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Is the RingCentral Deal Good for Avaya, Financially?
As I noted in the first piece in this three-part series, Avaya’s strategic partnership with RingCentral, announced two months ago, was a savvy strategic move considering the challenges the company faced internally. But was it the best financial deal for Avaya versus potential alternatives? Does it enable Avaya to finally achieve revenue growth?
Breaking Down the Basics
While neither Avaya nor RingCentral have disclosed specific details of the arrangement, I’ve gleaned some information in talking to teams at both companies. Here are some basic details:
- RingCentral will operate the UCaaS contracts, cloud services, and billing site for the Avaya Cloud Office (ACO)-branded service
- RingCentral will keep the billing for this offering separate from its current site/processes and the billing site will be ACO-branded
- Avaya will have all responsibility, including primary support, for interactions with channel partners and the end customers of ACO solution
- According to Avaya, to keep the ACO business operationally separate from its existing sales and channel environment, a dedicated ACO team within RingCentral will interface with Avaya
- Avaya sees potential sales of endpoints (IP phones), both in ACO cloud deals and in the larger RingCentral context
Overall, the relationship seems different enough from traditional channel relationships that it requires a new descriptive term. Typically, in the UCaaS market, the master agent (and the agents selling for the master agent) receive some immediate compensation at subscription signing (may be up to six months’ contract value) and some ongoing monthly compensation based on continued subscription value. Ongoing compensation to the master agent may be up to 20% to 25% of the monthly subscription value. As the finances for the Avaya-RingCentral deal reflect a typical master agent model and the product is branded as in more of an OEM relationship, the term “OEM master agent” is probably the best descriptor of the relationship. Clearly, for the end customers, the entire experience should be under the ACO brand, a fundamental difference to traditional master agents that generally do not promote their own branded solutions.
Analysis: Best Option for Avaya
I did a quick analysis of the opportunity, using the UCaaS/ACO-targeted SMB/midmarket IP Office customers as the primary base and contrasting this deal with the alternative of Avaya selling the entire IP Office business — i.e., exiting the SMB/midmarket space. Let’s assume the IP Office base is 20 million seats and the annual revenue is $300 million, with margin of 50% (these reflect recent report data). This yields some basic data about the current business that we can use to evaluate an alternative.
- Current annual gross margin: $150 million
- Current monthly Avaya ARPU per installed base seat: approximately $1.50
As indicated, neither Avaya nor RingCentral disclosed details, but, based on current cloud agent models, it’s possible to postulate the deal structure.
One area is the actual ACO subscription cost. Based on the pricing outlook RingCentral discussed at its analyst conference in October, (where they announced the Avaya deal), it appears that $25 is the new list pricing standard in UCaaS. As this is a price for single seat/low volume, a 20% average volume discount for customers that have between 50 and 200 seats (as the IP Office base is) would be reasonable. Therefore, for this analysis, I’ve used $20/month as the average ACO revenue and basis for the compensation model from RingCentral to Avaya.
Assuming the recurring revenue uses the master agent/agent model, Avaya would be the master agent — or OEM master agent, in this case — and the current value-added resellers (VARs) would be the agents. It’s reasonable to assume a 20% to 25% commission to the master agent, but Avaya may have negotiated a higher percentage for this deal, so we’ll use 30% as the commission value. Based on discussions in the channel, a commission range of 15% to 20% is probable for the channel/agents. Based on a presumed goal of maintaining a maximum number of VARs as ACO agents, we’ll assume the agent commission is 20%. This would leave 10% of recurring revenue to Avaya as margin (assuming minimal transfer/administration costs).
Based on current trends in UCaaS compensation models and the information presented so far by Avaya and RingCentral, the relationship is assumed to include some form of initial payment from RingCentral to Avaya at the UCaaS subscription initiation. Avaya would then distribute a percentage to the agents.
For example, over the initial six months after install, commissioned RingCentral agent earnings on a deployment of 110+ seats would be $6,050, or about $55 per seat. These initial payments, often referred to as SPIFFs, could be four to six times monthly revenue. Assuming that Avaya receives payment of six times an average monthly per-seat subscription revenue of $20 ($120 total) at the initial subscription, we can use this as part of the overall value of a migration. As with the recurring revenue, Avaya would have to pay the majority of this to the actual VAR/agent. If we assume that 75% of the SPIFF goes to the VAR/agent, then Avaya would keep $30 of average gross margin for each seat migration.
Finally, a contract could include phone purchases should a customer require new endpoints. This may be a bit of a red herring as one of the key potential advantages for existing IP Office customers migrating to the ACO offer would be Avaya IP phone reuse. In addition, cloud phones are very price sensitive, and are generally subsidized by the UCaaS vendor. If Avaya has to price phones aggressively for the ACO migrating base, achieving great margins may be difficult. Nonetheless, let’s do the math, assuming 50% of ACO seats get new IP phones. Based on on-line pricing for the mid-model J139 IP Phone of $80 to $100, the average Avaya sale price to the channel for a new IP phone for ACO will probably be $80 or less. If we assume an average $72 sale price and 50% gross margin, this is another $36 of gross margin for Avaya for every seat that migrates to ACO.
The table below shows Avaya revenue and gross margins for all three revenue sources per seat based on a four-year analysis using compensation data from above.
From here we can project Avaya’s 48-month lifecycle value from an ACO migration. Recurring revenue would be $240, or $5 per month times 48. The initial contract SPIFF would be $120 of revenue. As only 50% of the seats get a new phone, the $72 for a new phone would be divided by the 50% adoption for an average revenue of $36 per new subscriber seat. Total revenue over the four-year period, including the one-time items, would be $396. Margin for the same four years would be $48 recurring, $30 for the initial SPIFF, and $18 for the phone, for a total of $96 over four years.
Using this data, we can compare to the existing business. One simple analysis is to estimate the percentage of the existing IP Office base that would need to migrate to ACO to replace the existing gross margin dollars. With a $300 million revenue run rate and 50% margin, the current IP Office business will generate approximately $600 million of margin over four years. Using this, we can calculate what percentage of the IP Office base would have to migrate to ACO to replace the existing margin.
However, to make this a true comparison, we must remove the R&D costs in the current business P&L. If current R&D is 10% of revenue, this is $30 million of cost per year, or $120 million over four years. This reduces the four-year amount of gross margin the ACO offer must generate to replace the existing margin by $120 million to $480 million ($600 million minus $120 million). If the four-year gross margin of an ACO seat is $96, then maintaining the current margin will take about five million seats, or about 25% of the estimated 20 million IPO installed base seats, to migrate to ACO.
As there’s no data about the influence of an existing premises PBX on a branded UCaaS migration except for Cisco Webex Calling, just in its infancy, the evaluation of whether Avaya and RingCentral can influence 25% of the base to transition to the ACO UCaaS offer versus market alternatives is left to the reader. Based on conversations with VARs and customers of Avaya, I think this may be achievable, but will be challenging. While intellectually interesting, an all-in migration analysis is not realistic as the base will not migrate to the cloud immediately but rather take time, regardless of UCaaS vendor destination.
Another way of evaluating this deal is to contrast to an alternative option Avaya considered. Clearly, based on widely published reports, Mitel was willing to buy Avaya in whole. What if, after the Avaya shareholders rejected the offer to buy the whole company in a reverse merger, Mitel had offered to buy just the IP Office business for the same $500 million total that RingCentral put into this deal. In this case, Avaya would have sold not only all future UCaaS revenue (no commission to Avaya for UCaaS migrations), but also the future premises revenues.
Assuming a 10% annual cloud migration in the SMB/midmarket, the average life of the remaining installed base is five years (half of the 10). At the annual run rate of $300 million average revenue and $150 million gross margin, over five years this represents $750 million in future gross margin that would have been sold off with the base. In the RingCentral deal, Avaya gets to keep that revenue/margin/profit stream. With minimal future R&D, general marketing, etc. for the IPO base revenue/margin, the profitability of this business should be very good; let’s say Avaya can turn half of that, or $375 million, into profit.
The question then is whether the ACO revenue and margin can replace the difference between the $375 million and the potential of a $500 million sale? To do his in a four-year period requires only $125 million of revenue, a fraction of the $325 million estimated pre-paid from RingCentral.
Again, the Avaya management team is to be complimented for putting together a great deal. Even if a single ACO license never sells, the five-year “gross margin” value of the deal is the $375 million paid by RingCentral (not including the $125 million “investment”) and the $750 million of future premises gross margin from the retained base. This generates a total future margin of over $1.1 billion; at a 50% margin to profit result, this exceeds the $500 million cash value of a complete buyout of the business, even including the time value of money.
Deal Structure: Another Look
In fact, this analysis identifies an interesting fact built into the structure of the deal.
Assuming $325 million of the $375 million RingCentral payment is pre-paid future commission royalties, with an average four-year revenue to Avaya from RingCentral of $420 per seat, the four-year average subscriber level required to reach the pre-paid $325 million level is about 775,000. For an average of 775,000 subscribers over four years with a linear growth, the four-year total is twice the average, or 1.55 million subscribers after four years of growth. During this period, for each seat signed up through ACO, Avaya wouldn’t receive actual new cash, but still must pay the agent commissions out of the RingCentral pre-payment.
If Avaya were to retain about 25% of the RingCentral payments, this means it would need to pay out 75% of the pre-paid royalties to its VARs/agents. This reduces the gross margin value to Avaya at the point of achieving the pre-paid goals (1.55 million subscribers after four years) to about $83 million (plus the hardware IP phone value). If the 1.55 million subscriber level is achieved and the $20 price point holds, the 1.55 million subscribers would annually represent $372 million revenue and $93 million in gross margin going forward, though pricing competition may reduce those values.
Clearly, Avaya needs for ACO either to fail completely or succeed to the three- to five-million subscriber level to have it impact the long-term financial direction of the company. Achieving one million ACO subscribers is the worst-case margin scenario for Avaya, as it would mean continuing to pay out of the pre-paid reserve for the next four to five years with no new cash coming in for the ACO business except for endpoint revenue. Based on my conversations with the Avaya team, I am assured that Avaya is not thinking this way and is focused on making ACO successful. But it is helpful in defining what success is, that being at least three- to five-million seats of ACO in four years.
Overall, this seems to be an excellent deal for Avaya. As indicated in the previous article, it addresses multiple strategic challenges, including an exit path for a number of shareholders through the stock buyback. The analysis shows that this was a great option for repositioning the company and appears to be a much better option than some other for Avaya.
In the final article in this series, I’ll discuss the growth potential of each Avaya segment.