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Avaya Holdings Corp (AVYA) Q1 2019 Earnings Conference Call Transcript

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Avaya Holdings Corp  (NYSE: AVYA)
Q1 2019 Earnings Conference Call
Feb. 11, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. My name is Shelly and I will be your conference operator today. At this time, I would like to welcome everyone to the Avaya Holdings First Quarter Fiscal 2019 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Michael McCarthy, Vice President of Investor Relations. You may begin your conference.

Michael McCarthy -- Vice President of Investor Relations

Thank you, Shelly, and welcome everyone to Avaya's Q1 fiscal year 2019 investor call. Jim Chirico, our President and CEO; and Pat O'Malley, our Senior Vice President and CFO will lead the call this morning and share with you some prepared remarks before taking your questions. Shefali Shah, our Chief Administrative Officer and GC; Chris McGugan, Senior Vice President of Solutions and Technology; and Kieran McGrath who will be assuming the role of CFO are also here for today's call.

The earnings release, CFO commentary and investor slides referenced on this morning's call are accessible on the Investor page of our website and on the SEC website. And should aid you in your understanding of Avaya's financial results. We will reference non-GAAP financial measures and specifically note that all sequential and year-over-year comparisons reference our non-GAAP numbers, except or otherwise noted. A reconciliation of such measures to GAAP is included in the earnings release and investor slides, which are available on the Investor page of our website.

We may make forward-looking statements that are based on current expectations, forecasts and assumptions, which remain subject to risks and uncertainties that could cause actual results to differ materially. Information about risks and uncertainties may be found in our most recent filings with the SEC, including our Form 10-K. It is Avaya's policy not to reiterate guidance and we undertake no obligations to update or revise forward-looking statements in the event, facts or circumstances change.

I'll now turn the call over to Jim. Jim?

Jim Chirico -- President and Chief Executive Officer

Thanks, Mike. Good morning, everyone, and welcome to our first quarter conference call. Before I begin, earlier today, we announced a change in the leadership of our financial Organization. Kieran McGrath is joining as CFO. Kieran most recently served as Executive Vice President and CFO at CA Technologies and has been in the technology and software space for over 30 years. I first met Kieran working together at IBM and have known him for more than 20 years. Kieran is more than just a world-class public company CFO. He is an operator and has been involved in many successful transformations. I want to take this opportunity to welcome Kieran to our team.

I also want to thank Pat for all that he's accomplished as CFO. He has been instrumental in orchestrating our emergence and then standing up the infrastructure to transition Avaya to a publicly traded company and listed on the New York Stock Exchange, and for leading several significant financial initiatives, including fresh start accounting, our tax restructuring, the Company's move to ASC 606 and many more. I want to express my heartfelt appreciation to Pat for laying a solid financial foundation for Avaya. We look forward to working with Pat in his new capacity, driving Company growth initiatives.

Moving on to our first fiscal quarter results, our revenue was $748 million, adjusted EBITDA was $189 million or 25.3% of revenue. Gross margins were at 62.7% and we generated free cash flow of $65 million. While we did not meet our revenue expectations, I do not believe that this is indicative of the health of our business. In fact, there were two discrete items that impacted our performance. The first is currency exchange rates, which had $3 million negative impact. And the second was the Federal Government shutdown, which ended in late January and delayed roughly $3 million of shipments at the end of last quarter.

Operationally, the Company delivered outstanding performance in Q1 and was in line with our Investor Day presentations in December. I'm proud of the efforts by the Avaya team as we continue to strengthen our business model. We drove Company records across several metrics, including gross margins and net operating income. Software and Services were 83% of revenue. Software was greater than 60% of product revenues and productivity or revenue per employee was at $381,000. All of these are all time records.

We also maintained recurring revenue at 57%, delivered adjusted EBITDA in excess of 25% and generated cash from operations of $86 million and ended the quarter with $743 million in cash. Our operating strength coupled with significant momentum in our four growth pillars gives me confidence that we are successfully executing the plan we committed to deliver.

As we have said previously, on our last earnings call and at Investor Day, growth and execution are the two main drivers of the business. And we are innovating in ways that truly matter to our customers, which is positioning the business for long-term success. First, the revenue contribution from new products in our core business continues to increase. We're focused on developing a product portfolio that intercepts trends. Our products and solutions drove 42% of our overall product revenue, up from last quarter. Specific areas of high quarterly growth were 61% increase in revenue from our endpoints, formally launched about a year ago and a 200% increase in revenue from our digital contact center omni-channel solution, formally called Oceana. This is a clear indication that the investments we made over the last year are delivering results. Our product portfolio has never been stronger and we will continue to enhance it throughout the year.

Second, in our core contact center, revenues were up 6% quarter-over-quarter. Q1 was the strongest quarter in over two years. It was driven by new logos, traction with our omni-channel offering and customers moving to modernize their communication platforms. We are seeing deal flow increasing and we are also seeing the deals expand in seat count and size. We are pleased with the continued trajectory we are seeing in our contact center business. Case in point, one of the world's largest financial services companies, a longtime customer was feeling competitive pressures and needed to deliver a better customer experience to differentiate themselves in the market. They turned to us to upgrade their global contact centers and equip thousands of their agents with the latest application. The result, their customer experience is improving and they are successfully executing on their vision of digital transformation.

Over the course of last quarter, we modernized growth opportunities in our core and introduced several new products and solutions, including a Device as a Service offering, which allows customers to purchase smart desktop devices on a subscription basis. A next generation location solution for 911. This breakthrough provides real-time information to first responders that can help make a difference in life or death situations. New endpoints, including smart devices and devices designed specifically for verticals like healthcare and hospitality. We also launched headsets and a hotel room offering among others. Contrary to some thinking, endpoints aren't dead. They are alive and well and are a differentiator for us. A new integrated app with Slack enabling users to access Avaya's customer engagement solutions within a Slack channel, further proof that our openness to connect with any data, device or application. And Open SIP devices that enable service providers to deliver a richer experience to the business desktop. These are just to name a few.

Relative to cloud demand, we are seeing increased traction in all parts of our UC and contact center cloud portfolio. We added over 200,000 total seats, bringing our total seat count to 3.7 million. Mid-market cloud seats grew 20% sequentially to over 225,000 seats. Enterprise seats grew 18% sequentially and private cloud seats grew 6% sequentially. Cloud as a percent of total revenue stands at 11%. On the enterprise side, we recently announced a truly differentiated private cloud solution called ReadyNow for customers looking to move to an enterprise private cloud solution. This expands our competitive advantage as we are the only company in the market that offers this capability. ReadyNow features pre-configued, per seat consumption and standard bundles for both UCaaS and CCaaS solutions.

We already have two dozen pilots under way and two deals closed, one of which is with a Fortune 200 company with a total contract value of over $15 million, consistent with our strategy to provide a flexible migration path to the cloud for new and existing customers. This win is a great example of how we're doing exactly that. We also added new cloud capabilities, including our storefront in both the US and Germany. We are innovating in new ways that truly matter to our customers. We've recently launched several significant differentiated offerings in AI and mobility. The investments provided to our customers with capabilities that accelerate their digital transformation and improve their customer experience, while separating them from their competition. It's just the tip of the iceberg, and in fact, we are creating entirely new markets. Simply put, we are delivering innovation at scale today.

In AI, we launched Avaya's conversational intelligence solution or ACI. ACI provides contact centers with real-time transcription and analysis of calls. Benefits include real-time sentiment analysis, coaching from supervisors to improve customer experience, in addition, it reduces administrative time allowing agents to be much more productive. We already have two pilots under way, one with a major US retailer and one with a large industrial company. This is just one examples of the five offers we have in the market today with AI. Our Avaya IX Mobility solution continues to gain momentum and the possibilities are broad and powerful. We have three customers, including FatPipe and ACS Technologies with a continuing growing pipeline. The feedback has been so positive that we are winning additional wallet share from these customers for related support services. This underscores the fact that mobility is a sticky solution and a driver of significant value for our customers. More importantly, we are delivering value by accelerating the digital transformation of our customers' contact centers, enhancing smartphone interactions, driving down costs and delivering a superior customer experience.

Based on the momentum we are seeing, I'd like to share some thoughts on our overall market traction. Companies are continuing to move to Avaya for modern innovative communication solutions. In Q1, we signed nearly 1,600 new logos. This was across our premise and cloud offerings. These wins included 59 highly competitive displacements worth approximately $15 million. Underscoring the confidence and trust that our large scale enterprises have in us, we continue to sign a large number of deals greater than $1 million in total contract value or TCV. Last quarter, we signed three deals over $10 million, 10 over $5 million and 83 deals over $1 million. These wins to our existing book of business drove our total contract value up 8% year-over-year and it remains at $2.4 billion.

Private cloud seats grew by 200,000. Growth was strong for our private cloud enterprise solutions. We had over 15 deals with TCV greater than $1 million and we had one in excess of $25 million. Our transformation into a customer-led Organization is improving our ability to win and it's bending the curve on maintenance renewals. The progress here is evident with our renewal rates steadily improving. In many cases, they are significant in size, scope and reflecting a scale of depth and capability that our competition cannot deliver. For example in Q1, a Fortune 10 healthcare company renewed their service contract to continue providing critical support for their 40,000 seat contact center. This deal had a TCV of nearly $40 million.

The best measure of excitement and energy and momentum we are creating was the participation last month at Avaya ENGAGE in Austin. The event demonstrated how far we've come in our transition to becoming a customer-led customer-driven Company. We set a record with over 2,700 customers, partners, analysts, press and industry influencers and influencers from around the world. I met with many of the attendees and was encouraged by the positive discussions. The feedback we received is a strong indicator of the momentum we have built.

We are focused on delivering growth and executing with operational excellence. These are the highest priorities we have. We will achieve these by sticking to and executing on our strategy to innovate in our core, bringing emerging technologies to market and delivering investments being made to build out our industry's most comprehensive cloud portfolio. I'm pleased with how well we are performing and I can't thank our global team, our partners and our customers enough for their support and loyalty to Avaya.

I'll now turn the call over to Pat, who will provide you with some additional color on our financial performance for Q1 and a discussion of our guidance for Q2 and FY '19. Pat?

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Thank you, Jim, and good morning, everyone. Before we begin, I'd like to mention that all references to financial metrics are non-GAAP, unless otherwise indicated. Please also note that we have posted additional commentary regarding our quarterly financial results as well as any relevant tables and GAAP to non-GAAP reconciliations to our Investor Relations website.

Further, starting in the first quarter of fiscal year 2019, Avaya adopted ASC 606, the new revenue recognition standard under the modified retrospective transition method. Due to our adoption of the standard under this method, we did not restate any historical results. As a reminder, the most significant impact on our financial results relates to accounting for contracts that include professional services. Under ASC 606, services revenue is generally recognized as services are performed as opposed to the completion and acceptance of services. Additionally, when contracts also include products, product revenue is recognized when those products are delivered as opposed to the completion and acceptance of services.

Given the nature of the differences between the two revenue recognition standards and the material impact that they can have on our quarter-to-quarter performance due to the multi-threaded revenue streams within our services business, we have actively aligned our sales activities with our customer needs to optimize our financial performance each quarter. As such, my comments herein will reference our performance under the new standard.

Turning to our first quarter fiscal 2019 results. Total revenue was $748 million, slightly below our guidance. Overall, we continue to make important progress in our transition to becoming more software-centric and recurring revenue business. In the first quarter, a record 83% of our revenue came from software and services and 57% was classified as recurring, benefiting from the continued strong adoption of our cloud and software solutions. However, as Jim alluded to, this was offset by a pause in Federal spending due to the Government shutdown and a minor FX headwind. Nevertheless, spending levels with Government are normalizing, and as such, this should not have a long-standing impact on our business.

Product revenue in the first quarter was $326 million compared to $330 million in the prior year. While product revenue was negatively impacted by the aforementioned factors, we are pleased by the continued strong performance of our cloud offerings. Growth in the cloud was particularly strong in our mid-market segment, where we delivered 150% -- 156% year-over-year revenue growth and 339% seat growth. Enterprise cloud seats also grew 6% over the prior year, highlighting our unique ability to offer compelling solutions that resonate with buyers across multiple market segments.

Moving to services. First quarter services revenue was $422 million compared to $445 million last year. The decline in service revenue was driven predominantly by lower maintenance revenue. However, as we talked about previously , part of the decline in maintenance revenue is driven by customer buying behavior shifting from CapEx to an OpEx model. Consistent with this trend, we added roughly 200,000 private cloud seats in the quarter. Additionally, we've seen our maintenance renewal rates improve post our emergence from Chapter 11 and the slope of our maintenance revenue decline has improved as a result. As maintenance is still relatively large percentage of our overall revenue mix, this improved trajectory coupled with the continued momentum in our cloud offerings give us confidence that our growth outlook for the year is achievable.

Moving to profitability metrics. First quarter gross margin was 62.7%, roughly in line with the 62.6% gross margin we delivered last year. We believe that is a mix of our business changes, with a larger percentage of revenue coming from software, our gross margin will improve over time. Our operating margin in the quarter was 22.7% and our adjusted EBITDA margin was 25.3%. Overall, our margins continue to benefit from an improved revenue mix as well as the ongoing optimization of our business model. We believe this will better position us to deliver material earnings growth as we achieve our longer-term revenue objectives. Further, we generated $65 million in free cash flow in the quarter and we ended with $743 million in cash and cash equivalents on our balance sheet.

Before moving to our outlook for the next quarter and the remainder of the fiscal year, I'd like to touch briefly on our capital allocation strategy. As mentioned at our Investor Day in December, the Board looks at our capital allocation regular and on a holistic basis. Our overall strategy contemplates a combination of investing in our business, optimizing our capital structure and returning capital to our stockholders. We believe there is a large market opportunity in front of us, and as such, we need to have the flexibility and the resources available to invest appropriately. While organic investment remains our preferred approach, we also regularly evaluate inorganic opportunities that can meaningfully accelerate our product roadmap and consequently improve our competitive position.

Additionally, we are also targeting to optimize our capital structure by strengthening our balance sheet, improve our credit profile and reduce our cost of capital, while at the same time, enhancing returns to our stockholders. In summary, we believe that our balance sheet gives us a setup, where we can manage financial risk, while also preserving the flexibility to pursue strategic options, where appropriate. With that said, we do understand that it is our obligation to prudently allocate capital to whatever drives positive and sustainable returns over the long run.

Turning to our financial outlook. For the second quarter, we expect GAAP revenue to be in the range of $730 million to $760 million and non-GAAP revenue to be in the range of $740 million to $765 million. As a reminder, our second quarter is typically the softest quarter from a sequential growth perspective with our revenue. Historically, decline in the low to mid single-digit range quarter-to-quarter. In the second quarter, we expect GAAP operating income to be in the range of $40 million to $60 million and non-GAAP operating income to be in the range of $159 million to $172 million. Adjusted EBITDA is expected to be in the range of $178 million to $191 million or approximately 24% to 25% of non-GAAP revenue. Additionally, we expect $111 million shares to be outstanding in the second quarter.

For the full year, we expect GAAP revenue to be in the range of $3.01 billion to $3.12 billion and non-GAAP revenue to be in the range of $3.05 billion to $3.15 billion. We expect the software and services to account for approximately 83% to 85% of non-GAAP revenue and recurring revenue to account for approximately 58% to 59% of non-GAAP revenue. Our cloud innovation products are expected to account approximately for 12% to 14% of non-GAAP revenue, in line with our earlier expectations. For the full year, we expect GAAP and non-GAAP R&D expense to be in the range of $220 million to $225 million or approximately 15% to 16% of product revenue. GAAP operating income is expected to be in the range of $200 million to $280 million and non-GAAP operating income is expected to be in the range of $674 million to $730 million. Adjusted EBITDA is expected to be in the range of $763 million to $819 million or 25% to 26% of non-GAAP revenue. For the full year, we expect 113 million shares to be outstanding, consistent with our earlier expectations. Cash taxes and capital expenditures are both expected to be in the range of $75 million to $80 million each, respectively.

Before we answer questions, I'd just like to say it has been my pleasure serving as Chief Financial Officer of Avaya through what's been a pivotal point in the Company's history. I am excited to take on newly created role of Senior Vice President of Growth Initiatives and delighted to pass toward Kieran, who I am very confident will continue to drive the Organization to create long-term value for our stockholders.

Shelly, we are now ready for questions.

Questions and Answers:

Operator

Certainly. (Operator Instructions) Your first question comes from the line of Raimo Lenschow from Barclays. Your line is now open.

Mike -- Barclays -- Analyst

Hey, guys. This is Mike on for Raimo, thanks for taking my question. Can you talk a little bit more about the traction that you're seeing in the mid-market and enterprise cloud space? And kind of what some of the movement you guys have been doing there and what's been working for you in that space?

Jim Chirico -- President and Chief Executive Officer

Yeah, sure. Hey, Mike. Good morning. Thanks. This is Jim and I'll start off, then I'll ask Chris to just provide some additional color. On the mid-market, we're seeing some really good traction associated obviously with our IP Office powered by solution. Number one, we continue to bring on additional partners to help sell that offer. Secondly, it's extremely competitive. It's certainly priced for success and the feature set is actually quite rich, so we're seeing that. On the enterprise front, a couple. One our XCaaS offer continues to gain traction. Secondly, our ACP offer, which really provides the large enterprise customers to move to cloud in a private environment and hosted by Avaya, which allows them to also free up a significant amount of cost because actually we're going to be hosting this in five data centers at least initially around the world in a virtual environment provides significant capabilities that we didn't have before. Before it was more of a -- the private cloud offer was -- had more of a managed services design to it than, if you will, a true hosted private cloud offer. So those are couple of the key highlights.

I'll turn over to Chris to talk a little bit more about some of the feature content.

Chris McGugan -- Senior Vice President, Solutions and Technology

Yeah. Thanks, Jim. Mike, the IP Office or the UCaaS mid-market offer that Jim spoke to, we are seeing good traction on a global basis for that particular offer. We've added Device as a Service opportunities to it, we're adding trucking to it, it's making it much stickier for our partner community, which is really excited about that particular offer. Again, very competitive in the market space today. And as we continue to make that transition into multiple geographies around the globe, we will continue to see growth in that product.

Mike -- Barclays -- Analyst

Great, that's helpful. And then just one follow-up for Pat. On the Government shutdown headwinds that you saw in Q1, do you see any trickle effect that's going to come over into Q2 and kind of what type of headwinds are you seeing for the Q2 since some of that also came into that quarter?

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

So we did see that shutdown. We do believe our business with Federal Government is strong, is sustainable. So we believe that push out will cure itself. If not, in the following quarter, sometime during there, near after. Obviously, as we sit through the the wranglings of shutdowns or no shutdowns, we're very, very mindful of that. So we are very, very -- we're working very intently when the Government is open to ensure we do what we need to support them, but we feel we're very, very well aligned with the teams there and that that should close and then our business with the Government remains strong and we have not seen anything that would indicate that there is a budget flush or cut that would be coming. So we still -- all indications, we have some timing issues and that's how we're approaching it. And if things were to change, we will adapt accordingly. But right now, we feel pretty good where we're positioned with the Government.

Mike -- Barclays -- Analyst

Great, thanks. Thanks so much guys.

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Yeah.

Operator

Your next question comes from the line of Lance Vitanza from Cowen. Your line is now open.

Lance Vitanza -- Cowen -- Analyst

Hi. Thanks guys. One question on the revenues and then maybe my follow-up on the cost side. But you mentioned that revenues in the first quarter were disappointing, not indicative of the trends in the business, but it appears that the year became, at least from the standpoint of my model, it looks like the year became a bit more back-end loaded. When I look at the 2Q estimates, that's a bit below what we've been forecasting. So I'm wondering, if we were just too high or how does your 2Q budget compare to what that budget for the quarter had looked like three months ago?

Jim Chirico -- President and Chief Executive Officer

Yeah. Hey, Lance. This is Jim, then I'll turn over to Pat to see if he has any additional color. But we -- the way we're outlooking the second quarter is consistent to the internal plan we had. Couple things to note is typically the second quarter, as Pat pointed out, is down a bit. Clearly as we move more to a software services recurring revenue model, the impact to that is less. So in previous years, you would typically see a mid to high single-digit decline in the second quarter. As Pat indicated, we are in the low single-digits going into the quarter. So we're consistent with our outlooks. Our second half of the year, I think we've been pretty clear, as obviously projected have higher revenues in the first half of the year for a lot of reasons, mostly is the fact with some of the new product announcements like ACP, as an example, which we expect as that ramps because it is a cloud subscription offer, it takes a little bit of time to ramp. We've done a significant amount of work and have some nice wins in SPs that we'll start to see come to fruition in the second half. Our overall cloud business continues to grow nicely, so you'll see obviously second half revenues in excess of first half and we've also done a lot of work on alliances. We've referenced some of that at Investor Day, a bit more at ENGAGE, but we're starting to see some really good traction in our overall alliances and that's with our key sort of big friends as we go join -- go to market. So we're consistent with our views, so we're, as we've pointed out, we're not changing anything associated with overall guidance and the way we're seeing our business and we don't get into areas of pipeline type discussions, but we're still seeing some rather good traction that has us confident, as I mentioned in my opening that we're on track for that guidance number.

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Great. And then, Lance, answer to that is that, to your point, we are mindful of what consensus are and what our plan is and we're going to march our plan, we are very committed to our plan and we always saw back half when we talked in August. We started seeing strength in the new products we talked in November-December Investor Day. So the back half as you know is a great opportunity for us. So we -- as Jim said, we're off executing those now, so that gives us confidence there. And if I even look through what the consensus were versus we were, the stretch is not that -- it's not that much. So on your model, maybe a little more back-end loaded, but not to a point where it's reached by any stretch. So we feel fairly comfortable and that's why I went over the '19 guidance again.

Lance Vitanza -- Cowen -- Analyst

Sure. Thanks. My follow-up is actually on the cost side. I mean, you guys did a great job managing that to come in below pretty much right on our numbers for EBITDA and free cash flow. And so my question is, was that -- were you basically adjusting the cost structure on the fly in the face of the revenue disappointment or would you -- was this sort of more of a just actual cost structure, such that if the revenues had been there, we should have expected that much more EBITDA and cash flow or how should we be thinking about that?

Jim Chirico -- President and Chief Executive Officer

The answer is no. We did not adjust our cost structure, if you will, as you point out on the fly. The FX, we now have that adjusted in the model. The Government shutdown occurred in the last 10 days of the quarter, so no, there wasn't anything that we did to adjust our overall cost structure. In fact, we're focused on growth. We have and have and had what I call a world-class operating Organization because we spent many years refining and defining what that Organization needs to be. So we're extremely predictable and we have a very good understanding of where we are and where we are independent of top line. So this is not a year or a Company that's focused on restructuring, it's a Company that's focused on growth and make the necessary investments to grow.

As we pointed out last year, we pointed out last year's numbers were not indicative of the performance of the Company because as Chapter -- our resurgence from Chapter 11, there's many one-time cost elements. You think you know, but there's a lot you don't know. And even with that, we were able to come in, I think, in the neighborhood of 24% plus even as percent of revenue. That's behind us. So we know exactly where we are. We continue to drive productivity enhancements, we continue to bring on new systems and tools with the investments we communicated that we would make. Based upon the new capital structure, we're continuing to make those investments to further optimize the Company. So it's not something that we did in any type of reaction. In fact, it's consistent with our plan and we're continuing to invest back in the business.

Lance Vitanza -- Cowen -- Analyst

Thanks very much.

Operator

Your next question comes from the line of Meta Marshall from Morgan Stanley. Your line is now open.

Meta Marshall -- Morgan Stanley -- Analyst

Great, thanks. A couple of questions from me. One, has the replacement been identified for Laurent yet or who would you kind of imagine leading that Innovation portfolio? And then maybe the second one. Without the aid of kind of 606, the services or maintenance revenue would kind of be down more meaningfully and so just kind of what initiatives have you identified on kind of stabilizing the maintenance base? Thanks.

Jim Chirico -- President and Chief Executive Officer

Yeah. Sure. So -- hey, Meta, thanks. On the replacement further on, actually, no, we have obviously a very talented bench here in the Company. We've asked David Chavez to take on the interim role on driving the emerging technologies organization. So -- and Laurent had a very, very strong team underneath him. I would like to take a minute out to thank Laurent. I did it in the press announcement, but obviously with the opportunity to become the CEO is one that a lot of people aspire to and Laurent has been phenomenal to work with over the last five years, a true professional, a great guy and probably one of the best team members we've had. So I do wish as, every Avayan, Laurent the best of luck in his new assignment. But again, clearly the role of CEO is very, very enticing to Laurent. And -- so we wish the best. But we have a deep team. David will assume the responsibility. David has been running the mobility piece of the business, very familiar working with the AI team. So I don't suspect we'll miss a beat there at all. The team is more than capable to carry the torch.

On 606, I'll turn it over to Pat to provide some commentary.

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Yeah. Thanks. Obviously, this is our first quarter 605, 606 much of our services business. And I think you rightly highlighted that was probably where the, if you want to do a flux analysis or a change analysis, it was mostly seen there. But you got to remember, our business model in services is not just delivering services, many times delivering products. So as we were going through the 605, 606, we realized that the sales motion would have to change and then we would have to optimize across the board many contracts versus necessary closing contracts. It's still important to close contracts, but we're not going to send an army of folks in the last two weeks of the quarter to try to close thing. We're going to get in a more of a cadence, so you will see the 605, 606 gap get smaller over time as we close these projects, but we really did expect the majority of this. There were some things obviously in 605, 606 that caught us a little off guard, but nothing too major. But I would say that looking at 606, we really have aligned our business to 606, both with our customers and our field sales folks. So it was clearly a decision we made when we studied 605 and 606 and how we went and managed our professional services business. But you will see these projects close and then you'll see some 605 bumps and we'll try to get you more clarity on that, but I think the point is, if you look at our forecast for the year, we had that in consideration. We had how we were going to do our sales motion. And that's how we've lined up and that's why we reiterated today on the year, we still feel very comfortable with the revenue. So you will see ups and downs on that from 605, 606, but it's on line what we expected.

Meta Marshall -- Morgan Stanley -- Analyst

Okay, thanks.

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Yeah.

Operator

Your next question comes from the line of Rod Hall from Goldman Sachs. Your line is now open.

Balaji Krishnamurthy -- Goldman Sachs -- Analyst

Thanks. This is Balaji on behalf of Rod. I wanted to pick up on that Fed discussion and maybe if you could give us some quantification of how much your Fed exposure is as a percent of sales? And then on a real-time basis, what are you seeing with the Federal customers now that we are in between potentially two shutdowns? Are you seeing them pulling purchase orders or is there some level of hesitation and they're saying that they're going to wait for a resolution either way before they come back to make orders fully? And then I have a quick follow-up as well. Thanks.

Jim Chirico -- President and Chief Executive Officer

Yeah, hi. This is Jim. So as we've pointed out last quarter, it was in the neighborhood of $3 million of product that didn't ship that was scheduled to ship in the last 10 days of the quarter. It was a couple of orders, and in fact, in the month of January in full transparency, those orders did ship. So we don't suspect any additional impacts associated with the Federal Government, as Pat pointed out. Are we seeing any type of hesitation associated with our Government business? The answer is no, we're not seeing any hesitation. We're not seeing any, if you will, pull back. We're very close with our partner base, and in fact even the RFP, RFQ process, I would say has not slowed down at all. So I would say, it's sort of back to, if you will, business as usual. Now, at the end of this week in the US, depending on what may or may not happen, we can't project that or predict that. So that will -- we'll see exactly what the outcome of that is. But when the Government was opened again at the end of January, we were positioned today. We're seeing, if you will, normal activity, normal run rates associated with the Fed business. So we are not -- at this point, though, as Pat pointed out, we're mindful, but there's not a whole lot we can do to control the situation other than to watch the situation. But -- and working with our partner base and even with our direct team into the Government, we're not seeing anything today that would suggest someone has the brakes on depending and determining what the outcome may be associated with the discussions that are ongoing.

Balaji Krishnamurthy -- Goldman Sachs -- Analyst

Got it. And on the Q2 guide, you noted that it's the weakest quarter. And when I look back at the last couple of years, your Q2 over Q1 was down sequential quarter, whereas the guide you have provided, it is for up sequentially in Q2. So maybe, if you could bridge that, that'd be helpful. Thank you.

Jim Chirico -- President and Chief Executive Officer

Yeah. Well, yeah, I think it's a factor of two things. One is the fact, as we mentioned, we sort of had some one-time discrete events that hit us in Q1, some of that rolled over into Q2, if you will. The other is the fact with 83% of our business software and services, which is subscription license-based and annuity based revenues 57% being recurring revenue, even 60% of our product business being software. Our business is much more predictable and much less dependent upon, what I'll say, fluctuation simply because, again 83% for our intensive purposes being a subscription-oriented business, which is fantastic. In fact, we continue to improve that quarter-on-quarter. So I would say, the variability is less and -- as we go through. So historically, you would, as I mentioned, see the second quarter be anywhere between 6% to 8%, some would say 7% to 9% down Q2 versus Q1. As we pointed out, we -- all things being equal, we're seeing basically that being somewhat marginalized and Pat said low single-digits. So we are pretty confident and obviously very confident. In the outlook, we provided our business is more predictable, more stable and we're going to continue to drive to be more of a software services Company.

Balaji Krishnamurthy -- Goldman Sachs -- Analyst

Okay, thank you.

Operator

Your next question comes from Hamed Khorsand from BWS Financial. Your line is now open.

Hamed Khorsand -- BWS Financial -- Analyst

Hi, good morning. Could you talk about the public cloud initiative? You've had -- you're making progress there or if this is purely just more of a competitive process just to keep competitors away from your enterprise business?

Jim Chirico -- President and Chief Executive Officer

No, I actually think -- I'll ask Chris to give some more color. No, we're making I think -- in fairness, I think we're making tremendous progress. This ACP ReadyNow offer, no one else has it in the industry. It not only provides opportunity for us to provide our current installed base or customer base with an opportunity to move to cloud when and if and how they're ready, many of the, I'll say, mid to larger enterprises aren't really positioned to go move to what I'll say a public cloud offering. It's -- many of them can't because associated -- risk factors associated with the business that they operate with, being a new government or being in financial so on and so forth. So it's a perfect solution for that, not only that, it's also an opportunity for us now to compete in areas that we do not compete against the -- our competition because we now have a differentiated offer. So it's not only if -- to your term, a protect strategy, even though -- it's more of providing what our customers are asking us for, but it's also an opportunity for us to expand and expand in customers that we had -- didn't have an offer to really going in and penetrate. But I'll turn over to Chris and you can talk a little bit more about the offer, but it is truly differentiated. And as I said, we just recently announced a couple of big wins rather significant a number of POCs that are out there and I can tell you the interest because we announced that at our Engagement in last month in Austin significant, significant interest from a number of customers.

Chris McGugan -- Senior Vice President, Solutions and Technology

Yeah. Thanks, Jim. And as noted, we are seeing significant interest based on funnel activity and proof-of-concept requests for the ACP or ReadyNow offers. And as Jim mentioned, it's something that's differentiating the market. Their ability to go from order to dial tone, a four to five hour period is unique in the market, especially for some of these larger enterprises that require really complex deployments. That's where a lot of the mid-market UC players today have trouble transitioning because the feature set is unique for the larger enterprises and it's something that Avaya is uniquely positioned to deliver against. So we feel very compelled to continue driving the software in the market, enhancing it and really going after the enterprise cloud companies who want to move into that particular direction, as Jim noted in many cases, they have data privacy concerns, which slow their traction and we are uniquely positioned to deliver against those requirements.

Hamed Khorsand -- BWS Financial -- Analyst

Okay. And then the other question I had was your earlier commentary about some of the maintenance revenue transition to cloud service. So why isn't cloud as a percentage of revenue rising, right, it was only 11% this quarter? Wouldn't that imply it would have to be higher?

Jim Chirico -- President and Chief Executive Officer

So one, as you do transition to the cloud, you have to build up that -- the seats and then you start building up the revenue stream. So there is a bit of that. And so you just have to, as you move off of maintenance and you start turning on the seats, so you have that some of the transition, but it's nothing significant that would -- should take us outside of our range and that bowl, if you will, fills in pretty quick. As you see some of the numbers, we've had some large turn-ons this quarter. We grew our seats significantly. So you should start seeing that fueling the top line again next quarter, another why we get confidence in Q2.

Hamed Khorsand -- BWS Financial -- Analyst

Got it, OK. Thank you.

Jim Chirico -- President and Chief Executive Officer

Yeah. Thanks Hamed.

Operator

Your next question comes from the line of Asiya Merchant from Citigroup. Your line is now open.

Asiya Merchant -- Citigroup -- Analyst

Great. Thanks for clarifying that cloud commentary, Pat, because that was one of my questions, why, given you had the Spoken acquisition and lot of investment, why the market -- why your cloud revenues are still under-growing kind of where I think the overall market is growing in the 20% plus range. So I think the explanation you provided did help to clarify that. I just have a couple of very quick questions on the margins, like the product gross margins and I know it's -- there's a bunch of accounting stuff that we need to consider as well. But product gross margins under-growing on a year-on-year basis, is that a function of the ASC 606? And then I have a question on cash flow as well. You guys put out good cash flow numbers, free cash flow numbers. Given that, as Jim pointed out, the variability in revenues is much less volatile now as you guys become more of a software and services. Should we expect the same kind of reduced volatility in free cash flow on a quarter-on-quarter basis or are there one-time things to consider in free cash flow as we go from 1Q to 2Q through the rest of the year? Thank you.

Jim Chirico -- President and Chief Executive Officer

Yeah. Hi. Let me just touch on gross margin and then maybe Pat might want to add more. So product gross margin in the quarter were down about, I don't know, 1.5% to 2%, that's really a factor. A couple of things. One is, as we continue to increase our Loyalty Together volume and basically what we're doing there is it's -- we're providing customers who are either at CS1K customers or our customers that have CM licenses more than two releases down. We're providing them path, if you will, to get up to converting CS1K on to our base and we're providing customers on CM basically with the capability to do, in essence, a free upgrade as they want to extend the overall maintenance revenue. So the point there is, at some cases, we're giving away free phones in order to provide that promotional opportunity really to make sure that the customers stay with us. So you can consider sort of a modified sort of razor blade type model, which is having significant success. So it's not so much a factor and margins are down, it's a factor that we have these initiatives in place in order to benefit our customers, first and foremost, but also have longer-term benefits for us at the Company. So that's the primary driver on why it sounds clearly you need to take into account the price for the phones, but it's a great model, it's getting great acceptance and more importantly it's providing long-term maintenance and/or moving to the cloud revenues for the Company. So that's the -- that's probably the biggest driver.

Asiya Merchant -- Citigroup -- Analyst

Okay. And then on free cash flow?

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Yeah. So on free cash flow, I think as we define free cash flow, operational and CapEx, it should be -- become fairly stable. We talked about at Investor Day, but our last quarter DPO was with the Extreme Networks some way off and I said we get those days back, we got them back plus some. So we'll optimize our working capital as you said this business becomes more and more selling subscription. Now, outside of the free cash flow, we'll still have items such as investing like we'll have a potential earn-outs for the Spoken, we will have any potential tax payments and so those could get lumpy on your -- what you put vitamin on cash, but from a cash -- as defined as cash free flow, we should get much more stable, but -- so it's a good question. But, obviously, with the other items, you could have some ups and down, but we feel fairly comfortable with generating the cash flow we talked about from operations.

Asiya Merchant -- Citigroup -- Analyst

Great, thank you.

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Thank you.

Operator

Your next question comes from the line of Mike Latimore from Northland Capital. Your line is now open.

Mike Latimore -- Northland Capital -- Analyst

Yeah, great. Thanks. I guess, just the $3 million in Federal Government and $3 million in FX. You add that back and you get to the sort of the low-end of your revenue guidance. Any discussion on what factors were keeping it below the midpoint of your revenue guidance as well, anything incremental there?

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Yeah. I could add some color that Mike as -- I mean, there's a lot of things we can go through as much as going with you and that's our job to do, so don't want to put you through it. But there was some estimates in our guide that we -- on the 605, 606 honestly that as you learn about the 605 and then implement it, some of the things that came through was your recast contracts, which are daily occurrence in this business, they have some effect. And so those put us a little lower, but we've gotten those pretty much for the most parts figured out and that's probably the biggest, but we're not going to numerate everyone. But we feel very comfortable to Lance's earlier question about, hey, are we pushing more to the back end, we don't really think of the magnitude of where we think we can hit Q2 versus where the consensus may have been that it's a large gap and that we could easily close that with our product offering. So some of us figure out 605, 606, some of us just -- the last 10 days, holidays. I mean, it's always one of those quarters, you always have to make sure the things are lined there, but it's our job to deliver numbers and we expect to deliver next quarter as well. So -- but yeah, we understand why the difference was from where the Street might have had it versus we're comfortable what the message while we just numerate the couple real big ones that were fairly evident that posted understand fairly simplistically without going through all the pieces.

Mike Latimore -- Northland Capital -- Analyst

Yeah, makes sense. And then I think you talked at the Analyst Day about cash taxes this year at $81 million and I think you've guided to $30 million for this next quarter. I guess, can you just give us -- it seems like that's a little bit more spiky, let's say, cash taxes and -- maybe expected there, but how should cash taxes play throughout the year because $30 million is a big number there?

Jim Chirico -- President and Chief Executive Officer

Yeah. We only had $7 million this quarter, so as you're going to -- I mean, obviously, you will see it somewhat lumpier, but -- so you would expect it maybe to go down and back up. But -- so we haven't given model by quarter, but the $80 million is going to be probably about right in line. So we're almost halfway there after the year when we're $37 million of the $80 million, so just plan for the other $40 million in the second half of the year.

Mike Latimore -- Northland Capital -- Analyst

Yeah, got it. And then just last back on the cloud at 11% of revenue. I mean, earlier in the script, you talked about a number of cloud segments who grew pretty significantly sequentially, so I guess I'm still not sure why that 11% wouldn't have gone higher then?

Jim Chirico -- President and Chief Executive Officer

A big growth in part of the cloud world, Mike, that's actually going to obviously take a little bit time before it turns to software revenue. That's why we're suggesting the second half to be much stronger than the first half, simply because we had 200,000, but it takes a while to get those all activated, for lack of a better term, to have them all become revenue generating. So there's a bit of a lag. We did show as Pat pointed out 150% plus of revenues associated with mid-market. And we -- if you go back and look at our seat count, I think we've added like 50,000 plus seats in the fourth quarter, 40 some thousand seats this quarter, almost doubling in just the last two quarters the overall seat count of end markets, so we're starting to get significant traction. But there, again, it's -- you don't see a lot of that this particular quarter. So our expectation is that that will continue to increase as we go through the balance of this fiscal year. So that's really the real driver and it's price -- but it's actually selling and then activating and realizing the revenue, so there is a bit of a lag. But -- and the fact that we've kind of shot up so quick, for lack of a better term, is good news for momentum and traction. But to your point, when you do the math, you would suggest that maybe it would be a bit higher, but it's -- I can tell you, it's in the pipeline and one of the reasons why we're confident about the second half revenues.

Mike Latimore -- Northland Capital -- Analyst

Yeah. Great. Thank you.

Operator

There are no further questions at this time. I'd like to turn the call back over to Mr. McCarthy for closing remarks.

Michael McCarthy -- Vice President of Investor Relations

Thank you, Shelly, and thanks for joining us this morning. Over the next couple of weeks, we'll be participating at several investor conferences, including the Goldman Sachs Conference this week, Morgan Stanley and Stephens later on and the JPMorgan Leveraged Finance Conference. If you have any additional questions, please feel free to reach out to my office and we'll look forward to catching up with you there for -- on the conference circuit. Thanks very much and have a good afternoon.

Operator

This concludes today's conference call. You may now disconnect.

Duration: 60 minutes

Call participants:

Michael McCarthy -- Vice President of Investor Relations

Jim Chirico -- President and Chief Executive Officer

Patrick O'Malley -- Senior Vice President and Chief Financial Officer

Mike -- Barclays -- Analyst

Chris McGugan -- Senior Vice President, Solutions and Technology

Lance Vitanza -- Cowen -- Analyst

Meta Marshall -- Morgan Stanley -- Analyst

Balaji Krishnamurthy -- Goldman Sachs -- Analyst

Hamed Khorsand -- BWS Financial -- Analyst

Asiya Merchant -- Citigroup -- Analyst

Mike Latimore -- Northland Capital -- Analyst

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