Avaya – What is the Path Forward Through Bankruptcy?

Last week I was at the Avaya IAUG User event in Las Vegas. Now that Avaya has been in bankruptcy for a month, I was asked repeatedly what I thought was going to happen. Having been through a similar process at Nortel and having listened to the Avaya team and examined the available public documentation, I thought I would speculate on the potential options/outcomes and which may be best for the customers, Avaya, and the industry.

Clearly, Avaya emerging from the bankruptcy process as a stronger competitor has benefits for existing customers and helps to keep the industry moving forward. Other than for some competitors, Avaya emerging from the bankruptcy process as a strong vibrant company is a good thing. Over the past few years, Avaya has been innovating and delivering new capabilities that have differentiation and value in the market. The convergence on Equinox as the next generation UC user experience and on Oceana as the platform for customer experiences demonstrates that Avaya is moving forward to solutions that can carry their customers and new prospects into the digitized business era. The challenge is emerging from the bankruptcy stronger than before.

There are two potential outcomes from the process that is underway today. First, a plan may emerge that keeps the core elements (UC and CC) together and is acceptable to the existing bond creditors. Such a plan can move rapidly to a conclusion in the courts and emerge relatively quickly from the process. The Avaya management team indicated that they intend to have a plan that protects the core assets in place by the end of March. Alternatively, the bond creditors may conclude that they would be better served selling the assets and break the company up, similar to what happened to Nortel. For example, there is reasonable data that the contact center business was valued at over $3.5B in the sale discussions prior to the bankruptcy. In fact, an EBITDA analysis of the Avaya business shows that the business assets are worth somewhere between $6B and $7B based on projected EBITDA and assumed multiples. Ultimately this needs to be reduced by about $1.5B for the unfunded pension liabilities. So the value that needs to be created for the Bondholders to be comfortable with a core continuation plan is between $4.5 and $5.5B return as a combination of debt, cash or equity. The bond holders will contrast an offer that is a mix of cash and equity against an all cash break up option.

If Avaya can hold the bankruptcy line to the bondholders, that would suggest there are three key decisions in putting a plan together that keeps Avaya as a company with the core UC and CC assets intact:

1. Ongoing Debt Level - How much debt will be left at what interest rate/payment level? The pre-filing annual interest expense for 2016 was about $470M on debt of around $6B, indicating an effective average rate of about 7%. Assuming they negotiate a 8% rate (this is actually much lower than the current actual rate as their bonds were discounted by 30-60% before the filing), then a $2B remaining debt load is a $160M expense. Based on both the 6-8% revenue decline and the coming pressure on both margin and EBITDA of cloud, competition, and the challenges of the filing, I would think that management would push back very hard on anything above $200M of annual debt servicing expense on the company emerging from bankruptcy. The pension funding will probably require $50-100M of annual funding also. If the debt payments go to $200M per year then the bankruptcy is really only reducing cash burn by $270M. 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 $940M in EBITDA the result is only $176M of increased annual cash ($270M-$94M). 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 the new platforms for growth.
2. Split Of Proceeds Between 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, while the seniors would like 100% of theirs first, which may leave little or nothing for the juniors. The reality is that they 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. If they get into a protracted fight on this, that could take a long time. On the other hand, the creditors know that Avaya is a decreasing asset in bankruptcy, so there is hope they will buckle down and conclude an agreement. There is an active trading market in Avaya bonds as bond holders jockey on this topic.
3. New Management Oversight - Is there a new management firm or will Silverlake or TPG be involved as the general management firm? 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 as the PE guys are. I expect that a PE 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.

If 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 is how the assets will be structured in a sale. Even if there is a plan to go forward, management and the new owners need to take this opportunity to redefine the strategy and business model.  
The pre-bankruptcy thought, as revealed in the public documents, was to partition the company based on UC and CC, separating the company into two pieces where each business includes their respective services and services organizations. While this partitioning led to several parties interested in the CC business, the attempt failed, seemingly to the complexity from a business and technology perspective of separating the customers. Alternatives were a split based on size, with large enterprise and SMB/MM being split into two assets.

I believe an alternative option would be to split out the services business as a separate entity from the product organizations. This could either be done as part of the Avaya-proposed restructuring plan or to split up assets if a plan cannot be agreed and the assets must be sold off. While delivering software and services has been the mantra of the new Avaya, the reality is that product companies in high technology generally do not have large services organizations (whether they are hardware or software product companies). While product companies provide support for their products (updates, patches, warranty, etc.), services such as installation, break-fix, monitoring, and professional services are generally done by a range of third parties; the channel, systems integrators, consulting companies, and others. By having a large services organization and requiring customers to buy Avaya services, the relationship with Avaya channels and partners has become challenging. The result is that channels often recommend against upgrades or sell competitors platforms to protect existing services revenue streams.

Another major factor is the value of the services business. There are two values of the services business, the actual revenue stream and the relationships that Avaya services has with a significant percentage of large US and global companies. Using a current revenue stream of about $1.2B for non-support services (reduced from the public documents by 10% to account for the impact of the bankruptcy process), and current EBITDA of about 25-30%, the revenue stream can be extended for five years. Based on management projections and assumed impacts of the bankruptcy, the average annual five-year services business revenue can be projected to be about $1.1B and with a 25% EBITDA. The resulting five year average EBITDA is about $303M. 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 $3.6B value on the market. Clearly the debt load on the remaining core product businesses of UC and CC products would be dramatically reduced. For multiple MSPs, in addition to the basic value of the revenue stream, acquiring the Avaya services business could be an attractive way to expand their position in the market.

Finally, 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 portfolio as well as a wider range of IT systems. The resulting 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 Skype for Business services that are not available to a services organization as part of Avaya. Finally, with many of the new Avaya offers 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 offers in the market.

Another area is the data networking business. 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 $250M annual revenue, the market share is less than 1%. The result of this position is that the data business has had a negative EBITDA of $259M over the last three years. The negative EBITDA has been increasing, resulting in a negative EBITDA of $100M in 2016. As actual cash burn is general 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 $120-140M for 2016. Unless there is an immediate dramatic (100% plus) increase in revenue, it would appear that this business does not have a high current value. Assuming a buyer can be found that will support the existing customers, it would appear to be a high probability that a result of any restructuring would be the sale of the networking business. For customers of Avaya Networking and fabric networks, this may be the best outcome as it will assure an ongoing level of support and potentially investment levels that will be challenging for the networking business as part of Avaya.

In the end, how Avaya emerges from the bankruptcy process and the structure of the company going forward is critical for success and the industry. Over the last five years Avaya has had an average revenue decline of about 6%. This decline is not due to the capital structure, it is due to the market conditions and Avaya’s competitive position within the market. If Avaya does not take advantage of the reorganization process to change the company strategy and position, the result of even a “successful” capital structure exit may be just a continued gradual decline. However, if Avaya takes advantage of the opportunity that the capital restructuring offers to address the basic strategy, positioning, and competitive situation, there is a strong potential of a new path forward based on the innovation and new products entering the portfolio. A focus on the key elements for success is critical. Business success is a combination of great vision, strategy, innovation, positioning, and execution. To succeed in an ever more competitive marketplace, Avaya needs to make sure that all of these elements are clearly understood and aligned going forward.