead in the global enterprise telephony market. Now, let me turn the call over to Gary for a more detailed operational and financial review.
Thanks, Tom, and good afternoon. I'm going to start by discussing two key issues during the quarter: our restructuring action and a product supply issue. Then, I will take you through the income statement to discuss the performance of our segments and update you on cash flow and our balance sheet.
Following this, I will take a step back to discuss our progress to date relative to our key performance drivers in 2006. Most of my comments will discuss our performance on a year-over-year basis. But, given the nature of our rental and managed services and our services business, which include multi-year fixed-term contracts, I think it is also helpful to provide sequential comparisons and will do so when appropriate.
As Don indicated and as we have noted before, we have been experiencing disruptions in our supply chain, significant delays in deliveries of certain products. The delays stem primarily from the fact that our principal contract manufacturer moved production of our products to its plant in Mexico. The move caused operational issues in terms of manufacturing and materials management. The manufacturing issue first became apparent in late Q1 when we began to see product capacity constraints. The materials management issue became apparent later when component parts shortages in some products began to adversely impact production volumes. So, that is the cause of the problem. Now, let me expand on how it is being addressed.
We have worked with our CM to improve the production process and materials management. We now have an on-site presence at the plant, including our own management, quality, engineering and purchasing personnel on premise. We're closely monitoring production levels. We also have a commitment by our CM to source production of certain products to its other plants in order to mitigate capacity constraints in the future.
At this point in time, after closely working with both our CM and our materials suppliers, progress is being made in resolving the product supply issues. Unit production increased in February and again in March on a sequential basis. Our main focus now is on fixing the component parts shortages in dealing with specific product capacity constraints.
In terms of the revenue impact from the product supply issue, it is difficult to quantify the amount precisely. For instance, in some cases, our business partners changed the mix of their purchases and bought different products. Also, we saw some movement in customer delivery dates on the direct side that may have been supply related. But, we estimate -- and keep in mind this is only an estimate -- that the revenue impact may be as much as $30 million to $35 million.
It is not yet clear how much of the Q2 shortage will carry over into either Q3 or Q4. There is also the possibility we may lose some if we cannot fulfill customer orders on schedule. We did lose some revenue in margin in Q2 because some of the revenue was fulfilled through the indirect versus the direct channel.
At this point, based on commitments by our CM and suppliers, it appears that most, but not all, of the material shortages will be resolved during the June quarter. It is likely, however, that there will continue to be shortages of some key products in Q3. This means that orders might still get pushed out into Q4, but we expect the overall impact to be less than it was last quarter.
In Q4, we expect that with the capacity and sourcing actions that have been taken and based on the information we have today, supply should be aligned with demand and we should have enough product to cover Q4 demand as well as any carryover from previous quarters. I want to emphasize we are very focused on resolving the delays caused by the supply issue, meeting customer needs and on recovering revenue.
Let me move on now to discuss our restructuring action. As we have discussed with you, one of our challenges this year is mitigating the impact of higher cost and expenses we are incurring. We've told you in the past about the action we had taken or would take in services' SG&A in Europe to reduce cost. In addition, we discussed an additional $18 million in Europe that is currently underway. We also said we were targeting additional actions on top of what we have already done.
Our target has been to continue to reduce costs and expenses in EMEA in order to bring their metrics more in line with the rest of the Company. The Q2 restructuring will reduce headcount in EMEA by about 130 people. All of the people will have left by June. Pre-tax, the charge totals $20 million and after-tax $13 million or $0.03 per share. The payback from this action is about 18 months. Finally, in Q3, we expect to complete an additional restructuring and will take an additional charge to cover this.
Let me now briefly overview our results. Revenues in the second quarter were 1.238 billion, up 1.3% year over year. Currency had a fairly substantial negative impact in the quarter. And at constant currencies, total revenues were up 3.4% year over year. Operating income was $53 million and included the $20 million restructuring charge. Net income was $38 million or $0.08 per share and included the $13 million after-tax impact or $0.03 per share as a result of the restructuring charge. We continue to generate strong cash flow from operations -- $169 million in Q2 of '06 versus the $96 million in Q2 of '05, an increase of $73 million.
Let me give you some additional perspective on revenues. As Don mentioned, we had solid increases in sales of products during the quarter. As reported, sales of products rose 9.2% with strong growth in the US, Asia Pacific and Americas non-US, while EMEA was flat. At constant currencies, sales of products were up 11% with growth in all regions, including EMEA, which was up 6.5%. We did however see slippage in services and rental and managed services. Rental and managed services revenues were down 12.7%. And at constant currencies were off by 7.5%. US managed services declined year over year due to the renegotiation of several large contracts last year.
As Don mentioned, we are seeing some positive impact from new contracts we have signed. Looking at the rental business, we continue to see erosion in our European rental business, which I will address in more detail in a few minutes.
Services revenue declined 2.2%, and at constant currencies was done only 1%. Sequentially, services revenue declined 2.8%. I will address all of these areas in more detail in a few minutes.
As I look at revenues by geography, the US was up 4.4% year over year. Asia-Pacific and Americas non-US both increased, as reported, and at constant currencies. EMEA was down 8% as reported. But, excluding the impact of currency, EMEA was done only 1%.
Looking at revenue by channel, our channel mix changed compared to a year ago with a higher mix of indirect revenues. Indirect was 58% versus 51% in Q2 of '05. As you know, this has a negative impact on gross margin, and we believe the supply issue contributed to the change in mix. Inventories in the channel at quarter-end were up slightly compared to the end of Q1.
So, moving on to gross margin, gross margins were 46.7%, an increase of 0.6 compared to Q2 of last year. There were several puts and takes that affected margin in the quarter. Improved service gross margin had a positive impact, reflecting the cost-cutting actions we discussed. Channel and product mix were negative as I mentioned before.
Looking at operating expenses, excluding the impact of the restructuring charge, OpEx as a percentage of revenue improved by 1 percentage point year over year, decreasing from 41.8% to 40.8% in Q2 of '06. R&D was roughly the same, and SG&A expense declined as we have begun to improve operating efficiency in EMEA. Other income during the quarter was $6 million, an increase of $6 million year over year. You will recall that last year, we substantially reduced the Tenovis debt and incurred a loss related to this. Interest expense for the quarter was $2 million, down $3 million year over year because of the reduced debt level.
I will now turn to tax expense. Our effective tax rate in Q2 of '06 was 33.3%, lower than the 36% to 38% range we have estimated for the year. We had a more favorable mix of earnings from a tax standpoint as well as some favorable non-recurring international tax benefits. As a result, our tax expense for the quarter was $19 million.
In the year-ago period, our effective tax rate was 23.4% and our tax expense was $11 million. As you will remember, last year, we did not have a US federal income tax expense. Also, please keep in mind that with $1 billion in NOLs, our US federal income tax provision this year is a non-cash expense. I want to point out that we continue to expect our effective tax rate for the year to be in the 36% to 38% range.
Now, I would like to review the performance of our business segments. Revenue at our global communications systems segment rose 5.8% year over year, and operating income increased by $44 million from a loss of $12 million to earnings of $32 million. The increase in revenues was driven by growth in both large and small communications systems, with solid growth in the US, Asia-Pacific, and Americas non-US. EMEA was down 6% but was basically flat at constant FX.
Application sales compared to Q2 of '05 were down 3% with an increase in Asia Pacific, offset by declines in EMEA and the US. GCS gross margin was down slightly compared to Q2 of '05, reflecting channel and product mix. R&D was down year over year but as we've discussed, we do expect it to increase over the remainder of the year. SG&A declined substantially year over year, reflecting our expense reductions.
Now, turning to our Avaya Global Services segment, AGS revenues were down 3.4% year over year, and operating income improved by $14 million, increasing from $27 million to $41 million. The decline in revenues was due mostly to lower global managed services revenue in the US and lower maintenance and implementation and integration services in EMEA.
US maintenance revenues were about flat year over year. The increase in OI was due to higher gross margin and lower operating expenses, both the result of actions we took last year to improve the cost expense profile of this business.
Looking at the AGS segment on a sequential basis, revenues were down 1.9% sequentially and operating income declined by $19 million. About half of the decrease in OI is due to the favorable impact that we had in Q1 from the one-time benefit in our vacation policy change. The remainder is related to volume and mix.
Global managed services revenue increased sequentially in the US and EMEA. As mentioned, we are seeing the impact of new contracts rolling on. Offsetting this increase were lower maintenance and implementation and integration revenues in EMEA.
Also, while maintenance revenues in the US had been fairly steady in recent quarters, they declined sequentially in Q2. As we have told you, we traditionally have a large number of contracts that come up for renewal during this quarter. This impacted us in terms of scope and price changes. We did, however, see a lower percentage rate of decline in the US compared to the year-ago period.
We remain focused on stabilizing this business and also on aligning maintenance costs and expenses with revenue. As I have discussed, we took a number of actions last year to reduce costs in the business, and the majority of the cost reductions we took in Q2 will also positively impact the AGS cost structure going forward.
I would also like to touch on our corporate segment and note that corporate OI reflects the $20 million charge we were taking to reduce costs and expenses in Europe. So, that covers the performance of our segments. Let's move to cash flow and the balance sheet.
Operating cash flow increased $73 million and was $169 million. For the first half, operating cash flow was up $215 million to $275 million. With a strong cash flow, our cash position increased from Q1 to a balance of $745 million.
We also continued aggressive share repurchases under our program. We repurchased $103 million or 9.5 million of our shares in Q2. Since the $500 million buyback program was authorized by our Board last year, we have repurchased a total of $300 million or 28.9 million of our shares. We have reduced our share count by 4%.
Debt at quarter-end was $29 million. Subsequent to March 30, we redeemed the 13 million of senior notes that remained outstanding. Capital expenditures and capitalized software were $47 million during the quarter, and we continue to expect that this will be about $200 million for the full year.
Depreciation and amortization was $74 million. This includes about $8 million in amortization related to stock options and restricted stock units. DSOs stood at 58 days, and inventory turns were 9 times, both consistent with Q1 levels.
So, that covers our income statement, segment performance, cash flow and balance sheet. What I would like to do now is to discuss where we are relative to our key performance drivers now that we have reached the halfway point in our fiscal year.
In terms of revenue growth, revenues in the first half 2006 are up 5% year over year with sales of products growing 8%, rental and managed services up 6%, and services revenue up 1%. Looking at it at constant currencies and also factoring in the Tenovis pre-acquisition stub period from Q1 of last year, first-half over first-half revenue growth was 2.5%. On this same basis, sales of products rose 8.3%, rental and managed services were down 9.3% and services revenue was essentially flat.
Over the second half, we are focused on continuing to generate product sales growth. Obviously, this means resolving the product supply issues I previously discussed. As Don said, we are also focused on expanding our managed services offering in EMEA and in the US, and we are just beginning to gain some positive traction here. While we are encouraged by our initial progress, we need to continue to improve our closure rate and also to efficiently manage this business.
Another priority is to continue to effectively manage the changes we are implementing to our rental business model in Europe. As you know, we gained a large rental revenue base in Europe, mostly in Germany through our Tenovis acquisition. These contracts are generally long-term from three to seven years.
As we have discussed with you, one element of our strategy for the rental business involves adopting a new rental business model in Germany. Rather than carry the rental assets on our books on new rental contracts going forward, we reached an agreement with a third-party equipment finance company in which we sell the equipment to them and thereby recognize the product revenue. In turn, the finance company provides the rental agreement to our customers.
This changes the dynamics of the business for us. Instead of recognizing rental revenue over time, we will recognize the sale of product revenue at point-of-sale. The services portion of the contract continues to be recognized over the life of the contract and is now reflected in our maintenance revenue line, not the rental and managed services revenue line.
We are beginning to implement the new rental business model and over time, we would expect, all things being equal, that we would see a change in revenue mix in EMEA, with rental revenues declining and revenues flowing into product sales and maintenance revenues.
One of our key challenges going forward remains stabilizing our maintenance business. This business is in the midst of a transition, as we move from traditional TDM services contracts to higher value-added IP services offerings. The challenge here is effectively managing and maintaining the value of our traditional base and offerings as we execute on our new offerings. Those are our priorities from a revenue standpoint.
In terms of our key performance metrics, we targeted an improvement in gross margin for the year. At the halfway point of the year, gross margin improved modestly to 46.9% from 46.7%. In terms of OpEx, we expect that SG&A as a percentage of revenue to decline in fiscal '06 compared to fiscal '05. So far, we have achieved 0.7 reduction compared to the first six months of last year when SG&A was at 32.2% of revenue.
While we have made some modest improvements in these areas, clearly, we need to do more. Cost and expense management remain a priority. We took additional action in Q2, and we will take some more in Q3 as we look to improve our operating efficiency.
So, let me conclude with some thoughts about our 2006 second half. Strategically, we like our positioning. We operate in a good market that offers solid opportunities on a global scale. Product sales in our second half are typically higher than they are in the first half. So far this year, we have seen positive trends in IP line shipments, IP product sales and product sales overall, even with the supply issue. First half sales of products in the US are up 9%. Continuing these trends, capturing the second-half opportunity and getting the supply issue resolved are top priorities.
We will also work to continue the positive traction we are beginning to gain in managed service. We will focus on improving our maintenance and rental business, and we will remain disciplined in managing costs and expenses.
Based on the information we have today, assuming no major changes in currencies from their current levels and if product supply issues are resolved as discussed, we would expect to see a higher level of revenue in the second half of 2006 on both a sequential basis compared to the 2006 first half as well as on a year-over-year basis compared to the 2005 second half.
Thanks. Now, Don and I will take your questions.
(Operator Instructions). Your first question is from Inder Singh, Prudential Financial.
Inder Singh - Prudential Financial
It sounds like from your comments that the market demand, Don, is actually quite strong. What I heard you say was that IP line shipments were up, I think 30%, strong, US product sales. You seem to be guiding for a stronger second half. Of course, nobody wants a constraint. But in a growing market, it would seem to me that a supply constraint to the extent that you can manage it, whether it is boards or modules or whatever -- and I know you didn't identify the supplier. But, I presume that your biggest EMS supplier is Celestica.
Can you talk about the steps you are taking with your supplier to try to resolve this issue and whether you feel that you will be able to really leverage the end market growth in the second half of the year as you describe it?
Let me ask Garry to be more precise about that, and then I will come back if you would like some further color. Garry?
I will reiterate what we've already said that we've put people on the ground at the CM, doing everything from watching production to quality to material supply and so forth with them. We've worked out arrangements with them, where they will second source to some of their other plants so that we don't run into the capacity constraints, particularly as we look at the second half building a little bit for us.
As I said, we are beginning to see some traction there and production levels are up. They are up in February. There are up in March. We've got commitments to see continued improvements as we move through and into Q3.
The challenge that we've got is that there are still going to be some key elements that will flow into Q4 before they are completely resolved. But, I think the market should start seeing the benefit of some of these gains in the near-term and are looking for a complete resolution by the fourth quarter. So, I think that's kind of where we are relative to what we've done with them.
I would just emphasize a couple of the points within this. One is the close working relationship we have with them. We have people on the ground with them, helping them work with their suppliers and still taking advantage of their volume capabilities in the marketplace. So, we're not trying to substantively change those relationships. We're trying to tighten up the management processes that we employ and the management processes that they employ so that all of this becomes much more predictable as it has been in the past. We know how to do this. This is an execution issue. We will, I believe, get it right over the next quarter plus.
Inder Singh - Prudential Financial
Just a quick follow-up, does this change your strategy at all for managing down the number of suppliers you've had? Does this change that direction or not?
No, I don't think it does at all. I think it just draws our attention back to the fact that having the right strategy still requires good execution on the part of everybody. We are going through this thing soup to nuts to make sure that anything that got in the way of that good execution is removed and that all the resources and capabilities that both parties have are available to assure that the future is bright. As you said in your opening, the demand in the market does look reasonably good. Certainly, long-term, we've seen this market as very attractive for a while.
Our next question comes from Troy Jensen, Piper Jaffray.
Troy Jensen - Piper Jaffray
Two quick questions. First for Garry, I think at your Analyst Day you talked about driving toward double-digit operating margins. I'm curious to know if that's a realistic target for calendar '06, or is this something we should think about in '07?
We never put a timeframe on it, particularly '06. We said that that was a long-term goal.
Troy Jensen - Piper Jaffray
All right, perfect. Then, Don, could you talk about acquisition strategy? It's been a few quarters now since Avaya has done any deals. We're wondering if there would be more focus on applications, or would you be interested in acquiring market share?
We have done both in the past. I wouldn't say there is any reason to change from a perspective that would look at the changes in the marketplace and try to do either at the right moment. As you are aware, this is a marketplace that talks incessantly to itself -- has for the whole five years we've been in the marketplace. So, we will be looking and open to acquisitions in both spaces. When the right one comes along, we will certainly move on it.
Our next question comes from Tim Long, Banc of America.
Tim Long - Banc of America
Two questions if I could. Could you just talk a little bit about the direct business? It looks like two quarters in a row, we've seen some pretty deep declines there. Have their been departures or just maybe some big deals lost? Then secondly, can you talk a little bit about gigabit on phones? What's the timing there and the impact on any potential big deals? Thank you.
I'll take the first part here. Keep in mind that as we go from fourth quarter to first quarter, we always see a sequential decline. So, I think that's what you were looking at last quarter in the direct. Then this quarter, the supply issue that we've got had more potential to impact the direct side than the indirect, because you have to ship a complete system to the end customer on the direct side. If you have part shortages, you have things that are going to be hung up from revenue recognition.
Whereas on the indirect side, you are shipping materials to the channel and then they put together the systems for delivery. So, your revenue recognition on that is shipping material. On the other, it's a complete system. So, in this quarter, we had more of an impact of direct relative to supply issue than we would expect as we work our way through the supply issue that that would come back.
Tim Long - Banc of America
Then Garry to follow-up, so is it safe to assume then that there hasn't been turnover or churn issues there that head count has been stable or as expected?
I don't think we've had any substantial increase in normal turnover.
No, I don't think we have. Not to say that this isn't a busy market for people; it is. But we have not had dramatic changes in the level of sales resources or turnover in individuals, particularly different, at least that I'm tuned into, in the Company.
On that other question you asked, gigabit on the phones, I'm aware of that as an RFP issue. I have to say speaking as the non techie that I am, that it puzzles me a bit as to why that is important. But, it is apparently important to some of our customers. We have a product plan in that area. I honestly cannot recall the dates. I'm not sure we have committed a date on it. But it's in our overall plan, and we know the market wants it and I believe will be accommodating it.
Our next question comes from Samuel Wilson, JMP Securities.
Samuel Wilson - JMP Securities
Two questions for you. If you're having supply constraints, why would channel inventories be up? It should be that sell out is much higher than sell in. Therefore, channel inventories should be being bled down as you're having a problem refilling the channel.
This is more a question for Don, but you brought this up in your prepared remarks about end market demand. I know that you are having supply issues, therefore, meeting that demand. But, it seems like based on your forward forecast and the comments you are making that demand is relatively strong for your products in the market. I just want to see if you can give a little more color on that. Thank you.
I will take the easy one first. I think the end market demand is up. In terms of total telephony, it is growing in kind of at the rate of overall jobs, not growing as fast at least in the market statistics that I see in India and China as I would actually expect; but I tested that a few times and it's growing well, just not as big as I would think. The demand for IP telephony, of course, is growing much, much faster. We reflected our results over 30% growth year over year. I think that's in line with how people are expecting this market to continue to develop.
We see the market as about 50% IP, moving steadily to 100% over the next handful of years or less. On that basis, the turnover and the base is going to be a five to 10-year process. I see IP telephony certainly filling up the total enterprise demand of about 50 million plus lines.
My own expectation is that that will grow to maybe 60 million lines a year in the next couple of years and then be more moderate in terms of growth with job expansion. The caveat there is we may see people with multiple phones -- with a soft phone as well as a desk phone and so forth. That could have a somewhat positive impact to the numbers that I have reflected.
Sam, to your other question, on an overall basis, we are not up that much. It's only a couple days. If you look at the components of what's going on within it, we've got significant decrease in the SMB, which means that they were pushing it out the door as they got it. The increase came is in the large systems side, and that is really pretty much the same kind of initiative to some extent that we've got on the direct side. You need a complete system for the end-user customer there.
Our next question comes from Stanley Kohler, Merrill Lynch.
Stanley Kohler- Merrill Lynch
I'm dialing in for Tal Liani. I just want to come back to the supply issue for a second. I believe, in some of the filings you stated that you were not going to renew the supply contract with Celestica, which ends on May 15. I'm just wondering if you can clarify that situation for us and talk about potential for adding additional sources to mitigate some of the challenges there.
Yes, I don't think we've quite said that. I think what we did is give notice according to the contract, so it didn't automatically renew. In fact, we've extended our relationship with Celestica for another year, because it wouldn't do to introduce even more instability in this situation. We will be working with them over that time to determine exactly what the relationship is beyond that. But, we have not terminated the relationship with Celestica, nor do we plan to do that. We do plan to look at other suppliers, issue an RFP and so forth and that will be available to Celestica as well as others.
Stanley Kohler- Merrill Lynch
Great. Thanks. If I can just follow-up with a product question. On the converged voice application side of the business, it seems like -- so if year over year, for the quarter and year-to-date as well, the revenue has been pretty flattish there. I was wondering if you can talk about the trends there. Thank you.
To some degree, some of that is also impacted by supply. While we may not have a shortage in the software, obviously to some of the content center and messaging, it is part of a broad overall system. And, the system delays are impacting even that piece of the business. You know, it's hard to tell how much is related to that and how much might be some dynamic that's going on in the market right now. So, as we move through the supply issues, we're keeping both potential areas under a lot of scrutiny so that we understand if there is an issue that is beyond just the supply.
The year-over-year aggregate revenues are up about $40 million. They are, as you said, flat quarter on quarter. There is underlying all that, the substitution of IP or TDM, and that is a bigger issue with Tenovis than it was before that, where we had moved into the 60% plus of new shipments already IP.
We've been drawn back because of the portfolio that they had into having to replace diminishing TDM sales before we could count the growth. But, I think year over year, that comes through. I believe that the progress we've made with the product is actually reasonably good, especially in light of the supply issue. So, I feel optimistic or positive about our ongoing market participation on the product side.
Our next question comes from Manuel Recarey, Kaufman Brothers.
Manuel Recarey - Kaufman Brothers
First, a clarification -- your best estimate for the impact from the supply issues is $30 million. That was for the quarter and not for the first half of this year?
Manuel Recarey - Kaufman Brothers
Then, looking at the product gross margin for the past four quarters, it has been about 53% or so. Looking for the second half of this fiscal year, do you expect that to start to move up as you work through these supplies issues and you have more direct sales?
As you guess, there are things that obviously can help you; the direct sales can improve it. The supply can have an impact. I think just sheer volume will also have an impact, yes.
Manuel Recarey - Kaufman Brothers
Are there anything out there that you see that could negatively affect it, such as the European regulations about the hazardous materials?
The RoHS, as we call it, I don't know what the letters stand for. But we have revised that through our manufacturers and our suppliers. I'm not aware that that should impact our cost structure at this time. It was Gary who suggested, mix has been the most important driver of changes in our gross margin and products historically, and I would expect that to continue to be the case.
Our next question comes from Jiong Shao, Lehman Brothers.
Jiong Shao - Lehman Brothers
Two questions. The first question is on your regional revenue. It looks like from the table, US and Europe saw a small decline. Asia was very strong. I was hoping you could provide some color there why some of the drivers for that.
The second question is on Tenovis or for your European business in general. You talk about some head count reductions during the quarter. Could you give us an update on how many people you have in Europe and what's left in terms of the head count reductions going forward? What is your plan for that? Thank you.
Let me just deal with the first part first. I'm a little confused by your first statement because I see growth year over year.
Jiong Shao - Lehman Brothers
Oh, sorry, I meant sequential, sorry.
I think the big piece of the sequential issue is what we talked about relative to the supply.
Jiong Shao - Lehman Brothers
No. I mean, why the Asia was strong, I was hoping to get a little bit color from you; some of the drivers for that. I think Asia was up 13%, 14% sequentially.
Yes, they were up about actually about 15% sequentially, and Asia is almost 100% indirect business. So, they would have less of an impact from a supply standpoint. In India, there are long lead times there, and they are probably less impacted. So, those two things probably had more to do with what was going on with Asia Pac compared to the rest of the business.
The AGC business, the India business, also has a March 31 year end, and we may have seen kind of a seasonality pattern, as people were trying to top up the comp plans and so forth. That's a performance thing that we see frequently here in the US as well.
Now the second part of your question had to do with I think the original Tenovis. There was about 7,100 people when we acquired it. We probably have taken out close to 700, since the time of the acquisition. We are not giving guidance as to where and how many we're taking in the future.
Our next question comes from John Marchetti, Morgan Stanley.
John Marchetti - Morgan Stanley
On the services side, you had mentioned that this was obviously a big quarter for you guys from a renewal standpoint, as you had some customers coming off the one-year guarantees. I was just wondering if we could get a little color on what sort of attach rate and how the economics of that worked out for you?
Then on the SG&A side, as we're going into the second half of the year, how should we think about your sponsorship of the World Cup and how it might affect some of your sales and marketing activities as we're looking at this relative to the revenue in the second half?
Relative to your first question on the services, our comments were not about stuff rolling off at the end of the warranty period and having anything to do with the attach rates. What we were referring to was a large number of maintenance contracts that come up for renewal in that timeframe. Because of the large numbers, a lot of the positive actions you take in other quarters doesn't have the same impact as it does in Q2.
We indicated that the rate of decline had improved this year over last year, so some of the things we're doing are beginning to get some traction but not all the way there yet.
Relative to the World Cup, we will be spending most of the variable support money in the second half. Obviously, the games occur in June and July. So, we will be working that expenditure into our results. So in terms of the direct impact of that, I would expect that will be a marginal increase in spending around marketing --
Marketing and some sales.
And some sales, both in Q3 and Q4 as the gain is spread over both.
Operator, I believe we have time for maybe one more question.
Our last question comes from Eric Buck, Brean Murray.
Eric Buck - Brean Murray
A couple of questions. When you look at the actions you took last year in the first quarter, that was changing your distribution strategy, I think the focus of that was to try to bring more of the high-end systems to the direct sales force and the SMBs to indirect. Yet, it almost looks like we've had an opposite impact on a year-over-year basis with indirect channels up fairly significantly and certainly much more than the SMB business in general. Can you address whether you think that the strategy change last year has been fruitful for you and what is your look on it going forward there?
I will let Don also comment. The model that we moved to is one that we thought at the time and I think we still believe is the right model for the long-term. I think that the results that you are seeing right now are more being impacted by the supply issue than an execution against the new model at this point.
Again, I would think that some of what we were looking for is as we put this model into play will become more evident as we work through the supply issue and take advantage of the focus that we've got in each of those areas. I don't know if Don had any other comment on that.
I would say that those comments are right. Certainly, the model is still the model that we would choose today and that we will be executing as we go forward. I think the variation that is reflected in the numbers had to do with recognizing revenue when a sale into the indirect channel and this quarter and for that matter at the end of Q1 and having delays in acceptances and some things hung up on the direct side, where we didn't get it completed because of part shortages and such. But, I wouldn't read too much directly into that. I don't see any de-commitment to the model decisions we made last year. That is exactly where we are going.
Yes, one other thing that I would point out too is that all of our indirect is done on a dollar basis, and the FX impact is the one that hits the direct line more than anything. So, you've got that FX in there as well impacting your year-over-year comparisons.
This concludes today's 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: email@example.com. Thank you!