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Edited Transcript of AVYA earnings conference call or presentation 9-May-19 12:30pm GMT

Q2 2019 Avaya Holdings Corp Earnings Call

BASKING RIDGE May 20, 2019 (Thomson StreetEvents) -- Edited Transcript of Avaya Holdings Corp earnings conference call or presentation Thursday, May 9, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Chris McGugan

Avaya Holdings Corp. - SVP of Solutions & Technology

* James M. Chirico

Avaya Holdings Corp. - President, CEO & Director

* Kieran J. McGrath

Avaya Holdings Corp. - Senior VP & CFO

* Michael W. McCarthy

Avaya Holdings Corp. - VP of IR

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Conference Call Participants

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* Asiya Merchant

Citigroup Inc, Research Division - Research Analyst

* Balaji Krishnamurthy

Goldman Sachs Group Inc., Research Division - Associate

* Dmitry G. Netis

Stephens Inc. - MD of Equity Capital Markets & Senior Research Analyst

* Erik Taylor Lapinski

Morgan Stanley, Research Division - Research Associate

* Hamed Khorsand

BWS Financial Inc. - Principal & Research Analyst

* Lance William Vitanza

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

* Nandan Girish Amladi

Guggenheim Securities, LLC, Research Division - Senior Analyst

* Raimo Lenschow

Barclays Bank PLC, Research Division - MD & Analyst

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Presentation

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Operator [1]

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Good morning. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the Avaya Second Quarter Fiscal 2019 Financial Results Conference Call. (Operator Instructions) Mr. Michael McCarthy, Vice President of Investor Relations, you may begin your conference, sir.

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Michael W. McCarthy, Avaya Holdings Corp. - VP of IR [2]

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Welcome to Avaya's Q2 fiscal year 2019 investor call. Jim Chirico, our President and CEO; and Kieran McGrath, our Senior Vice President and CFO, will lead this morning's call and share with you some prepared remarks before taking your questions.

Shefali Shah, our Senior Vice President and Chief Administrative Officer and GC; and Chris McGugan, Senior Vice President of Solutions and Technology, are also here for this morning's call.

The earnings release, CFO commentary and investor slides referenced on this morning's call are accessible on the Investor Relations page of our website as well as the 8-K filed today with the SEC 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 our non-GAAP numbers, except where otherwise noted. A reconciliation of such measures to GAAP is included in the earnings release and the investor slides, which are available on the Investor Relations page of our website.

We may make some forward-looking statements that are based on some 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 and subsequent Form 10-Q reports. 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, except as otherwise required by law. I'll now turn the call over to Jim.

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

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Thanks, Mike. Good morning, everyone, and thank you for joining us. My comments this morning are focused mostly on our Q2 FY '19 performance, and then Kieran will take you through the numbers. Our top line results and earnings fell short of expectations and this was not the way we wanted to begin the calendar year. In response, we have implemented a number of corrective actions to drive improved performance. While I'm disappointed in our results last quarter, overall, I remain confident about our path forward given the momentum and traction we are seeing in many segments of our business, including cloud, services and emerging technologies. Our revenue shortfall was due to a combination of 2 factors. Number 1, we experienced product transition execution issues. Specifically, in contact center we missed a key internal technical deliverable associated with a new partner offer. We have moved quickly to address this issue and it will be rectified later this quarter. In UC, we experienced operational execution issues in channel inventory related to the transition from our older model endpoints to the new J Series. We have addressed the root causes and implemented corrective actions, but it will likely take us until early Q4 to return to normal operating levels.

The second was the result of the Reuters story published in late March about a potential transaction involving the company. This created uncertainty among our customers and partners and led to a noticeable change in buying behavior. We have implemented a customer outreach and communications plan that emphasizes our innovation, strength and market leadership to help address this situation. But bottom line, the timing of the speculation, while difficult to pinpoint a quantitative impact, clearly had an effect.

Moving forward, I continue to believe in a long-term outlook for Avaya as it remains solid. We've invested in our technology and talent and re-engineered our go-to-market systems and processes to drive a customer-led strategy.

We have and are implementing our playbook to deliver against the company's long-term growth strategy.

In the second quarter, the team maintained an aggressive focus on our key growth initiatives, which are investing in our core, accelerating innovation and bringing new and emerging technologies to market, growth in cloud and providing high-value services to our clients.

We made progress and showed strength in a number of key areas. Our transition to software and services now stands at 83% and recurring revenues are at 59%. Public cloud seat growth of over 165% year-over-year and 25% quarter-over-quarter to over 290,000 seats. Private cloud traction was over $60 million in new total contract value bookings in Q2 led by our launch of ReadyNow private cloud. In the area of services, we had our best Professional Services revenue performance in the last 4 quarters. And we see improvements in our maintenance base. Our total contract value remained at approximately $2.4 billion and grew 3% year-over-year. We are building out a broader ecosystem, including alliances with big friends such as Salesforce, IBM and Google. Our continued focus is to identify and capitalize on key growth opportunities in the market. Let me provide a few examples.

We continue to seek traction with both new and existing customers and in the second quarter we added approximately 1,500 new logos, signed 78 transactions with a value of over $1 million in total contract value. This included 9 deals over $5 million and 2 deals over $10 million. Of these key deals, 1 was with the department of U.S. military to modernize their entire communications infrastructure. Avaya was the only company able to address this agency's specialized needs and interoperability challenges with unique systems. Our continued ability to deliver differentiated solutions is commonplace. Another example is CHRISTUS Health, an Avaya customer for over 20 years. They chose to migrate from a multi-vendor environment that included a mix of Mitel, Shoretel, and Cisco products to an Avaya contact center solution. They chose Avaya because of the value we bring from an improved customer experience perspective. Their full implementation of 60 hospitals and 175 clinics will be completed later next year.

Now let me turn to cloud. In cloud, we saw a continued momentum in both our mid-market and enterprise offerings. We added nearly 60,000 public cloud seats, bringing our total to just over 290,000 seats, driven by, powered by [NX CaaS]. 2/3s of our seat growth came from outside of the U.S. and was spread across South America, Asia, Europe, highlighting the strength of our global capabilities. Additionally, we are beginning to see traction with Storefront, a simple online purchase and fulfillment portal. This has been available to U.S.-based customers since early this year and is now available in Germany. Rollouts into Canadian and U.K. markets are on the road map and will move through the second half of this year.

This expands our go-to-market approach into the SMB space where customers can leverage the benefits of buying UC and CC cloud offerings from 1 vendor online. In private cloud, we ended the quarter with 3.4 million seats. Our private cloud strategy and ready-now solutions just launched in January are being embraced by mid-market and global enterprises as they look to move to the cloud in a secure and reliable way. We are still early in ramping this solution, but we are already signing customers.

I would like to take a moment to highlight 2 notable private cloud customer wins. In a deal worth approximately $11 million, a large Mexican telecommunications company chose us to consolidate approximately 10,000 contact center seats in a private cloud model. As part of the deal, we will displace 3,500 Genesys seats, and a workforce management solution from NICE. This transaction also provides further upside in new applications and the ability to potentially replicate globally. Additionally, a U.S.-based insurance company signed a deal in excess of $30 million to migrate 60,000 unified communications along with 30,000 contact center seats to our private cloud solution. This customer also chose to leverage our newly released Device-as-a-Service offering.

The ability to offer compelling solutions through multiple delivery models and market segments is a unique differentiator for Avaya. And our embrace of emerging technologies is clearly resonating. We are at the forefront of delivering innovation at scale and made important progress across our mobility and artificial intelligence offerings in Q2.

In mobility, we signed transactions with an innovative business process outsourcer and an 811 provider for high fidelity mobile routing. The disruptive impact of our technology is showing itself with increased frequency.

Last month, we signed a new customer that had just learned about our mobility solution at our users group conference that occurred a couple weeks prior. The customer was anxious to begin accelerating their digital transformation journey. In artificial intelligence, we are continuing proof of concept work for 2 high-profile customers, a large retail and a large infrastructure provider, testing our conversational intelligence solution. Both are eager to leverage their existing contact center investments to improve overall customer experience.

Also in the area of AI, our partnership with Afiniti continues to provide real and measurable benefits to our customers. We now have over 20 joint customers benefiting from Avaya and Afiniti enterprise behavioral pairing and pair over 20,000 agents with their customers.

These are some of the world's largest wireless, cable, health care and hospitality providers in the U.S., Mexico, Canada, Australia, Brazil, U.K. and Turkey. We have 5 customers running on our new native integration and expect 2 more customers to go live just this month.

Our success in bringing innovation to the market was again recognized by a third-party industry analyst. Aragon Research again rated Avaya as a leader for Unified Communications and Collaboration in 2019, while Avaya also earned the Gartner Peer Insights Customer Choice in Unified Communications for the second year in a row.

Now I would like to shift gears and I would like to reiterate comments shared on our earnings release this morning. Following the receipt of expressions of interest, the company has engaged JPMorgan, a leading investment banking firm, to assist in exploring strategic alternatives intended to maximize shareholder value.

The Board has not set a timetable for the process nor has it made any decisions related to any strategic alternatives at this time. There can be no assurances that the exploration of strategic alternatives will result in any particular outcome. The company does not intend to provide updates unless or until it determines that further disclosure is appropriate or necessary.

Let me share my thoughts on our full year reset. Our conversations with partners and customers over the last several weeks have made several things clear. They are confident in the company, in our innovation and the value we are driving along with our capabilities. But with our performance in the first half, the product transition issues that will continue in Q3 and the announcement that we have engaged JPM, we believe it prudent to reassess and revise our full year expectations.

Before I turn it over to Kieran, I'll end by restating that my confidence in our company, partners, people and customers remains high. Our brand and pipeline of new products has never been more relevant, more customer driven. And we continue to make strides on our path forward.

Kieran will now walk you through second quarter financials and second half guidance in more detail. Kieran?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [4]

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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. Additionally, please note that we have posted supplementary commentary on our quarterly financial results as well as any relevant tables and GAAP to non-GAAP reconciliations on our Investor Relations website.

Turning to our second quarter fiscal 2019 results. Non-GAAP revenue was $714 million and was well below our guidance range. Software and services accounted for approximately 83% of our revenue in the second quarter and 59% of our revenue was recurring.

The cloud was approximately 11% of our revenue in the period. Second quarter non-GAAP product revenue was $289 million compared to $317 million in the year ago period. Within our product business, both contact center and Unified Communications significantly underperformed our expectations. As Jim mentioned in his remarks, product transition issues within our control accounted for approximately $20 million to $25 million of the shortfall, while we believe that the remaining balance was attributable to the Reuters story published at the end of the quarter.

Second quarter non-GAAP services revenue was $425 million compared to $440 million in the year ago period. The year-over-year decline in service revenue was again driven by a lower maintenance revenue while Professional Services and private cloud revenue was largely unchanged compared to last year.

Although we expect maintenance revenue to remain a headwind to total revenue growth, we are encouraged by the ongoing improvement in our renewal rates, which we believe will help mitigate maintenance revenue declines over time.

The improvement in our renewal rates, coupled with encouraging data points, like another quarter of year-over-year growth in our total contract value, gives us visibility and consequently increased confidence in our revised outlook for the second half.

Geographically, the U.S. accounted for 53% of our revenue while EMEA, Asia-Pacific and Americas International represented 27%, 11% and 9% of our revenues, respectively.

Before moving on from our revenue performance, I want to spend a few minutes discussing the impact of ASC 606. As mentioned on our last quarter earnings call, the most significant impact of the accounting change relates to how we account for Professional Services contracts, which under the new standard are largely recognized as performed as opposed to upon completion and acceptance of services.

Additionally, when service contracts also include products, product revenue is recognized when those products are delivered as opposed to the completion and acceptance of services.

At the beginning of our fiscal year, we proactively aligned our internal key performance indicators as well as our incentive compensation plans to drive performance under the new standard. Given these operational changes, our fiscal '19 financial results are not directly comparable using the ASC 605 reconciliation table disclosed in our press release. Further, in addition to the aforementioned impact to revenue, this change also has a corresponding effect on our cash flow performance as revenue recognition now precedes customer billing and cash collection in many cases. We anticipate the difference between the 2 standards will normalize as services engagements reach completion milestones throughout the subsequent quarters.

Turning to profitability metrics. Non-GAAP gross margin in the second quarter was 61.5% compared to 62.4% in the year ago period. Overall, our gross margin was negatively impacted by lower volumes and an unfavorable mix resulting from lower software revenues in the quarter, partially offset by a decrease in platform costs and productivity improvements across our offerings.

Non-GAAP product gross margin was 63.7% compared to 68.5% in the prior year and non-GAAP services margin was 60.0% compared to 58.0% in the prior year.

Despite our lower-than-expected non-GAAP gross margin in the quarter, we continue to believe that non-GAAP gross margin will trend upward as the mix of our businesses better align with our shift to a software-centric model. Second quarter non-GAAP operating income was $149 million, representing a non-GAAP operating margin of 20.9%; and adjusted EBITDA was $166 million, representing an adjusted EBITDA margin of 23.2%.

Further, we generated $37 million in cash flow from operations, $11 million in free cash flow and ended the quarter with $735 million in cash and cash equivalents on our balance sheet. Our cash balance decreased sequentially due primarily to an increase in cash tax payments.

Moving to our third quarter and fiscal 2019 outlook. As mentioned in our press release issued earlier today, we are lowering our guidance for fiscal 2019. Our revised outlook is both prudent and conservative as it contemplates the impact of the uncertainty created by the inbound interest and lower-than-expected product sales in the first half of our fiscal year. Further, our quarterly historical sequential patterns support a fiscal third quarter roughly in line with our second quarter revenue followed by a stronger fiscal fourth quarter.

Our outlook for the second half of the year is supported by both our current backlog as well as current visibility into our pipeline; coupled with an expected to ramp up in cloud seats; further traction with service providers and system integrators; and, most importantly, improved sales and channel execution across graphic areas.

Specifically for the third quarter, we anticipate non-GAAP revenue of $710 million to $725 million. Our non-GAAP operating margin is expected to be approximately 20% and our adjusted EBITDA margin is expected to be approximately 23%.

We expect our third quarter weighted average shares outstanding to be roughly 111 million shares. For the full fiscal year, we currently expect our non-GAAP revenue to be in the range of $2.925 billion to $2.975 billion. We now anticipate that cloud revenues will be between 11% to 12% of our revenue compared with our previous expectation of 12% to 14%. Our updated view reflects a higher-than-anticipated mix of public cloud seats sold by our partner channel which, due to associated with rebid fees, correspond to lower net revenue for the fiscal year.

Additionally, although we are very pleased by the market traction of ReadyNow since our launch in January, the conversion from bookings to revenue is somewhat slower than expected, given the size and complexity of early transactions. While we anticipate that the early mix of customers will be more heavily weighted to simple deployments, encouragingly, early adopters have been large complex global enterprises with a unique set of requirements reflecting the broad appeal of the platform. We expect that this dynamic to abate over time as a more diversified customer base leverages the platform.

Further, going forward, apart from cloud revenues, we are no longer going to provide annual guidance as it relates to our anticipated revenue mix. While we will continue to report actual results so that investors can understand what our software, services and importantly recurring revenues are in any given period, our mix of revenue can have a great degree of variability due to the timing and composition of large transactions, which are very difficult to forecast with precision. As such, we believe it's more appropriate to view our revenue mix in the context of our longer-term expectations.

Turning to margin. For the full year, we expect our non-GAAP operating margin to be approximately 22% and our adjusted EBITDA margin to be approximately 24%.

Additionally, we expect our cash flow from operations to be in the range of 7% to 8% of our revenue. Finally, we expect our full year weighted average shares outstanding to be approximately 111 million shares.

Operator, we are now ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Raimo Lenschow, Barclays.

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Raimo Lenschow, Barclays Bank PLC, Research Division - MD & Analyst [2]

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Jim, can you talk in more detail about the issues around the product line? I get -- I think I get it, but then I'm still wondering why it takes a couple of quarters to rectify it?

And then a question for Kieran. Can you, like, on the 605, 606 comparison, like what would the numbers be if I do like an apples-to-apples comparison?

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

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Yes, Raimo. It's -- has to do with our endpoints, not products in general. And we did a transition from the current product set to a new J series. The fact of the matter is that we were a little bit aggressive in shipping some of the older endpoints into the channel early on in the beginning of the quarter, predicated on what we thought would be some -- predicated on what we thought would have sales out velocity. The fact of the matter is, our new endpoints frankly had taken on, from a [grant] perspective, more aggressively than we thought. And as such, those actually performed better than expectation. But unfortunately, we -- the channel had still a fair amount of our older 96xx phones. So as a result, obviously you only can afford so much within the channel and obviously we have mechanisms in place to ensure that we do not overpopulate the channel. So there was a slower turn, if you will, on the older endpoints. And it's not going to take us through the end of the year, it will take us through the end of this quarter and maybe into early July, which is the fourth quarter, before we get both back to normal operating levels. But I can tell you that J Series is actually doing much better, but the 96x series is a bit slower. As you take a look at where we are through the first 5 or 6 weeks of the quarter, we're actually on track if not a bit ahead of track on the flow through of the 96x phones. So I think we are aligned to our expectations that we set. But again, it's a good news, bad news story. And the good news is, the J series are moving faster than we had anticipated and as a result of that, the bad news is the 96xx's are moving a bit slower. But it will all be balanced out probably in the July timeframe.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [4]

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So Raimo, as I said before, with the change over from 606 to 605 (sic) [605 to 606], we actually realigned a lot of our internal key performance indicators as well as our incentive compensation plans to really just focus on driving revenue under the new standard. With the adoption of 606, the concept of installed, complete or customer acceptance is less critical for quarterly revenue recognition. So what we found year-to-date as a result of our business experience is that a greater percentage of our products are not hitting the IC, or the installed complete, criteria nearly as quickly as what our historical experience would have suggested. So let me give you an example. We flushed $96 million of our deferred revenue from the end of our last fiscal year to retained earnings in terms of the opening balance restate. History would have said that through the first 6 months of the year, that over 3/4 of that would already have been formally accepted by the customer and signed-off in this installed complete criteria. What we've -- what we're currently tracking is that in reality only about 1/3 has been closed by the end of the second quarter. So if you think that -- we've talked about that the value of 606 was worth about $50 million incremental in Q1 and $36 million in Q2, of that $86 million, essentially $40-plus million of it is really due to the fact that we haven't hit this install complete criteria just yet. We think this is going to balance out at the end of the year. We've actually put in some system implementations to drive this on a more proactive and faster basis to help with this. But certainly, I just don't think we have an apples-and-apples comparison. So if you look at 605 versus 605 on a year-to-date basis, it's -- I would say it would be down about 10%. I'd say of that, half of it is literally due to this first half -- this opening balance restate taking longer to reach installed commit. A point of it is actually going to be related to currency, where we've taken a small impact; and then the rest of it is going to be a combination of existing Professional Services contracts that are bundled, not getting to installed commit as close -- as quickly as we would've wanted; as well as the operational issues that we just addressed in our script today. So certainly, it's something that -- unintended consequences and we're working to really get our arms around that much quicker. But I do think we've probably over-rotated a bit in terms of our shift in focus.

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Operator [5]

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And your 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 [6]

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And Kieran, thanks for that helpful explanation on why you look at it the way that you do. And I think you answered part of this, but on the currency side, I wanted to ask you, you mentioned 1 point of negative growth, but that was in the context, I think, of 605 to 605. In the context of -- if we look at it as reported versus as reported, which is the way I think we're supposed to look at it, what was the impact of those currency headwinds? Does that change at all or is it still sort of about 1 point?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [7]

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Yes, in the quarter it was slightly more than 1 point.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [8]

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Okay. Slightly more than 1 point. Okay. And then I wanted to ask you also about the cloud seats. I apologize if I -- I think you called this out and missed it, from many cloud seats did you add in the second fiscal quarter?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [9]

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Actually, we added about 60,000 public cloud seats in the quarter.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [10]

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60,000 public. And do you have the number for the private cloud seats as well? Or...

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [11]

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So from a private perspective, the way we've currently been doing is actually those that are physically booking from a revenue perspective. Clearly, we added a lot more contractually but just, as I discussed, given the rate and pace of time to money, so to speak, on those, I'm not reporting those as seats just yet just because I want to stay consistent in really just tracking revenue.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [12]

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Sure. Okay. So that's a change, I think, from last quarter, right, when you had the big -- the 200,000k (sic) [200,000] private seat -- cloud seat number, which -- and I think those were all announced but had not yet begun booking. Is that right?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [13]

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So I think you just have to separate the private -- or what we're calling now our ReadyNow versus our public. So from a public cloud perspective, everything is much quicker time to money and time to billing on those. And in aggregate, we added about 60,000 of those seats this quarter and are now about 290,000.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [14]

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Okay. And then on the revenue guidance, the revenue guidance for the full year down $150 million at the midpoint. If we go back to those 3 factors, you had the technical deliverable on the contact center side; you have the, obviously, the end point piece in UC; and then this Reuters story. Could you sort of bucket the $150 million downdraft into those 3 categories, I mean, just rough numbers?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [15]

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Yes. So when I think about this, I say first and foremost, our services business, which is actually performing very close to our plan through the first half of the year, is going to be impacted just because any of our subscription revenues or any of our maintenance that was dependent on first half product shipments is going to be impacted. And I would put that somewhere probably in the -- I'm looking at one of my guys here, the 10% to 20% of the total reduction related to the less maintenance and subscription that I'll get from the first half of the year. I also think that just from an operating perspective, we're probably talking about another 20% to 25% as well just coming from the fact that we're going to take us a little while to shake out the operational issues that we had, mostly in the first half of the year. And then finally, a couple of big items that we have. We've got some really large government contracts within our eyesight. The issue that you always have when you're dealing with the government is the partners that actually end up getting selected to actually help do the actual physical delivery to your -- to the customer, the timing of the SoWs get -- that get released will have an implication on our timing of revenue. So prudently, while I see some really substantial opportunities for us in the second half of the year in that space, I really think that some of these are going probably timeout in the first -- potentially in the first part of next year. And I'd say that's probably worth almost half of what my number is in aggregate. And then I'd say after that, I'm just being somewhat consist -- somewhat conservative that this uncertainty related to the rumors and the like hanging over our head could probably drag a little bit more.

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Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [16]

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Great. And then just 1 more question for me that sort of segues from that. Jim, if you believe in the fundamental trajectory of the business as you've laid it out, isn't this is the absolute worst time to consider a sale of the company? Wouldn't you be better proving out the return to growth and then engaging with some wind in your sails? I mean, I understand that you received unsolicited expressions of interest, but why not tell them, no thanks, this isn't the right time?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [17]

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Look, first and foremost, maybe I'll answer it 2 ways. First is obviously directed to what we -- the clear and concise sort of disclosure that we've provided this morning in our earnings call. But maybe in the spirit of making this -- because there may be more questions following you on the same thing, we would make it a bit more productive. Maybe I'll just add a little bit more color at this time as well. Like every other public company, our goal is to create shareholder value. So we retained JPMorgan to evaluate strategic alternatives. And they include sort of, if you will, the full spectrum of exactly those strategic alternatives. So the evaluation of a standalone, evaluation of capital allocation, evaluation of acquisition versus other strategic financial transactions and so on. So I guess I'll end it by just saying, like every other public company, there really isn't much I should -- I could say beyond that in fairness, Lance.

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Operator [18]

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And your next question comes from the line of Nandan Amladi with Guggenheim.

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Nandan Girish Amladi, Guggenheim Securities, LLC, Research Division - Senior Analyst [19]

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So I wanted to ask about maintenance renewals in relation to transitioning or migrating customers from maintenance contracts to some sort of subscription arrangement. Can you characterize how that's going? And if any of this news from the Reuters article has had any impact on that?

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

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Yes. Sure, this is Jim. First and foremost, we didn't see the impact on the Reuters article so much associated with, what I'll say, renewals to shift to cloud. We saw it more based on, what I'll say, buying habits. Traditionally at the end of the quarter, which in fairness more aligns to contact center, software-type shipments where people just took a pause, if you will, for lack of a better term. Based upon the first article, obviously there's been following subsequent speculations since then. As far as overall renewals and the move to cloud, I'll turn it over to Kieran for some additional color. But we are doing quite well from an overall renewals perspective in the business. There's been a significant focus on that. And as Kieran pointed out, our maintenance business is actually on plan and fairly stable. But the expectation going forward is, as Kieran said, conservative and prudent based upon some of the -- where we've finished the (inaudible) from a first half perspective. But I'll turn it over to Kieran for some additional color.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [21]

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Yes. I guess I would just say to that, in terms of how I think about the maintenance, clearly some of this is going to move to the cloud. But I would say that's still relatively early days. A lot of the public cloud seats that we've gotten actually are -- many of them are new logos as well. I'd say what you're seeing here is proof in our private cloud and our ReadyNow that we're starting to see some of that shift occurring. But in terms of wholesale impact on maintenance related to the conversion to the cloud real time, I don't see it being a very material impact on the second half revenue. I would put more of the issue on the maintenance in the second half of the year really related to the product shipment shortfalls that we've talked about in the first half of the year.

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

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Yes. And just as Kieran pointed out earlier, we are very encouraged by the attraction of the Avaya private-cloud ReadyNow. But those are large, complex deals. We have 15 to 18, what I'll say, significant POCs underway. I highlighted 2 specific deals in my commentary. One of $11 million, 1 of $30 million. So they are significant. But based upon these being obviously subscription oriented, cloud oriented, and we indeed are starting to get revenues even this quarter from those. But the time it gets into sort of a -- more of a steady-state ramping perspective, it will be into 2020. So it won't have a significant impact on FY '19, on numbers. But it's a great baseline for us as we move into 2020 and beyond. And I can tell you that all of the POCs are going along quite well and we're encouraged. But it's not something that we'll see significant revenues this year but provides opportunities for us as we move into 2020.

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Operator [23]

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And your next question comes from the line of Meta Marshall with Morgan Stanley.

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Erik Taylor Lapinski, Morgan Stanley, Research Division - Research Associate [24]

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This is Erik on for Meta. Maybe just looking at the public cloud product. Can you comment on where master agents are finding some of the most traction? And what's the typical seat size that they are having (inaudible) with?

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

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Yes. Sure, Erik. I'll probably -- Chris McGugan is here, I'll turn it over to Chris after. But, when you take a look at master agents, that's more on your SMB portfolio. Anywhere typically for us, in fairness based upon the current product offering, because storefront is just starting to gain traction and has been in the neighborhood of, say 25-to-50 seats up to, say 200 seats max. The traction, in fairness has been a little slow for us and one of the reasons why we've come out with this storefront, and in fairness revamped the storefront, which Chris will talk about. Our Germany storefront that we recently announced is actually gaining good traction that is targeted more for your lower end. Your 5-to-50 versus sort of where we are currently with our offerings here in the States. So it's at the lower end of the SMB market.

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Chris McGugan, Avaya Holdings Corp. - SVP of Solutions & Technology [26]

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Yes. I think Jim characterized it very, very well, the storefront. We have made some optimizations to it to enhance the offer that goes out through our master agents and enabling them not only to sell just the UC service but also trunking and our CPaaS platform as well. So we've expanded the offers that are available to them. And we think that creates additional stickiness in the market for those master agents and opens up additional opportunities for them to drive revenue.

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Erik Taylor Lapinski, Morgan Stanley, Research Division - Research Associate [27]

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That's really helpful. And if I could just -- one more quick. If you're thinking through your channel partners, is there anything they are asking for today? Maybe more incentives or anything around refreshed products?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [28]

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This is Jim. No, I wouldn't say that they're asking for anything incentive-wise or anything like that. I would -- we work fairly closely with our channel partners. Or IP office mid-market solution is actually going quite well in the marketplace, as Kieran said, equal to our -- if not a little bit above our expectations. I think the plays that we're running with them, the incentive programs that we have in place with them, I would say are adequate. And -- so they're not asking, if you will, the new storefront opportunity I think opens up some additional opportunities with a couple of our partners as well. So -- and even the private cloud solution will also be sold through the channel. So they are actually quite excited as we are now rolling that out and providing that capability to our channel partners as another go-to-market vehicle for them. So they are actually very excited about the ReadyNow private-cloud solution.

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Operator [29]

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And your next question comes from the line of Rod Hall with Goldman Sachs.

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Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [30]

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This is Balaji on behalf of Rod Hall. I wanted to follow up on the cloud comment -- private cloud comment you made earlier. So that cloud count -- seat count was about 3.7 million last quarter and it was 3.7 million this quarter. So I just wanted to confirm that the private cloud seats did not decline? And then I have a follow-up.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [31]

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Yes. There's a little rounding in there, as you would expect any time you are renewing with customers. They'll have some reset of the amount of seats that they drive some productivity in the [old shop]. So there would be some slight reductions there that actually lead to rounding, which is why you're probably hearing 3.4 million implication on the private. As I said before, if we start counting all the revenue producing ones as -- we're only counting revenue-producing, if we start counting those under contract, the number would be little higher than that. But just trying to be consistent in how we call it out.

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Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [32]

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Okay. And then on the guide, can you quantify the Spoken contribution to your June and September guidance? And beyond that, I think if we look at your full year guidance, even though you've taken it down, you do need a pretty meaningful improvement in Q4 to hit your -- hit the low end of the guide. And you are looking at a couple of quarters of significant declines here. So can you comment on the visibility to the fiscal year end? And how confident you are on hitting that target?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [33]

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Yes. So I guess -- let me start with the last part of your question first. If we go back and look, we have 7, 8 years of history looking at the company. There is a pretty consistent seasonality by quarter between our business. And in general, honestly, even though we guided -- we certainly were guiding more aggressive in Q1 in anticipation of where we want to drive the business towards, but history would've said that Q2 versus Q1 would always have been down roughly 4% to 5% -- actually, closer to 7%. We ended up down around 4%, so down around 7%. History also says that Q2 to Q3 is roughly flat to maybe up 0.1% or 0.2% Q2 to Q3. And it's always followed by a very strong Q4. Traditionally for any company, Q4 is stronger. Ours is made even stronger just because it's also the government year-end as well. So actually when I -- when we selected this guidance, I mean I did it really looking at a lot of history as well, as I said in my prepared remarks, having a pretty good visibility into my backlog, into my pipeline and the rates of what I would expect to monetize that pipeline as well. So you're absolutely right, I would expect that we will have a stronger Q4. And that would be very consistent with historical performance as well as supported by the pipeline and the backlogs that I see.

And related to your question around Spoken, I mean, we don't guide at that level of granularity in the business. Just suffice it to say that it's obviously a critical part of our offering to date.

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Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [34]

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Okay. And maybe if I could sneak in one more. So SG&A cost, you have delivered on reducing those as you talked about earlier in the year. But at the same time, your product sales declines have been accelerating. Do you feel like you need to maybe invest more in SG&A to support some growth towards the end of the year? I know you had elevated spend last year, but is this -- SG&A cost reduction much -- is it harmful to your revenue growth in any way is probably what I'm trying to ask.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [35]

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Yes, so I would say that the focus -- really, a lot of what we see on a year-on-year basis in terms of the reduction is actually based upon 2 key items. One is going to be that actually variable commissions is actually down just because the teams as a percentage of what they were expected to do have not delivered as much. That's not a headcount statement. That's just they're earning their variable compensation. The other is -- actually I'd say half of the reduction is actually also attributable to the fact that FX is also reducing the amount of dollars. We convert our non U.S. spend back into dollars. Similar to having less revenue, I also have less expense. So if I look at my year-on-year reductions, I'd say it's probably split pretty much 50-50, half being commissions attainment by our sales force and the other half being really related to FX.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [36]

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Yes. This is Jim. You shouldn't view that as a reduction in quota-carrying headcount at all. And in fact, we're expanding in our go-to-market footprint in a lot of areas as we transform, as we move more to cloud-oriented, subscription-oriented go-to-market company. In areas like consultative services, in areas of driving architects that actually can work on complex solutions and one of the areas why you see Professional Services doing better. So I wouldn't you that as we're pulling back the reins on, if you will, headcount.

The other thing we're doing is also building out our partner community with strategic alliances that provides us the opportunity there as well, not only to leverage our partners and customers but also leverage the expertise through strategic alliances to generate and drive more sales. So it's -- by no stretch of the imagination should be interpreted by pulling back the reins on sort of your frontline go-to-market organization. [That is not the case] at all.

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Operator [37]

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And your next question comes from the line of Dmitry Netis with Stephens Inc.

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Dmitry G. Netis, Stephens Inc. - MD of Equity Capital Markets & Senior Research Analyst [38]

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I had 2 questions, if I may. One on the competitive environment, the other is on channel. So I'll pack it into 1, if you allow me. On the competitive side, if I bucket your business into 3 buckets, the small business, mid-market and then large enterprise, is the SMB where you still continue to experience kind of the biggest drag from the competitive dynamic? Or there's other buckets that you're seeing pressure as well? I suppose you do, but just wanted to give -- get some color on how maybe that competitive landscape is changing as you step quarter-over-quarter here?

And then the second question more on the channel, and you did mention kind of the down trend mix shift in cloud as you progressed through the year or as you exit the year and your expectations there, and relative to the rebates step-up that you mention. If you could give us your puts and take there? And maybe explain what really is going on? Are you driving bigger commissions with your channel partners? Is that what's causing the rebates or -- to step up? Give us a little bit of an outlook there as well?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [39]

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Yes. This is Jim. Why don't I hit the first -- second question first and then I'll turn it over to Chris to provide color on the competitive landscape. So first on the channel. Obviously -- so, a couple things. Number 1, aside from, if you will, the transition where you think you can sort of understand and how you move the market to the reality in fact that just how the market moves is why we have a little -- currently a little extra inventory, if you will, versus -- on the old versus what one would have if they were looking at sort of optimum levels. And again, the good news is the J Series we're selling through faster, but there's only so much room at the inn and we obviously get revenue on sales in. But the velocity is -- still remains strong on the sales out side. If you take a look at the cloud business, and what we're doing associated with the cloud and as Kieran pointed out especially an IP offices mid-market, we do have some SPIFFs like everybody else associated with the program. So the good news, bad news story there is we're seeing sort of the demand being higher than we had anticipated. Therefore, the rebates being adjusted and it's going to just take us a period of time to get that into sort of steady state. So, the point is so we provide free phones in our promotions associated with IP office, typically takes us in a neighborhood of about 3 to 4 months before those are flushed through based upon the sort of the bill of material price that we get for them. So we've seen an increase in sales over the last couple of quarters, therefore an increase in rebates and the overall cloud revenues are down slightly, but that's more from a sort of an MRR perspective, but if you look at ARR, it's actually quite strong and we'll get balanced out here as we go through the balance of the next few months. But our incentive programs -- everybody has different programs, whether it's through master agents and how they pay agents or master agents and how they work T's and C's with partners. I would not say that we're normal and consistent and we're certainly not jeopardizing anything or trying to do anything to move the market differently than the overall competition.

On the differentiation or the different segments of the market associated with competitive landscape, I'll turn it over to Chris to give you some insights.

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Chris McGugan, Avaya Holdings Corp. - SVP of Solutions & Technology [40]

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Yes, Jim. Dmitry, when -- you asked about the 3 market segments and where we're seeing competition. Definitely seeing competition in the small side of the market as it relates to many of the UCaaS players and the CCaaS players taking some of those smaller spaces there. And a small amount in the mid-market sector. But we still see strong demand for our UCaaS in the mid-market for -- from a cloud perspective as well as our premise-based technology that services that particular market.

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Operator [41]

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

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Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [42]

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A lot of my questions have been answered, but one for Kieran. CapEx took a step up relative to your prior requirement that management shared at Analyst Day. Maybe you can give a little bit more color, seems like restructuring and some of the other ones took a step down. Is this -- yes, if you could just provide some more color on that, that would be great.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [43]

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Just to make sure I heard you properly, you said the CapEx?

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Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [44]

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Yes. Your capital expenditure requirements as I understand took a step up relative to what was shared earlier. I think it was $75 million to $85 million, now you're expecting $100 million and -- yes, if you can just clarify that.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [45]

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I think part of that has to do with what we're seeing in terms of the rate and pace of acceptance and piloting of a lot of our big enterprise customers in our private cloud. So obviously, you have to start building up that infrastructure. As I described, we initially thought that much of the early acceptance of our private cloud offerings would be more of the vanilla type. What we're seeing is actually much more complexity from the largest of our big enterprises. And with that, we're just trying to get ahead of it from a build-out perspective. You know, I don't think it's anything that we would say is going to be, long-term, any different than what I built into our long-term model in terms of annual CapEx.

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Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [46]

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Okay. And then so related to that, I mean, as the private cloud offerings require more complex CapEx or [traffic] transactions. Is that -- you guys at the Analyst Day had talked about margin expansion as we go into fiscal '19 and then the longer-term targets were shared as well relative to the actuals in fiscal '18. How did this incremental CapEx, hence higher depreciation, I don't know, changes in OpEx related to rebates or et cetera? How does that factor in then to your long-term outlook for margin expansion?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [47]

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Yes. I think our overriding thesis really is unchanged. As we shift more away from a traditional hardware device type of business to more of a software and, more importantly, recurring software type of business, I think our margins are going to mix more positive. Clearly, there is a couple of quarters or tactically of some short-term hits. But we don't see any change to the longer-term remixing of the model towards software and the higher gross margins that, that should bring along with it.

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Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [48]

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Okay. And then if I may, one more. Cloud tends to be a very scale-oriented game. And maybe -- and if you can clarify this, when you talk to customers and they look at the trajectory in your cloud revenue growth relative to some of your other competitors and, admittedly, they might be smaller scale relative to Avaya's installed base and customer base. Do you get pushback that your trajectory is underperforming the overall market? And does that get into any discussion, because cloud tends to be much more of a scale game, and compared to your competitors you are clearly underperforming on the cloud side in growth as well.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [49]

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Well, if we take a look at -- we grew 165% year-on-year. We grew 25% quarter-on-quarter. We're not actively engaged in a low-margin, low-profit SMB space. If you take a look at our private cloud, we didn't touch on the overall size of funnel, and as Kieran said, we're going to be prudent in how we publicize because we'll do it based upon when we actually receive the overall bookings. We're actually doing quite well. We have, as I've said, 15 POCs. There'll be more that we we'll obviously highlight as a result of this quarter's performance as it continues to gain momentum and traction. In fact, no one in the marketplace has a private-cloud solution geared at our large enterprise. And personally, if you are -- I would much rather focus on what we have, which is the crown jewel of the enterprises, versus trying to be one of many fighting for a piece of turf in the world of SMB. So I think it's how you look at it. But I personally am quite proud of the fact that the IP office mid-market is growing at the rate and pace that it is growing at. In fact, the expectations are for it to continue to grow at past performance levels. And the private cloud, as we mentioned, these are $30 million deals, $11 million deals, so on and so forth. And we have 15 POCs that are going well and the funnel behind that is actually quite strong. So stay tuned for that message.

So I think you need to look at what the value prop you bring, what differentiation you bring. Probably more importantly in the long run is what technology you are actually able to bring to market as well. And that's what our focus is as we continue to focus on our long-term strategy.

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Operator [50]

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And our next question comes from the line of Hamed Khorsand with BWS Financial.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [51]

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So first off, could you just talk about this rounding you're talking about in private seats? Because I mean, that's almost 10%. That can't be a rounding error, going from 3.7 million to 3.4 million?

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [52]

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No, no, no. Hold on. Let's just cut that one right off quickly. When we -- we're talking about in aggregate 3.7 million seats in total, of which we have -- I think we said almost 300,000 in the public cloud seats, which implies 3.4 million. I think the implication was, last quarter, that private was probably closer to 3.5 million. What I'm saying is there's a little bit of rounding between the 3.5 million and 3.4 million in the private only. In total, we're still talking about 3.7 million seats.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [53]

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Okay. So the seat count hasn't changed then. Okay. That's what I was -- that was confusing me. And then lastly, I wanted to ask you was, if you're adding to headcount, why hasn't there been any kind of improvement? Where are those headcounts being added in the business? And the improvement I'm referring to is, just as far as the customer retention and the actual revenue growth?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [54]

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Yes. So we began the year at 7,900 people, I think we closed the quarter at 8,100 folks. So overall from a company level, we've actually grown as committed to the investment thesis about putting more resources across the board at new and emerging technologies, both go-to-market R&D and some other services are the 3 main functions. I honestly don't know the specifics off the top of my head where everybody actually ended up. But we are indeed continuing to invest in what I'll call new growth opportunities. We're also rebalancing as one would expect as well as you move from a hardware-oriented company to one that's more of a software and services subscription-oriented company. So there's also a bit of rebalancing underneath of that as well. So we're actually hiring quite a few folks within the company. So not quite sure how to provide any more color, if there was any questions on the overall (inaudible)?

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [55]

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So it is more -- is it really like a product development issue as far as being able to get customers to spend more with you? Or is it really more of a relationship standpoint that just created some issues because of those Reuters headline?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [56]

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The Reuters headline could probably best be characterized as, the article came out, people didn't know how to interpret the article, our customers per se. Competition, in fairness, took advantage of that article to provide their kind of perspective to customer base. And they basically -- even though we were very proactive when it comes out, and you do a fair amount of your business in the last week to 10 days of a quarter, it was where they came out basically and wanted to get a better understanding about where we're going. So we spent a fair amount of time, as I mentioned in my earnings script, being proactive and sort of talking our customers through it. But it did have a change in the buying behaviors that we have historically seen at quarter end based upon that the timing of that article. It was just...

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [57]

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It just -- might be interested just to add here that we make somewhere around approximately 50% of our revenue in the last month of every quarter. And of that, a very substantial percentage of that actually happens in the last week of the quarter.

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Hamed Khorsand, BWS Financial Inc. - Principal & Research Analyst [58]

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Why would these customers actually start changing up their order habits when you -- they didn't do this kind of activity when you were in bankruptcy. I mean, now you're in better footing and not in bankruptcy and you're getting -- you're talking about someone taking you over having more of a negative sequence than going Chapter 11?

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [59]

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Yes. Well, I mean we saw the same.

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Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [60]

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I mean this is actually, absolutely what we saw from bankruptcy. Customers freezing and procurement people coming in and driving, strategic people coming in and questioning the commitment to it.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [61]

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I mean I hate to be -- to go back to the past, but that day in November when the Wall Street Journal article came out with speculation 2.5 years, 3 years ago, the U.S. orders basically stopped overnight until people wanted to sort out. People interpret things the way to they do and it was similar in design only around the fact of uncertainty. So they -- we saw a pretty significant change of buying patterns, like "Can someone please explain to me what's going on and what does this mean and how do I interpret this? And are you..." You know, the laundry list goes on, which I won't bore everybody on the call. But -- so it just took a little bit of time. But again, the timing of that article and the speculation in customers' minds had an effect on the buying behavior. And in fact, as Kieran said, we're prudent in our going forward business based upon what we announced in the earnings release. So I -- and I think that's probably fair and wise.

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Operator [62]

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And we have no have further questions at this time. I'll turn the call over to Mr. Jim Chirico, President and CEO for closing remarks.

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James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [63]

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Yes. Thank you, operator. Before we conclude the call, I just want to take a moment to reiterate a couple of key points. First, Avaya is uniquely positioned to lead our customers through this digital transmission journey with a reach that spans the globe as we continue to operate at scale. Our growth investments are aligned with opportunities opening up as our mid-market and enterprise customers turn more aggressively into cloud-based solutions where we can deliver the full and feature-rich functionality in both private, hybrid, as well as public offers in both UC and CC. We are layering in the right strategic partnerships and those partnerships are with companies that are in the forefront of shaping the cloud landscape. Companies that include Salesforce, IBM, Google, Afiniti and Verint. And we're taking advantage of the opportunities to work with these partners to drive solutions to the market that our customers are demanding. We are continuing to invest in our growth areas as well.

So with that, I do want to thank you for your time this morning and hope you have a great day. Thank you.

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Operator [64]

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And this concludes today's conference call.

You may now disconnect.