Analyzing the Avaya Path Through BankruptcyAnalyzing the Avaya Path Through Bankruptcy

Shortly after Avaya filed for Chapter 11 bankruptcy protection, on Jan. 19, I shared my initial thoughts with No Jitter readers about whether the move was good or bad for customers based on my experiences having lived through the process at Nortel. Since that writing, I've examined the available public documentation and spoken with the Avaya team on various occasions to enrich my understanding of the situation.

Avaya executives have clearly stated, both in published materials and public presentations, that the company will emerge from the bankruptcy process as a more vibrant, stronger competitor. In fact, for the latest word on this from Avaya, see today's companion post, "Avaya: Turning the Page on Chapter 11," from John Sullivan, Avaya VP and corporate treasurer. But I can see other potential options and outcomes, as well, and have some thoughts on which are best for key players -- Avaya itself, customers, and the industry at large.

Two Post-Bankruptcy Scenarios

Avaya's bankruptcy process has two potential outcomes. In the first, a go-forward plan that keeps the core UC and contact center elements together is accepted by Avaya's bond creditors. In this case, the bankruptcy would move rapidly to a conclusion in the courts, and Avaya would emerge relatively quickly from the process.

This is the outcome the Avaya management team envisions, and executives have indicated they intend to have a plan that protects the core assets in place by the end of March.

However, if the bond creditors cannot come to an agreement on this plan, they may conclude that they would be better served selling the assets and breaking Avaya into pieces. This second outcome is similar to what happened during the Nortel bankruptcy.

Why might this happen? For example, reasonable data shows the contact center business had been valued at more than $3.7 billion in the sale discussions prior to the bankruptcy. In fact, an EBITDA analysis of the total Avaya business shows that the business assets are worth somewhere between $6 billion and $7 billion based on projected EBITDA and assumed multiples. From this total, subtract $1.5 billion for unfunded pension liabilities, and the core continuation plan would need to return between $4.5 billion and $5.5 billion of value -- a combination of debt, cash, or equity -- to provide bondholders a necessary level of comfort. The bondholders will contrast an offer that is a mix of cash and equity against an all-cash break-up option.

Avaya: the Unfolding Story

For No Jitter's ongoing coverage of the Avaya situation pre- and post-bankruptcy, read:

- Avaya: Turning the Page on Chapter 11, by John Sullivan, Avaya VP and corporate treasurer

- Avaya Customers: Calling in Backup, by Eric Krapf, No Jitter publisher

- Avaya Users: Time to Build Your Contingency Plans, by Steve Leaden, independent communications consultant

- Avaya Bankruptcy: Good or Bad for Customers?, by Phil Edholm, independent consultant

- Avaya Ends Speculation, Files for Bankruptcy Protection, by Beth Schultz, No Jitter editor

- Genesys, Avaya Rumor Provokes Conversation, by Sheila McGee-Smith, communications industry analyst

- Avaya Angst Must Come to an End, by Beth Schultz, No Jitter editor

- Avaya Considers Asset Sale, by Dave Michels, communications analyst

Three Decision Points
Assuming Avaya can hold the bankruptcy impact to the bondholders and not have it extend to pension and other liabilities, three key decisions would seem to come into play in putting together a plan that keeps Avaya intact with its core UC and CC assets:

1. Post-Bankruptcy Debt Level -- how much debt will be left and at what interest rate/payment level? Avaya's pre-filing annual interest expense for 2016 was about $470 million on debt of around $6 billion, indicating an effective average rate of about 7%. Assuming Avaya negotiates an 8% rate (this is actually much lower than the current actual rate as the market, due to financial risk, discounted the Avaya bonds by 30% to 60% before the filing), then a remaining debt load of $2 billion is an expense of $160 million. Based on both the 6% to 8% revenue decline and the coming pressure on both margin and EBITDA of cloud, competition, and the challenges of the filing, I would think management would push back very hard on anything above $200 million of annual debt servicing expense on the company emerging from bankruptcy. The pension funding will probably require $50 million to $100 million of annual funding as well.

If the debt payments go to $200 million per year, then the bankruptcy is really only reducing cash burn by $270 million. The value of this reduction may be limited, especially if the bankruptcy results in a 10% reduction in ongoing revenue, margin, and EBITDA. If the bankruptcy impacts 10% of the current $940 million in EBITDA, the result is only $176 million of increased annual cash ($270 million minus $94 million). With revenues continuing to drop, this headroom will only last so long.

The key to ongoing success is not saddling the company with too much debt. Negotiating with the creditors to minimize the cash/debt they receive versus equity to minimize the debt will be critical. Avaya needs the headroom to invest and build out its new Equinox user experience and Oceana customer experience platforms for growth (see today's post, "Avaya: Positioning its Portfolio for the Future).

2. Allocation of Proceeds Among Creditors -- how is the remaining equity and the debt obligations (or cash if new debt instruments are to be sold) split between the senior (secured) and junior (unsecured) debt holders? This may be the tough question. Clearly, the junior bondholders would like an equal/proportional distribution. Meantime, the seniors would like 100% of their distributions first, which may leave little or nothing for the juniors.

The reality is that the bondholders must agree to a partitioning based on percentage of debt/equity/cash and a factoring formula that gives precedence to the senior secured debt holders but gives the juniors some level of return. A protracted fight over this could take a long time. On the other hand, the creditors know that Avaya is a decreasing asset in bankruptcy, so hopefully they'll buckle down and reach agreement. The trading market in Avaya bonds continues trending upward as bondholders jockey on this topic.

3. Ongoing Management Oversight -- will a new management firm enter the fray or will Silver Lake and/or TPG Capital continue on in that capacity? Based on comments from Avaya executives, part of the plan is to have the existing bondholders take an equity position in the company. The reality is that the debt holders are banks and investment houses that are not well structured to manage businesses and generally look to have a private equity firm involved for the day-to-day management oversight. I expect that a private equity firm will join as the post-bankruptcy adult supervision. I do not believe the creditors will accept the current players in that role. In all probability the plan will include active participation of a new private equity firm.

Assuming Avaya and its bankruptcy advisors can find the right new private equity partner and get the creditors to agree, then Avaya should be able to move through the bankruptcy process intact. If the value offered to the creditors is not sufficient or the creditors cannot come to an agreement on allocation, then the entire process may move to an asset sale. If the company and courts move to a sale, the question then becomes one of how the assets will be structured in a sale.

Continue to next page for a look at potential strategic refinements

Continued from previous page

Time for Strategic Refinement
Even if Avaya has a go-forward plan, management and the new owners need to take this opportunity to redefine the strategy and overall business model. The pre-bankruptcy thought, as revealed in the public documents, was to partition the company into UC and contact center pieces, with each business maintaining its respective services and services organizations. While the potential partitioning of the contact center business led to interest from several parties and, ultimately, a $3.9 billion offer (as disclosed in bankruptcy-related documentation), the attempt to sell off that chunk of the business failed, seemingly due to the business, customer, and technology complexity of separating contact center from UC. Another alternative considered was a split based on size, with the separation by large enterprise and SMB/midmarket assets.

While splitting the company on products or size are obvious options, better in my mind would be to split out the services business as a separate entity from the product organizations. Avaya could do this either as part of its proposed restructuring plan or by splitting up assets if bondholders can't agree on a plan and Avaya must sell off the assets.

While delivering software and services has been the new Avaya's mantra, the reality is that high-tech companies, whether offering hardware or software products, generally do not have large services organizations. While product companies provide support for their products (updates, patches, warranties, etc.), they generally outsource services such as installation, break-fix, monitoring, and professional care to a range of third parties -- the channel, systems integrators, consulting companies, and others. By having a large services organization with 50% of revenue and requiring customers to buy Avaya services, Avaya's relationship with its channel and other partners has become challenging. The result is that channels often recommend against upgrades or sell competitors' platforms to protect existing services revenue streams.

 Schedule

Attend Enterprise Connect 2017, coming March 27 to 30 in Orlando, Fla., for up-to-the-minute analysis and perspectives on how you should approach the evolving Avaya situation and ongoing change in the UC&C and contact center marketplaces. Check out these two Monday, March 27, sessions:

- Avaya Update: What Enterprises Need to Know Right Now

- Managing for and Through Vendor Consolidation

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The value of the services business should be another factor in deciding to split that part off. The services business provides value in two ways -- from the actual revenue stream and from the relationships that Avaya services has with a significant percentage of large U.S. and global companies. Using a current revenue stream of about $1.2 billion for non-product support services (reduced from the public documents by 10% to account for the impact of the bankruptcy process) and current EBITDA of about 25% to 30%, the revenue stream can extend five years.

Based on management projections and assumed impacts of the bankruptcy, projecting the average annual five-year services business revenue to be about $1.1 billion, and with a 25% EBITDA, is reasonable. The resulting five-year average EBITDA would be about $303 million. If the EBITDA multiple is assumed to be at the top of the generally accepted range due to the value of the relationships and the ability of an acquirer to use those relationships to sell other services offers, a 12 times EBITDA multiple is achievable.

With this analysis, the services business could have a $3.6 billion value on the market -- and this would dramatically reduce the debt load on the remaining core UC and contact center product businesses. In addition to the basic value of the revenue stream, acquiring the Avaya services business could be an attractive way for any number of managed services providers to expand their market positions.

While Avaya customers have been used to getting Avaya services and products together, I believe the customer base would clearly understand splitting off the services organization and would be generally accepting of a new services partner that could both service their Avaya portfolios as well as a wider range of IT systems. This vendor-services relationship matches other vendors' services strategies, and the resulting organization could expand the strategic services footprint in many Avaya customers. The resulting organization could also become a channel and compete with other channels in the market.

A non-Avaya connected services organization could make substantial inroads into services adjacencies like Cisco networking and Microsoft Skype for Business services that are not available to a services organization as part of Avaya. Finally, with many of the new Avaya offerings including a strong digital transformation component, having the Avaya services organization acquired by an organization with strong digital transformation skill sets could accelerate the position of those offerings in the market.

Little Promise in Networking
Data networking is the other business that needs consideration. In discussions at the analyst and consultant sessions at the recent Avaya Engage meeting, Avaya executives made clear that UC and contact center are core. They did not include the data networking business in that grouping.

While the new fabric networking has some significant differentiation and value, the Avaya data networking business is very challenged, both in market share and financially. At the 2016 level of $250 million annual revenue, its market share is less than 1%. The result of this position is that the data business has had a negative EBITDA of $259 million over the last three years. The negative EBITDA has been increasing, resulting in a negative EBITDA of $100 million in 2016. As actual cash burn is generally higher than EBITDA in a negative situation (EBITDA is before some costs like restructuring, taxes, debt, etc.), the actual cash burn is probably higher, closer to $120 million to $140 million for 2016.

Unless Avaya realizes an immediate dramatic (100% plus) increase in revenue, with prospects for even more future growth, this business probably does not have a high current value. It's likely that a result of the restructuring will be the sale of the networking business, assuming a buyer can be found that will support the existing customers. For customers of Avaya Networking and fabric networks, this may be the best outcome as it will assure an ongoing level of support and potential increased investment levels that will be challenging for the networking business as part of Avaya.

Addressing Root Cause
How Avaya emerges from the bankruptcy process and the structure of the company going forward is critical for both Avaya's success and the industry overall. For the last five years, Avaya has had an average revenue decline of about 6%. This ongoing decline is not due to the capital structure, but rather due to market conditions and Avaya's competitive position within the market. Avaya must take advantage of the reorganization process to change the company strategy and position. The result of just having a "successful" capital structure exit from bankruptcy may be just a continued gradual decline if Avaya doesn't address the underlying business issues.

If Avaya takes advantage of the opportunity that the capital restructuring offers to address the basic strategy, positioning, and competitive situation, the potential for a new path forward based on the innovation and new products entering the portfolio is strong. Focus on the key elements for success is critical -- a combination of great vision, strategy, innovation, positioning, and execution. To succeed in an ever-more competitive marketplace, Avaya needs to make sure that it clearly understands and aligns these elements going forward.