Analyzing the Avaya Path Through Bankruptcy

Shortly after Avaya filed for Chapter 11 bankruptcy protection, on Jan. 19, I shared my initial thoughts with No Jitter readers about whether the move was good or bad for customers based on my experiences having lived through the process at Nortel. Since that writing, I've examined the available public documentation and spoken with the Avaya team on various occasions to enrich my understanding of the situation.

Avaya executives have clearly stated, both in published materials and public presentations, that the company will emerge from the bankruptcy process as a more vibrant, stronger competitor. In fact, for the latest word on this from Avaya, see today's companion post, "Avaya: Turning the Page on Chapter 11," from John Sullivan, Avaya VP and corporate treasurer. But I can see other potential options and outcomes, as well, and have some thoughts on which are best for key players -- Avaya itself, customers, and the industry at large.

Two Post-Bankruptcy Scenarios

Avaya's bankruptcy process has two potential outcomes. In the first, a go-forward plan that keeps the core UC and contact center elements together is accepted by Avaya's bond creditors. In this case, the bankruptcy would move rapidly to a conclusion in the courts, and Avaya would emerge relatively quickly from the process.

This is the outcome the Avaya management team envisions, and executives have indicated they intend to have a plan that protects the core assets in place by the end of March.

However, if the bond creditors cannot come to an agreement on this plan, they may conclude that they would be better served selling the assets and breaking Avaya into pieces. This second outcome is similar to what happened during the Nortel bankruptcy.

Why might this happen? For example, reasonable data shows the contact center business had been valued at more than $3.7 billion in the sale discussions prior to the bankruptcy. In fact, an EBITDA analysis of the total Avaya business shows that the business assets are worth somewhere between $6 billion and $7 billion based on projected EBITDA and assumed multiples. From this total, subtract $1.5 billion for unfunded pension liabilities, and the core continuation plan would need to return between $4.5 billion and $5.5 billion of value -- a combination of debt, cash, or equity -- to provide bondholders a necessary level of comfort. The bondholders will contrast an offer that is a mix of cash and equity against an all-cash break-up option.

Avaya: the Unfolding Story

For No Jitter's ongoing coverage of the Avaya situation pre- and post-bankruptcy, read:

- Avaya: Turning the Page on Chapter 11, by John Sullivan, Avaya VP and corporate treasurer

- Avaya Customers: Calling in Backup, by Eric Krapf, No Jitter publisher

- Avaya Users: Time to Build Your Contingency Plans, by Steve Leaden, independent communications consultant

- Avaya Bankruptcy: Good or Bad for Customers?, by Phil Edholm, independent consultant

- Avaya Ends Speculation, Files for Bankruptcy Protection, by Beth Schultz, No Jitter editor

- Genesys, Avaya Rumor Provokes Conversation, by Sheila McGee-Smith, communications industry analyst

- Avaya Angst Must Come to an End, by Beth Schultz, No Jitter editor

- Avaya Considers Asset Sale, by Dave Michels, communications analyst

Three Decision Points

Assuming Avaya can hold the bankruptcy impact to the bondholders and not have it extend to pension and other liabilities, three key decisions would seem to come into play in putting together a plan that keeps Avaya intact with its core UC and CC assets:

1. Post-Bankruptcy Debt Level -- how much debt will be left and at what interest rate/payment level? Avaya's pre-filing annual interest expense for 2016 was about $470 million on debt of around $6 billion, indicating an effective average rate of about 7%. Assuming Avaya negotiates an 8% rate (this is actually much lower than the current actual rate as the market, due to financial risk, discounted the Avaya bonds by 30% to 60% before the filing), then a remaining debt load of $2 billion is an expense of $160 million. Based on both the 6% to 8% revenue decline and the coming pressure on both margin and EBITDA of cloud, competition, and the challenges of the filing, I would think management would push back very hard on anything above $200 million of annual debt servicing expense on the company emerging from bankruptcy. The pension funding will probably require $50 million to $100 million of annual funding as well.

If the debt payments go to $200 million per year, then the bankruptcy is really only reducing cash burn by $270 million. The value of this reduction may be limited, especially if the bankruptcy results in a 10% reduction in ongoing revenue, margin, and EBITDA. If the bankruptcy impacts 10% of the current $940 million in EBITDA, the result is only $176 million of increased annual cash ($270 million minus $94 million). With revenues continuing to drop, this headroom will only last so long.

The key to ongoing success is not saddling the company with too much debt. Negotiating with the creditors to minimize the cash/debt they receive versus equity to minimize the debt will be critical. Avaya needs the headroom to invest and build out its new Equinox user experience and Oceana customer experience platforms for growth (see today's post, "Avaya: Positioning its Portfolio for the Future).

2. Allocation of Proceeds Among Creditors -- how is the remaining equity and the debt obligations (or cash if new debt instruments are to be sold) split between the senior (secured) and junior (unsecured) debt holders? This may be the tough question. Clearly, the junior bondholders would like an equal/proportional distribution. Meantime, the seniors would like 100% of their distributions first, which may leave little or nothing for the juniors.

The reality is that the bondholders must agree to a partitioning based on percentage of debt/equity/cash and a factoring formula that gives precedence to the senior secured debt holders but gives the juniors some level of return. A protracted fight over this could take a long time. On the other hand, the creditors know that Avaya is a decreasing asset in bankruptcy, so hopefully they'll buckle down and reach agreement. The trading market in Avaya bonds continues trending upward as bondholders jockey on this topic.

3. Ongoing Management Oversight -- will a new management firm enter the fray or will Silver Lake and/or TPG Capital continue on in that capacity? Based on comments from Avaya executives, part of the plan is to have the existing bondholders take an equity position in the company. The reality is that the debt holders are banks and investment houses that are not well structured to manage businesses and generally look to have a private equity firm involved for the day-to-day management oversight. I expect that a private equity firm will join as the post-bankruptcy adult supervision. I do not believe the creditors will accept the current players in that role. In all probability the plan will include active participation of a new private equity firm.

Assuming Avaya and its bankruptcy advisors can find the right new private equity partner and get the creditors to agree, then Avaya should be able to move through the bankruptcy process intact. If the value offered to the creditors is not sufficient or the creditors cannot come to an agreement on allocation, then the entire process may move to an asset sale. If the company and courts move to a sale, the question then becomes one of how the assets will be structured in a sale.

Continue to next page for a look at potential strategic refinements