SSB:AV Spin Positions 1st For Margin Expansion,then For Accelerating Growth
October 2, 2000 SUMMARY
* Lucent spin-off Avaya to start trading under symbol AV.
TELECOMMUNICATIONS * Rediscovery of Enterprise market should benefit Avaya.
EQUIPMENT * For the next 12-24 months, AV is targeting a doubling of
B. Alexander its operating margins.
Henderson * Longer term, Avaya expects to emerge as a solid growth
vehicle with revenue growth in the 10% plus vicinity and
potentially as much as 15% annually
Timothy Anderson * While these targets appear attainable to us, we think
there is a lot of work to do to attain these lofty
goals.
* Avaya is trading is around 0.8 times last year's
normalized sales. With near term revenue growth
projected revenue growth projected at flat, this
multiple seems reasonable for a margin expansion story,
however, as Avaya establishes a growth trajectory we
think there is considerable upside to the valuation.
AVAYA WELL POSITIONED TO SUCCEED IN THE RESURGING ENTERPRISE SPACE
Lucent's spin-off Avaya is expected to start trading under symbol AV on
Monday October 2nd. We expect the enterprise market to resurge and believe
Avaya is well positioned to benefit from this growth. Over the next 12-24
months, Avaya intends to double its operating margins while modestly
reaccelerating growth. Over the 12-36 month time frame, Avaya hopes to drive
top-line growth back above the 10% level and hopefully back to the 15% plus
vicinity. Avaya's targets over the next 2 to 4 years are fairly aggressive
but may be achievable. Yet based on the expected growth of enterprise
markets, strength of the management team and R&D capabilities in place we
believe Avaya has a reasonable chance of reaching these goals Avaya is
trading is around 0.8 times last year's normalized sales. With near term
revenue growth projected revenue growth projected at flat, this multiple
seems reasonable for a margin expansion story, however, as Avaya establishes
a growth trajectory we think there is considerable upside to the valuation.
We Believe The Enterprise Space Is Resurging And Should Experience Solid
Growth. We think the pendulum has shifted too far away from the enterprise
and is poised to swing back in force. We think the enterprise market is
resurging as businesses discover the productivity implications of network
access, and bandwidth availability as they deploy Net centric mission
critical applications and a wide range of other e-business solutions.
The area of the enterprise space in which Avaya plays is anticipated to grow
at a respectable 16% percent annual rate, fueled by a new cycle of demand.
Avaya's addressable market is expected to reach a level above $300 billion
from around $180 billion in 1998. Specific sub-segments of Avaya's target
markets are projected to grow at even higher rates:
* IP based telephony market is expected to grow at rates well in excess of
200%
* By 2003, the market for next generation of customer relationship management
applications is forecasted to reach close to $10 billion expanding by 25%
annually.
* The professional services space is anticipated to grow at over 30% annually
to around $20 billion by 2003.
* Unified messaging markets are expanding at rates above 40%. Estimates for
2003 are in the range of $6 billion.
We believe the overall enterprise space should grow at a fast pace as well.
On the most recent Cisco conference call, management indicated that they
believe enterprise spending on IT would increase from 3.0%-3.5% of revenues
today to as much as 7.0% of revenues over the next 3-5 years with much of the
increase captured by data networking investments. We note only 0.5% of the
current spending finds its way into this equipment class and this could
increase to as much as 1.5% over this time frame suggesting potentially a
tripling of enterprise spending on networking equipment. Cisco punctuated
these thoughts with a 40% quarter-to-quarter growth rate in its small to
medium scale business segment revenues. This is a huge driver of demand
that's independent of the health of the service providers and hasn't received
the respect that is due, in our view. Enterasys made similar comments on the
Cabletron call as it increased its revenue growth rate guidance by 50% to 30%
from 20%.
Avaya Is Solidly Positioned In The Faster Growing Enterprise Segments. Avaya
starts with a solid position and has the capability to capitalize on this
significant market opportunity through its portfolio of next generation
products; strong R&D and professional services capabilities; experienced and
enthusiastic management team and an established track record in its target
markets.
* With revenues of around $8 billion and about 1 million customers of which
500,000 are under maintenance contracts, Avaya has a strong established
presence in the enterprise space. It holds leading positions in most of
the sub-segments in which it participates. In enterprise telephone systems
Avaya leads in the US while being number three worldwide. It boasts a
strong stable of customers including around 80% of the Fortune 500 and a
large number of non-US based multinationals. The company has 18,000 call
centers and automated call distributors around the world in every
geographical areas. Avaya boasts the number one rank in voice messaging
and interactive voice response.
* Avaya's current leading position and portfolio of products and services
represents an excellent base to build upon. Existing customer
relationships are a superb starting point in the implementation of a
variety of e-business initiatives. For example, the company can leverage
its leadership position in voice messaging into gaining market share in the
fast growing unified messaging market. We expect Avaya's current equipment
offerings to evolve at a rapid pace into next generation products including
convergence between voice and data. With more than 16 products offering
100% replication of traditional telephony features, Avaya is a major
participant in the high growth IP telephony market. Moreover, Avaya plans
to enlarge the scope of its R&D effort to several other areas including
gigabit Ethernet, virtual private networks and extending the CRM concept to
the enterprise level.
* Avaya has a strong, motivated and enthusiastic management team. Although
some may argue that Avaya was spun off because of playing in a low growth
field, in actuality it seems they took good management with them. The fact
that most managers are in new positions should reinvigorate the
organization and increases the general level of enthusiasm. Its R&D staff
includes more than 3,000 employees transferred from Lucent's Bell Labs. We
estimate the employee ownership interest carry through option plans is in
the lower twenties. This value, comparable with other companies in the
high tech space, is a key element in retaining employees and attracting
talent from competitors.
* Avaya plays almost 100% in the enterprise space. Therefore we believe it
is insulated from recent concerns regarding capital spending by service
providers. Moreover, the company is expected to benefit from the
rejuvenation of enterprise markets.
* In our opinion the competitive environment in the enterprise space is far
from being a major concern for Avaya. The market is fragmented -- Avaya
and Cisco account to about 10% of the market between them -- and is growing
at a rapid pace leaving enough room for growth for all major players.
Avaya's Targets Are Aggressive But Achievable In Our View. Avaya has set for
itself a number of fairly aggressive targets regarding revenue, earnings and
R&D spending growth, margins improvement, tax rate reduction and cost
management in the immediate future and over the next 2 to 4 years. The
company is looking to reach eventually growth rates above the forecasted
market level of 16% from almost flat in the near future and double its
operating margin while increasing R&D spending.
* Although not generating a lot of growth near term -- next two to three
quarters to be almost flat because of the timing of spin and mix shifts in
the business-- the company expects an acceleration during the 2001
timeframe. Management's game plan is to accelerate growth to low single
digits in the second half of 2001 and gradually move towards the 15% target
over the next couple of years.
* The gross margin based on the first nine months of 2000 is at 44.5%. The
management expects to reduce it by 100 to 200 basis points by gradually
migrating revenue towards applications software and solutions over the next
24 to 48 months.
* Currently 33% of revenues are SG&A while competitors are in the low 20s.
Management targets 7-10 points reduction in SG&A and plans to split the
benefit between increasing R&D spending -currently at 6.5% level well below
industry average-- by 200 to 400 basis points starting in the immediate
future and the rest of 6 to 8 points to double operating margin currently
at the 5% level. . SG&A reduction would require a very active cost
management process that Avaya expects to pursue to an extent that was not
possible given the complexities of the larger Lucent structures
* Avaya plans to start increasing the level of R&D spending which currently
at 6.5% of revenues is significantly under industry average.
* Another immediate goal is to reduce the tax rate from the current level of
39.4% down to 35%. The current rate is the result of the optimization
effort across the entire Lucent organization. The spin-off frees Avaya to
take the required steps to optimize the level of tax rates according to its
own situation.
Achieving these goals is no mean feat. Nevertheless, based on the expected
growth of the enterprise markets, strength of the management team, R&D
capabilities in place and given that some of the targets are "low hanging
fruit" and Lucent has been through similar processes before, we believe Avaya
has a reasonable chance of reaching these goals. |
