U.S. Markets close in 1 hr 39 mins

Edited Transcript of AVYA earnings conference call or presentation 13-Aug-19 12:30pm GMT

Q3 2019 Avaya Holdings Corp Earnings Call

BASKING RIDGE Aug 19, 2019 (Thomson StreetEvents) -- Edited Transcript of Avaya Holdings Corp earnings conference call or presentation Tuesday, August 13, 2019 at 12:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* 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

================================================================================

Conference Call Participants

================================================================================

* Asiya Merchant

Citigroup Inc, Research Division - Research Analyst

* Balaji Krishnamurthy

Goldman Sachs Group Inc., Research Division - Associate

* Erik Taylor Lapinski

Morgan Stanley, Research Division - Research Associate

* Lance William Vitanza

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

* Michael Donald Maguire

Barclays Bank PLC, Research Division - Research Analyst

* Michael James Latimore

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

* Nandan Girish Amladi

Guggenheim Securities, LLC, Research Division - Senior Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good morning. My name is Marcella, and I will be your conference operator today.

At this time, I'd like to welcome everyone to the Avaya Third Quarter Fiscal 2019 Financial Results Conference Call and Webcast. (Operator Instructions) Thank you.

Mike McCarthy, Vice President of Investor Relations, you may begin your conference.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Welcome to Avaya's Q3 Fiscal Year 2019 Investor Call. Jim Chirico, our President and CEO; and Kieran McGrath, our Senior VP 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, Chief Administrative Officer and GC; Chris McGugan, Senior Vice President of Solutions and Technology, are also here for today's call.

The earnings release and investor slides referenced on this morning's call are accessible on the investor page of our website as well as our 8-K filed today with the SEC and should aid in your understanding of Avaya's financial results.

We will reference our 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, which are available on the investor page of our website.

We may make forward-looking statements that are based on our 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 the 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 will now turn the call over to Jim.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thanks, Mike. Good morning, everyone, and thank you for joining us. Before discussing our third quarter, I'd like to provide 2 updates. First is an update on the process we are conducting with JPMorgan. At this time, we are in advanced discussions with multiple parties on a range of strategic transactions to maximize shareholder value. We expect to bring this process to a conclusion within the next 30 days. Second, I'd like to address the goodwill impairment charge that we took this quarter. In short, the recent decline in our stock price and our year-to-date performance prompted an interim goodwill impairment test resulting in a $657 million noncash charge. Kieran will provide additional context around this charge.

Let me start with our results. In the third quarter of fiscal 2019, we delivered revenues of $720 million, gross margins of 60.8%, adjusted EBITDA of $167 million, and we generated $52 million in cash flow from operations. Software and services as a percent of revenue increased to 83.6%, and recurring revenue was 59.3%. Importantly, our financial results were above the midpoint of the range demonstrating progress across our business.

In particular, I mentioned on our last call 2 product transition issues that impacted our performance. I am really happy with the way the company tackled each one of them and the progress that we made.

First, we addressed the operational execution issues impacting the transition of our new endpoints. The momentum generated by our new J series phones has exceeded expectations and sales were up significantly quarter-over-quarter. Second, in the contact center, we have successfully achieved a technical deliverable associated with our partner offer and it went GA at the end of June. We have already booked 3 new deals associated with the solution, have a pipeline of another 20 opportunities, and we've launched marketing campaigns into our installed base, and sales and partner enablement activities are underway. I consider these 2 issues behind us.

Turning to the details of the quarter. We have discussed our strategic growth levers on previous calls and we are seeing success across all 4. First in our core business, we continue to see progress on a number of fronts. As I mentioned, our new endpoints are gaining traction. In total, revenue from the new device portfolio increased meaningfully both sequentially and year-over-year. More than just showing a successful transition, these modern refreshed devices also provide new features and capabilities to our customers, including the ability to deliver custom applications via Android OS, industry-specific solutions such as our hospitality endpoints and Open SIP phones to connect to any IP-based system just to name a few. In our contact center omnichannel offering, we continue to see improved traction following the release of our 3.6 version of the platform. Bookings increased for the third consecutive quarter and pipeline conversion rates are also increasing. Together, contributions from the new products in our core portfolio continues to increase, proof that our customer-led focus is making a difference.

One more point about the improvements in our core. Customers are showing their confidence in Avaya and our innovative capabilities. A clear indicator of this is the health of our Upgrade Advantage offer. UA is a recurring subscription that entitles customers to upgrade in the future. Renewal rates for this offer returned to historic highs last quarter demonstrating customers' commitment in Avaya.

Second, let me turn to cloud. Total cloud seats came in at 3.6 million for the quarter. In public cloud, we saw a seat growth of over 170% year-over-year and 24% sequentially. We added nearly 70,000 public cloud seats driven by the continued strength of our Powered by xCaaS solutions. This brought our public seat count to over 360,000. Equally noteworthy, total contract value, or TCV, for this solution has more than doubled since the first quarter of the fiscal year. These solutions provide our customers excellent reliability and high ROI. This value proposition is driving strong growth across the U.S. and international markets, particularly in Brazil and the U.K.

In Q3, we booked $30 million in private cloud enabled by our ReadyNow solutions. We continue to see impressive demand for ReadyNow across our customer base, which has generated about $75 million TCV since launch. We have recently expanded this capability to the Netherlands, Japan, Australia, Mexico, Brazil and Canada by the end of the calendar year. I am particularly pleased by the continued traction of ReadyNow.

Just one example of a recent win, a U.S.-based health care provider in the mid-Atlantic chose to transition to ReadyNow in a deal representing over $10 million in TCV. This customer will implement ReadyNow to support nearly 5,000 UC seats and 650 contact center agents, supplemented with our collaboration and workforce engagement solutions. Once fully implemented, Avaya will displace the West cloud IVR, the Televox Patient Appointment Reminder, WebEx, Skype and GoToMeeting. Thirdly, in the area of emerging tech, we continue to add value for our customers across multiple segments and delivery models through our reference in mobility and artificial intelligence. In Mobility, we began to roll out our call deflection security capability. This allows voice calls to be natively converted into digital interaction before the call connects, providing users with greater flexibility in how to maximize their customer experience during these interactions.

We are currently implementing this capability into one of the largest logistics management companies in the U.S., an existing customer with more than 25,000 seats. We have also begun to trial with 4 additional customers: 2 BPOs that manage over 60,000 seats and 2 other enterprise customers with 25,000 and 40,000 seats, respectively. We have also initiated proof of concept in trials with 6 existing enterprise-class customers working to upgrade their contact centers by providing them with sentiment and intent analysis designed to improve both the agent and the agent supervisor experience. To date, our team has processed over 1 million minutes of call analysis using this feature. Our partnership with Afiniti continues to gain traction, and we are rolling out 30 new deployments at 15 different companies, including some of the industry's largest BPOs.

Our investment in innovation, coupled with our customer-driven focus, continued to be recognized by third-party analysts. This quarter, IDC recognized Avaya's leadership in their 2019 Worldwide Unified Communications and Collaboration MarketScape. Lastly, in the area of services, we continue to see positive signs in our APCS-managed cloud business, and especially in the area of maintenance services where revenues were flat to last quarter. Maintenance like our UA offering is a measure of customer long-term commitment to the company.

I'd like to share another key area of services' success. We launched a modernization program called Loyalty Together over a year ago. The purpose of the program is to bring customers that are on older releases of CM and a CS1K solutions where we have one of our largest maintenance headwinds to a more current level. Last quarter alone, we upgraded 68,000 lines of CS1K and 191,000 lines of CM to the latest version. This not only locks in these customers, but more importantly, gets them current in our technology to take full advantage of the spectrum of solutions we can offer. It also pulls through additional services revenues for Avaya and our partners. Success with this program has been a significant contributor to the overall renewal rates and stabilization of our maintenance revenues.

Let me share a few more data points on how we're successfully competing in the market. In the third quarter, we added roughly 1,400 new customers and signed 68 transactions with a TCV over $1 million. This included 6 deals over $5 million and 1 deal over $10 million. Our 1,400 new customers this quarter underscores our ability to win new business from our competitors and demonstrates we are delivering compelling value to our customers. Importantly, we maintained our TCV balance of approximately $2.4 billion. Our ability to win multimillion dollar commitments from large organizations across both private and public sector is unique in the industry. This momentum is carried into the fourth quarter. In July and August, we won 2 landmark contracts with the U.S. federal government. The first is a 10-year deal with the Social Security Administration worth up to $400 million, and that's to modernize the entire UC and CC infrastructure, supporting more than 100,000 UC ports, 1,600 field offices and 12,000 contact center agents. The second is an award to provide secure FedRAMP certified cloud services across several agencies that could be worth up to several hundred million dollars. Not only do these represent some of the largest wins in the history of Avaya, but more importantly, they serve as proof points regarding our strategy, the sound investments we are making in innovation and our product portfolio and in our ability to execute. It is also important to note that both of these opportunities were won in partnership with major service providers, underscoring the important role SPs and SIs play as part of the broader Avaya channel ecosystem.

As I had said previously, we have increased our focus and investment in SPs and SIs and it's beginning to bear fruit. As our third quarter results demonstrate, we are improving our competitiveness, winning in the marketplace and are making great progress in the cloud both in private and public.

We continue to remain laser focused on delivering value to our customers, and we continue to show signs of pivoting the business to capitalize on our revamped product portfolio.

Now I'll turn it over to Kieran.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

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.

Before I discuss our third quarter performance in greater detail, I would like to address the goodwill impairment charge that was disclosed in our earnings press release this morning. Following the sustained decline in our stock price during the third quarter combined with our year-to-date financial results, the fiscal 2019 reset and the resulting implications to our long-range forecast, we determined that a triggering event had occurred and consequently performed an interim goodwill impairment test. As part of the goodwill impairment test, we compared the fair values of our reporting units to their respective carrying amounts as well as their allocated goodwill that was established as part of fresh-start accounting in December of 2017. Based on our analysis, we determined that the carrying amount for one of the reporting units within our product and solutions segment exceeded its estimated fair value due to our revised outlook. As a result, we recorded a noncash goodwill impairment charge of $657 million. Further, due to the ongoing review of strategic alternatives, we are not currently in a position to update our long-term outlook at this time. We will provide this information after the conclusion of the process. Our previous expectations that were set at the company's Investor Day last December are no longer applicable and should not be relied upon given our fiscal 2019 reset.

Turning to our third quarter financial results. Non-GAAP revenue was in line with our expectations at $720 million compared to $755 million in the year ago period. Software and services were approximately 84% of non-GAAP revenue while recurring revenue was 59% of non-GAAP revenue. The mix of software and services as well as recurring revenues improved over the prior year. Cloud was approximately 11% of the non-GAAP revenues and was consistent with the prior quarter. Third quarter non-GAAP product revenue was $298 million compared to $322 million in the year ago period. In our UC portfolio, we saw improved demand for our software solutions driven by both new and capacity transactions offset by a lower contribution from endpoints and gateways.

In CC, we saw signs of stabilization in the quarter as we realized the benefit from updated product releases. Third quarter non-GAAP services revenue was $422 million compared to $433 million in the year ago period. The year-over-year decline in services revenue was again driven primarily by lower maintenance revenue. However, our overall maintenance renewal rates continue to trend upward in the quarter, helping keep maintenance revenues roughly flat on a sequential basis. While we expect maintenance revenues to remain a headwind to our overall growth outlook, particularly as we migrate customers to our cloud solutions, we are encouraged by the underlying improvements in our maintenance business.

Geographically, the U.S. accounted for 55% of our revenue while EMEA, Asia-Pacific and Americas International represented 25%, 12% and 8% of our revenues, respectively.

Turning to our profitability metrics. Non-GAAP gross margin was 60.8% in the third quarter compared to 61.9% in the year ago period. Non-GAAP product gross margin was 63.8% compared to 65.5% in the prior year. Product gross margins benefited from an improved software mix. However, this was more than offset by an unfavorable mix in our hardware portfolio due to a larger-than-expected mix of servers delivered in the period. Non-GAAP services margin was 58.8% compared to 59.1% in the prior year.

Third quarter non-GAAP operating income was $145 million representing a non-GAAP operating margin of 20.1%, and adjusted EBITDA was $167 million representing an adjusted EBITDA margin of 23.2%. Despite lower gross margins, we were able to realize efficiencies across our expenses that help keep our operating and adjusted EBITDA margins largely unchanged compared to the prior year.

Further, we generated $52 million in cash flow from operations and $15 million in free cash flow. As we mentioned last quarter, we are continuing to see an uptick in capital investments for the continued build out of our ReadyNow infrastructure to support the solution's global rollout. Additionally, we ended the third quarter with $729 million in cash and cash equivalents on our balance sheet. Our cash balance decreased modestly on a sequential basis due to an investment in a public sector UCaaS provider with FedRAMP security requirements capabilities.

Turning to our fourth quarter outlook. We anticipate non-GAAP revenue of between $738 million to $758 million. Our non-GAAP operating margin is expected to be between 22% and 23%, and our adjusted EBITDA margin is expected to be between 25% and 26%. We expect our fourth quarter weighted average shares outstanding to be roughly 111 million shares.

Turning to our full year outlook. As we highlighted during last quarter's earnings conference call, our full year guidance consider a few assumptions around the award and expected revenue recognition of a large contract with a government agency. As Jim mentioned in his prepared remarks, this transaction worth approximately $400 million in TCV over 10 years with the Social Security Administration was awarded at the beginning of our fiscal fourth quarter. While we are pleased that there is no further ambiguity around the timing of the award, there are still some uncertainties around the timing of revenue recognition due to final contracting and issuance of POs. As such, the low end of our fiscal fourth quarter revenue guidance continues to contemplate the scenario where we would not recognize any revenue from the SSA contract in the current fiscal year. As such, for the full year, we now anticipate non-GAAP revenues to be in the range of $2.92 billion to $2.94 billion with cloud expected to represent approximately 11% of our revenue. We expect our non-GAAP operating margin for the full year to be between 21% and 22% and our adjusted EBITDA margin to be approximately 24%. We expect our cash flow from operations to be approximately 7% 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.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Michael Donald Maguire, Barclays Bank PLC, Research Division - Research Analyst [2]

--------------------------------------------------------------------------------

This is Mike Maguire on for Raimo. Congrats on the quarter, guys. You've called out -- so the 2 large wins on the federal side in Q4. But can you give a little bit more detail, I guess, into your like overall federal pipeline, how that looks kind of going into the quarter? And then the second question I had, this is more for Kieran. On the public cloud seats, you saw impressive growth again, but can you kind of touch on the timing between converting those seats and the seat growth into more revenues since the percent of revenue was -- kind of remained flat at that 11% for a little while?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. Sure. Mike, Jim. Thank you very much. Yes. On your first question, actually the government business is actually doing -- it's doing quite well. If you remember back in -- I think it was December, we signed -- or got certification on FedRAMP, which has really generated and really lifted the momentum around opportunities for us in the government space coupled with the investment we just made in the last quarter with a partner of ours to further drive additional cloud opportunities and cloud certification in the government. So we're seeing a significant uplift. And this quarter, obviously, being the end of the fiscal year for the government, it's typically a rather large quarter as compared to the other 3 quarters with -- throughout the fiscal year. But we can't get into pipeline and opportunities. But I can tell you that both at a federal level and state and local, the government business is really showing signs of strength, and we expect that to continue with the investments that we made as we go into 2020. As far as overall cloud, I'll turn it over to Kieran to provide some additional color both on the private side as well as on the public side of the business.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

So Mike, to your point, first and foremost on the public cloud activity, we actually saw nice growth, again, relatively small dollar amounts in aggregate with good quarter-on-quarter growth in our public cloud seats to go along with that 70,000-seat expansion. As we talked about before, we pay these rebates upfront and we take them all at a point in time. What will happen is as we go through time and we start to build up a nice recurring revenue base, obviously, the rebates are onetime in nature only and then you start to get the rebounding effect. So we were up strong double digits just on a quarter-on-quarter basis, just on the public cloud to go along with the 70,000 seats in aggregate. Again -- and that's on a net basis after you take into account the impact of those items, the rebate items. When you talk about the ReadyNow and our private cloud, as we mentioned before, the time to -- from booking perspective to revenue recognition, really hinders on the complexity of actually the deployment that the client is engaged with us on. As Jim pointed out in his example in his script, once again, we see a -- another big signing this quarter with another very complex -- a very complex deployment. We are putting all the infrastructure in place as you can see from our CapEx numbers as well. So we really expect that the growth rate is going to dramatically accelerate for the ReadyNow private cloud aspects when we are in fiscal 2020.

--------------------------------------------------------------------------------

Operator [5]

--------------------------------------------------------------------------------

Your next question comes from the line of Lance Venenza (sic) [Lance Vitanza] from Cowen.

--------------------------------------------------------------------------------

Lance William Vitanza, Cowen and Company, LLC, Research Division - MD & Cross-Cap Structure Analyst [6]

--------------------------------------------------------------------------------

Congratulations on a nice quarter. Couple of questions. The first is, could you remind me what's the typical seasonal revenue pattern you'd expect as you move from Q2 to Q3? I mean revenue grew sequentially. I'm trying to put the modest gain into context.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. For -- the 7-year average was actually flat. It was down actually 0.10 point, and we were up about almost 1 point on a quarter-on-quarter basis. So historically, it would've been -- yes, flat to -- flat basically. And then as we look from Q3 to Q4, our average is usually around between 3% and 4% growth between 3Q and 4Q.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Okay. That's great. On the gross margin pressure, I know you talked a little bit about this in the prepared remarks. But it -- was that in line with your business plan? I mean it seems to some extent that we perhaps should expect continued gross margin pressure given that you are seeking to ramp the revenues, but could you talk a little bit about that and where you would expect gross margins to trend just generally, if not qualitatively, if not quantitatively?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Sure. Sure. So let me tackle this in a couple of different manners. The first is, in aggregate on a quarter-on-quarter basis, we did see a reduction of about 0.70 point versus Q2. That was really all specifically driven by one engagement that we have in Germany. It's a very complex -- we've actually been working on it for quite some time, but now we're starting to drive the cost. We expect to start to recognize revenue on those -- at this particular engagement in Q4. So it was really a significant amount of cost incurred in a quarter. We'll start to see the revenue next quarter, and that really was responsible for the entire Q3 versus Q2 margin decline. On a year-on-year basis, I would say, if you look, we were down about a little over 1 point, about 1.1 points on a year-over-year basis. That same transaction that we talked about drives about half of that value. The other half was actually driven by some promotions that we've been driving, as Jim might have described, this Loyalty Together, which is a way that we were able to migrate some of our customers and some of the legacy, Nortel and older versions of our UC or a product on to the more -- on to more recent versions. And what we did was we had some promotions around some of the devices that we sent out to the customers. That -- we started that in Q2 of last year, but quite frankly, it sort of peaked in the last couple of quarters. And I think we're kind of stable in that now as we go forward. That'll become less and less of a headwind. When we think about -- where I think your question was going was, what do we expect the implications of -- from having more cloud in our business. Certainly, there's going to be some headwinds from ReadyNow initially, just at the very early stages until you really achieve some level of scale. We would hope to put that behind us fairly quickly after we get through next year. In aggregate, still being a reasonably small part of the total business, honestly, I don't think we could -- I don't think we really see a big headwind to margin in aggregate as we look out into the next year as we shift more to cloud.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Okay. Great. And speaking of cloud, just a couple of questions there. Can you talk at all about what you're seeing in monthly revenue per seat? And then also how much did the upfront -- I think you talked about this last quarter, there is an upfront netting in public cloud of the channel partner fees that -- net against gross revenues and that as you grow as -- quarter-to-quarter as the number of cloud seats that you're adding expands then that actually intensifies the pressure a little bit. And I'm wondering if you could give us a sense for how much that impacted performance -- or the reported results in Q3.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. I think it's probably fair, just if I think about third quarter year-to-date, it's probably been a headwind of about half of what our revenue has been. So we would've seen about double the amount of our public cloud revenue this year with the exception of the rebates that we've been taking. So as you say -- yes. Go ahead.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. Well, and the rebates, you're basically -- you're sort of front loading the entire programs' worth of fees in the period in which you turned the revenues on. How long typically when you're setting up these programs? Are these sort of 1-year programs, multiyear programs?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. Usually -- I mean usually, we take these one time. Right now, we've been trying to take them under 1-year programs. I mean we've seen different types. Obviously, we offer a lot of different models from wholesale across our UC or UCaaS and our -- and CCaaS- or xCaaS-type offerings. But in general, 1 year is what we've seen.

--------------------------------------------------------------------------------

Operator [14]

--------------------------------------------------------------------------------

Your next question comes from the line of Nandan Almandi (sic) [Nandan Amladi] from Guggenheim Partners.

--------------------------------------------------------------------------------

Nandan Girish Amladi, Guggenheim Securities, LLC, Research Division - Senior Analyst [15]

--------------------------------------------------------------------------------

So you touched a little bit on this, but how has the reaction been from the partner community on the strategic alternatives process these past few months?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. This is Jim here. Great question. Look as we -- to be honest, the teams have done a really nice job. I mean if you take a look at not only from our partner community but also if you take a look at the customer base, I think our sales organization has done a phenomenal job keeping our partners abreast of the situation, focusing obviously on what we need to do, deliver the solutions, deliver their technology in order to make them competitive. We have seen -- when there's areas and times of uncertainty, the teams have stepped up and have actually done a great job. We've kind of been through obviously a situation where we had uncertainty before. But I think they've actually prevailed and have done an excellent job staying focused on the task at hand and really driving the right solutions to the -- to our partner base community -- in our customer base. So -- and we've seen a little bit of disruption. We talked about that last quarter. I would say it's still there but it certainly isn't to where it was in the June quarter simply because of the timing and -- number one, the teams have had an opportunity to continue to operate and everybody understands sort of the environment. I would also say that if you take a look at the government wins, and you take a look at just the overall number of wins that we've had greater than $1 million and the way the business momentum is picking up, shows great support for the company and really shows great support for the outlook and more importantly the roadmap. One thing I will point out is that SSA win was a competitive displacement as well. So not only was it significant in size, but we displaced Cisco and Ribbon in order to win that deal. So again, further proof points in our overall product, our overall execution, and more importantly the confidence within the company. So it -- there is -- it's still there. As we said, we expect that within the next 30 days, we'll bring it to a conclusion. But I think the teams have done an excellent job working through it.

--------------------------------------------------------------------------------

Nandan Girish Amladi, Guggenheim Securities, LLC, Research Division - Senior Analyst [17]

--------------------------------------------------------------------------------

A quick follow-up if I might. On the R&D front, we're starting to see some consolidation happen in the CPaaS space. Anything on your product roadmap that is different than what we saw at Insight?

--------------------------------------------------------------------------------

Chris McGugan, Avaya Holdings Corp. - SVP of Solutions & Technology [18]

--------------------------------------------------------------------------------

Nandan, this is Chris McGugan. We continue to invest in our CPaaS platform. Yes. We have a nice book of business both in the U.S. market and in Canada. And so we are seeing consolidation across the market space, and it's technology that we've had embedded in our solutions stack. We're going to make it deeper ingrained with some of our premise technology to enable cloud access into our premise with CPaaS. So you'll see that as we go into the end of the year.

--------------------------------------------------------------------------------

Operator [19]

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Erik Taylor Lapinski, Morgan Stanley, Research Division - Research Associate [20]

--------------------------------------------------------------------------------

This is Erik on for Meta. We're just wondering, are there certain verticals or customer types where you're seeing more traction with your public cloud seats?

--------------------------------------------------------------------------------

James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [21]

--------------------------------------------------------------------------------

No. There isn't any one particular vertical differentiated from another to be honest with you. What we're seeing, obviously, the traction or public cloud is our IP Office Powered by solution. And we're seeing that -- obviously, if you take a look at it from a geography perspective, it's actually doing well across all geographies, whether it's in Latin America, U.S., U.K., Europe as well. So not so much, I'll say, vertically dependent. It's more of a -- it's more driven from our partner community and driven across the board. So it's -- obviously, it's an SMB play for all intents and purposes low into the mid-market. But I don't -- I wouldn't say that there's one vertical per se that is really driving it. It's more broad based across the -- across our partner base.

--------------------------------------------------------------------------------

Erik Taylor Lapinski, Morgan Stanley, Research Division - Research Associate [22]

--------------------------------------------------------------------------------

That make sense. And then if I could just another one. Are there -- do you have any kind of update on the strategic alternatives that you are considering, maybe the options there?

--------------------------------------------------------------------------------

James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [23]

--------------------------------------------------------------------------------

Yes. Look, in fairness -- and I trust you all can understand, the only comment that we can make at this time is basically what we have said in the fact that we're in advanced discussions with multiple parties on a range of strategic transactions to maximize shareholder value, and we expect that we'll have a conclusion to this process within the next 30 days. So I can imagine that there are probably many questions about the process and where we are and expected outcomes and so on and so forth. But I trust you all can understand that these are the only comments we can make at this time.

--------------------------------------------------------------------------------

Operator [24]

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [25]

--------------------------------------------------------------------------------

This is Balaji on for Rod. If I could clarify on your Q4 guidance. You mentioned that the government contracts are not being contemplated at the low end. But in terms of the range of $20 million, how much of that would you expect to be driven by the government contracts?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [26]

--------------------------------------------------------------------------------

Yes. So very consistent with what we talked about last quarter when we said the low end really did not have any of these mega government contract deals and the high end did, all of the delta between the low end and the high end is related to this -- these government contracts, and the SSA deal in particular. And it really has to do with just -- we have the award. Now we've got to go through the contracting with the partner that we're using and then obviously the issuance of POs. We also think that based upon -- looking at the award originally, we'll probably see more of that revenue come to us in a ratable model, more as a sort of a longer-term private cloud hosting on our part as well, which is better for us as we think about our long-term business as well. We'd like that more ratable. But we will have the possibility of some upfront point-in-time UC product, both from software and a device perspective. And hopefully, we'll be able to get some of that done in time for Q4. If not, it rolls into next year.

--------------------------------------------------------------------------------

Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [27]

--------------------------------------------------------------------------------

Got it. In terms of the geographical trends, it looks like EMEA stepped down pretty meaningfully this quarter. Any color there?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [28]

--------------------------------------------------------------------------------

In any given quarter, one particular deal -- one particular large deal like we might have had in the quarter before had heavily colored that quarter. Honestly, the EMEA team I think -- or from a revenue perspective hurt us, but actually did pretty well in the booking side of it. So it has more to do with just the size of one particular transaction in any quarter -- or another can impact it. I think we'd say, we saw the same thing in AI where a couple of larger deals given some of the government issues that have been going on, especially in Mexico and Brazil, impacted them. If that's -- some stability hits there. We'd expect that to bounce back nicely in Q4. We were happy with the U.S., which saw a pretty significant quarter-on-quarter increase. Again, a lot of that was we worked through some of those device issues that we talked about.

--------------------------------------------------------------------------------

Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [29]

--------------------------------------------------------------------------------

Okay. And if I could just sneak in one more. The R&D -- not R&D, the product gross margins, it looks like the Q4 tends to be a pretty strong quarter. At least in the last couple of years, that was the case. If you could comment on whether there are some underlying drivers that caused that, and if you expect similar trends in Q4 here.

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [30]

--------------------------------------------------------------------------------

Yes. I'd say a couple of things. One is, you're right. In aggregate, I would expect to see a bounce back a lot closer to 63% for the quarter just based upon historical trends. In general, what we see is -- especially because of the federal government outside of the large SSA deal that we're talking about, Q4 tends to be a larger quarter for us with the government. We'll be -- tend to ship more product. The only thing that might be different, we never quite know how much of it's going to be software, which is obviously going to have a very, very high gross profit margin versus maybe more of a device, which won't be quite as healthy. So there'll be some dynamics around that. But I think you're right, I would expect to see a bounce back in margins in total and in the products in Q4.

--------------------------------------------------------------------------------

Operator [31]

--------------------------------------------------------------------------------

(Operator Instructions) Your next question comes from the line of Asiya Merchant from Citigroup.

--------------------------------------------------------------------------------

Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [32]

--------------------------------------------------------------------------------

Congratulations on a good quarter as well. Kieran, I think in the last earnings call, you mentioned something about being able to provide more bookings and billings on a more quarterly basis so we kind of could see what the book-to-bill ratio is. Is that something that you're able to provide at this point?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. So not at this point. I mean clearly, as we move out through time, we want to start to be able to demonstrate and provide the proof points of us as a software and a cloud company. We clearly recognize that. My hope is to begin that in the new fiscal year.

--------------------------------------------------------------------------------

Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [34]

--------------------------------------------------------------------------------

Okay. And then if I look at ASC 606 impact and kind of do -- a little bit more of an apples-to-apples compare, it seems like excluding the 606, on a 605 basis, the decline is accelerating. Is that an unfair comparison again as I look at those numbers? So basically, just looking at what you reported on a non-GAAP basis, taking out the ASC 606 impact and then comparing it to what it was last year.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

In reality, it's the exact same explanation that I gave you last quarter. As we think about the sort of drag we're seeing from a 605 perspective for those contracts that were actually put into retained earnings, we don't get to recognize those. If we had recognized them, obviously, we need complete customer sign off. The contracts -- if we go back to beginning of the year when we took this out of backlog and put it into retained earnings, these contracts were by and large heavily Professional Services contracts with a lot of CC content inside of them. These CC contracts tend to be the most heavily customized, the most complex. It's driving about half that point -- half of the decline on a year-on-year basis as we've discussed the last time. So really not much of a change. All I would say is that right now, we've got about 40% of these deals that are 90% -- 98% or higher. Just waiting the final signature sign off from the customer so that we can actually bill it from a cash perspective. And then obviously, for this 605, 606 comparison, we'd be able to include that from a normalization perspective. But in terms of any change, honestly, it's the exact same description that I had last quarter. Quite frankly, I'm a little disappointed that I didn't make more progress in getting more sign off and customer acceptance. But again, these are pretty complex deals the customers are taking a very long view on. I would hope that this starts to become much less a drag on us, and we're seeing some of this rollover into our cash as well where it's affecting these from a working capital perspective. So we've got a full quarter -- press on now to try and get these things signed off and billed on a much more timely basis just so I can start to reduce this drag from the -- from a working capital perspective.

--------------------------------------------------------------------------------

Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [36]

--------------------------------------------------------------------------------

Great. And if I can squeeze in one more. Your CapEx requirements that were listed on the slide seems to have ticked up again into third quarter '19 from $100 million to $120 million. If you can help explain what's driving the increase in the CapEx requirement. Is it a function of going towards more private clouds, et cetera? Just so that we can understand as we look forward and model, is the shift to cloud driving incremental CapEx? And how we should think about that run rate going into the next year?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [37]

--------------------------------------------------------------------------------

Right. So it's a great question. And I would say 2 things. One is there's no doubt that ReadyNow, in particular, especially as Jim described the rollout, not just in the U.S. but around the world, is seeing an initial increase to start to build out all of that infrastructure. I'd say, as we go forward through time, it will probably be between $20 million to $30 million a year. It's what we've modeled out that we will need for ReadyNow, assuming the growth rates that we've projected over the longer time. We also do have some costs from an IT perspective as we have been putting in some additional tools internally to help ourselves move more towards -- more of a cloud-oriented company. So a lot of our different tools even need some level of capitalization taking place with some of the tools I'm employing just for how I account for -- for how I do 606. So it's things like that, that I think will fall behind us. I really do think over the long haul, $100 million a year is about the right CapEx number. I do think this year is a little anomalous just because we have the combination of the ramp of ReadyNow as well as some of this IT tooling for internal IT tools to help us manage the business a little bit more efficiently. I think we've put that behind us and we're sort back in that $100 million run rate longer term.

--------------------------------------------------------------------------------

Asiya Merchant, Citigroup Inc, Research Division - Research Analyst [38]

--------------------------------------------------------------------------------

Okay. And then the cash that you guys have, I know the strategic review is underway. But any color you can provide on how the Board is thinking about $700 million plus of cash that sits on your balance sheet?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [39]

--------------------------------------------------------------------------------

Honestly I think -- as we said before, I hate to keep giving the same answer, but we probably need to wait for the review to play out. I think prior to the review taking out, we've always said that the Board didn't envision us having that amount of cash for any extended period of time. So nothing would've changed from that perspective in terms of the Board's view. But in terms of the exact disposition of it, I do think we need to let the process play out here over the next 30 days, yes.

--------------------------------------------------------------------------------

Operator [40]

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Michael James Latimore, Northland Capital Markets, Research Division - MD & Senior Research Analyst [41]

--------------------------------------------------------------------------------

I guess on the cash topic, can you give any guidance on cash taxes sort of next fiscal year?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [42]

--------------------------------------------------------------------------------

Yes. I don't want to get ahead of myself in terms of -- we'll provide the fiscal '20 guidance as we exit Q4. At this point in time, I really don't have anything to say in terms of long-term cash taxes. I don't think it's going to be all that different than what we had advised back in December of last year. Maybe modestly lower, maybe $10-ish million lower as we go through time. But I don't have an updated view of it just yet that I'm ready to publish.

--------------------------------------------------------------------------------

Michael James Latimore, Northland Capital Markets, Research Division - MD & Senior Research Analyst [43]

--------------------------------------------------------------------------------

And then on the cloud, obviously, good trends in public and private cloud. How is the kind of just general churn in the business? Anything notable from a churn perspective?

--------------------------------------------------------------------------------

Kieran J. McGrath, Avaya Holdings Corp. - Senior VP & CFO [44]

--------------------------------------------------------------------------------

Well, from a cloud perspective, most of the deals that we're signing are actually multiyear deals, 3 years. So we really haven't experienced any churn to speak of yet in this particular space. If I move away from the cloud, as Jim mentioned in his comments and I mentioned in mine as well, our renewal rates overall for our business, from both a maintenance perspective as well as our Upgrade Advantage subscription, continue to improve and certainly bouncing back from where we were back in Chapter 11.

--------------------------------------------------------------------------------

James M. Chirico, Avaya Holdings Corp. - President, CEO & Director [45]

--------------------------------------------------------------------------------

Yes. I'll just add to that, Mike, that the ReadyNow, we're seeing a nice transition from, if you will, GSS maintenance revenues to the cloud solutions. So that's advantageous 2 ways. One, just from an overall dollar per seat count. And then secondly, obviously, from a stickiness perspective embeds us deeper in with our customer base. So on a positive side, that churn is actually progressing well and from better economics, if you will, from a company perspective. I think secondly to that point is the work that the team is doing in the activities around what we call Loyalty Together, as I mentioned, and really bringing up releases, greater than 2 releases old, and bringing those up to current technology levels. We're also doing better than we had anticipated. As Kieran pointed out, we are doing some promos associated with that. But getting folks up to the latest release is obviously helping us on an overall maintenance and renewal rates, which are back to all-time highs. So I think from an overall churn perspective, there is some -- there is certainly some positives that we're seeing in the business. We're seeing there our maintenance stabilizing, which is obviously very, very important for us. So -- and we look forward to seeing ReadyNow continue to grow as we go through the rest of this, obviously, fiscal year, which is on the next 6 weeks, but certainly as we get into 2020 and beyond.

--------------------------------------------------------------------------------

Michael James Latimore, Northland Capital Markets, Research Division - MD & Senior Research Analyst [46]

--------------------------------------------------------------------------------

Great. And lastly, on these 2 very large deals that you announced, how does that flow into backlog? Should we assume backlog moves up materially on these? Or can you just help on the -- kind of the calculation there?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. So we would expect to see -- as you can imagine, the way the government tends to contract, they tend to break things up into smaller periods. And usually depending on the specific terms, the government always has the right for an annual out. So usually -- again, having seen the exact terms here that will be finally negotiated, but usually you book them a year at a time is tended -- is what we've tended to see. So I would expect in Q4, we start to see the benefit of some of these bookings enabling us from a TCV perspective, but probably not to the entire $400 million amount, more likely just the annual portion of that.

--------------------------------------------------------------------------------

Operator [48]

--------------------------------------------------------------------------------

There are no further questions at this time. I'll turn the call back over to Mike McCarthy.

--------------------------------------------------------------------------------

Michael W. McCarthy, Avaya Holdings Corp. - VP of IR [49]

--------------------------------------------------------------------------------

Thanks, Marcella, and thanks, everyone, for joining us this morning. We'll look forward to speaking with you shortly. Have a good afternoon.

--------------------------------------------------------------------------------

Operator [50]

--------------------------------------------------------------------------------

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