Last week was a big one for Avaya, with three significant announcements: It closed its second-quarter fiscal 2016 with revenue at $904 million, down $54 million year over year; it has retained advisors to evaluate expressions of interest and its capital structure; and it has made changes to executive compensation.
Avaya's Q2 results, for the period ending March 31, indicate the company has positive cash flow and operating margins, but progressively declining revenues and GAAP net losses. Management has responded with a major transformation toward services and cost reductions. For example, research and development spending is declining (both in total dollars and as a percentage of revenue) to 7.7% of revenue in this past quarter. Adjusted earnings before interest, taxes, depreciation, and amortization were up slightly, at $205 million year over year. Avaya ended the quarter with $312 million in cash.
Avaya's Q2 revenue dropped 8% from last year, and 5% from the previous quarter. The company mostly attributed the shortfall to its ongoing transformation away from hardware, as well as a slowing of enterprise purchasing due to macroeconomic conditions.
While the decline in revenue is concerning, there are many indications of a healthy core business, including year-over-year revenue growth in contact center, cloud, and managed services. The company reported improvements in gross margin and operating income, and it noted growth in its emerging fabric-based networking business. The problem really lies in its debt service; the company pays about $400 million in annual interest created from its 2007 leveraged buyout.
Avaya, which is controlled by Silver Lake and TPG Capital, said it has retained Goldman Sachs to explore asset sales and CenterView Partners to evaluate its capital structure.
Avaya faces several upcoming debt maturities: $600 million becomes due in October 2017, with an additional $5.3 billion maturing in the 2018-2021 timeframe. Previously Avaya successfully refinanced its debt maturities, but that will be harder this time. In February Moody's Investors Service downgraded Avaya from B3 to Caa1, reflecting "concerns about sustainability of the capital structure." And in April Standard & Poor's Ratings Services lowered Avaya's credit rating from B- to CCC.
During last week's Q2 briefing, Avaya CEO Kevin Kennedy stated, "Goldman Sachs is helping Avaya evaluate expressions of interest that have been received relative to specific assets, as well as explore other potential strategic opportunities."
To raise the funds necessary for its debt obligations, Avaya will likely have to convert debt for equity and/or sell off assets. Separating out portions of its UC, contact center, or services businesses would be complex, as these divisions represent the heart of the company's assets and liabilities.
Some assets appear relatively simple to separate -- namely the networking division, hosting business, its collection of patents, and possibly its newly created subsidiary, Zang. Avaya fabric-based networking revenue was up 20%, but Networking is a small part of overall business, contributing $233 million in revenue in FY 2015. Avaya cited its fabric deployments now total 600, about double from a year ago.
Changes to Compensation
Possibly in anticipation of a change in control, the Avaya board approved revisions to executive compensation with a new change-in-control agreement that entitles Kennedy and other senior executives to receive bonus compensation upon qualifying termination. Additionally, the board updated executive incentive compensation to favor cash bonuses over restricted stock units.
The intent of the changes are to ensure ongoing executive dedication. These changes imply board confidence in Avaya's current leadership as well as the increased likelihood of a change of control and/or capital restructuring.
Naturally, executives aren't the only personnel who might be by concerned about declining revenues and looming maturities. As Synergy Research reported in its 2015 worldwide UC collaboration study, Avaya lost share to competitors last year.
It's possible that the company's recent performance is already impacting employees, partners, prospects, and customers. Revenue declines have ramifications on headcount, marketing, and research efforts. While Avaya is making significant progress toward becoming a software and services company, its multiple competitors are also making aggressive investments in cloud-delivered services and acquisitions.
Dave Michels is a contributing editor and analyst at TalkingPointz.
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