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Edited Transcript of AVYA earnings conference call or presentation 4-Dec-18 1:30pm GMT

Q4 2018 Avaya Holdings Corp Earnings Call

BASKING RIDGE Dec 13, 2018 (Thomson StreetEvents) -- Edited Transcript of Avaya Holdings Corp earnings conference call or presentation Tuesday, December 4, 2018 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gaurav Passi

Avaya Holdings Corp. - President of Cloud Business Group

* James M. Chirico

Avaya Holdings Corp. - President, CEO & Director

* Patrick J. O'Malley

Avaya Holdings Corp. - Senior VP & CFO

* Peter Schuman

Avaya Holdings Corp. - Senior Director of IR

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Conference Call Participants

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* Asiya Merchant

Citigroup Inc, Research Division - Research Analyst

* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking

* Hamed Khorsand

BWS Financial Inc. - Principal & Research Analyst

* Lance William Vitanza

Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst

* Michael James Latimore

Northland Capital Markets, Research Division - MD & Senior Research Analyst

* Mohit Gogia

Barclays Bank PLC, Research Division - Research Analyst

* Robert Jost

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Presentation

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Operator [1]

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Good morning. My name is Matthew, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the third (sic) [fourth] quarter fiscal 2018 earnings conference call. (Operator Instructions)

Mr. Peter Schuman, Senior Director of Investor Relations, you may begin your conference.

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Peter Schuman, Avaya Holdings Corp. - Senior Director of IR [2]

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Thank you, Matt. Welcome to Avaya's Q4 Fiscal Year '18 Investor Call. Jim Chirico, our President and CEO; Pat O'Malley, our SVP and CFO; Shefali Shah, our CAO and GC; and Gaurav Passi, Avaya's President of the Cloud Business group, are here for today's call.

The earnings release, CFO commentary, and investor slides referenced on this call are accessible on the Investor page of our website and the SEC website and should aid 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 non-GAAP numbers, except where otherwise noted. A reconciliation of such measures to GAAP is included in the earnings release and investor slides and is available on the Investor page of our website.

We may make forward-looking statements that are based on current expectations, forecast, assumptions and 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 and subsequent Form 10-Qs and in our earnings release today. It is Avaya's policy not to reiterate guidance, and we undertake no obligation to update or revise forward-looking statements in the event facts or circumstances change.

Couple of notes upfront. First, as a reminder, unless otherwise indicated, all financial results discussed on this call are non-GAAP and exclude our Networking business revenue for all periods divested in Q4 2017, and references to year-to-date results on this call will be on a combined basis. Reconciliations from GAAP to non-GAAP are included in the earnings release, investor slides and CFO commentary and are also available on the Investor page of our website.

Second, when referencing Q3 FY '18, Q4 FY '18, it refers to fiscal year 2018; and Q1 FY '19, it refers to fiscal year 2019 and will be referred to as Q3 and Q4 or Q1, unless otherwise noted.

I will now hand the call over to Jim.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [3]

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Thank you, Peter. Good morning, everyone, and welcome to our fourth quarter and full year earnings call. I'm very pleased with our results, and first and foremost, I'd like to thank our global team. I am so proud of the work that they put into making Q4 and FY '18 a success.

Taking a look at FY '18, we not only furthered our goals around predictability and credibility by delivering results in line with guidance, but more importantly, we have built velocity and momentum in our business and have made strategic investments that have yielded results and set the foundation for our future growth and continued success.

These include changing our trajectory towards revenue growth, building a new pipeline of products and solutions with significant shift of R&D investments to cloud and emerging technologies, assembling a management team of industry-leading executives and redoubling our focus on being a customer-led organization, resulting in higher customer satisfaction, increased win rates as well as improved renewal rates. We have confidence in our strategy. We are successfully executing it. And FY '18 was proof positive that we are on the right path in creating long-term sustainable value.

Without going into every detail, here are some examples of the momentum we've created.

We've expanded Cloud by launching multi-tenant CCaaS, implementing a Master Agent model, growing our UCaaS public cloud to nearly 200,000 seats. And next week, we will be launching a retail offer to compete in the SMB market.

Our new product front, we launched 120 new solutions. Those new offers represent 40% of our product revenue in Q4, demonstrating a real traction from these customer-driven offerings. We've launched and expanded the strategic partnerships with Salesforce, IBM, Google, Afiniti and Verint just to name a few. We've invested in key additional growth levers like Professional Services. And we are building up backlog, showing up in our total contract value, which includes our recurring revenue in maintenance, cloud, managed services and recurring software, which now stands at more than $2.4 billion, which is up $160 million from the prior year and at our highest levels in over 2 years. What a difference a year makes.

Now let me turn to Q4 and highlight some results. Non-GAAP revenue was $770 million and adjusted EBITDA was at $178 million. Our core UC and CC businesses showed strength on the numbers front. Product revenue increased over 4% to $14 million this quarter. Of that, contact center grew $12 million, nearly 15% from the prior quarter and nearly 11% from the prior year, reflecting a return to health in our flagship business. Unified Communications grew $2 million quarter-over-quarter, its best performance in more than a year. Notably, we have transformed to a software and services company, as 60% of our product revenue is now comprised of software. Just 3 years ago, that number was 42%.

And on the new product front, just a couple of examples of success. First, following our first endpoint refresh in more than 8 years, revenues from these new endpoints increased over 70% from Q3. Second, Oceana, our contact center omni-channel offering grew 24% this quarter and 100% year-over-year.

Taking a look at Cloud. Total Cloud revenue was at $82 million. Revenue from our public cloud grew 37% quarter-over-quarter and by 60% year-over-year. We experienced a significant growth in UCaaS seats and revenue both in mid-market and enterprise. In this area, we grew more -- we grew by more than 55,000 seats, representing a 66% increase, Q4 alone. This is consistent with our strategy to transition our base to the cloud.

On the private cloud front, we signed 7 deals over $5 million and 20 deals greater than $1 million in Q4. This underscores that large enterprises are focused on private or hybrid as their cloud path, where Avaya excels and the competition has no offer.

Let me add some color on customer wins this quarter. We continued to win head to head and displaced the competition. We recorded over $60 million of competitive wins, led by our contact center. Let me give you a few examples. At the Australian Department of Defense, we displaced a key competitor, where we signed a 5-year contract, translating to 14 contract -- contact centers, comprising of more than 40 lines of businesses to the Avaya Oceana omni-channel platform. Another contact center win was Palace Resorts, which has 11 hotels across Mexico and Jamaica, with 5,500 rooms that host more than 2 million guests a year. On the UC side, we announced a significant win with China Eastern Airline, one of China's largest aviation company, serving more than 100 million people. The project connects their headquarters with all their branches, offices and subsidiaries.

In Q4, we won 12 deals in total over $5 million and 117 deals greater than $1 million. To summarize, Q4 was a strong finish to a truly transformative year for Avaya.

Now let me punctuate how much progress we've made this past year as demonstrated by our full year results.

First, we generated non-GAAP revenue of $3.06 billion and adjusted EBITDA of $746 million. Second, the company drove several all-time annual performance records across key financial and productivity measures. Let me share a handful. Gross margin was at an all-time high of 62.3%, up 30 basis points year-over-year. Services and software as a percent of revenue was 82.2%, a record, and up 410 basis points from the prior year. Software alone represents 58.3% of all product revenue, up from 50% last year, further demonstrating that our UC and CC core business have shifted to a software subscription business model. Recurring revenue was up 130 basis points year-over-year to a record of 57.4% of total revenue.

Now for a brief update into early traction and our key growth engines for FY '19. Number one, innovating in the core. Let me remind you that we have the world's largest installed base in UC and CC communications, with 145 million seats. Demand for these technologies remains significant, and serving these customers requires a global presence and an ongoing ability to invest in innovation. We are going to continue the investment here, while accelerating our efforts in cloud. Gartner recognized our progress by returning us to the Leaders Quadrant for both CC and UC. New products driven through our R&D investments are having a positive impact. We are designing and developing the solutions our customers and the market want. Revenue from new products and solutions accounted for nearly 40% of all product revenue. Bottom line, our innovation continues as we were granted over 130 patents this year, further demonstrating our technology leadership. We won nearly 7,000 new logos in FY '18. In FY '18, we are the only company in our space that signed 15 mega deals, those that have values over $10 million. We signed 55 deals with values over $5 million and over 440 deals with values over $1 million.

The second growth engine is services. We deliver them globally at scale, and this is a key differentiator for Avaya. Couple of proof points. Renewal rates were a major focus item as we entered FY '18. Through our focused efforts, we drove renewals to the best levels we've seen in the last 4 years.

Secondly, reflecting strong demand for our world-class implementation and consultative services, our Professional Services revenues grew by 14%, a validation that our customers truly want our expertise to help them through the digital transformation.

Our third growth area is innovation in solutions and new markets. Translated, this means artificial intelligence and mobility. We have 5 A offers in the market today. Customers are using it and more importantly, AI is driving revenue.

On mobility, here, again, we have a revolutionary offer in the market called, Avaya Mobile Experience, no else has it. We have 2 customers that are live, up and running, and we're working 60 opportunities as we speak. Lastly, we've commercialized IntelligentWire capabilities from our Spoken acquisition and the list goes on and on.

Fourth is cloud. We've made a significant shift in our business and are now heavily biased towards cloud and we are seeing the results. Case in point, cloud revenue was up approximately 11 to -- approximately 11% of total revenue in FY '18, heading towards north of 13% in FY '19. We now have nearly 3.5 million cloud seats between public and private offerings. We started this year in UCaaS, we had approximately only 40,000 seats. And we are now close to 200,000 seats, approximately 55,000 of those were added in the fourth quarter alone.

In our mid-market, powered by offering, where we have approximately 2,000 customers. It is important to note nearly 2/3 of those customers are net new to Avaya. We are aggressively going after the mid-market. And as I mentioned, we recently announced and will be launching a retail offer to compete directly in the SMB space.

Let me also provide a brief update on our Spoken acquisition, which, as we pointed out, has now been fully integrated into the business. We are showing significant traction on the customer, technology and revenue front. The offering is broadly applicable to BPOs, of which we have 10 live today, representing nearly 40,000 seats. Since integration, we've made several technology enhancements that unlock additional opportunities for us to expand the solution to a broader set of customers, including adding multichannel services to the platform, and we are currently the only provider that offers virtual desktop interface environments. The pipeline continues to build as do the capabilities and now stands at tens of millions of dollars in TCV. I am very pleased with our progress here.

We also announced, 2 weeks ago, that Gaurav Passi has joined Avaya to lead Cloud. Gaurav has been in the business of SaaS and cloud for more than 20 years, and comes to us most recently from Five9. I can tell you he is already making an impact and will help us accelerate our transformation.

We have built a strong foundation for growth. We are crystal clear on how we will grow in FY '19 and deliver value to our customers and shareholders. You will see this in the projections that Pat will walk you through.

Now for additional financial detail on FY '18 and guidance for FY '19, let me hand it off to our CFO, Pat O'Malley.

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [4]

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Thank you, Jim. Before discussing our outlook and reviewing our fourth quarter and fiscal year financial results, I'll make some observations I believe provide useful context.

One, we have achieved a fundamental 2018 objective of driving revenue stability, following a 10-year history of declines in the high single digits. After multiple-digit declines, we have seen growth in our total contract value, improved bookings, a return to growth for our contact center business and slower erosion of our maintenance revenue due to higher renewal rates, larger deal sizes and improved financial metrics since emerging from restructuring.

Two, we are increasing longer-term shareholder value by investing back into the business. We launched 117 new product offerings during the past year, established an innovation incubator, obtained our first patent in customer implementation for groundbreaking Avaya Mobile Experience technology, entered a strategic alliance with Afiniti International Holding with our industry-leading contact center platform and reinvigorated our customer base with programs such as Loyalty Together, which was an extraordinary success in fiscal 2018, enabling hundreds of customers to upgrade their older CS1K devices to our latest offerings. Avaya had cumulative over 1.3 million connections or lines from the Loyalty Together program since the program started in February 2018. We accomplish this all while maintaining our industry-leading financial model.

Three, increased confidence. Total contract value of revenue increased 7% year-over-year at over $2.4 billion. We continue to move towards a software and services business model. This was confirmed by both the Q4 and fiscal year '18 records, with software and services up 340 basis points year-over-year and up 410 basis points for fiscal year '18. While recurring revenue for the fiscal year reached an all-time high of over 57% of revenue, up 140 basis points for fiscal year '18 over the previous year.

And our business model remains sound. Gross margin was a record for both the Q4, 63.4%, and fiscal year '18, 62.5%. These numbers include our investment in Spoken for the enterprise cloud, undertaken to accelerate our growth in the cloud for our enterprise customers. We expect to continue to improve the business model in our future periods, as confirmed in today's outlook.

I will now highlight selected Q4 financial results. Revenue was lower 2% year-over-year but increased by 2% from Q3, again highlighting how we have stabilized our revenue during fiscal year '18, which was one of our strategic imperatives. Fiscal year '18 revenue from software and services was a record of over 82% of our revenue, up from 78% the prior year. For fiscal year '18, recurring revenue was a record of over 50% (sic) [58%] of revenue, up from 56% during fiscal year '17.

Nonrecurring revenue consists of hardware, nonrecurring software and onetime Professional Services. Hardware predominantly consist of endpoints and represents approximately 18% of revenue, down from 22% during fiscal year '17. Nonrecurring software is predominantly comprised of perpetual licenses and it represents approximately 14% of revenue during the fiscal year '18 compared to 13% of revenue for fiscal year '17. Onetime Professional Services, which includes installation services as well as project-based deployment, design and optimization services represented approximately 11% of the revenue for fiscal year 18, an increase from 8% of revenue for fiscal year '17.

Product revenue of $334 million decreased 2% year-over-year, increased 4% sequentially. For fiscal year '18, non-GAAP product revenue of $1.3 billion increased by $3 million compared to fiscal year '17.

The growth for the full year was led by our Cloud Business and recovery in the contact center business, which returned to growth for the full year. Contact center also had an outstanding Q4, growing by 11% year-over-year and 16% quarter-over-quarter. The UC side of our business also continued to improve with product revenue decreasing 7% year-over-year, although growing 1% quarter-over-quarter. Our UC product revenue stabilized for the full year, declining only 1% for fiscal '18, which is a tremendous turnaround compared to the past several years.

Service revenues of $434 million was down $10 million from the prior year and increased slightly sequentially. The year-over-year decrease of 2% was primarily from lower maintenance revenue as a result of the continued shift to OpEx models. Within services, our Professional Services posted healthy year-over-year and sequential revenue gains in Q4. As predicted, Professional Services rebounded during the fourth quarter, with Q4 improving 14% from Q3. Enterprise cloud and managed services grew year-over-year and declined slightly sequentially.

Maintenance revenue declined slightly from the prior year and decreased year-over-year.

Gross margin of 63.4% was a record, improving year-over-year by 10 basis points and was higher by 150 basis points sequentially. The year-over-year improvement is mostly a result of productivity gains through productivity improvements in our services business, while the sequential improvement is driven by productivity gains in both our products and the services business due to cost reduction efforts on platform costs, higher volumes and improved product mix, with an increase in the contact center business.

Operating expenses, R&D plus SG&A of $331 million increased $14 million year-over-year and increased $15 million sequentially. R&D increased by $4 million year-over-year, and SG&A increased $10 million year-over-year. Focusing on R&D expense, it was $51 million for the quarter. R&D expense increased $4 million year-over-year and was $1 million higher sequentially.

The increased R&D spend reflects our continued commitment to drive innovation in our products and technology that will enable us to expand our customer base and enable top line revenue growth in fiscal 2019.

SG&A increased both year-over-year and sequentially, primarily due to higher sales commission expense related to the increased bookings as we compensated our sales staff on total contract value as accelerators to ensure that we rebuild our revenue foundation for fiscal year '18 and beyond due to the erosion we saw during -- in the restructuring period. The longer-term benefit is high recurring revenue in future periods and higher predictability of revenue streams.

Also during fiscal '18, we paid approximately $8 million for tax planning purposes as our NOLs were expiring. The result is we will save approximately $20 million a year in cash taxes for the next 15 years.

Operating income was $157 million or 20.4% of revenue for Q4 of fiscal year '18. For the full year, operating income was $637 million or 20.8% of revenue. Adjusted EBITDA was $178 million or 23.1% of revenue for Q4 fiscal year '18. Adjusted EBITDA for the full year was $746 million or 24.4% of revenue.

Looking at our capital structure. As part of our ongoing activities to improve Avaya's capital structure, we recently announced that our Board of Directors has approved warrant repurchase, authorizing Avaya to use up to $15 million to repurchase the dilution of warrants, with our intent to reduce the potential dilution of up to 5% with respect to Avaya's common stock.

Turning to the balance sheet. Cash and cash equivalents were $700 million at the end of Q4 compared to $685 million at the end of the prior quarter. The sequential increase of $15 million in cash and cash equivalents is primarily due to the positive cash flows from operating activities and the proceeds from the sale of assets, partially offset by capital expenditures.

Operating cash flow was $25 million, offset by capital expenditures of $25 million.

Our days payable, down -- was down significantly from 100 days in Q3 to 83 days in Q4. This was affected primarily by the final settlement with Extreme Networks in the amount of $36 million for the completion of the transfer sale agreement that negatively impacted working capital and will not repeat. We'd expect our DPO to return to 85 to 89 days in the upcoming quarter. We continue to look at opportunities to optimize our cash conversion cycle, and we expect to improve on working capital in this current quarter.

Turning to our outlook. Our financial outlook represented -- presented below reflects the adoption of the new ASC 606 revenue recognition standard that became effective, October 1, 2018, and replaced ASC 605. Avaya has adopted the modified retrospective transition method. The net impact of adoption is expected to be a decrease of fiscal 2019 adjusted EBITDA compared to ASC 605, substantially offset by earlier revenue recognition for certain products and services under ASC 606 and incremental revenue.

Taking into consideration our continued investment in R&D, sales enablement, tools and people and our ongoing efforts to improve our operating efficiencies, we are providing the following forecast for the first quarter of -- and fiscal 2019.

For Q1, under ASC 606, GAAP revenue of $740 million to $765 million, non-GAAP revenue of $750 million to $775 million, GAAP operating income of 4% to 7% of revenue, non-GAAP operating income of 21.5% to 22.5% of non-GAAP revenue, GAAP operating income of $30 million to $50 million, non-GAAP operating income of $162 million to $173 million, cash taxes of approximately $8 million, adjusted EBITDA of $185 million to $197 million or adjusted EBITDA margin of approximately 24.5% to 25.5% of non-GAAP revenue, approximately 111 million shares outstanding.

For fiscal 2019 under ASC 606, GAAP revenue of $3.01 billion to $3.12 billion, non-GAAP revenue of $3.05 billion to $3.15 billion, GAAP and non-GAAP R&D of $220 million to $225 million or 15% to 16% of product revenue, operating income of $200 million to $280 million, non-GAAP operating income of $674 million to $730 million or between 22% to 23% of non-GAAP revenue, adjusted EBITDA of $763 million to $819 million or between 25% to 26% of non-GAAP revenue, approximately 113 million shares outstanding, cash taxes of $75 million to $80 million, CapEx of $75 million to $80 million, cloud and innovation, 12% to 14% of non-GAAP revenue, recurring revenue of 58% to 59% of non-GAAP revenue, software and services of 83% to 85% of non-GAAP revenue.

This concludes my prepared remarks. Now I'll turn the call over the Matthew and begin the Q&A session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Raimo Lenschow. (Operator Instructions)

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Mohit Gogia, Barclays Bank PLC, Research Division - Research Analyst [2]

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This is actually Mohit on for -- Mohit Gogia on for Raimo. So really solid quarter, guys, shows a solid follow through on the guidance numbers you have given and good guidance on fiscal '19 as well. So just, my first question is for Jim, and then I have a follow-up question for Pat. So Jim, so the contact center business, clearly, we have seen an inflection this fiscal year, so returning back to growth. Unified Communications seems like you're headed in the right direction but some work needs to be done there as well. So I'm just wondering if you can give us an overview of things that have worked well in contact center? And I guess, what, sort of, like in terms of Unified Communications, the core UC as to what steps you need to take there so that it can also, sort of, like reach the inflection point that the contact center has in this year. So maybe it's product investment, maybe it's more, sort of, like seamless marketing strategy or a go to market? So just wondering if you could give us color on those 2 core product lines.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [3]

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Yes, sure. Thank you very much. Appreciate the question. So first, on contact center, thanks, yes, the team has been working hard around the globe and really continuing to drive new innovation inside of the overall contact center office. Clearly, with Oceana omni-channel really starting to take hold in the marketplace has really provided a nice uplift. And as we look into FY '19, we see continued strength. And more importantly, really, where we're seeing that is not only just from the Oceana platform and continuing to build that out, but also adding mobility in AI and really driving additional productivity, customer experience for our key enterprise customers, we're starting to see significant demand. And with mobility and with AI, offers a real differentiator for us to compete against the -- our competition. If you take a look at UC, actually, I'm quite pleased with the results in UC, especially the fact, you've been hearing quite a bit from a number of folks out there about how that market is under a fair amount of duress. In fact, some have said frankly, the move to cloud is really taking a huge bite out of, if you will, the UC business. We are seeing that our products are competitive, both from a collaboration perspective, endpoint perspective, and we have new open phones coming, huddle rooms, the list goes on and on. So we're not seeing, by any stretch of imagination, that UC is dead. Our -- we're seeing -- we -- as Pat pointed out, we were basically flat year-on-year. We're seeing significant strength around the globe. And then we think with the enhancements that we're making or we know with the enhancements that we're making not only in UCaaS but with our SMB offer now, a retail storefront offer that would be available starting next week, we see some real opportunities for us as we go into FY '19. And last but not least is the convergence really between UC and CC. You'll hear a lot more about that when we're together next week in New York for our Investor Day. But we already have seen 12,000 of our customers really taking full advantage of the convergence of UC and CC, really driving that to a single platform. I firmly believe that will open up significant opportunities for us as we go into FY '19 as well. So kind of a long-winded answer, but hopefully, I addressed your question.

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Mohit Gogia, Barclays Bank PLC, Research Division - Research Analyst [4]

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No. Really appreciate the color, Jim, there. And a follow-up question for Pat. So Pat on the fiscal '19 guidance, the 1% -- 1% to 1.5% growth at the midpoint seems very -- I mean, it seemed to be better than our expectations, so congrats on that. And I'm just wondering, I'm trying to figure out what happens on the maintenance line here? So the renewal rates you mentioned are trending in the right direction, they are -- they have actually been the highest levels in 4 years. But if you look to the maintenance revenue as to how it will trend for fiscal '19, any color you can provide there will be helpful.

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [5]

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Yes. I think, thanks for the questions. Maintenance, as you know, there's a continuing shift from the maintenance in -- as to go to cloud. So in some ways, that maintenance as you shift to cloud will go down, but as we look at -- as you highlight, and we discussed the higher retention renewal rates has really bolstered that revenue. And then if you take a look at next year, we see sort of a slower decline than we saw this year because we got to the trajectory, come in -- remember the first quarter, we were still in the restructuring. So as the year has been built up, the team's done a really good job, higher touch points with the customer, higher engagement and even greater potential up-sale. So we really see that slowing down to erosion of slower levels than we've seen over the last several years, even better performance than what we saw in '17 to '18. So you would see that number is one of the reasons why you see that growth because we're growing -- we have a part of our engines growing inside of -- Avaya's growing at 4 plus percent, and it's been with a drag, with a maintenance that -- maintenance drag is slowing down because of all the positive momentum. So that's part of helping us start to see real top line growth. So it's a combination of growth plus the management of that maintenance either through renewals and retention and conversion to potentially cloud. So we feel pretty positive where that trajectory is going. So '19, we feel really comfortable with the maintenance.

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Operator [6]

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Our next question comes from the line of Asiya Merchant with Citigroup.

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Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [7]

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Quick question, as I look at cloud accelerating from 11% of your revenues to about 13% next fiscal year, can you help us understand how you think about margin as you project -- as you accelerate that, not just as it relates to fiscal '19, but even beyond. My understanding is, fiscal '19, you'll see some benefit of some onetimers that impacted your fiscal '18 performance, financial performance, whether that was Spoken integration, some of the admin costs and financial planning costs that you alluded to earlier. So just help us think about how you think about margins because those are pretty -- those are one of your key points as cloud accelerates and grows into a bigger portion of your revenues.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [8]

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Yes. So this is Jim. Then I'll turn it over to Pat. So clearly, if you take a look at the overall business model, and how we're moving, we certainly see an increase in the overall margins of the company. Pat pointed that out as we get into FY '19. A fair amount of that, as we get into '19, will be driven off of the growth that we're seeing in our cloud business. The exact numbers, they're in the, I would say, from the cloud business in the upper 80s or so percentage. I can give you the exact number, but it's somewhere in the upper 80% range. So somewhat consistent with our software business, which is good. And that transition to more of a subscription base, as Pat pointed out, moving from 82% this year up to 84% -- or 83%, 84% next year as service offerings, services percent of revenue will be a big driver in continued margin expansion for the company. If you take a look at cloud, our strategy, obviously, is to offer solutions across all markets, SMB to enterprise, UC to contact center. And I think we're -- I know, we're uniquely positioned to deliver across those, whether it's public, private or hybrid. Enterprise, today, we offer flexibility, functionality, security and scale, options that our customers want clearly in private and hybrid that uniquely positions us, that others do not have in the marketplace. So we are going to continue that transition when and how our customers want. But clearly, they're not going to move directly to public. So having that private offer in that hybrid solution, and we're starting to see additional traction is key for our growth. I would tell you that we're going to be focusing significantly on the mid-market this year. Certainly, a lot easier to move down, if you will, then move up. We had a great fourth quarter. We grew significantly in our overall number of seats last year, and we're off to a pretty fast start. And with the Spoken acquisition, gives us the opportunity to really play in the mid-market and CCaaS as well. So we're -- I think we're on track. Obviously, from -- we've made a lot of progress over the last year. I think everybody knew where we were about a year ago in cloud. And a real kudos to the team. They've done a great job over the last 12 months positioning us for revenue growth as we go into '19 and beyond.

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [9]

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I'd add one item, as Jim alluded, that if you took a look at, we're, as Jim said, we're certainly getting traction on the cloud and as we grow more and more scale, where we can believe this can in longer term, start becoming a larger percentage of our business, that's when you should start seeing margin -- gross margin accretion because software -- it is a software model, so as we shift to that and get more scale, it'll go there. As we go from 11 to 12 to 14. We're still gaining that scale. But it's certainly not a drag, it's actually -- it's -- it lines up to our business model. So we think, next year, it supports our business model and longer term, as we get more and more scale in cloud, it actually enhances the business model on the margin. So we look at cloud as a positive here in both the transition for our customer and for our business model.

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Operator [10]

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Our next question comes from the line of Lance Vitanza with Cowen.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [11]

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And thank you for providing the clear guidance on the below-the-line cash flow items in the CFO commentary. And I think there's been a fair amount of confusion around some of those items up to this point, but if I'm doing the math right, if I start with the midpoint of your guidance for EBITDA, I get to around $300 million of aftertax levered free cash flow, which I think is about $2.65 per share, a pretty good growth rate versus 2018. Would you describe that as sustainable? Would you describe that as a point in time where you see additional growth potential in 2020 and beyond, or is there sort of onetime items that might be juicing that number in 2019?

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [12]

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It's a great question. We tried to give more guidance on that, given that we really had a different capital structure this year with our shares outstanding due to the restructuring period from December on. So we live with that EBITDA, so we realized that we want to give you more color on those cash items, so I'm glad you liked it. We'll continue to enhance our disclosure on that. But I think there's a couple of things in that. One, I don't if it was juicing as much, as we've talked about earlier, Lance, and we've talked to you about is that we took some significant, what we'll call onetime expenses emerging out of the restructuring, whether it was the restructuring of tax, whether implementing a sales commission plan that we needed, whether it was looking at our NOLs. So during this year, we took a burden on our cash line quite honestly and our EBITDA that we believe that those numbers really will fall off pretty substantially. So I wouldn't call it juicing '19. It's just getting back to the true cash earning potential of '19 that we had, that you really didn't see in '18 because of all these other activities. So I think what we have there is really sort of representative of the what the model is and if we could improve on the higher end, we should have a lot of the cash go to the bottom line, which gives us enhanced confidence, enhanced flexibility what we want to do, investing in the business or managing our capital structure on a much more proactive basis.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [13]

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And my follow-up is, great job on the operating front, but I've never seen a company report so many metrics between GAAP this and non-GAAP that. Could you just, if it's possible to do it succinctly, could you explain why you focused today on the non-GAAP metrics, remind me -- remind us, and will that change going forward now that you are lapping your first year out of bankruptcy? Or is this just related to other issues?

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [14]

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So as you know, we had fresh start accounting, and when you do a GAAP to non-GAAP revenue line, that starts the dialogue right there, Lance, so a great question. You'll start seeing that non-GAAP to GAAP revenue really fall off substantially. We saw it already starting to close the gap. You'll see a little more this quarter and then really fall off quite a bit after Q2. And so you will see these adjusted EBITDA to EBITDA items dissipate. And then all we'll really have left are the amortizations, so we'll be a lot less, and so next year, we won't really be excluding networks because we had that transaction last year. The non-GAAP to GAAP becomes a much smaller differential on the top line in the gross margin. And so to your point, Lance, we'd like to start moving away from that. But given the heavy fresh start, charges flowing through the P&L that we really had to give the investors the best color, as dry as it may sound, we were hoping to give the best color and articulate what we think of the business model. So we gave those, but they should start diminishing.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [15]

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If I could sneak in one last one. Investors ask me all the time. What are you going to do with all of the cash that you've built up between positive cash flow, obviously the recent convertible bond issuance and so forth?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [16]

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Yes. I'll take -- so we've -- I think we've been pretty clear on our strategy since becoming public that we really want to do everything we can to enhance the financial flexibility of the company. So obviously, part of that, as you pointed out, is strengthening the balance sheet and obviously increasing our overall liquidity. So we've got -- we've taken a number of actions to build on that, with some of the things that Pat talked about with opportunities around tax and so on. So looking forward, I can tell you that we'll take a look, but we will be prudent on whatever investments that we've done. We'll take a look at what we want to do as we look at 2019. But we will certainly keep an eye open as far as what we're going to do with. It's always been our policy not to provide, sort of, guidance, if you will. So other than the fact that we'll be prudent as we -- with the use of cash as we move forward.

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [17]

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Yes. As Jim said, we're continuing to invest in the business model as you saw for the operating results and what we think we'll deliver next year. We took a step, one, to look at our capital structure, we looked at that holistically. So the board authorized us $15 million to go procure potentially those warrants to help our potential long-term dilution model. So we look at it holistically, Lance, and -- but like Jim said, it was really about flexibility. And if you look back over time, we really sort of hit the market right. And that's just sometimes you're -- you get okay in that, we were okay. So it really gave us a financial flexibility to look at the range of any public company has to look at every day, for your whole capital allocation, your investment in the business, your partnerships, et cetera. So we run that playbook every day, every quarter, we look at that, and I can tell you that's top of mind with Jim and his management team.

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Operator [18]

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Our next question comes from the line of Hamed Khorsand from BWS Financial.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [19]

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So first off, I wanted to ask you, are you seeing a net addition in the customer base? I mean, you're talking about these new logos that you're adding, is that net basis?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [20]

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Yes. The simple answer to that's yes. This is Jim. Yes.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [21]

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Okay. And then my other question was going to be on the retail side that you're talking about going after on the cloud. Is that pure cloud product? And are you able to stem off the competition with what's going on with the pure cloud players?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [22]

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A, it's a pure cloud offer. B, it's a retail, if you will, storefront offer. It's in proof of concept, now going live next week, and we expect that, that offer will provide opportunities for us to drive additional revenue. The -- and we expect our partners have been asking for it, so -- as well as our master agents. I don't know, Gaurav if you're going to add more color to that or not.

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Gaurav Passi, Avaya Holdings Corp. - President of Cloud Business Group [23]

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Absolutely. I think first of all, we're very uniquely positioned in this market when it comes to cloud. Jim pointed out, we have 145 million seats, both when you think about UC and CC, that's about 1/3 of the market overall. We're uniquely positioned because we own these customers. We don't have to go spend all the energy on customer acquisition costs. So that really is a unique proposition over here. We have pure cloud assets. You have been following us, you know that we acquired Spoken assets. And we took the Spoken asset and integrated into our overall technology over here, added omni-channel on top, along with integrations with CRMs like Salesforce and Google and other technologies that has made us very competitive in the space now with the pure cloud players, so watch us coming very aggressively in this space. Jim pointed about mid-market. We'll be going very aggressively in the mid-market and also introducing ourselves more disruptively, if you will, in the SMB space with the storefront that we're launching this month.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [24]

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Okay. And just quickly, did you add more channel partners? And what's the count now?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [25]

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The overall count on channel partners is in the mid-4,000 range, 4,800 or so channel partners. Yes, we've added more channel partners. So we added about 200 channel partners. But overall, year-on-year, we're down. So we added but -- where we're adding is obviously centered around the fact that where technologies are moving. So we've gotten away from, sort of, your traditional partner base, and we've moved more and are continuing to add more partners around, if you will, cloud and emerging technologies. And we're doing a lot of that i.e., through our Master Agent Program. So we are -- we're getting a sort of a different construct within our partner base. So -- but we did add about 200 partners in the fourth quarter.

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Operator [26]

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Our next question comes from the line of Mike Latimore with Northland Capital.

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Michael James Latimore, Northland Capital Markets, Research Division - MD & Senior Research Analyst [27]

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In terms of just the growth pattern throughout fiscal '19, obviously, you guys seem very confident in growth this year. I guess, the first quarter has -- the guidance suggests little bit of a decline and then the year is obviously up. So can you talk a little bit about that pattern? Why do you have confidence that you'll go from a decline in the first quarter to, kind of, growth later in the year?

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Patrick J. O'Malley, Avaya Holdings Corp. - Senior VP & CFO [28]

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So it's -- one, we do get somewhat of a seasonal decline. And so we're lining up to there. We also at the high end -- and I'm not implying that, that's where we're pegging our numbers, but the high end, we do see a world that we could sort of hold it flat now. I think that would be a very good quarter if we got there. But we do -- the reason we put that guide is we do see optionality there. So we -- and there's reasons for that, whether there was some RPs that didn't close last quarter, that can close this quarter. So we feel comfortable within that range. But like I said, there is normally a seasonal decline, but the other thing, Mike, is that as we continue to build our cloud platforms out, we not only could we transition new customers, we could acquire new customers. I mean so it's not just -- it's just not a conversion of a large base that Gaurav and Jim talked about, which are -- is invaluable because it's a very valuable asset to us. But we also have the opportunity with our platforms now to acquire new customers that can drive incremental top line growth. And that'll be building momentum through the year. And so that gives us more confidence as the year goes on. And then also some of the things that Jim talked about, whether it's the mobility and some of our innovation on AI. That'll start kicking in the back half of the year. So we got the irons in the fire, if you will, and they start heating up and start delivering top line results as the year progresses. And so we see this year as a rolling thunder and where it builds up. So that's sort of the view of the world in a -- in that synopsis.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [29]

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Yes. That's exactly right. We've invested quite a bit this past year. And we've started to see some of that come to fruition in the latter part of '18. But as Pat pointed out, as we move through '19, you'll start to see a lot of momentum associated with a lot of new products that we recently...

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Operator [30]

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Our next question comes from the line of Catharine Trebnick with Dougherty.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [31]

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Could you talk a little bit more about your partner program in terms of domestic versus international? And how are you enabling these -- your newer technology to be sold to the partners? And what type of training programs you're putting in place to make it more successful?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [32]

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Yes, sure. Obviously, our channel's really important to us. And all in all, it represents in the range of about 60% of our revenue, and it's growing. As you take a look at cloud as an example, we're obviously seeing a bit more momentum in the U.S. associated with cloud and the overall cloud deployment. If you look at compensation and so on, it's pretty much a global program. So it's fairly similar to the international communities. Obviously, it's a bit more diverse as far as the customers that they serve, you see -- obviously, you'll see more if you will from a deal size perspective in the U.K. and Germany as an example as compared to some of the markets in the APAC region. We are -- we do have and are growing international in the overall channel business. And so we're seeing growth there as well. But again, it's, for the most part, more around, I'll say, traditional Unified Communications than more cloud. That being said, as we look towards FY '19, we did just release a retail offer in Germany this past quarter, back in the October time frame. We're starting to see significant traction there, which is great. And we've also have sort of reinvested in and repurposed our SISP organization. And that will be another vehicle for us to really drive cloud growth as we look into FY '19. So there's significant activity going on in that space that we expect to see nice growth in '19 over '18 really led by Dino, who we brought in to run in North American sales force from Broadsoft as well as Mark Vella, who's running SISP for us. So you'll hear more about that for those of you that will be at Investor Day next week. But we're seeing good traction, kind of, sum it up around the globe, we have continued to add new partners, and we think we have our pulse on what's working and we'll continue to build that out.

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Operator [33]

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And we have a question from Rob Jost with Invesco.

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Robert Jost, [34]

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I wanted to go back to a comment you made, Jim, about the cloud in the enterprise space. And your thoughts on, is the enterprise space ready for cloud UC and even where -- potentially CC. And maybe tied to that, my second question, a related question would be the economics. Are the economics on the cloud similar to what we see on the private cloud? Or is there a step-down from there?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [35]

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Yes, so I'll touch on it. Then I'll turn it over to Gaurav to add a bit more color, so I'll start with the economics. The economics are actually quite favorable for us as we take a look at moving customers to the enterprise cloud, which is good. You'll hear more next week about some new offers that we're going to be -- that we'll have available in January and February that will add to the overall economics on how we're -- we will be deploying private cloud solutions as we move forward. The economics are also strong because most of these deployments also have a Professional Services element to them as well. It's one of the reasons why you're seeing a nice uplift in our Professional Services revenue, really around that consultative piece of the business and really helping our enterprise customers through this digital transformation journey, as I mentioned. We are seeing movement in the enterprise to cloud but not nearly at rates much like the industry publishes, what you would see on the, sort of, the low-end mass-market opportunity. There's a number of reasons for that, regulatory security, the list goes on and on with a number of our large enterprises. But they are willing to take a look at doing a hybrid-type solution, which we have a great offer for as well as obviously more and more folks want to move to a private. But they want to move more to a virtual private, which we'll talk more to you guys about next week and what we're doing there as, again, a key differentiator on the solution that Avaya has that others frankly do not that we think would be a big play for us as we go into '19 and beyond. But, Gaurav, I don't know if you want to add anything.

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Gaurav Passi, Avaya Holdings Corp. - President of Cloud Business Group [36]

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Absolutely. I think what we're hearing from our customers, large enterprises, whether these are large airlines or banks or health care companies, is really the whole digital transformation notion. These companies want to be where their customers are, and that's embarking the whole transformation journey for them. And what we're noticing is that one of the first things that these customers are doing is they're taking their customer management system, aka, CRM system and pushing that up to the cloud. And as we all know in the industry, the moment you push your customer management system up to the cloud, the next thing you got to do is push the communications up to the cloud. And that's where they're coming to us because these are our customers coming to us immediately and saying, hey, we want to help with you do to get embarked in this journey of digital transformation, give us an OpEx model, give us a subscription model, give us security that Jim talked about, secure cloud. In a lot of these cases, these customers are coming out and saying, hey, give us a model where we can take digital channels on the cloud and integrate that to the existing voice communication that we have -- whether on prem or on hybrid for them. So that's a great path that we're seeing with these customers, frankly speaking, the competition cannot provide that integration on a hybrid model, that Jim talked about earlier.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [37]

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So look, I think, we're up against the hour here. So Peter?

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Peter Schuman, Avaya Holdings Corp. - Senior Director of IR [38]

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Yes. Avaya will move the start time for the 2018 Investor Day on Wednesday, December 12 in New York City by 30 minutes. The event is now scheduled to begin promptly at 12:30 p.m. Eastern and is expected to conclude at approximately 4:30 Eastern. The event will be webcast live and all interested parties are invited to access the webcast from the Investor page of Avaya's website, investors.avaya.com.

During the first quarter, the fiscal 2019, Avaya will be attending one-on-ones at Barclays conference in San Francisco on December 6. We also hope to see you at Avaya ENGAGE in Austin, Texas on January 20 to 23. In the meantime, you're always welcome to contact our investor relations department at (669) 242-8098 with any questions. Thank you, and this concludes today's call.

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Operator [39]

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Ladies and gentlemen, this concludes today's quarterly earnings call. Thank you for your participation. You may now log off.