UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-15951
AVAYA INC.
(Exact name of registrant as specified in its charter)
Delaware |
| 22-3713430 |
(State or other jurisdiction of |
| (I.R.S. Employer |
211 Mount Airy Road |
| 07920 |
(Address of principal executive offices) |
| (Zip Code) |
(908) 953-6000
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x |
| Accelerated filer o |
| Non-accelerated filer o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of July 31, 2007, 456,934,358 shares of Common Stock, $.01 par value of Avaya Inc. were outstanding.
Item |
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| Management’s Discussion and Analysis of Financial Condition and Results of Operations |
| 29 |
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| 51 |
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This Quarterly Report on Form 10-Q contains trademarks, service marks and registered marks of Avaya Inc. and its subsidiaries and other companies, as indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q, trademarks identified by ® and ™ are registered trademarks or trademarks, respectively, of Avaya Inc. or its subsidiaries. All other trademarks are the properties of their respective owners.
2
AVAYA INC.
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
|
| Three months ended |
| Nine months ended |
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| June 30, |
| June 30, |
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| 2007 |
| 2006 |
| 2007 |
| 2006 |
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| Dollars in millions, except per share amounts |
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REVENUE |
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Sales of products |
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| $ | 626 |
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| $ | 636 |
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| $ | 1,884 |
| $ | 1,820 |
| ||
Services |
|
| 507 |
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|
| 507 |
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| 1,525 |
| 1,503 |
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Rental and managed services |
|
| 143 |
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|
| 154 |
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| 441 |
| 461 |
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| 1,276 |
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| 1,297 |
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| 3,850 |
| 3,784 |
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COSTS |
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Sales of products |
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| 302 |
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| 304 |
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| 892 |
| 856 |
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Services |
|
| 312 |
|
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| 335 |
|
| 960 |
| 976 |
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Rental and managed services |
|
| 65 |
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|
| 70 |
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| 204 |
| 197 |
| ||||||
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| 679 |
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| 709 |
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| 2,056 |
| 2,029 |
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GROSS MARGIN |
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| 597 |
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| 588 |
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| 1,794 |
| 1,755 |
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OPERATING EXPENSES |
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Selling, general and administrative |
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| 402 |
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|
| 423 |
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| 1,184 |
| 1,207 |
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Research and development |
|
| 104 |
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| 115 |
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| 332 |
| 318 |
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Restructuring charges, net |
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| 13 |
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| 22 |
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| 29 |
| 42 |
| ||||||
Merger-related costs |
|
| 8 |
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|
| — |
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| 8 |
| — |
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TOTAL OPERATING EXPENSES |
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| 527 |
|
|
| 560 |
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| 1,553 |
| 1,567 |
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OPERATING INCOME |
|
| 70 |
|
|
| 28 |
|
| 241 |
| 188 |
| ||||||
Other income, net |
|
| 10 |
|
|
| 5 |
|
| 23 |
| 16 |
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Interest expense |
|
| (1 | ) |
|
| — |
|
| (1 | ) | (3 | ) | ||||||
INCOME BEFORE INCOME TAXES |
|
| 79 |
|
|
| 33 |
|
| 263 |
| 201 |
| ||||||
Provision for (benefit from) income taxes |
|
| 24 |
|
|
| (11 | ) |
| 80 |
| 48 |
| ||||||
NET INCOME |
|
| $ | 55 |
|
|
| $ | 44 |
|
| $ | 183 |
| $ | 153 |
| ||
Earnings Per Common Share—Basic: |
|
| $ | 0.12 |
|
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| $ | 0.10 |
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| $ | 0.40 |
| $ | 0.33 |
| ||
Earnings Per Common Share—Diluted: |
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| $ | 0.12 |
|
|
| $ | 0.10 |
|
| $ | 0.40 |
| $ | 0.32 |
|
The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.
3
AVAYA INC.
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
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| June 30, 2007 |
| September 30, 2006 |
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| Dollars in millions, |
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ASSETS |
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Current assets: |
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Cash and cash equivalents |
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| $ | 1,057 |
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| $ | 899 |
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Accounts receivable, less allowances of $59 million and $57 million |
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| 869 |
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| 871 |
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Inventory |
|
| 304 |
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| 285 |
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Deferred income taxes, net |
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| 177 |
|
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| 153 |
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Other current assets |
|
| 212 |
|
|
| 151 |
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TOTAL CURRENT ASSETS |
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| 2,619 |
|
|
| 2,359 |
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| ||||
Property, plant and equipment, net |
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| 626 |
|
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| 668 |
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Deferred income taxes, net |
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| 700 |
|
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| 787 |
|
| ||||
Intangible assets |
|
| 275 |
|
|
| 263 |
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| ||||
Goodwill |
|
| 1,121 |
|
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| 941 |
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Other assets |
|
| 222 |
|
|
| 182 |
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TOTAL ASSETS |
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| $ | 5,563 |
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| $ | 5,200 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY |
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Current liabilities: |
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Accounts payable |
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| $ | 395 |
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| $ | 418 |
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Payroll and benefit obligations |
|
| 400 |
|
|
| 377 |
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Deferred revenue |
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| 327 |
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| 286 |
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Business restructuring reserve |
|
| 70 |
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| 98 |
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Other current liabilities |
|
| 228 |
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| 249 |
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TOTAL CURRENT LIABILITIES |
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| 1,420 |
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| 1,428 |
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Benefit obligations |
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| 1,372 |
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| 1,321 |
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Deferred income taxes, net |
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| 79 |
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| 77 |
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Other liabilities |
|
| 266 |
|
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| 288 |
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TOTAL NON-CURRENT LIABILITIES |
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| 1,717 |
|
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| 1,686 |
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Commitments and contingencies |
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STOCKHOLDERS’ EQUITY |
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Series A junior participating preferred stock, par value $1.00 per |
|
| — |
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|
| — |
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Common stock, par value $0.01 per share, 1.5 billion shares |
|
| 5 |
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| 5 |
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Additional paid-in-capital |
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| 2,713 |
|
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| 2,637 |
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Retained earnings |
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| 331 |
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|
| 148 |
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Accumulated other comprehensive loss |
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| (609 | ) |
|
| (698 | ) |
| ||||
Less: Treasury stock at cost |
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| (14 | ) |
|
| (6 | ) |
| ||||
TOTAL STOCKHOLDERS’ EQUITY |
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| 2,426 |
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|
| 2,086 |
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TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |
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| $ | 5,563 |
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| $ | 5,200 |
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The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.
4
AVAYA INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
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| Nine months ended |
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| June 30, |
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| 2007 |
| 2006 |
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| Dollars in millions |
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OPERATING ACTIVITIES: |
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Net income |
| $ | 183 |
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| $ | 153 |
|
|
Adjustments to reconcile net income to net cash provided by operating activities: |
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|
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Depreciation and amortization |
| 221 |
|
| 202 |
|
| ||
Share-based compensation |
| 28 |
|
| 22 |
|
| ||
Deferred income taxes, net |
| 55 |
|
| 24 |
|
| ||
Impairment charges |
| — |
|
| 29 |
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| ||
Reversal of liabilities related to tax settlements |
| (8 | ) |
| (25 | ) |
| ||
Gain resulting from sale of real estate |
| (8 | ) |
| — |
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Restructuring charges, net |
| 29 |
|
| 42 |
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Unrealized losses on foreign currency exchange |
| 19 |
|
| 11 |
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Adjustments for other non-cash items, net |
| 5 |
|
| 7 |
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Changes in operating assets and liabilities, net of effects of acquired businesses: |
|
|
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Accounts receivable |
| 14 |
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| 40 |
|
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Inventory |
| (9 | ) |
| (4 | ) |
| ||
Accounts payable |
| (28 | ) |
| (12 | ) |
| ||
Payroll and benefit obligations |
| 38 |
|
| 42 |
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Business restructuring reserve |
| (83 | ) |
| (56 | ) |
| ||
Deferred revenue |
| 57 |
|
| 29 |
|
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Other assets and liabilities |
| (89 | ) |
| (48 | ) |
| ||
NET CASH PROVIDED BY OPERATING ACTIVITIES |
| 424 |
|
| 456 |
|
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INVESTING ACTIVITIES: |
|
|
|
|
|
|
| ||
Capital expenditures |
| (79 | ) |
| (83 | ) |
| ||
Capitalized software development costs |
| (71 | ) |
| (53 | ) |
| ||
Acquisitions of businesses, net of cash acquired |
| (162 | ) |
| — |
|
| ||
Proceeds from sale of real estate |
| 13 |
|
| 2 |
|
| ||
Other investing activities, net |
| (5 | ) |
| (5 | ) |
| ||
NET CASH USED FOR INVESTING ACTIVITIES |
| (304 | ) |
| (139 | ) |
| ||
FINANCING ACTIVITIES: |
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|
|
|
|
|
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Issuance of common stock |
| 110 |
|
| 20 |
|
| ||
Repurchase of common stock |
| (94 | ) |
| (256 | ) |
| ||
Capital lease payments |
| (3 | ) |
| (14 | ) |
| ||
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES |
| 13 |
|
| (250 | ) |
| ||
Effect of exchange rate changes on cash and cash equivalents |
| 25 |
|
| 5 |
|
| ||
Net increase in cash and cash equivalents |
| 158 |
|
| 72 |
|
| ||
Cash and cash equivalents at beginning of fiscal year |
| 899 |
|
| 750 |
|
| ||
Cash and cash equivalents at end of period |
| $ | 1,057 |
|
| $ | 822 |
|
|
The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.
5
AVAYA INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Background and Basis of Presentation
Background
Unless otherwise indicated by the context in this Quarterly Report on Form 10-Q, “we,” “us,” “our,” “the Company” and “Avaya” refer to Avaya Inc. and its consolidated subsidiaries. We are a leading provider of communications solutions that help enterprises transform their businesses by intelligently connecting customers, employees and business partners with enhanced business processes. Our enterprise communications solutions offerings are comprised of a product portfolio that includes infrastructure hardware, application software, phone appliances and a comprehensive portfolio of enterprises services focused on IT and communications solutions. We support our broad customer base with comprehensive global service offerings that enable our customers to plan, design, implement, monitor and manage their communications systems and/or converged networks. The term “traditional” with respect to “voice communications,” “enterprise voice communications,” “telephony,” “voice telephony,” “voice systems,” or “TDM,” refers to circuit-based enterprise voice communications.
Basis of Presentation
The accompanying unaudited interim Consolidated Financial Statements as of June 30, 2007 and for the three and nine months ended June 30, 2007 and 2006, have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial statements and the rules and regulations of the U.S. Securities and Exchange Commission (“the SEC”) for interim financial statements, and should be read in conjunction with our Consolidated Financial Statements and other financial information for the fiscal year ended September 30, 2006, which were included in our Annual Report on Form 10-K filed with the SEC on December 8, 2006. The significant accounting policies used in preparing these unaudited interim Consolidated Financial Statements are the same as those described in Note 2 to our Annual Report on Form 10-K filed with the SEC on December 8, 2006. In our opinion, the unaudited interim Consolidated Financial Statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair statement of the financial condition, results of operations and cash flows for the periods indicated.
Certain prior year amounts have been reclassified to conform to the current year presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year.
Merger Agreement with Silver Lake Partners and TPG Partners
On June 4, 2007, Avaya entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Sierra Holdings Corp., a Delaware corporation (“Parent”), and Sierra Merger Corp., a Delaware corporation and wholly owned subsidiary of Parent (“Merger Sub”). Under the terms of the Merger Agreement, Merger Sub will be merged with and into the Company, with the Company continuing as the surviving corporation and a wholly owned subsidiary of Parent (the “Merger”). Parent was formed by two private equity funds, Silver Lake Partners III, L.P. and TPG Partners V, L.P. (collectively, the “Sponsors”), solely for the purpose of entering into the Merger Agreement and consummating the Merger. The Merger Agreement provides for a purchase price of $17.50 per share of Avaya common stock (the “Merger Consideration”), or approximately $8.21 billion in the aggregate (excluding fees and expenses in connection with the Merger of approximately $0.28 billion).
6
The proposed transaction is expected to be completed in the fall of 2007, subject to receipt of shareholder approval and customary regulatory approvals, as well as satisfaction of other customary closing conditions. There is no financing condition to the obligations of the Sponsors to consummate the transaction, and equity and debt commitments sufficient to fund the Merger Consideration have been delivered to Parent. The Company filed its preliminary proxy statement with the SEC on July 18, 2007 and filed its Hart-Scott-Rodino notification with the Federal Trade Commission and the Department of Justice on June 15, 2007. The Department of Justice and the Federal Trade Commission granted early termination of the Hart-Scott-Rodino waiting period effective June 28, 2007. The date for the special meeting of shareholders to vote on adoption of the Merger Agreement is September 28, 2007, and the record date related to this meeting is August 9, 2007.
During the three months ended June 30, 2007, the Company incurred third-party costs associated with the Merger of $8 million (approximately $4.6 million after tax, or $0.01 per diluted share) consisting primarily of investment banking and legal fees directly related to the proposed Merger.
2. Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”) which permits companies the option, at specified election dates, to measure financial assets and liabilities at their current fair value, with any corresponding changes in fair value from period to period recognized in the income statement. Additionally, SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar assets and liabilities. SFAS 159 is effective for the Company beginning in fiscal 2009. The Company is currently evaluating the impact that adoption of SFAS 159 may have on its Consolidated Financial Statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post Retirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 improves reporting of obligations for pensions and other post-retirement benefits by recognizing the over-funded or under-funded status of plans as an asset or liability. The pronouncement does not change how plan assets and benefit obligations are measured under FAS 87 and FAS 106 nor does it change the approach for measuring annual benefit cost reported in earnings. Instead, it eliminates the provisions that permit plan assets and obligations to be measured as of a date not more than three months prior to the balance sheet date, instead requiring measurement as of the reporting date. In addition, the pronouncement requires previously unrecognized items, such as actuarial gains or losses and unrecognized prior service costs or credits to be recognized on the balance sheet as a component of other comprehensive income (loss). The Company will adopt the provisions of SFAS 158 by the end of fiscal 2007. The estimated impact of adopting this new standard depends upon several factors, including the market discount rate at September 30, 2007 and the actual return on plan assets. The Company estimates an increase in the liability for benefit obligations recognized on the September 30, 2007 Consolidated Balance Sheet of approximately $150 to $180 million with an addition to accumulated other comprehensive loss. This range is an estimate and is subject to change pending the funded status of the plans as of the measurement date, which is September 30, 2007. The Company is also assessing the potential impact that adoption of SFAS 158 may have on the Company’s postemployment liabilities established under SFAS No. 112, “Employers’ Accounting for Postemployment Benefits.”
7
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value and establishes a framework for measuring fair value under U.S. GAAP. The pronouncement describes fair value as being based on a hypothetical transaction to sell an asset or transfer a liability at a specific measurement date, as considered from the perspective of a market participant who holds the asset or owes the liability. In addition, fair value should be viewed as a market-based measurement, not an entity-specific measurement. Therefore fair value should be determined based on the assumptions that market participants would use in pricing an asset or liability, including all risks associated with that asset or liability. SFAS 157 will be effective for the Company beginning in fiscal 2009. The adoption of SFAS 157 is not expected to have a material impact on the Company’s Consolidated Financial Statements.
In September 2006, the SEC issued SAB 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effect of the misstatements on each of the Company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain (year-end balance sheet effect) and the rollover (current-year effect on consolidated statements of operations) methods, along with the evaluation of all relevant qualitative factors.
SAB 108 permits existing public companies to initially apply its provisions either by (i) restating prior financial statements as if the “dual approach” had always been used or (ii) recording the “cumulative effect” of initially applying the “dual approach” as adjustments recorded to the opening balance of retained earnings. Use of the “cumulative effect” transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and why it arose. We expect to initially apply the provisions of SAB 108 in connection with the preparation of our annual financial statements for the year ended September 30, 2007. We are currently evaluating the impact that the adoption of SAB 108 will have on our consolidated results of operation and financial position.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in tax positions and requires that companies recognize in their financial statements the impact of a tax position if it is more likely than not that the position would be sustained on audit, based on the technical merits of the position. The Company will be required to adopt the provisions of FIN 48 beginning in fiscal 2008, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings as well as requiring additional disclosures. The Company is currently assessing the impact that adoption of FIN 48 may have on its Consolidated Financial Statements.
3. Business Combinations
Acquisition of Ubiquity
On January 12, 2007, the Company announced that Avaya International Enterprises Limited (“AIEL”), a wholly-owned subsidiary of the Company, commenced a conditional tender offer to acquire Ubiquity Software Corporation plc (“Ubiquity”). Ubiquity develops and markets SIP-based communications software. Ubiquity was publicly traded on the Alternative Investment Market of the
8
London Stock Exchange and is headquartered in the United Kingdom. Terms of the offer provided for a purchase price of 37.3 pence per Ubiquity share.
On February 15, 2007, the Company announced that it received binding acceptances representing 96.7 percent of the outstanding shares of Ubiquity through its tender offer and declared the offer wholly unconditional. On February 28, 2007, the Company used $146 million of cash to acquire substantially all of the Ubiquity shares. During April 2007, the Company purchased the remaining outstanding shares for $1 million.
Based upon a preliminary purchase price allocation, the Company recognized $41 million of intangible assets related primarily to existing core technology with a weighted average useful life of approximately nine years, and recorded $122 million of goodwill. Management has made estimates and assumptions in the preliminary purchase price allocation that could affect the reported amounts of assets, liabilities and expenses resulting from this acquisition. Actual amounts could differ from these estimates. Management expects to finalize its purchase price allocation by the end of fiscal 2007. The purchase price for this acquisition is not considered to be material to the Consolidated Financial Statements and, therefore, pro forma financial information has not been presented. The financial results of Ubiquity are included in the Company’s Consolidated Financial Statements beginning on February 28, 2007.
Acquisition of Traverse
On November 9, 2006, the Company acquired Traverse Networks, Inc. (“Traverse”) for $15 million in cash. Traverse is a U.S.-based developer of enterprise mobility solutions for unified communications. The Company acquired $3 million in intangible assets with a weighted average useful life of 4.5 years, $4 million in other assets and recorded $8 million of goodwill as part of the purchase price allocation. Management has made estimates and assumptions that could affect the reported amounts of assets, liabilities and expenses resulting from this acquisition. Actual amounts could differ from these estimates. The purchase price for this acquisition is not considered to be material to the Consolidated Financial Statements and, therefore, pro forma financial information has not been presented. The financial results of Traverse are included in the Company’s Consolidated Financial Statements beginning on November 9, 2006.
4. Goodwill and Intangible Assets
The changes in the carrying value of goodwill for the nine months ended June 30, 2007 by operating segment are as follows:
|
| Global |
| Avaya |
|
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| |||||||||
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| Communications |
| Global |
|
|
| |||||||||
|
|
|
| Solutions |
| Services |
| Total |
| |||||||
|
|
|
| Dollars in millions |
| |||||||||||
Balance as of September 30, 2006 |
|
| $ | 658 |
|
|
| $ | 283 |
|
| $ | 941 |
| ||
Acquisition of Traverse |
|
| 8 |
|
|
| — |
|
| 8 |
| |||||
Acquisition of Ubiquity |
|
| 122 |
|
|
| — |
|
| 122 |
| |||||
Impact of foreign currency exchange rate fluctuations |
|
| 37 |
|
|
| 13 |
|
| 50 |
| |||||
Balance as of June 30, 2007 |
|
| $ | 825 |
|
|
| $ | 296 |
|
| $ | 1,121 |
|
9
The following table presents the components of the Company’s acquired intangible assets:
|
| June 30, 2007 |
| September 30, 2006 |
| ||||||||||||||||||||||||
|
| Gross |
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|
|
| Gross |
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| ||||||||||||||||
|
| Carrying |
| Accumulated |
|
|
| Carrying |
| Accumulated |
|
|
| ||||||||||||||||
|
|
|
| Amount |
| Amortization |
| Net |
| Amount |
| Amortization |
| Net |
| ||||||||||||||
|
|
|
| Dollars in millions |
| ||||||||||||||||||||||||
Existing technology |
|
| $ | 161 |
|
|
| $ | 74 |
|
| $ | 87 |
|
| $ | 103 |
|
|
| $ | 57 |
|
| $ | 46 |
| ||
Customer relationships and other intangibles |
|
| 303 |
|
|
| 134 |
|
| 169 |
|
| 292 |
|
|
| 94 |
|
| 198 |
| ||||||||
Total amortizable intangible assets |
|
| $ | 464 |
|
|
| $ | 208 |
|
| $ | 256 |
|
| $ | 395 |
|
|
| $ | 151 |
|
| $ | 244 |
| ||
Minimum pension adjustment |
|
| 19 |
|
|
| — |
|
| 19 |
|
| 19 |
|
|
| — |
|
| 19 |
| ||||||||
Total intangible assets |
|
| $ | 483 |
|
|
| $ | 208 |
|
| $ | 275 |
|
| $ | 414 |
|
|
| $ | 151 |
|
| $ | 263 |
|
During the nine months ended June 30, 2007, the acquisitions of Ubiquity and Traverse as well as the impact of foreign currency, partially offset by amortization, resulted in a net increase of $12 million in the net intangible assets balance. The weighted average useful lives of the existing technology and customer relationships and other intangibles are approximately six years and seven years, respectively.
Amortization expense for the Company’s acquired intangible assets was $17 million and $49 million for the three and nine months ended June 30, 2007, respectively, and was $15 million and $48 million for the three and nine months ended June 30, 2006, respectively. Estimated future amortization expense is shown in the following table:
|
| Estimated future |
| |||
|
| amortization expense |
| |||
|
| Dollars in millions |
| |||
Remainder of fiscal 2007 |
|
| $ | 19 |
|
|
2008 |
|
| 70 |
|
| |
2009 |
|
| 68 |
|
| |
2010 |
|
| 54 |
|
| |
2011 |
|
| 14 |
|
| |
2012 and thereafter |
|
| 31 |
|
| |
Future amortization expense |
|
| $ | 256 |
|
|
The minimum pension adjustment represents unrecognized prior service costs associated with the recording of a minimum pension liability in prior fiscal years. This intangible asset may be eliminated or adjusted as necessary when the amount of minimum pension liability is reassessed, which is conducted on an annual basis.
10
5. Supplementary Financial Information
Statements of Income Information
|
| Three months ended |
| Nine months ended |
| ||||||||||||||||
|
| June 30, |
| June 30, |
| ||||||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| ||||||||||||
|
| Dollars in millions |
| ||||||||||||||||||
OTHER INCOME, NET |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Interest income |
|
| $ | 13 |
|
|
| $ | 9 |
|
|
| $ | 35 |
|
|
| $ | 24 |
|
|
Loss on foreign currency transactions |
|
| (1 | ) |
|
| (1 | ) |
|
| (4 | ) |
|
| (3 | ) |
| ||||
Other, net |
|
| (2 | ) |
|
| (3 | ) |
|
| (8 | ) |
|
| (5 | ) |
| ||||
Total other income, net |
|
| $ | 10 |
|
|
| $ | 5 |
|
|
| $ | 23 |
|
|
| $ | 16 |
|
|
COMPREHENSIVE INCOME: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Net income |
|
| $ | 55 |
|
|
| $ | 44 |
|
|
| $ | 183 |
|
|
| $ | 153 |
|
|
Other comprehensive income: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Cumulative translation adjustment |
|
| 22 |
|
|
| 53 |
|
|
| 88 |
|
|
| 102 |
|
| ||||
Unrealized holding (loss) gain on available for sale securities |
|
| — |
|
|
| (1 | ) |
|
| 1 |
|
|
| (4 | ) |
| ||||
Total comprehensive income |
|
| $ | 77 |
|
|
| $ | 96 |
|
|
| $ | 272 |
|
|
| $ | 251 |
|
|
Balance Sheet Information
|
| June 30, |
| September 30, |
| ||||
|
| Dollars in millions |
| ||||||
INVENTORY: |
|
|
|
|
|
|
| ||
Finished goods |
| $ | 300 |
|
| $ | 281 |
|
|
Raw materials |
| 4 |
|
| 4 |
|
| ||
Total inventory |
| $ | 304 |
|
| $ | 285 |
|
|
PROPERTY, PLANT AND EQUIPMENT, NET: |
|
|
|
|
|
|
| ||
Land and improvements |
| $ | 47 |
|
| $ | 56 |
|
|
Buildings and improvements |
| 473 |
|
| 460 |
|
| ||
Machinery and equipment |
| 697 |
|
| 654 |
|
| ||
Rental equipment |
| 251 |
|
| 230 |
|
| ||
Assets under construction |
| 9 |
|
| 8 |
|
| ||
Internal use software |
| 234 |
|
| 226 |
|
| ||
Total property, plant and equipment |
| 1,711 |
|
| 1,634 |
|
| ||
Less: Accumulated depreciation and amortization |
| (1,085 | ) |
| (966 | ) |
| ||
Property, plant and equipment, net |
| $ | 626 |
|
| $ | 668 |
|
|
6. Restructuring Programs
The net restructuring charge of $29 million recorded in the nine months ended June 30, 2007 is primarily comprised of employee separation charges related to our Europe, Middle East and Africa (“EMEA”) operations, in addition to operating lease obligations. These charges were partially offset by a net benefit due to changes in estimates for prior restructuring plans.
Restructuring charges, net, of $13 million for the third quarter of fiscal 2007 represent charges for employee separation costs recorded with respect to the fiscal 2007 restructuring plan.
11
Fiscal 2007 Restructuring Plan
The following table summarizes the components of this reserve during the nine months ended June 30, 2007:
|
| Employee |
|
|
|
|
| |||||||
|
| Separation |
| Lease |
|
|
| |||||||
|
| Costs |
| Obligations |
| Total |
| |||||||
|
| Dollars in millions |
| |||||||||||
Balance as of September 30, 2006 |
|
| $ | — |
|
|
| $ | — |
|
| $ | — |
|
Charges |
|
| 30 |
|
|
| 6 |
|
| 36 |
| |||
Cash payments |
|
| (10 | ) |
|
| (3 | ) |
| (13 | ) | |||
Balance as of June 30, 2007 |
|
| $ | 20 |
|
|
| $ | 3 |
|
| $ | 23 |
|
The employee separation costs are primarily related to workforce actions in the EMEA region as a result of the Company’s continuing efforts to improve the region’s operational performance, in addition to other charges in the U.S. The operating lease obligations relate to future rent payments, net of estimated sublease income, for unused space in connection with the closing or consolidation of office facilities.
Fiscal 2006 Restructuring Plan
This reserve reflects the remaining balances associated with restructuring actions initiated during fiscal 2006. The following table summarizes the components of this reserve during the nine months ended June 30, 2007:
|
| Employee |
|
|
|
|
| |||||||
|
| Separation |
| Lease |
|
|
| |||||||
|
| Costs |
| Obligations |
| Total |
| |||||||
|
| Dollars in millions |
| |||||||||||
Balance as of September 30, 2006 |
|
| $ | 70 |
|
|
| $ | 17 |
|
| $ | 87 |
|
Adjustments |
|
| (2 | ) |
|
| (7 | ) |
| (9 | ) | |||
Cash payments |
|
| (43 | ) |
|
| (3 | ) |
| (46 | ) | |||
Impact of foreign currency fluctuations |
|
| 1 |
|
|
| 1 |
|
| 2 |
| |||
Balance as of June 30, 2007 |
|
| $ | 26 |
|
|
| $ | 8 |
|
| $ | 34 |
|
The employee separation costs are related to workforce actions in the EMEA region, as well as a reduction in the number of service technicians in the U.S. The headcount reductions identified in this action have been completed and the cash payments are expected to be made through the end of fiscal 2008. The operating lease obligations relate to future rent payments, net of estimated sublease income, for unused space in connection with the closing or consolidation of international office facilities, primarily located in the United Kingdom. During the nine months ended June 30, 2007, the Company concluded lease renegotiations, resulting in a change in the estimate and a $7 million reversal of the initial liability.
12
Restructuring Plans Prior to Fiscal 2006
This reserve reflects the remaining balances associated with restructuring actions initiated prior to fiscal 2006. During the fourth quarter of fiscal 2005, the Company recorded a restructuring charge to reorganize its North American sales and service organizations, consolidate facilities and reduce the workforce in order to optimize the cost structure. The Company also previously recorded reserves in fiscal 2000 and 2002 for lease terminations. The following summarizes the components of this restructuring reserve during the nine months ended June 30, 2007:
|
| Employee |
|
|
|
|
| |||||||||
|
| Separation |
| Lease |
|
|
| |||||||||
|
| Costs |
| Obligations |
| Total |
| |||||||||
|
| Dollars in millions |
| |||||||||||||
Balance as of September 30, 2006 |
|
| $ | 1 |
|
|
| $ | 22 |
|
|
| $ | 23 |
|
|
Adjustments |
|
| 1 |
|
|
| 1 |
|
|
| 2 |
|
| |||
Cash payments |
|
| (2 | ) |
|
| (7 | ) |
|
| (9 | ) |
| |||
Impact of foreign currency fluctuations |
|
| — |
|
|
| 1 |
|
|
| 1 |
|
| |||
Balance as of June 30, 2007 |
|
| $ | — |
|
|
| $ | 17 |
|
|
| $ | 17 |
|
|
EITF 95-3 Reserve
This reserve reflects the remaining balance associated with employee separation costs related to the acquisition of Tenovis Germany GmbH in November 2004 (“Tenovis”). The following table summarizes the components of this reserve during the nine months ended June 30, 2007:
|
| Employee |
| |||
|
| Separation |
| |||
|
| Costs |
| |||
|
| Dollars in millions |
| |||
Balance as of September 30, 2006 |
|
| $ | 30 |
|
|
Cash payments |
|
| (15 | ) |
| |
Impact of foreign currency fluctuations |
|
| 1 |
|
| |
Balance as of June 30, 2007 |
|
| $ | 16 |
|
|
The headcount reductions identified in this action have been completed. The remaining balance includes costs related to some former employees who have elected to receive payments over an extended period of time.
7. Financing Arrangements
Capital Lease Obligations
The Company has entered into capital lease obligations for certain equipment and automobiles, for which payment obligations extend through fiscal 2010. These obligations are classified as other current liabilities and other liabilities within the Consolidated Balance Sheets and consist of the following:
|
| June 30, |
| September 30, |
| ||||||
|
| Dollars in millions |
| ||||||||
As reported in other current liabilities |
|
| $ | 3 |
|
|
| $ | 4 |
|
|
As reported in other liabilities |
|
| 7 |
|
|
| 9 |
|
| ||
Total capital lease obligations |
|
| $ | 10 |
|
|
| $ | 13 |
|
|
13
Credit Facility Amendments
On February 23, 2005, the Company entered into a Credit Agreement among the Company, Avaya International Sales Limited, an indirect subsidiary of the Company, a syndicate of lenders and Citicorp USA, Inc., as agent for the lenders (the “credit facility”). The commitments pursuant to the Company’s previous Amended and Restated Five Year Revolving Credit Facility Agreement, dated as of April 30, 2003 (as amended), among the Company, the lenders party thereto and Citibank, N.A., as agent for the lenders, were terminated and the security interests securing obligations under that facility were fully released.
Under the credit facility, borrowings are available in U.S. dollars or euros, and the maximum amount of borrowings that can be outstanding at any time is $400 million, of which $150 million may be in the form of letters of credit. The credit facility is a five-year revolving facility and is not secured by any of the Company’s assets. The credit facility was amended in May 2006 to extend the expiration date of the credit facility to May 24, 2011 and to amend certain definitions resulting in reductions in interest and various fees payable to the lenders. The credit facility contains affirmative and restrictive covenants, including: (a) periodic financial reporting requirements, (b) maintaining a maximum ratio of consolidated debt to earnings before interest, taxes, depreciation and amortization, adjusted for certain business restructuring charges and related expenses and non-cash charges, referred to as adjusted EBITDA, a non-GAAP measure, of 2.00 to 1.00, (c) maintaining a minimum ratio of adjusted EBITDA, as defined, to interest expense of 4.00 to 1.00, (d) limitations on the incurrence of subsidiary indebtedness, (e) limitations on liens, (f) limitations on investments and (g) limitations on the creation or existence of agreements that prohibit liens on our properties.
The credit facility also limits our ability to make dividend payments or distributions or to repurchase, redeem or otherwise acquire shares of our common stock to an amount not to exceed 50% of consolidated net income for the fiscal year immediately preceding the fiscal year in which such dividend, purchase, redemption, retirement or acquisition is paid or made. On September 8, 2006, the credit facility was amended to provide that the Company may use an additional $500 million during the period from October 1, 2006 through September 30, 2008 for such activities, over the amount provided for under the 50% of consolidated net income test each year. Therefore, as of June 30, 2007, Avaya has remaining availability of $507 million in fiscal 2007 for share repurchases under the credit facility.
Provided that the Company is in compliance with the terms of the credit facility, the Company may use up to $1 billion in cash (excluding transaction fees) and assumed debt for acquisitions completed after February 23, 2005, and the Company has used $200 million as of June 30, 2007. The acquisition amount will be permanently increased to $1.5 billion after consolidated adjusted EBITDA of the Company and its subsidiaries for any period of twelve consecutive months equals or exceeds $750 million.
As of June 30, 2007, the Company was in compliance with all of the covenants included in the credit facility. There are currently $27 million of letters of credit issued under the credit facility. There are no other outstanding borrowings under the facility and the remaining availability is $373 million as of June 30, 2007.
In addition, the Merger Agreement limits Avaya’s ability without the Sponsors’ consent during the period from the date of the Merger Agreement until the closing of the Merger to, among other things, incur indebtedness and make acquisitions over certain thresholds. The Merger Agreement also prohibits Avaya without the Sponsors’ consent from repurchasing shares of its common stock or issuing shares of its common stock, in each case subject to certain exceptions.
14
8. Earnings Per Share of Common Stock
Basic earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by adjusting net income and weighted average outstanding shares, assuming conversion of all potentially dilutive securities including stock options and restricted stock units (“RSUs”).
|
| Three months ended |
| Nine months ended |
| ||||||||||||||||
|
| June 30, |
| June 30, |
| ||||||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| ||||||||||||
|
| Dollars in millions, except per share amounts |
| ||||||||||||||||||
Earnings Per Common Share—Basic: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Net income |
|
| $ | 55 |
|
|
| $ | 44 |
|
|
| $ | 183 |
|
|
| $ | 153 |
|
|
Earnings per share—basic |
|
| $ | 0.12 |
|
|
| $ | 0.10 |
|
|
| $ | 0.40 |
|
|
| $ | 0.33 |
|
|
Weighted average shares outstanding—basic |
|
| 452 |
|
|
| 459 |
|
|
| 453 |
|
|
| 465 |
|
| ||||
Earnings Per Common Share—Diluted: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Net income |
|
| $ | 55 |
|
|
| $ | 44 |
|
|
| $ | 183 |
|
|
| $ | 153 |
|
|
Earnings per share—diluted |
|
| $ | 0.12 |
|
|
| $ | 0.10 |
|
|
| $ | 0.40 |
|
|
| $ | 0.32 |
|
|
Diluted Weighted Average Shares Outstanding: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Weighted average shares outstanding—basic |
|
| 452 |
|
|
| 459 |
|
|
| 453 |
|
|
| 465 |
|
| ||||
Dilutive Potential Common Shares: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Stock Options |
|
| 5 |
|
|
| 5 |
|
|
| 5 |
|
|
| 5 |
|
| ||||
Restricted Stock Units |
|
| 2 |
|
|
| 1 |
|
|
| 1 |
|
|
| 1 |
|
| ||||
Warrants |
|
| — |
|
|
| — |
|
|
| — |
|
|
| 1 |
|
| ||||
Weighted average shares outstanding—diluted |
|
| 459 |
|
|
| 465 |
|
|
| 459 |
|
|
| 472 |
|
| ||||
Securities excluded from the computation of diluted earnings per common share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Stock options(1) |
|
| 20 |
|
|
| 40 |
|
|
| 25 |
|
|
| 40 |
|
|
(1) These securities have been excluded from the diluted earnings per common share calculation because their inclusion would have been antidilutive as their exercise prices were higher than the average market price during the period.
On April 19, 2005, the Board of Directors authorized a share repurchase plan (the “2005 plan”). Under the provisions of the 2005 plan, Avaya was authorized to use up to $500 million of cash to repurchase shares of its outstanding common stock through April 2007. During February 2007, Avaya completed the 2005 plan.
On February 15, 2007, the Board of Directors authorized another share repurchase plan (the “2007 plan”), under which Avaya may use up to $500 million of cash for repurchases of its outstanding shares through February 2009. Avaya repurchased 7,304,779 shares of its common stock during the nine months ended June 30, 2007. This represented 5,008,479 shares of common stock pursuant to the 2005 plan and 2,296,300 shares of common stock pursuant to the 2007 plan. Approximately $471 million is available through February 2009 for further share repurchases under the 2007 plan.
All repurchases are made at management’s discretion in the open market or in privately negotiated transactions in compliance with applicable securities laws and other legal requirements and are subject to market conditions, share price, the terms of Avaya’s credit facility and other factors.
The Merger Agreement prohibits Avaya without the Sponsors’ consent from repurchasing shares of its common stock during the period from the date of the Merger Agreement until the closing of the Merger, subject to certain exceptions.
15
9. Income Taxes
The following table provides the provision for (benefit from) income taxes for the three and nine months ended June 30, 2007 and 2006:
|
| Three months ended |
| Nine months ended |
| ||||||||||||||||
|
| June 30, |
| June 30, |
| ||||||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| ||||||||||||
|
| Dollars in millions |
| ||||||||||||||||||
Provision for (benefit from) income taxes |
|
| $ | 24 |
|
|
| $ | (11 | ) |
|
| $ | 80 |
|
|
| $ | 48 |
|
|
The provision for (benefit from) income taxes for the periods shown above are comprised of U.S. Federal, state and non-U.S. taxes. The provision for the nine months ended June 30, 2007 includes a $6 million benefit from the retroactive extension to January 1, 2006 of the research tax credit pursuant to the Tax Relief and Health Care Act of 2006, a $7 million tax benefit due to a reduction in estimated taxes payable for fiscal 2006 in Germany as a result of additional restructuring charges reported for statutory purposes, and a $4 million tax benefit attributable to tax return to provision adjustments due to the filing of U.S. and non-U.S. income tax returns in the quarter.
10. Benefit Obligations
The components of net periodic benefit cost for the three and nine months ended June 30, 2007 and 2006 are provided in the table below:
|
| Pension Benefits— |
| Pension Benefits— |
| Postretirement |
| ||||||||||||||||||||||||
|
| Three months ended |
| Three months ended |
| Three months ended |
| ||||||||||||||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| ||||||||||||||||||
|
| Dollars in millions |
| ||||||||||||||||||||||||||||
Components of Net Periodic Benefit Cost |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Service cost |
|
| $ | 3 |
|
|
| $ | 4 |
|
|
| $ | 3 |
|
|
| $ | 4 |
|
|
| $ | 1 |
|
|
| $ | 1 |
|
|
Interest cost |
|
| 42 |
|
|
| 41 |
|
|
| 4 |
|
|
| 4 |
|
|
| 11 |
|
|
| 8 |
|
| ||||||
Expected return on plan assets |
|
| (50 | ) |
|
| (51 | ) |
|
| — |
|
|
| (1 | ) |
|
| (3 | ) |
|
| (2 | ) |
| ||||||
Amortization of unrecognized prior service cost |
|
| — |
|
|
| 1 |
|
|
| — |
|
|
| — |
|
|
| 8 |
|
|
| 4 |
|
| ||||||
Recognized net actuarial loss |
|
| 11 |
|
|
| 14 |
|
|
| — |
|
|
| — |
|
|
| — |
|
|
| 1 |
|
| ||||||
Net periodic benefit cost |
|
| $ | 6 |
|
|
| $ | 9 |
|
|
| $ | 7 |
|
|
| $ | 7 |
|
|
| $ | 17 |
|
|
| $ | 12 |
|
|
|
| Pension Benefits— |
| Pension Benefits— |
| Postretirement |
| ||||||||||||||||||||||||
|
| Nine months ended |
| Nine months ended |
| Nine months ended |
| ||||||||||||||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| ||||||||||||||||||
|
| Dollars in millions |
| ||||||||||||||||||||||||||||
Components of Net Periodic Benefit Cost |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||
Service cost |
|
| $ | 10 |
|
|
| $ | 13 |
|
|
| $ | 8 |
|
|
| $ | 9 |
|
|
| $ | 3 |
|
|
| $ | 3 |
|
|
Interest cost |
|
| 125 |
|
|
| 124 |
|
|
| 14 |
|
|
| 12 |
|
|
| 31 |
|
|
| 25 |
|
| ||||||
Expected return on plan assets |
|
| (152 | ) |
|
| (154 | ) |
|
| (1 | ) |
|
| (1 | ) |
|
| (7 | ) |
|
| (6 | ) |
| ||||||
Amortization of unrecognized prior service cost |
|
| 2 |
|
|
| 4 |
|
|
| — |
|
|
| — |
|
|
| 24 |
|
|
| 12 |
|
| ||||||
Recognized net actuarial loss |
|
| 34 |
|
|
| 42 |
|
|
| — |
|
|
| — |
|
|
| — |
|
|
| 2 |
|
| ||||||
Net periodic benefit cost |
|
| $ | 19 |
|
|
| $ | 29 |
|
|
| $ | 21 |
|
|
| $ | 20 |
|
|
| $ | 51 |
|
|
| $ | 36 |
|
|
16
The Company provides certain pension benefits for U.S. and non-U.S. employees, which are not pre-funded. The Company makes payments as these benefits are disbursed. For the nine months ended June 30, 2007, the Company made payments for these U.S. and non-U.S. pension benefits totaling $7 million and $11 million, respectively. Estimated payments for these U.S. and non-U.S. pension benefits for the remainder of fiscal 2007 are $2 million and $2 million, respectively.
In compliance with the terms of the Agreement dated May 28, 2006 between the Company and the Communications Workers of America, the Company has contributed $24 million to the represented employees’ post-retirement health trust for the nine months ended June 30, 2007, and expects to make additional contributions totaling $11 million for the remainder of fiscal 2007. The Company also provides certain retiree medical benefits for U.S. employees, which are not pre-funded. Consequently, the Company makes payments as these benefits are disbursed. For the nine months ended June 30, 2007, the Company made payments totaling $22 million for these retiree medical benefits. Estimated payments for these retiree medical benefits for the remainder of fiscal 2007 are $5 million.
11. Stock Compensation Plans
The Company has a stock compensation plan that provides for the issuance to eligible employees of nonqualified stock options and restricted stock units representing Avaya common stock. In addition, the Company has a stock purchase plan under which eligible employees have the ability to purchase shares of Avaya common stock at 85% of market value. As of June 30, 2007, there were 36 million shares authorized for future grants to purchase Avaya common stock under the Company’s stock compensation plan. The Merger Agreement contains a covenant requiring Avaya to suspend or terminate its employee stock purchase plan as soon as practicable.
Stock options are generally granted with an exercise price equal to the market value of a share of common stock on the date of grant, have a term of 10 years or less and vest within four years from the date of grant. Most of the stock options granted in fiscal 2004 or later have a term of seven years and vest over three years. For the nine months ended June 30, 2007 and 2006, approximately $14 million and $9 million, respectively, of compensation expense related to stock options was recorded.
In connection with certain of the Company’s acquisitions, outstanding stock options held by employees of acquired companies became exercisable for Avaya’s common stock, according to their terms, effective at the acquisition date. The fair value of these options was included as part of the purchase price of the acquisition.
The Company considers several factors in calculating the fair value of share-based awards based on the lattice-binomial model. The Company calculates expected volatility based on implied and historical volatility of the Company’s common stock and other factors. The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of the Company’s employee stock options. The dividend yield assumption is based on the Company’s intent not to issue a dividend under its dividend policy. The expected holding period assumption was estimated based on the Company’s historical experience.
Share-based compensation expense recognized in the Consolidated Statements of Income for the nine months ended June 30, 2007 and 2006 is based on awards ultimately expected to vest, reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on the Company��s historical experience.
17
The fair value of each fiscal 2007 option grant was estimated on the grant-date using the lattice-binomial model with the following weighted average assumptions:
|
| Nine months ended |
| ||
|
| June 30, 2007 |
| ||
WEIGHTED AVERAGE ASSUMPTIONS: |
|
|
|
|
|
Dividend yield |
|
| 0.00 | % |
|
Expected volatility |
|
| 56.59 | % |
|
Risk-free interest rate |
|
| 4.65 | % |
|
Annual forfeiture rate |
|
| 5.13 | % |
|
Expected holding period (in years) |
|
| 3.57 |
|
|
The following table summarizes information concerning options granted under the Company’s stock compensation plan for the year ended September 30, 2006 and the nine months ended June 30, 2007, including information regarding exercises, forfeitures and expirations of stock options granted under the Company’s stock compensation plan and predecessor plans:
|
| Shares |
| Weighted Average |
| |||
|
| (000’s) |
| Exercise Price |
| |||
OPTIONS OUTSTANDING AS OF SEPTEMBER 30, 2005 |
| 48,525 |
|
| $ | 13.95 |
|
|
Granted |
| 6,503 |
|
| 10.85 |
|
| |
Exercised |
| (3,338 | ) |
| 4.25 |
|
| |
Forfeited and Expired |
| (2,759 | ) |
| 15.57 |
|
| |
OPTIONS OUTSTANDING AS OF SEPTEMBER 30, 2006 |
| 48,931 |
|
| 14.10 |
|
| |
Granted |
| 5,681 |
|
| 12.56 |
|
| |
Exercised |
| (9,513 | ) |
| 9.97 |
|
| |
Forfeited and Expired |
| (6,564 | ) |
| 14.90 |
|
| |
OPTIONS OUTSTANDING AS OF JUNE 30, 2007 |
| 38,535 |
|
| $ | 14.76 |
|
|
The following table summarizes the status of the Company’s outstanding stock options as of June 30, 2007:
|
| Stock Options Outstanding |
| Stock Options Exercisable |
|
| |||||||||||||||||||||||||
|
|
|
| Average |
| Weighted |
| Aggregate |
|
|
| Weighted |
| Aggregate |
|
| |||||||||||||||
|
|
|
| Remaining |
| Average |
| Intrinsic |
|
|
| Average |
| Intrinsic |
|
| |||||||||||||||
Range of |
| Shares |
| Contractual |
| Exercise |
| Value |
| Shares |
| Exercise |
| Value |
|
| |||||||||||||||
Exercise Prices |
|
|
| (000’s) |
| Life (Years) |
| Price |
| (000’s) |
| (000’s) |
| Price |
| (000’s) |
|
| |||||||||||||
$0.01 to $6.39 |
| 3,451 |
|
| 2.18 |
|
|
| $ | 4.24 |
|
| $ | 43,678 |
| 3,451 |
|
| $ | 4.24 |
|
|
| $ | 43,678 |
|
| ||||
$6.40 to $11.18 |
| 5,564 |
|
| 5.15 |
|
|
| 10.46 |
|
| 35,821 |
| 1,555 |
|
| 10.42 |
|
|
| 10,083 |
|
| ||||||||
$11.19 to $14.84 |
| 11,483 |
|
| 4.87 |
|
|
| 12.82 |
|
| 46,843 |
| 5,841 |
|
| 13.19 |
|
|
| 21,697 |
|
| ||||||||
$14.85 to $17.44 |
| 11,409 |
|
| 3.61 |
|
|
| 15.28 |
|
| 18,616 |
| 11,281 |
|
| 15.27 |
|
|
| 18,497 |
|
| ||||||||
$17.45 to $51.21 |
| 6,628 |
|
| 1.62 |
|
|
| 26.34 |
|
| — |
| 6,628 |
|
| 26.34 |
|
|
| — |
|
| ||||||||
Total |
| 38,535 |
|
|
|
|
|
| $ | 14.76 |
|
| $ | 144,958 |
| 28,756 |
|
| $ | 15.81 |
|
|
| $ | 93,955 |
|
| ||||
The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s average stock price on June 30, 2007, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable on June 30, 2007 was approximately 22 million. The weighted average remaining contractual life on June 30, 2007 for outstanding and exercisable options is 3.74 and 2.96 years, respectively.
18
Time-Vesting Restricted Stock Units
The Company’s stock compensation plan permits the granting of RSUs to eligible employees and non-employee Directors at fair market value at the date of grant. RSUs typically become fully vested over a four-year period and are payable in shares of the Company’s common stock upon vesting.
The following table summarizes information concerning unvested RSUs granted under the Company’s stock compensation plan as of September 30, 2006, and includes information regarding grants under that plan and vesting and forfeitures of RSUs granted under that plan and predecessor plans that occurred during the nine months ended June 30, 2007:
|
|
|
| Weighted-Average |
| |||||
|
| Shares |
| Grant-Date |
| |||||
Unvested Shares |
|
|
| (000’s) |
| Fair Value |
| |||
Unvested shares at September 30, 2006 |
| 5,319 |
|
| $ | 12.44 |
|
| ||
Granted |
| 2,800 |
|
| 12.64 |
|
| |||
Vested |
| (390 | ) |
| 10.99 |
|
| |||
Forfeited |
| (1,138 | ) |
| 13.00 |
|
| |||
Unvested shares at June 30, 2007 |
| 6,591 |
|
| $ | 12.51 |
|
| ||
As of June 30, 2007, there was approximately $53 million of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the Company’s stock compensation plan and predecessor plans. That cost is expected to be recognized over a weighted average period of four years. Compensation expense related to RSUs was $4 million for each of the three month periods ended June 30, 2007 and 2006, and was $12 and $11 million for the nine month periods ended June 30, 2007 and 2006, respectively.
Performance-Vesting and Market-Vesting Restricted Stock Units
Performance-vesting and market-vesting RSUs vest upon the achievement of certain targets and are payable in shares of the Company’s common stock upon vesting, typically with a three-year performance period. Different targets may be established for different awards, some of which may contain “performance-vesting” conditions and some of which may contain “market-vesting” conditions.
“Performance-vesting” awards measure the Company’s performance against pre-established targets. The fair value of RSUs containing a performance-vesting condition is based on the market price of the Company’s stock on the grant-date and assumes that the target payout level will be achieved. Compensation cost is adjusted for subsequent changes in the expected outcome of the performance-vesting condition until the vesting date.
“Market-vesting” awards measure the Company’s relative market performance against that of other companies. The fair value of RSUs containing a market-vesting condition is based on the market price of the Company’s stock on the grant date modified to reflect the impact of the market-vesting condition including the estimated payout level based on that condition. Compensation cost is not adjusted for subsequent changes in the expected outcome of the market-vesting condition.
Effective December 19, 2006, the Compensation Committee of the Board of Directors approved awards of 381,000 RSUs to executive officers of the Company pursuant to the terms of the Company’s stock compensation plan, each with a market-vesting condition based on the Company’s total shareholder return performance as a percentile against a peer group.
19
Under the terms of the employee stock purchase plan, eligible employees may have up to 10% of eligible compensation deducted from their pay to purchase Avaya common stock. The per share purchase price is 85% of the average high and low per share trading price of Avaya’s common stock on the New York Stock Exchange on the last trading day of each month. Compensation expense related to the employee stock purchase plan was $0.6 million for each of the three month periods ended June 30, 2007 and 2006, and was $1.8 million for each of the nine month periods ended June 30, 2007 and 2006.
The Merger Agreement contains a covenant requiring Avaya to suspend or terminate its employee stock purchase plan as soon as practicable
12. Operating Segments
The Company reports its operations in two segments—Global Communications Solutions (“GCS”) and Avaya Global Services (“AGS”). The GCS segment develops, markets and sells communications systems including IP telephony systems, multi-media contact center infrastructure and converged applications in support of customer relationship management, unified communications applications, appliances such as IP telephone sets and traditional voice communications systems. The AGS segment develops, markets and sells comprehensive end-to-end global service offerings that enable customers to plan, design, implement, monitor and manage their converged communications networks worldwide.
The GCS segment includes the portion of the rental and managed services revenue attributed to the equipment used in connection with the customer rental and managed services contracts. The portion of these contracts attributed to maintenance and other services is included in the AGS segment.
The segments are managed as two individual businesses and, as a result, include certain allocated costs and expenses of shared services, such as information technology, human resources, legal and finance (collectively, “corporate overhead expenses”). At the beginning of each fiscal year, the amount of certain corporate overhead expenses, including targeted annual incentive awards, to be charged to operating segments is determined and fixed for the entire year. The annual incentive award accrual is adjusted quarterly based on actual year to date results and those estimated for the remainder of the year. Any adjustment of the annual incentive award accrual, as well as any other over/under absorption of corporate overhead expenses against planned amounts, is recorded within Corporate/Other Unallocated Amounts. Restructuring and impairment charges, as well as Merger-related costs, are also recorded and reported within Corporate/Other Unallocated Amounts.
20
Summarized financial information relating to the Company’s reportable segments is shown in the following table:
|
| Reportable Segments |
|
|
|
|
| ||||||||||||
|
| Global |
| Avaya |
| Corporate/Other |
|
|
| ||||||||||
|
| Communications |
| Global |
| Unallocated |
|
|
| ||||||||||
|
| Solutions |
| Services |
| Amounts |
| Total |
| ||||||||||
|
| Dollars in millions |
| ||||||||||||||||
Three months ended June 30, 2007 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Revenue |
|
| $ | 686 |
|
|
| $ | 590 |
|
|
| $ | — |
|
| $ | 1,276 |
|
Operating income (loss) |
|
| 25 |
|
|
| 63 |
|
|
| (18 | ) |
| 70 |
| ||||
Three months ended June 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Revenue |
|
| $ | 704 |
|
|
| $ | 593 |
|
|
| $ | — |
|
| $ | 1,297 |
|
Operating income (loss) |
|
| 36 |
|
|
| 34 |
|
|
| (42 | ) |
| 28 |
| ||||
Nine months ended June 30, 2007 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Revenue |
|
| $ | 2,066 |
|
|
| $ | 1,784 |
|
|
| $ | — |
|
| $ | 3,850 |
|
Operating income (loss) |
|
| 85 |
|
|
| 172 |
|
|
| (16 | ) |
| 241 |
| ||||
Nine months ended June 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||
Revenue |
|
| $ | 2,026 |
|
|
| $ | 1,758 |
|
|
| $ | — |
|
| $ | 3,784 |
|
Operating income (loss) |
|
| 111 |
|
|
| 135 |
|
|
| (58 | ) |
| 188 |
|
The following table sets forth the Company’s long-lived assets by geographic area:
|
| June 30, |
| September 30, |
| ||||||
|
| Dollars in millions |
| ||||||||
U.S. |
|
| $ | 373 |
|
|
| $ | 399 |
|
|
Outside the U.S.: |
|
|
|
|
|
|
|
|
| ||
Germany |
|
| 184 |
|
|
| 200 |
|
| ||
EMEA—Europe / Middle East / Africa (excluding Germany) |
|
| 42 |
|
|
| 45 |
|
| ||
APAC—Asia Pacific |
|
| 18 |
|
|
| 18 |
|
| ||
Americas, non-U.S. |
|
| 9 |
|
|
| 6 |
|
| ||
Total outside the U.S. |
|
| 253 |
|
|
| 269 |
|
| ||
Total |
|
| $ | 626 |
|
|
| $ | 668 |
|
|
13. Commitments and Contingencies
In the ordinary course of business, the Company is involved in litigation, claims, government inquiries, investigations, charges and proceedings, including, but not limited to, those identified below, relating to intellectual property, commercial, securities, employment, employee benefits, environmental and regulatory matters. Other than as described below, the Company believes there is no litigation pending against the Company that could have, individually or in the aggregate, a material adverse effect on the Company’s financial position, results of operations or cash flows.
In accordance with SFAS No. 5, “Accounting for Contingencies,” the Company records an accrual for a contingency when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. If a range of liability is probable and estimable and some amount within the range appears to be a better estimate than any other amount within the range, the Company accrues that amount. If a range of liability is probable and estimable and no amount within the range appears to be a better estimate than any other amount within the range, the Company accrues the minimum of such probable range. Often these issues are subject to substantial uncertainties and, therefore, the probability of
21
loss and an estimation of damages are difficult to ascertain. These assessments can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions that have been deemed reasonable by management. Although the Company believes it has substantial defenses in these matters, it could in the future incur judgments or enter into settlements of claims that could have a material adverse effect on its financial position, results of operations or cash flows in any particular period.
Securities Litigation
In April and May of 2005, purported class action lawsuits were filed in the U.S. District Court for the District of New Jersey against us and certain of our officers alleging violations of the federal securities laws. The actions purport to be filed on behalf of purchasers of our common stock during the period from October 5, 2004 (the date of our signing of the agreement to acquire Tenovis) through April 19, 2005.
The complaints, which are substantially similar to one another, allege, among other things, that the plaintiffs were injured by reason of certain allegedly false and misleading statements made by us relating to the cost of the Tenovis integration, the disruption caused by changes in the delivery of our products to the market and reductions in the demand for our products in the U.S., and that based on the foregoing we had no basis to project our stated revenue goals for fiscal 2005. The Company has been served with a number of these complaints. No class has been certified in the actions. The complaints seek compensatory damages plus interest and attorneys’ fees. In August 2005, the court entered an order identifying a lead plaintiff and lead plaintiff’s counsel. A consolidated amended complaint was filed in October 2005. Pursuant to a scheduling order issued by the District Court, defendants filed their motion to dismiss the consolidated complaint in December 2005. In September 2006, the District Court granted defendants’ motion to dismiss the case in its entirety and with prejudice, which was appealed by the plaintiffs. The appeal is currently pending with the United States Court of Appeals for the Third Circuit, with the parties having completed their briefing submissions.
Derivative Litigation
In May and July of 2005, three derivative complaints were filed against certain officers and the members of the Board of Directors (“Board”) of the Company. Two complaints were filed in the United States District Court for the District of New Jersey, and one was filed in the Superior Court of New Jersey—Somerset County. The allegations in each of the complaints are substantially similar and include the Company as a nominal defendant. The complaints allege, among other things, that defendants violated their fiduciary duties by failing to disclose material information and/or by misleading the investing public about the Company’s business, asserting claims substantially similar to those asserted in the actions described above under “Securities Litigation.” The complaints seek contribution from the defendants to the Company for alleged violations of the securities laws, restitution to the Company and disgorgement of profits earned by defendants, and fees and costs. The state court matter has been dismissed without prejudice to plaintiff’s possibly re-filing the complaint, pending outcome of the appeal in the “Securities Litigation” action described above. The matters pending in federal court have been administratively terminated possibly to be reinstated pending the outcome of the appeal in the “Securities Litigation” action described above. Insofar as all of these actions are inactive, but subject to reinstatement, outcomes cannot be predicted and, as a result, we cannot be assured that these cases will not have a material adverse effect on our financial position, results of operations or cash flows.
ERISA Class Action—Securities Litigation
In July 2005, a purported class action lawsuit was filed in the United States District Court for the District of New Jersey against the Company and certain of its officers, employees and members of the Board of Directors (the “Directors”), alleging violations of certain laws under the Employee Retirement Income Security Act of 1974 (“ERISA”). On October 17, 2005, an amended purported class action was
22
filed against us and certain of our officers, employees and Directors. Like the initial complaint, the amended complaint purports to be filed on behalf of all participants and beneficiaries of the Avaya Inc. Savings Plan, the Avaya Inc. Savings Plan for Salaried Employees and the Avaya Inc. Savings Plan for the Variable Workforce (collectively, the “Plans”), during the period from October 5, 2004 through July 20, 2005. It contains factual allegations substantially similar to those asserted in the matters under the heading of “Securities Litigation.”
The complaint alleged, among other things, that the named defendants breached their fiduciary duties owed to participants and beneficiaries of the Plans and failed to act in the interests of the Plans’ participants and beneficiaries in offering Avaya common stock as an investment option, purchasing Avaya common stock for the Plans and communicating information to the Plans’ participants and beneficiaries. The complaint sought a monetary payment to the plans to make them whole for the alleged breaches, costs and attorneys’ fees. The Defendants filed a motion to dismiss the amended complaint in December 2005. In an order and opinion dated April 24, 2006, the District Court judge granted the Defendants’ motion and dismissed the amended complaint in its entirety. In May 2006, the plaintiffs filed a Notice of Appeal with the United States Court of Appeals for the Third Circuit. The parties have completed their respective briefing submissions and the court heard argument on the matter in April 2007. Although the defendants believe that the District Court correctly decided the motion to dismiss, given the uncertainties of the appeal, at this time the Company cannot determine if this matter will have an effect on its business or, if it does, whether its outcome will have a material adverse effect on its financial position, results of operations or cash flows. Due to the uncertainty surrounding the issues involved in this matter and based on the facts and circumstances known to date, the Company believes that an estimate or potential range of any loss that may be incurred cannot be made at this time.
ERISA Class Action—Stock Funds
In April 2006, a purported class action was filed in the United States District Court for the District of New Jersey, alleging that the Company, certain employees and the Pension and Employee Benefits Investment Committee violated the Employee Retirement Income Security Act of 1974 (“ERISA”), by including in the Avaya Inc. Savings Plan for Salaried Employees, the Avaya Inc. Savings Plan and the Avaya Inc. Savings Plan for the Variable Workforce (“Plans”), investment options for the Lucent Technologies Inc. Stock Fund (“Lucent Fund”) and the Avaya Inc. Stock Fund (“Avaya Fund”) for the period of October 2000 to April 2003 (“Alleged Class Period”). The complaint asserts, among other things, that during the Alleged Class Period defendants breached their fiduciary duties under ERISA by violating ERISA’s provisions against prohibited transactions; offering the Lucent Fund and Avaya Fund imprudently as investment options; failing properly to monitor the funds; and, failing properly to monitor the actions of other plan fiduciaries, thus causing the Plans to suffer damages. The complaint seeks monetary relief on behalf of the Plans and their participants, and also seeks injunctive relief and costs, including attorneys’ fees. Defendants have filed a motion to dismiss this case in its entirety and with prejudice. In April 2007, the District Court issued an opinion dismissing all but one portion of one count of the complaint, reasoning that the circumstances surrounding the distribution of Avaya shares of common stock prior to the spin-off of Avaya from Lucent in October 2000 into the various Avaya Plans could not be addressed in the procedural posture of a motion to dismiss. In July 2007, the District Court dismissed the remaining count of the complaint with prejudice. The Plaintiff has appealed this case to the United States Third Circuit Court of Appeals.
Antitrust Lawsuit
In July 2005, United Asset Coverage, Inc. (“UAC”) filed a verified complaint against the Company in the United States District Court, Northern District of Illinois, alleging, among other things, violations of federal and state antitrust laws, in the manner in which the Company seeks to protect its proprietary
23
information. The verified complaint sought a temporary restraining order against the Company to enjoin immediately its practice of limiting the use of its proprietary information in a manner which UAC believes is in violation of its contracts and licensing agreements. The court denied UAC’s motion for temporary restraints in August 2005 as well as its motion for preliminary injunction in January 2006. The plaintiff, after pursuing this action for over a year after the preliminary injunction was denied, has dismissed this matter in its entirety and with prejudice.
Shareholder Litigation Related to Proposed Merger
In June and July 2007, seven purported class action complaints were filed against Avaya Inc., members of the Board, certain officers of Avaya who are members of the Board, and Silver Lake Partners, L.L.P. and TPG Capital, L.P., in the Superior Court of New Jersey, Chancery and Law Divisions, Somerset County, related to the Merger Agreement. The complaints contain allegations substantially similar to one another and allege that the purchase price of $17.50 per share of outstanding Avaya common stock is inadequate and unfair consideration for the acquisition of the Company. The complaints also allege that defendants, including the Directors and/or officers of Avaya, breached their fiduciary duties to shareholders in entering into the Merger Agreement, including, but not limited to, their duties of loyalty, good faith, and independence and engaged in self-dealing and in conflicts of interests with respect to the proposed Merger. Plaintiffs seek to have the court certify these cases as class actions, enjoin the proposed Merger and award plaintiffs costs and expenses, including attorneys’ fees. Plaintiffs have also requested the court to consolidate the various actions into one consolidated case, which defendants have not opposed. The motion is pending. While the defendants believe these cases to be without merit, because they are in their early stages, an outcome cannot be predicted at this time, and we cannot be assured that they will not prevent or delay the consummation of the Merger and/or result in substantial costs. Due to the uncertainties surrounding the issues involved in these matters and based on the facts and circumstances known to date, the Company believes that an estimate or potential range of any loss that may be incurred or the scope of any injunctive relief that may occur cannot be made at this time.
Government Subpoenas
On April 29, 2005, the Company received a subpoena to produce documents before a grand jury of the United States District Court, District of South Carolina, relating to the United States’ investigation of potential antitrust and other violations in connection with the federal E-Rate Program. The subpoena requests records from the period January 1, 1997 to the present. The Company complied with the subpoena and has received no indication from the Department of Justice that it has any further obligations or involvement in this matter. Nonetheless, at this time, we cannot determine if this matter will have an effect on our business or, if it does, whether its outcome will have a material adverse effect on our financial position, results of operations or cash flows.
On May 3, 2005, the Company received a subpoena from the Office of Inspector General, U.S. General Services Administration, relating to a federal investigation of billing by the Company for telecommunications equipment and maintenance services. The subpoena requests records from the period January 1, 1990 to the present. At this time, we cannot determine if this matter will have an effect on our business or, if it does, whether its outcome will have a material adverse effect on our financial position, results of operations or cash flows.
The Company is cooperating with the relevant government entities with respect to these subpoenas. Based on the facts and circumstances known to date, the Company believes that an estimate or potential range of any loss that may be incurred with respect to these subpoenas cannot be made at this time.
24
Environmental, Health and Safety Matters
The Company is subject to a wide range of governmental requirements relating to employee safety and health and to the handling and emission into the environment of various substances used in its operations. The Company is subject to certain provisions of environmental laws, particularly in the United States and Germany, governing the cleanup of soil and groundwater contamination. Such provisions impose liability for the costs of investigating and remediating releases of hazardous materials at currently or formerly owned or operated sites. In certain circumstances, this liability may also include the cost of cleaning up historical contamination, whether or not caused by the Company. The Company is currently conducting investigation and/or cleanup of known contamination at nine of its current or former facilities either voluntarily or pursuant to government directives. Based on currently available information, none of the sites is reasonably likely to generate environmental costs that will be individually material, nor will environmental costs for all sites in the aggregate be material, to the Company’s financial position, results of operations or cash flows, in any fiscal year. There are no known third parties who may be responsible for investigation and/or cleanup at these sites and therefore, for purposes of assessing the adequacy of accruals for these liabilities, the Company has not assumed that it will recover amounts from any third party, including under any insurance coverage or indemnification arrangement.
It is often difficult to estimate the future impact of environmental matters, including potential liabilities. The Company has established financial reserves to cover environmental liabilities where they are probable and reasonably estimable. Reserves for estimated losses from environmental matters are undiscounted and consist primarily of estimated remediation and monitoring costs and are, depending on the site, based primarily upon internal or third party environmental studies and the extent of contamination and the type of required cleanup. The Company is not aware of, and has not included in reserves any provision for, unasserted environmental claims.
The reliability and precision of estimates of the Company’s environmental costs may be affected by a variety of factors, including whether the remediation treatment will be effective, contamination sources have been accurately identified and assumptions regarding the movement of contaminants are accurate. In addition, estimates of environmental costs may be affected by changes in law and regulation, including the willingness of regulatory authorities to conclude that remediation and/or monitoring performed by the Company is adequate.
The Company assesses the adequacy of environmental reserves on a quarterly basis. The Company does not expect the outcome of these matters to have a material impact on its financial position. Expenditures for environmental matters for the three and nine months ended June 30, 2007 and 2006 were not material to the Company’s financial position, results of operations or cash flows. Payment for the environmental costs covered by the reserves may be made over a 30-year period. Although the Company does not separately track recurring costs of managing hazardous substances and pollutants in ongoing operations, it does not believe them to be material.
We also may from time to time be subject to various state, federal and international laws and regulations governing the environment, including those restricting the presence of certain substances in electronic products and making producers of those products financially responsible for the collection, treatment, recycling and disposal of certain products. For example, the European Union (“EU”) has adopted the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) and Waste Electrical and Electronic Equipment (“WEEE”) directives. RoHS prohibits the use of certain substances, including mercury and lead, in certain products put on the market after July 1, 2006. The WEEE directive obligates parties that place electrical and electronic equipment onto the market in the EU to put a clearly identifiable mark on the equipment, register with and report to EU member countries regarding distribution of the equipment, and provide a mechanism to take back and properly dispose of the equipment. Each EU member country has enacted, or is expected soon to enact,
25
legislation clarifying what is and what is not covered by the WEEE directive in that country. We believe that we have met the requirements of the RoHS and WEEE directives. Similar laws and regulations have been or may be enacted in other regions which may require additional obligations to be undertaken by the Company.
The Company recognizes a liability for the estimated costs that may be incurred to remedy certain deficiencies of quality or performance of the Company’s products. These product warranties extend over a specified period of time generally ranging up to two years from the date of sale depending upon the product subject to the warranty. The Company accrues a provision for estimated future warranty costs based upon the historical relationship of warranty claims to sales. The Company periodically reviews the adequacy of its product warranties and adjusts, if necessary, the warranty percentage and accrued warranty reserve, which is included in other current liabilities in the Consolidated Balance Sheets, for actual experience.
|
| Dollars in millions |
| |||
Balance as of September 30, 2006 |
|
| $ | 29 |
|
|
Reductions for payments and costs to satisfy claims |
|
| (37 | ) |
| |
Accruals for warranties issued during the period |
|
| 39 |
|
| |
Balance as of June 30, 2007 |
|
| $ | 31 |
|
|
Guarantees of Indebtedness and Other Off-Balance Sheet Arrangements
Letters of Credit
In addition to its $400 million committed credit facility, which is discussed in Note 7, “Financing Arrangements,” the Company has entered into uncommitted credit facilities that vary in term totaling $133 million as of June 30, 2007. These uncommitted facilities are for the purpose of securing third party financial guarantees such as letters of credit that ensure the Company’s performance or payment to third parties. As of June 30, 2007, the Company has outstanding an aggregate of $102 million in irrevocable letters of credit under the committed and uncommitted credit facilities ($27 million under its committed credit facility and $75 million under uncommitted facilities).
Surety Bonds
The Company arranges for the issuance of various types of surety bonds, such as license, permit, bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. These bonds vary in duration although most are issued and outstanding from six months to three years. These bonds are backed by $5 million of our letters of credit. If the Company fails to perform under its obligations, the maximum potential payment under these surety bonds is $33 million as of June 30, 2007. Historically, no surety bonds have been drawn upon.
Purchase Commitments and Termination Fees
The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and to help assure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that allow them to produce and procure inventory based upon forecasted requirements provided by the Company. If the Company does not meet these specified purchase commitments, it could be required to purchase the inventory, or in the case of certain agreements, pay an early termination fee. As of June 30, 2007, the maximum potential payment
26
under these commitments was approximately $120 million. Historically, the Company has not been required to pay a charge for not meeting its designated purchase commitments with these suppliers.
All manufacturing of the Company’s products is performed in accordance with detailed specifications and product designs furnished by the Company and is subject to rigorous quality control standards.
Product Financing Arrangements
The Company sells products to various resellers that may obtain financing from certain unaffiliated third party lending institutions. For the Company’s product financing arrangement with resellers outside the U.S., in the event participating resellers default on their payment obligations to the lending institution, the Company is obligated under certain circumstances to guarantee repayment to the lending institution. The repayment amount fluctuates with the level of product financing activity. The guaranteed repayment amount was approximately $7 million as of June 30, 2007. The Company reviews and sets the maximum credit limit for each reseller participating in this financing arrangement. Historically, there have not been any guarantee repayments by the Company since it became publicly traded in 2000. The Company has estimated the fair value of this guarantee as of June 30, 2007, and has determined that it is not significant. There can be no assurance that the Company will not be obligated to repurchase inventory under this arrangement in the future.
Performance Guarantee
In connection with the sales of certain businesses, the Company has assigned its rights and obligations under several real estate leases to the acquiring companies (the “assignees”). The remaining terms of these leases vary from one year to eight years. While the Company is no longer the primary obligor under these leases, the lessor has not completely released the Company from its obligation, and holds it secondarily liable in the event that the assignees default on these leases. The maximum potential future payments the Company could be required to make, if all of the assignees were to default as of June 30, 2007, would be approximately $13 million. The Company has assessed the probability of default by the assignees and has determined it to be remote.
Credit Facility Indemnification
In connection with its obligations under the credit facility described in Note 7, “Financing Arrangements,” the Company has agreed to indemnify the third party lending institutions for costs incurred by the institutions related to changes in tax law or other legal requirements. While there have been no amounts paid to the lenders pursuant to this indemnity in the past, there can be no assurance that the Company will not be obligated to indemnify the lenders under this arrangement in the future.
Transactions with Lucent Technologies Inc.
Pursuant to the Contribution and Distribution Agreement, Lucent Technologies Inc., predecessor to Alcatel-Lucent (“Lucent”), contributed to the Company substantially all of the assets, liabilities and operations associated with its enterprise networking businesses (“Company’s Businesses”). The Contribution and Distribution Agreement, among other things, provides that, in general, the Company will indemnify Lucent for all liabilities including certain pre-distribution tax obligations of Lucent relating to the Company’s Businesses and all contingent liabilities primarily relating to the Company’s Businesses or otherwise assigned to the Company. In addition, the Contribution and Distribution Agreement provides that certain contingent liabilities not allocated to one of the parties will be shared by Lucent and the Company in prescribed percentages. The Contribution and Distribution Agreement also provides that each party will share specified portions of contingent liabilities based upon agreed percentages related to
27
the business of the other party that exceed $50 million. The Company is unable to determine the maximum potential amount of other future payments, if any, that it could be required to make under this agreement.
In addition, if the separation from Lucent fails to qualify as a tax-free distribution under Section 355 of the Internal Revenue Code because of an acquisition of the Company’s stock or assets, or some other actions of the Company, then the Company will be solely liable for any resulting corporate taxes.
The Tax Sharing Agreement governs Lucent’s and the Company’s respective rights, responsibilities and obligations after the distribution with respect to taxes for the periods ending on or before the distribution. Generally, pre-distribution taxes or benefits that are clearly attributable to the business of one party will be borne solely by that party, and other pre-distribution taxes or benefits will be shared by the parties based on a formula set forth in the Tax Sharing Agreement. The Company may be subject to additional taxes or benefits pursuant to the Tax Sharing Agreement related to future settlements of audits by state and local and foreign taxing authorities for the periods prior to the Company’s separation from Lucent.
28
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
“Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with the unaudited interim Consolidated Financial Statements and the notes included elsewhere in this Quarterly Report on Form 10-Q.
Our accompanying unaudited interim Consolidated Financial Statements as of June 30, 2007 and for the three and nine months ended June 30, 2007 and 2006, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the U.S. Securities and Exchange Commission, or the SEC, for interim financial statements, and should be read in conjunction with our Consolidated Financial Statements and other financial information for the fiscal year ended September 30, 2006, which were included in our Annual Report on Form 10-K filed with the SEC on December 8, 2006. In our opinion, the unaudited interim Consolidated Financial Statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated.
Certain prior year amounts have been reclassified to conform to the current year presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the results to be experienced for the entire fiscal year.
Merger Agreement with Silver Lake Partners and TPG Partners
On June 4, 2007, Avaya entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Sierra Holdings Corp., a Delaware corporation (“Parent”), and Sierra Merger Corp., a Delaware corporation and wholly owned subsidiary of Parent (“Merger Sub”). Under the terms of the Merger Agreement, Merger Sub will be merged with and into the Company, with the Company continuing as the surviving corporation and a wholly owned subsidiary of Parent (the “Merger”). Parent was formed by two private equity funds, Silver Lake Partners III, L.P. and TPG Partners V, L.P. (collectively, the “Sponsors”), solely for the purpose of entering into the Merger Agreement and consummating the Merger. The Merger Agreement provides for a purchase price of $17.50 per share of Avaya common stock (the “Merger Consideration”), or approximately $8.21 billion in the aggregate (excluding fees and expenses in connection with the Merger of approximately $0.28 billion).
The proposed transaction is expected to be completed in the fall of 2007, subject to receipt of shareholder approval and customary regulatory approvals, as well as satisfaction of other customary closing conditions. There is no financing condition to the obligations of the Sponsors to consummate the transaction, and equity and debt commitments sufficient to fund the Merger Consideration have been delivered to Parent. The Company filed its preliminary proxy statement with the SEC on July 18, 2007 and filed its Hart-Scott-Rodino notification with the Federal Trade Commission and the Department of Justice on June 15, 2007. The Department of Justice and the Federal Trade Commission granted early termination of the Hart-Scott-Rodino waiting period effective June 28, 2007. The date for the special meeting of shareholders to vote on adoption of the Merger Agreement is September 28, 2007, and the record date related to this meeting is August 9, 2007.
During the three months ended June 30, 2007, the Company incurred costs associated with the Merger of $8 million (approximately $4.6 million after tax, or $0.01 per diluted share) consisting primarily of investment banking and legal fees directly related to the proposed Merger.
Pursuant to the terms of the stock compensation plans under which they were issued, outstanding stock options and time-vesting RSUs will vest and become exercisable on the later of: (i) the adoption by the Company’s stockholders of the Merger Agreement and (ii) the date on which all governmental consents required to complete the Merger, if any, are obtained (the “Vesting Conditions”). The proposed
29
Merger is the contingent event which would result in cash settlement of the Company’s outstanding stock options and time-vesting RSUs. Due to the existence of certain unfulfilled conditions, including the approval of the proposed Merger by the Company’s stockholders, that must be satisfied before the transaction is completed, no accelerated stock compensation expense was recorded during the third quarter of fiscal 2007. If the Vesting Conditions are satisfied, the Company expects to record an accelerated stock compensation charge of approximately $85 million related to time-vesting RSUs. If a Vesting Condition occurs or is to occur during a performance period, then the Compensation Committee of the Board shall determine the extent to which performance-vesting RSUs and market-vesting RSUs shall vest or shall be adjusted.
Our disclosure and analysis in this Quarterly Report on Form 10-Q contains some forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts. They use words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public.
Any or all of our forward-looking statements in this report and in any other public statements we make may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section below entitled “Risk Factors.” Consequently, no forward-looking statement can be guaranteed and you are cautioned not to place undue reliance on these forward-looking statements. Actual future results may vary materially. Except as may be required under the federal securities laws, we undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our reports to the SEC.
Products, Applications and Services
We are a leading provider of communications solutions that help enterprises transform their businesses by intelligently connecting customers, employees and business partners with enhanced business processes. A key component of our enterprise communications strategy is to leverage our substantial experience and expertise in voice communications systems with an innovative communications platform, advanced software development and expert services to capitalize on the transition of traditional voice systems to our mature IP telephony solutions. Our offers support advanced business communications applications that can help our customers gain cost efficiencies, higher workforce productivity, new types of business automation and more responsive connections for all enterprise constituents.
Our enterprise communications solutions offerings are comprised of a product portfolio that includes infrastructure hardware, application software, phone appliances and a comprehensive portfolio of enterprises services focused on IT and communications solutions. These offerings are used by enterprises to deploy our platforms of IP telephony systems and/or circuit-based voice telephony systems that can be converged with IP networks to enable IP telephony. Our communication solutions platforms are the basis for us to provide enterprises with communications systems in the following key areas: multi-media contact center communications in support of customer relationship management, unified communications that
30
integrate unified desktop, conferencing, messaging and mobility solutions with third party enterprise applications and business communication applications that combine specialized services with software connectors to facilitate communications-enabled business processes. We support our broad customer base with comprehensive global service offerings that enable our customers to plan, design, implement, monitor and manage their communications systems and/or converged networks.
Our global services organization is an important consideration for customers purchasing our products and applications and is a source of significant revenue for us, primarily from maintenance contracts, but with a growing emphasis by us to provide our customers with communications focused professional services. Our end-to-end portfolio of services offerings provides a single point of accountability that connects the skilled professionals of our services organization together with our network of business partners, development partners and our ability to diagnose customer network faults remotely, can provide 24-hours-a-day, seven-days-a-week service to our customers around the world.
These offerings are part of what we collectively refer to as “Intelligent Communications,” which is about embedding communications solutions into our customers’ business processes and business interactions to help them transform their businesses and innovate their business models. We believe our comprehensive suite of Intelligent Communications offerings, as supported by our global services organization and extensive network of business and development partners, transforms the enterprise communications system into a strategic asset for businesses, by enabling them to communicate to “anyone, at any place, at any time and in any way” they choose.
Customers and Competitive Advantages
Our customer base is diverse, ranging in size from small businesses employing a few employees to large government agencies and multinational companies with over 100,000 employees. Our customers include enterprises operating in a broad range of industries around the world, including financial services, manufacturing, media and communications, professional services, health care, education and government.
We operate in approximately 50 countries and sell products and services through a network of business partners, distributors and dealers who have customers in nearly 100 other countries. In the first nine months of fiscal 2007, approximately 44% of our revenues were generated outside the U.S.
We enjoy several strengths that we believe provide us with a competitive advantage in the enterprise communications market:
· business focus on IP telephony and converged network technologies;
· extensive voice experience and expertise, and a reputation for superior products and technology for voice processing and applications;
· a comprehensive suite of industry-leading communications applications, including remote/mobile offerings such as speech access, remote agents and softphones, which allow our customers to improve worker productivity and reduce network and real estate costs by providing secure business communications to a dispersed workforce;
· investment protection for traditional telephony systems, allowing customers to upgrade and take advantage of the benefits of IP communications while maintaining a significant portion of their previous equipment investment (i.e. “IP-enable” their existing voice communications systems);
· a large installed global customer base;
· world-class contact center offerings that assist our customers in managing communications with their clients;
31
· a global services organization that offers end-to-end customer solutions, including remote maintenance and diagnostic services that sense and fix software outages, often before customers even realize there may be a problem; and
· strategic alliances with world-class business partners, including our large network of software development partners who develop vertical and other software applications that work with our telephony and contact center offerings to meet specific customer needs.
Financial Results Summary
Revenue—Revenue was $3,850 million and $3,784 million for the first nine months of fiscal 2007 and 2006, respectively. Overall revenue grew by 1.7% as a result of increases in both of our operating segments outside the U.S. Revenues for the first nine months of fiscal 2007 included a favorable currency impact of $93 million that benefited both operating segments, primarily in Europe.
Gross Margin—Our gross margin for the first nine months of fiscal 2007 increased by $39 million to $1,794 million compared with the first nine months of fiscal 2006 due to an increase in sales volume and a benefit from foreign currency, and the gross margin rate for fiscal 2007 was slightly higher at 46.6% versus 46.4% for the first nine months of fiscal 2006. The increase in the overall rate was the result of lower costs in our services segment. The gross margin for the first nine months of fiscal 2006 includes an $11 million benefit, or a 0.3 percentage point impact, from a change in our vacation policy eliminating carryover vacation days for U.S. non-represented employees.
Operating Expenses—Our selling, general and administrative (SG&A) expenses decreased by $23 million to $1,184 million for the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. This net decrease was primarily due to lower headcount and lower discretionary spending in connection with our cost management initiatives, as well as several benefits in the first nine months of fiscal 2007, including a gain on the sale of real estate and an $8 million benefit from the favorable resolution of non-income tax audits in several jurisdictions. These benefits were partially offset by expected increased employee benefit costs and unfavorable foreign currency. The increased employee benefit costs were primarily due to the previously-disclosed increase in post-retirement health benefits for union employees. The first nine months of fiscal 2006 included a $22 million benefit from the favorable resolution of non-income tax audits in several jurisdictions and a $7 million benefit related to the change in our vacation policy, as well as $29 million of asset impairment charges, primarily related to internal-use software assets.
During the first nine months of fiscal 2007, our research and development (R&D) expenses increased by $14 million to $332 million compared with the first nine months of fiscal 2006 due to an increase in gross investment and to a lesser extent, the acquisitions of Traverse and Ubiquity. The first nine months of fiscal 2006 included a $3 million benefit related to the change in our vacation policy.
We also recorded $29 million in net charges for restructuring actions during the first nine months of fiscal 2007. These represent $36 million of charges for employee separation costs and lease obligations, partially offset by a net benefit of $7 million for changes in estimates for prior restructuring plans primarily related to leased facilities. During the first nine months of fiscal 2006, we recorded net restructuring charges of $42 million.
During the first nine months of fiscal 2007, we incurred costs associated with the Merger of $8 million consisting primarily of investment banking and legal fees directly related to the proposed Merger.
Profitability—We earned net income of $183 million and $153 million for the first nine months of fiscal 2007 and 2006, respectively. Our operating income was $241 million, or 6.3% of revenue, for the first nine months of fiscal 2007, compared to $188 million, or 5.0% of revenue, for the first nine months of fiscal 2006. Operating income for the first nine months of fiscal 2007 includes an increase in gross margin dollars
32
due to sales volume and favorable foreign currency, as well as several benefits in costs and operating expenses as described above, partially offset by increased R&D investment and Merger-related costs. Operating income for the first nine months of fiscal 2006 included a $21 million benefit from the change in our vacation policy and the $22 million benefit from the favorable resolution of non-income tax audits in several jurisdictions, as well as the $29 million asset impairment charge.
Key Trends and Uncertainties Affecting Our Results
Trends and Uncertainties Affecting Our Revenue
The following are the key factors we believe are currently affecting our revenue:
· Technology transition—Our growth strategy relies heavily on capturing a significant share of the spending by enterprises on their transition of technology from traditional communications systems to IP communications. We believe that IP communications has gained widespread acceptance in the marketplace and over time we expect demand to continue to increase as the industry goes through the mainstream adoption phase in the product lifecycle. According to the latest available industry statistics, approximately half of all lines currently being shipped are IP rather than traditional, or TDM. As a result of the technology transition, spending by enterprises on traditional voice communication systems has been declining. Increases in our product revenue attributable to sales of IP telephony systems continue to be offset in part by declines in product revenue attributable to traditional voice communication systems.
· Competitive environment—We have historically operated, and continue to operate, in an extremely competitive environment. However, the migration of traditional technology to IP communications has resulted in an increased number of competitors offering similar products and applications. One aspect of this environment is that we regularly face pricing pressures in the markets in which we operate which may negatively impact our gross margins. In addition, we also face pricing pressure when long-term maintenance and managed services contracts expire. They are typically renewed at lower prices due to continuing competitive pressure and expectations from the marketplace to acquire technology at lower costs. The impact of the price erosion affects both our rental and managed services offers, as well as maintenance. We have been able to partially mitigate the effects of pricing pressures on profitability through our cost reduction initiatives.
For other uncertainties related to the competitive environment in which we operate, see “Risk Factors—Risks Related To Our Revenue and Business Strategy—We face intense competition from our current competitors and, as the enterprise communications and information technology markets evolve, may face increased competition from companies that do not currently compete directly against us.”
· Pressures on services business—Due to advances in technology, our customers continue to expect traditional services to be at lower prices to them. In addition, our customers routinely look for opportunities to reduce their information technology and related costs. A high correlation exists with respect to customers in our direct channel who purchase products also electing to purchase maintenance contracts at the time of the product purchase. However, at the time of contract renewal, maintenance and managed services revenues have been affected by reductions in scope of contracted services (i.e. number of ports, number of sites, or hours and levels of coverage), cancellations and increased competition, as well as the price erosion noted above. These factors have resulted in challenges to our Avaya Global Services segment. We have been able to partially offset these impacts by focusing on new types of services such as consulting and system integration. These new types of services may have lower margins than our traditional services. In addition, we have also been able to reduce our costs to minimize the impact on our operating income.
33
· Disruption in logistics—As we continue to seek to optimize our end-to-end supply chain, we have been outsourcing various logistics functions over the course of the past few years. As previously disclosed, in the fourth quarter of fiscal 2006 and the first half of fiscal 2007, we moved certain warehousing and physical distribution operations to a different third party provider at a new facility. Following this move we experienced disruption, resulting in delays in delivery of products from this warehouse and warehousing operational inefficiencies. We have been working with this third party provider to resolve these issues. See “Manufacturing and Logistics” for more information.
· Foreign currency—Our revenues outside of the U.S. were 44% of our consolidated revenues in the first nine months of fiscal 2007 compared to 42% in the first nine months of fiscal 2006. Revenues for the first nine months of fiscal 2007 include a favorable currency impact of $93 million as compared to the first nine months of fiscal 2006. Any strengthening of the U.S. dollar against other currencies, particularly the euro, will have a negative impact on our reported revenues. Conversely, any weakening of the U.S. dollar will have a positive impact.
· Economic conditions—An important factor affecting our ability to generate revenue is the effect of general economic conditions on our customers’ willingness to spend on information technology and, particularly, enterprise communications technology. Variability in employment, corporate profit growth, interest rates, energy prices and other factors in specific markets could impact corporate willingness to spend on communications technology in the near term. Additionally, country-to-country variability in worldwide economic growth could also impact our business as growth rates of developed and more stable economies tend to be lower than that of emerging economies, where there could be more variables affecting the economic growth.
Manufacturing and Logistics
The Company’s products are supplied through contract manufacturers and original equipment manufacturers. Our manufacturers produce a majority of our products in facilities located in Mexico, Malaysia, the Czech Republic, China, Israel, Poland, Ireland, France, Germany and the United States. The contract manufacturing of the Company’s products is performed in accordance with detailed specifications and product designs furnished by the Company and is subject to rigorous quality control standards.
As we continue to seek to optimize our end-to-end supply chain, we have outsourced various logistics functions. We rely on third-party logistics (3PL) service providers to provide certain services for our business, including warehousing, physical distribution, repairs and returns processing. If a logistics service provider does not meet our service level and quality requirements, we may be unable to fulfill our customers’ orders or meet certain customer support obligations in a timely and accurate manner, which could delay or decrease our revenue or otherwise have an adverse effect on our revenue and our costs. In the fourth quarter of fiscal 2006 and first quarter of fiscal 2007, we moved certain warehousing and physical distribution operations to a different 3PL service provider at a new facility. That provider and facility provide our 3PL needs in North America and certain 3PL needs outside of North America. There were disruptions and delays in delivery of certain products from this facility in the first quarter of fiscal 2007. Additionally, there was an adverse impact on our costs at this facility throughout the first half of fiscal 2007. We and the 3PL service provider operating this facility continue to work to promote stability in the 3PL operations there. We have been making improvements as we progress through this transition. However, we cannot assure you that this issue will not continue to have an adverse effect on our revenue and our costs.
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We also face increasing complexity in our product design, logistics and procurement operations due to existing and upcoming requirements relating to the materials composition of our products, such as the European Union (“EU”) directives regarding Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) and the Waste Electrical and Electronic Equipment (“WEEE”) directive. We may be required to reengineer products to utilize components compatible with these changing environmental requirements and the resulting reengineering and component substitution may result in additional costs to us. Even if we are able and willing to reengineer products or pay additional costs, we still may be adversely affected if the materials and components that we need are unavailable to us. In addition, if we were found to be in violation of these regulations, we could be subject to government fines, noncompliant products may be banned from markets covered by the regulations and our customers could incur liability. Although we do not anticipate any material adverse effects based on the nature of our operations and the effect of such regulations, there is no assurance that existing regulations or future regulations will not have an adverse effect on us.
We also purchase certain hardware components and license certain software components from third-party original equipment manufacturers and resell them under the Avaya brand. In some cases certain components are only available from a single source or from a limited source of suppliers. Delays or shortages associated with these components could cause significant disruption to our operations.
For more information on risks associated with all of the above activities, see Item 1A. “Risk Factors—Risks Related To Our Operations—We rely on outsourced product manufacturers, distributors and warehousing agents for our products and various issues with respect to the delivery of our products could arise which could adversely impact both our revenue and our costs.”
Results from Continuing Operations
Three Months Ended June 30, 2007 Compared with Three Months Ended June 30, 2006
Revenue
The following table sets forth a comparison of revenue by type:
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Mix |
|
|
| |||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||
$ | 636 |
| $ | 690 |
| $ | 619 |
| $ | 639 |
| Sales of products |
| $ | 626 |
| $ | 636 |
|
| 49 | % |
|
| 49 | % |
|
| $ | (10 | ) |
| -1.6 | % |
507 |
| 514 |
| 509 |
| 509 |
| Services |
| 507 |
| 507 |
|
| 40 | % |
|
| 39 | % |
|
| — |
|
| 0.0 | % | |||||||
154 |
| 160 |
| 152 |
| 146 |
| Rental and managed |
| 143 |
| 154 |
|
| 11 | % |
|
| 12 | % |
|
| (11 | ) |
| -7.1 | % | |||||||
$ | 1,297 |
| $ | 1,364 |
| $ | 1,280 |
| $ | 1,294 |
| Total revenue |
| $ | 1,276 |
| $ | 1,297 |
|
| 100 | % |
|
| 100 | % |
|
| $ | (21 | ) |
| -1.6 | % |
The decrease in revenue for the third quarter of fiscal 2007 compared to the same period last fiscal year was due to decline in sales of products and rental and managed services, partially offset by a $30 million benefit from favorable foreign currency.
35
The following table sets forth a geographic comparison of revenue:
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| Third Fiscal Quarter |
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|
|
|
|
| Mix |
|
|
| |||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||
$ | 753 |
| $ | 788 |
| $ | 732 |
| $ | 746 |
| U.S. |
| $ | 694 |
| $ | 753 |
|
| 54 | % |
|
| 58 | % |
|
| $ | (59 | ) |
| -7.8 | % |
|
|
|
|
|
|
|
| Outside the U.S.: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||||||
182 |
| 183 |
| 186 |
| 178 |
| Germany |
| 172 |
| 182 |
|
| 13 | % |
|
| 14 | % |
|
| (10 | ) |
| -5.5 | % | |||||||
205 |
| 208 |
| 203 |
| 190 |
| EMEA—Europe / Middle East / Africa (Excluding Germany) |
| 216 |
| 205 |
|
| 17 | % |
|
| 16 | % |
|
| 11 |
|
| 5.4 | % | |||||||
387 |
| 391 |
| 389 |
| 368 |
| Total EMEA |
| 388 |
| 387 |
|
| 30 | % |
|
| 30 | % |
|
| 1 |
|
| 0.3 | % | |||||||
87 |
| 110 |
| 88 |
| 111 |
| APAC—Asia Pacific |
| 116 |
| 87 |
|
| 10 | % |
|
| 7 | % |
|
| 29 |
|
| 33.3 | % | |||||||
70 |
| 75 |
| 71 |
| 69 |
| Americas, non-U.S. |
| 78 |
| 70 |
|
| 6 | % |
|
| 5 | % |
|
| 8 |
|
| 11.4 | % | |||||||
544 |
| 576 |
| 548 |
| 548 |
| Total outside the U.S. |
| 582 |
| 544 |
|
| 46 | % |
|
| 42 | % |
|
| 38 |
|
| 7.0 | % | |||||||
$ | 1,297 |
| $ | 1,364 |
| $ | 1,280 |
| $ | 1,294 |
| Total revenue |
| $ | 1,276 |
| $ | 1,297 |
|
| 100 | % |
|
| 100 | % |
|
| $ | (21 | ) |
| -1.6 | % |
Revenues in the U.S. decreased by 7.8% compared with the third quarter of fiscal 2006, primarily due to declines in sales of products and related implementation services. Germany revenue declined due to lower sales of products, the decline in our rental base and lower implementation services, partially offset by the benefit from foreign currency. EMEA revenue, excluding Germany, grew by 5.4%, helped by strong demand in Eastern Europe, as well as a benefit from foreign currency. Revenues in APAC and Americas, non-U.S. increased by 33% and 11%, respectively.
The following table sets forth a comparison of revenue from sales of products by channel:
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| ||||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Mix |
|
|
| |||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||
$ | 277 |
| $ | 302 |
| $ | 259 |
| $ | 277 |
| Direct |
| $ | 258 |
| $ | 277 |
|
| 41 | % |
|
| 44 | % |
|
| $ | (19 | ) |
| -6.9 | % |
359 |
| 388 |
| 360 |
| 362 |
| Indirect |
| 368 |
| 359 |
|
| 59 | % |
|
| 56 | % |
|
| 9 |
|
| 2.5 | % | |||||||
$ | 636 |
| $ | 690 |
| $ | 619 |
| $ | 639 |
| Total sales of products |
| $ | 626 |
| $ | 636 |
|
| 100 | % |
|
| 100 | % |
|
| $ | (10 | ) |
| -1.6 | % |
The mix of sales of products in the third quarter of fiscal 2007 shifted three percentage points toward indirect due to the decline in U.S. and Germany direct product sales compared to the same quarter last fiscal year. The revenue growth in APAC and in EMEA, primarily Eastern Europe, is primarily driven through the indirect channel.
36
Gross Margin
The following table sets forth a comparison of gross margin by type:
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| ||||||||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Percent of Revenue |
|
|
| |||||||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||||||
| 52.2 | % |
|
| 54.8 | % |
|
| 53.3 | % |
|
| 52.9 | % |
| On sales of products |
| $ | 324 |
| $ | 332 |
|
| 51.8 | % |
|
| 52.2 | % |
|
| $ | (8 | ) |
| -2.4 | % |
| 33.9 | % |
|
| 32.1 | % |
|
| 36.3 | % |
|
| 36.3 | % |
| On services |
| 195 |
| 172 |
|
| 38.5 | % |
|
| 33.9 | % |
|
| 23 |
|
| 13.4 | % | |||
| 54.5 | % |
|
| 57.5 | % |
|
| 55.3 | % |
|
| 51.4 | % |
| On rental and managed services |
| 78 |
| 84 |
|
| 54.5 | % |
|
| 54.5 | % |
|
| (6 | ) |
| -7.1 | % | |||
| 45.3 | % |
|
| 46.6 | % |
|
| 46.8 | % |
|
| 46.2 | % |
| Total gross |
| $ | 597 |
| $ | 588 |
|
| 46.8 | % |
|
| 45.3 | % |
|
| $ | 9 |
|
| 1.5 | % |
The $9 million increase in gross margin for the third quarter of fiscal 2007 reflects a benefit from foreign currency and reductions in cost of products and services.
Sales of products gross margin and rate both decreased primarily due to the decline in the volume of U.S. and Germany direct product sales, resulting in a higher proportion of indirect channel non-U.S. sales, which generally carry lower margins.
Services gross margin increased by $23 million compared to third quarter of fiscal 2006, and the gross margin rate increased by over four percentage points. The increase in gross margin was due to improved efficiencies and expense controls.
Rental and managed services gross margin decreased due to reductions in scope of contracted services at the time of contract renewal particularly related to our rental base in Germany, cancellations of contracts with historically higher margins, and price erosion on new contracts. The gross margin rate was flat.
Operating expenses
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Percent of Revenue |
|
|
|
|
| |||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||
$423 |
| $ | 388 |
| $ | 389 |
| $ | 393 |
| Selling, general and administrative |
| $ | 402 |
| $ | 423 |
|
| 31.5 | % |
|
| 32.6 | % |
|
| $ | (21 | ) |
| -5.0 | % | |
115 |
| 110 |
| 114 |
| 114 |
| Research and development |
| 104 |
| 115 |
|
| 8.2 | % |
|
| 8.9 | % |
|
| (11 | ) |
| -9.6 | % | |||||||
22 |
| 62 |
| 6 |
| 10 |
| Restructuring charges, net |
| 13 |
| 22 |
|
| 1.0 | % |
|
| 1.7 | % |
|
| (9 | ) |
| -40.9 | % | |||||||
— |
| — |
| — |
| — |
| Merger-related costs |
| 8 |
| — |
|
| 0.6 | % |
|
| 0.0 | % |
|
| 8 |
|
| 100.0 | % | |||||||
$560 |
| $ | 560 |
| $ | 509 |
| $ | 517 |
| Total operating expenses |
| $ | 527 |
| $ | 560 |
|
| 41.3 | % |
|
| 43.2 | % |
|
| $ | (33 | ) |
| -5.9 | % | |
The $21 million decrease in SG&A expenses is primarily due to the impact of lower headcount and lower discretionary spending in connection with our cost management initiatives, partially offset by expected higher employee benefit costs. The third quarter of fiscal 2006 also included $29 million of asset impairment charges primarily related to internal-use software assets, partially offset by a $22 million benefit for the favorable resolution of non-income tax audits.
37
R&D expenses decreased by $11 million compared to the same quarter last fiscal year due to a higher proportion of costs for development of software products, resulting in increased capitalization of R&D spending. This decrease is partially offset by spending in connection with Traverse and a full quarter of Ubiquity expenses, two companies which we have acquired during the fiscal year.
Restructuring charges, net for the third quarter of fiscal 2007 represent $13 million of net charges for employee separation costs.
Merger-related costs consist primarily of investment banking and legal costs associated with the proposed Merger with an entity controlled by the Sponsors.
Other Income, Net
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| Change |
| |||||||||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||||
| $ | 5 |
|
|
| $ | 8 |
|
|
| $ | 6 |
|
|
| $ | 7 |
|
| Other income, net |
|
| $ | 10 |
|
|
| $ | 5 |
|
| $ | 5 |
| 100 | % |
Other income, net for the third quarters of fiscal 2007 and 2006 primarily represents interest income earned on cash and cash equivalents.
Interest Expense
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| Change |
| |||||||||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||||||
| $ | — |
|
|
| $ | — |
|
|
| $ | — |
|
|
| $ | — |
|
| Interest expense |
|
| $ | 1 |
|
|
| $ | — |
|
| $ | 1 |
| 100 | % |
Capital lease obligations of $10 million represent our only financing arrangement as of June 30, 2007, and therefore, we have incurred insignificant interest expense.
Provision for (Benefit from) Income Taxes
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| Change |
| |||||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||
$ | (11) |
|
| $ | 35 |
|
|
| $ | 25 |
|
|
| $ | 31 |
|
| Provision for (benefit from) income taxes |
|
| $ | 24 |
|
| $ | (11 | ) | $ | 35 |
| -318 | % |
The provision for income taxes in the third quarter of fiscal 2007 is comprised of U.S. Federal, state and non-U.S. taxes including a $4 million tax benefit attributable to tax return to provision adjustments due to the filing, in the quarter, of U.S. and non-U.S. income tax returns resulting in an effective tax rate of 31.3%.
The benefit from income taxes in the third quarter of fiscal 2006 was primarily due to an $18 million tax benefit associated with transfer pricing adjustments and a $3 million tax benefit resulting from a non-U.S. audit settlement. These benefits were partially offset by provisions for U.S. Federal, state and non-U.S. taxes, resulting in an effective tax benefit rate of 33.1%.
Global Communications Solutions (“GCS”)
The GCS segment is focused on the sale of communications systems, equipment and applications to our enterprise customers. Our primary offerings in this segment include IP communications and traditional
38
voice communications solutions, multi-media contact center infrastructure and applications in support of customer relationship management, unified communications applications and appliances.
Large communications systems are IP and traditional communications systems marketed to large enterprises. These systems include:
· media servers which provide call processing on the customer’s local area network;
· media gateways which support traffic routing between traditional voice and IP communications solutions;
· associated appliances, such as telephone handsets and related software applications;
· Avaya Integrated Management, a Web-based comprehensive set of tools that manages complex voice and data network infrastructures;
· Avaya Communications Manager, a voice application software that manages call processing, facilitates secure customer interactions across a variety of media and supports a range of Avaya and third-party applications; and
· Avaya Extension to Cellular, which transparently bridges any cellular phone to any Avaya communications server.
Small communications systems are IP and traditional telephony systems marketed to smaller enterprises. These systems include:
· Avaya IP Office, an IP telephony solution for small and medium-sized enterprises;
· traditional key systems, Partner®, Merlin Magix®, Merlin Legend™ and I5 brands;
· associated appliances, such as telephone handsets; and
· media servers for voice applications used by smaller businesses.
Converged voice applications consist of applications for multi-media contact centers and unified communications. These include:
· applications in support of customer relationship management;
· messaging for IP and traditional systems;
· application enablement services; and
· unified communication client applications.
The following table sets forth revenue by similar class of products within the GCS segment:
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Mix |
|
|
| |||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||||||||
$ | 455 |
| $ | 483 |
| $ | 435 |
| $ | 440 |
| Large Communications Systems |
| $ | 437 |
| $ | 455 |
|
| 64 | % |
|
| 65 | % |
| $ | (18 | ) | -4.0 | % |
92 |
| 96 |
| 85 |
| 84 |
| Small Communications Systems |
| 74 |
| 92 |
|
| 11 | % |
|
| 13 | % |
| (18 | ) | -19.6 | % | |||||||
144 |
| 169 |
| 151 |
| 162 |
| Converged Voice |
| 153 |
| 144 |
|
| 22 | % |
|
| 20 | % |
| 9 |
| 6.3 | % | |||||||
13 |
| 12 |
| 11 |
| 12 |
| Other |
| 22 |
| 13 |
|
| 3 | % |
|
| 2 | % |
| 9 |
| 69.2 | % | |||||||
$ | 704 |
| $ | 760 |
| $ | 682 |
| $ | 698 |
| Total GCS revenue |
| $ | 686 |
| $ | 704 |
|
| 100 | % |
|
| 100 | % |
| $ | (18 | ) | -2.6 | % |
39
Overall GCS revenue declined by $18 million, or 2.6% due to product revenue decreases in the U.S. and a decline in our rental base in Germany. These declines were partially offset by a benefit from foreign currency and increased sales volume in EMEA, excluding Germany, and APAC. The $18 million decrease in large communications systems revenue was primarily the result of decreased sales of enterprise gateways and other equipment, particularly in our U.S. direct market, partially offset by growth in Asia Pacific and Latin America. Small communications systems revenues decreased by $18 million due to continued declines of our sales of traditional products in the U.S. and in our Germany rental base. Converged voice applications revenues increased by $9 million due to increased demand for applications outside of the U.S., especially IP messaging and certain contact center applications, offset by declines in demand for traditional messaging products.
The following table sets forth operating income of the GCS segment:
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| ||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Percent of Revenue |
|
|
| ||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
|
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| ||||||||
| $ | 36 |
|
|
| $ | 86 |
|
|
| $ | 22 |
|
|
| $ | 38 |
|
| Operating income |
|
| $ | 25 |
|
|
| $ | 36 |
|
|
| 3.6 | % |
|
| 5.1 | % |
| $ | (11 | ) | -30.6 | % |
The $11 million decrease in operating income was primarily due to lower gross margin as a result of decreased sales volumes in the U.S. and Germany and unfavorable channel mix, as well as expenses associated with Ubiquity and Traverse. These unfavorable items were partially offset by decreases in net R&D expense due to a higher proportion of costs for development of software products resulting in increased capitalization of R&D spending and benefits from our cost savings initiatives.
Avaya Global Services (“AGS”)
The AGS segment is focused on supporting our broad customer base with comprehensive end-to-end global service offerings that enable our customers to plan, design, implement, monitor and manage their converged communications networks and contact center systems worldwide. AGS provides its services through the following offerings:
Product Support Services—AGS monitors and optimizes customers’ network performance ensuring availability and keeps communication networks current with the latest software releases. In the event of an outage, our services team helps customers restore their networks. This division was previously referred to as “Maintenance.”
Consulting and Systems Integration—Through operation, implementation and integration specialists and consultants worldwide, AGS helps customers leverage and optimize their multi-technology, multi-vendor environments through the use of contact centers, unified communication networks and IP communications. This division was previously referred to as “Implementation and Integration Services.”
Global Managed Services—AGS supplements our customers’ in-house staff and manages complex multi-vendor, multi-technology networks, optimizes network performance and configurations, backs up systems, detects and resolves faults, performs moves, adds and changes, and manages our customers’ communication environment and related assets. This category includes customers who have chosen a bundled solution with enhanced services not provided in a basic maintenance contract, and service of solutions sold under a rental payment basis. The managed services business generally involves larger contracts with customers who outsource responsibility for their voice applications domain to us. We face challenges in this area, including ensuring that we deliver consistent levels of service globally to these large, and often multi-national, customers while controlling costs and expanding the required skill set of our AGS organization.
40
The profitability of our AGS segment is also affected by the fixed costs associated with our represented workforces in the U.S. and EMEA and includes the impact of increases in employee benefit costs. In addition, our profitability is impacted by the complexities associated with maintenance of global, multi-vendor IP networks as compared with local, closed, proprietary TDM networks, such as the need to assure a sufficient level of service technicians with IP skills.
The following table sets forth revenue by similar class of services within the AGS segment:
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| ||||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Mix |
|
|
|
|
| ||||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| ||||||||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| ||||||||||||||||||||||||
$402 |
| $ | 404 |
| $ | 411 |
| $ | 412 |
| Product Support Services |
| $ | 408 |
| $ | 402 |
|
| 69 | % |
|
| 68 | % |
|
| $ | 6 |
|
| 1.5 | % | ||
106 |
| 111 |
| 98 |
| 97 |
| Consulting and Systems Integration |
| 99 |
| 106 |
|
| 17 | % |
|
| 18 | % |
|
| (7 | ) |
| -6.6 | % | ||||||||
84 |
| 89 |
| 89 |
| 87 |
| Global Managed Services |
| 83 |
| 84 |
|
| 14 | % |
|
| 14 | % |
|
| (1 | ) |
| -1.2 | % | ||||||||
1 |
| — |
| — |
| — |
| Other |
| — |
| 1 |
|
| 0 | % |
|
| 0 | % |
|
| (1 | ) |
| -100.0 | % | ||||||||
$593 |
| $ | 604 |
| $ | 598 |
| $ | 596 |
| Total AGS revenue |
| $ | 590 |
| $ | 593 |
|
| 100 | % |
|
| 100 | % |
|
| $ | (3 | ) |
| -0.5 | % | ||
Overall AGS revenue for the third quarter of fiscal 2007 was roughly flat compared to the same quarter last fiscal year. Product support services revenues increased by $6 million, due to growth in contract maintenance revenues outside the U.S. Consulting and systems integration revenues declined by $7 million due to lower direct product sales, resulting in lower implementation revenues, particularly in the U.S and Germany. Global managed services revenues were relatively flat due to reductions in scope related to our Germany rental base, cancellations of contracted services, and price erosion on new contracts, substantially offset by a benefit from foreign currency.
The following table sets forth operating income of the Avaya Global Services segment:
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| ||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
| Percent of Revenue |
|
|
| ||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
|
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| ||||||||
| $ | 34 |
|
|
| $ | 36 |
|
|
| $ | 53 |
|
|
| $ | 56 |
|
| Operating income |
|
| $ | 63 |
|
|
| $ | 34 |
|
|
| 10.7 | % |
|
| 5.7 | % |
| $ | 29 |
| 85.3 | % |
The $29 million increase in operating income is primarily due to higher gross margin as a result of improved efficiencies and expense controls, partially offset by expected increased employee benefit costs.
Corporate/Other Unallocated Amounts
|
|
|
|
|
|
|
|
|
| Third Fiscal Quarter |
| |||||||||||||||
3Q06 |
| 4Q06 |
| 1Q07 |
| 2Q07 |
|
|
| 2007 |
| 2006 |
| Change |
| |||||||||||
|
|
|
|
|
|
|
|
|
| Dollars in millions |
| |||||||||||||||
$ | (42) |
| $ | (47 | ) |
| $ | 15 |
|
| $ | (13 | ) | Operating (loss) income |
| $ | (18 | ) | $ | (42 | ) | $ | 24 |
| 57 | % |
Corporate/Other Unallocated amounts include a $13 million net restructuring charge and $8 million of Merger-related costs in the third quarter of fiscal 2007. At the beginning of each fiscal year, the amount of corporate overhead and certain other expenses, including targeted annual incentive awards, to be charged to operating segments is determined and fixed for the entire year. Any adjustment of the annual incentive accrual, as well as any other over/under absorption of corporate overhead expenses against planned amounts, is recorded within Corporate/Other Unallocated Amounts. In addition, certain discrete items, such as charges relating to restructuring actions, as well as Merger-related costs, are not allocated to the operating segments and remain in Corporate/Other Unallocated Amounts.
41
The operating loss for the third quarter of fiscal 2006 was primarily related to restructuring charges of $22 million and asset impairment charges of $29 million primarily related to certain internal-use software assets. These items were partially offset by $22 million related to the favorable resolution on non-income tax audits in several jurisdictions.
Nine Months Ended June 30, 2007 Compared with Nine Months Ended June 30, 2006
Revenue
The following table sets forth a comparison of revenue by type:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Mix |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
Sales of products |
| $ | 1,884 |
| $ | 1,820 |
|
| 49 | % |
|
| 48 | % |
| $ | 64 |
| 3.5 | % |
Services |
| 1,525 |
| 1,503 |
|
| 40 | % |
|
| 40 | % |
| 22 |
| 1.5 | % | |||
Rental and managed services |
| 441 |
| 461 |
|
| 11 | % |
|
| 12 | % |
| (20 | ) | -4.3 | % | |||
Total revenue |
| $ | 3,850 |
| $ | 3,784 |
|
| 100 | % |
|
| 100 | % |
| $ | 66 |
| 1.7 | % |
The increase in revenue for the nine months ended June 30, 2007 compared to the same period last fiscal year was due to increases in sales of products and services, partially offset by a decline in rental and managed services. Revenue for the nine months of fiscal 2007 include a benefit of $93 million from favorable foreign currency.
The following table sets forth a geographic comparison of revenue:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Mix |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
U.S. |
| $ | 2,172 |
| $ | 2,206 |
|
| 56 | % |
|
| 58 | % |
| $ | (34 | ) | -1.5 | % |
Outside the U.S.: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||
Germany |
| 536 |
| 550 |
|
| 14 | % |
|
| 14 | % |
| (14 | ) | -2.5 | % | |||
EMEA—Europe / Middle East / Africa (Excluding Germany) |
| 609 |
| 557 |
|
| 16 | % |
|
| 15 | % |
| 52 |
| 9.3 | % | |||
Total EMEA |
| 1,145 |
| 1,107 |
|
| 30 | % |
|
| 29 | % |
| 38 |
| 3.4 | % | |||
APAC—Asia Pacific |
| 315 |
| 273 |
|
| 8 | % |
|
| 8 | % |
| 42 |
| 15.4 | % | |||
Americas, non-U.S. |
| 218 |
| 198 |
|
| 6 | % |
|
| 5 | % |
| 20 |
| 10.1 | % | |||
Total outside the U.S. |
| 1,678 |
| 1,578 |
|
| 44 | % |
|
| 42 | % |
| 100 |
| 6.3 | % | |||
Total revenue |
| $ | 3,850 |
| $ | 3,784 |
|
| 100 | % |
|
| 100 | % |
| $ | 66 |
| 1.7 | % |
Revenues in the U.S. decreased 1.5% compared with the first nine months of fiscal 2006, primarily due to decreases in sales of large and small communications systems and product support services. Germany’s revenue decreased 2.5% due to the decline in our rental base, partially offset by a benefit from foreign currency. EMEA revenue, excluding Germany, grew by 9.3% due to a benefit from foreign currency and strong demand in Eastern Europe. The increases in APAC and Americas, non-U.S. revenue were primarily due to the increased demand for IP products through the direct channel.
42
The following table sets forth a comparison of revenue from sales of products by channel:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Mix |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
Direct |
| $ | 794 |
| $ | 795 |
|
| 42 | % |
|
| 44 | % |
| $ | (1 | ) | -0.1 | % |
Indirect |
| 1,090 |
| 1,025 |
|
| 58 | % |
|
| 56 | % |
| 65 |
| 6.3 | % | |||
Total sales of products |
| $ | 1,884 |
| $ | 1,820 |
|
| 100 | % |
|
| 100 | % |
| $ | 64 |
| 3.5 | % |
The mix of sales of products in the first nine months of fiscal 2007 shifted two percentage points toward indirect due to the decline in the U.S. and Germany direct product sales compared to the same period last fiscal year.
Gross Margin
The following table sets forth a comparison of gross margin by type:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Percent of Revenue |
|
|
| |||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
On sales of products |
| $ | 992 |
| $ | 964 |
|
| 52.7 | % |
|
| 53.0 | % |
| $ | 28 |
| 2.9 | % |
On services |
| 565 |
| 527 |
|
| 37.0 | % |
|
| 35.1 | % |
| 38 |
| 7.2 | % | |||
On rental and managed services |
| 237 |
| 264 |
|
| 53.7 | % |
|
| 57.3 | % |
| (27 | ) | -10.2 | % | |||
Total gross margin |
| $ | 1,794 |
| $ | 1,755 |
|
| 46.6 | % |
|
| 46.4 | % |
| $ | 39 |
| 2.2 | % |
The $39 million increase in gross margin for the first nine months of fiscal 2007 reflects an increase in the volume of sales of products, the impact of improved efficiencies and a benefit from foreign currency. The overall gross margin rate was flat compared to the first nine months of fiscal 2006. The first nine months of fiscal 2006 gross margin includes an $11 million benefit, or a 0.3 percentage point impact, from the change in our vacation policy.
Gross margin on sales of products increased by $28 million primarily due to higher sales volume. Factors affecting the slight decline in the gross margin rate included higher costs associated with our warehousing issues and the higher proportion of indirect sales which generally carry lower margins, partially offset by benefits from cost reductions from employee restructuring actions.
Services gross margin increased by $38 million and the rate increased by almost two percentage points when compared to first nine months of fiscal 2006. Cost reductions from employee restructuring actions in prior periods and from improved efficiencies and expense controls were partially offset by expected increases in employee benefit costs.
Rental and managed services gross margin and rate both decreased due to reductions in scope of contracted services at the time of contract renewal particularly related to our rental base in Germany, cancellation of contracts with historically higher margins and price erosion on new contracts.
43
Operating expenses
|
| Nine Months Ended June 30, |
|
| |||||||||||||||||
|
|
|
|
|
| Percent of Revenue |
|
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
|
| |||||||||
|
| Dollars in millions |
|
| |||||||||||||||||
Selling, general and administrative |
| $ | 1,184 |
| $ | 1,207 |
|
| 30.7 | % |
|
| 31.9 | % |
| $ | (23 | ) | -1.9 | % | |
Research and development |
| 332 |
| 318 |
|
| 8.6 | % |
|
| 8.4 | % |
| 14 |
| 4.4 | % | ||||
Restructuring charges, net |
| 29 |
| 42 |
|
| 0.8 | % |
|
| 1.1 | % |
| (13 | ) | -31.0 | % | ||||
Merger-related costs |
| 8 |
| — |
|
| 0.2 | % |
|
| 0.0 | % |
| 8 |
| 100.0 | % | ||||
Total operating expenses |
| $ | 1,553 |
| $ | 1,567 |
|
| 40.3 | % |
|
| 41.4 | % |
| $ | (14 | ) | -0.9 | % |
The $23 million decrease in SG&A expenses is primarily due to lower headcount, lower discretionary spending, an $8 million benefit resulting from the favorable resolution of non-income tax audits and a gain on the sale of real estate in fiscal 2007, partially offset by expected increases in employee benefit costs. The first nine months of fiscal 2006 included a $7 million benefit related to the change in our vacation policy, as well as a $29 million asset impairment charge primarily related to internal-use software assets.
R&D expenses increased by $14 million compared to the first nine months of the last fiscal year due to increased gross investment and to a lesser extent, the acquisitions of Traverse and Ubiquity. The first nine months of fiscal 2006 included a $3 million benefit related to the change in our vacation policy.
Restructuring charges, net for the first nine months of fiscal 2007 represent $36 million of charges for employee separation costs and lease obligations, partially offset by a net benefit of $7 million for changes in estimates for prior restructuring plans primarily related to facilities.
Merger-related costs for the first nine months of fiscal 2007 consist primarily of investment banking and legal costs associated with the proposed Merger.
Other Income, Net
|
| Nine Months Ended June 30, |
| |||||||||||||
|
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||
Other income, net |
|
| $ | 23 |
|
|
| $ | 16 |
|
| $ | 7 |
| 44 | % |
Other income, net for the first nine months of fiscal 2007 and 2006 primarily represents interest income earned on cash and cash equivalents.
Interest Expense
|
| Nine Months Ended June 30, |
| |||||||||||||
|
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||
Interest expense |
|
| $ | 1 |
|
|
| $ | 3 |
|
| $ | (2 | ) | -67 | % |
Capital lease obligations of $10 million represent our only financing arrangement as of June 30, 2007, and therefore, we have incurred insignificant interest expense.
Provision for Income Taxes
|
| Nine Months Ended June 30, |
| |||||||||||||
|
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||
Provision for income taxes |
|
| $ | 80 |
|
|
| $ | 48 |
|
| $ | 32 |
| 67 | % |
44
The provision for income taxes for the nine month periods shown above is comprised of U.S. Federal, state and non-U.S. taxes. The provision for the nine months ended June 30, 2007 includes a $6 million benefit from the retroactive extension to January 1, 2006 of the research tax credit pursuant to the Tax Relief and Health Care Act of 2006, a $7 million tax benefit due to a reduction in estimated tax payable for fiscal 2006 in Germany as a result of additional restructuring charges reported for statutory purposes, and a $4 million tax benefit attributable to tax return to provision adjustments due to the filing, in the quarter, of U.S. and non-U.S. income tax returns. The provision for the first nine months of fiscal 2007 resulted in an effective tax rate of 30.5%, which we believe is not indicative of the estimated tax rate for the full fiscal year.
The provision for income taxes for the nine months ended June 30, 2006 was impacted by an $18 million tax benefit associated with transfer pricing adjustments. The provision for income taxes for the nine months ended June 30, 2006 resulted in an effective rate of 23.9%.
Global Communications Solutions
The following table sets forth revenue by similar class of products within the GCS segment:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Mix |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
Large Communications Systems |
| $ | 1,312 |
| $ | 1,282 |
|
| 64 | % |
|
| 62 | % |
| $ | 30 |
| 2.3 | % |
Small Communications Systems |
| 243 |
| 274 |
|
| 12 | % |
|
| 14 | % |
| (31 | ) | -11.3 | % | |||
Converged Voice Applications |
| 466 |
| 436 |
|
| 22 | % |
|
| 22 | % |
| 30 |
| 6.9 | % | |||
Other |
| 45 |
| 34 |
|
| 2 | % |
|
| 2 | % |
| 11 |
| 32.4 | % | |||
Total GCS revenue |
| $ | 2,066 |
| $ | 2,026 |
|
| 100 | % |
|
| 100 | % |
| $ | 40 |
| 2.0 | % |
Overall GCS revenue grew by $40 million, or 2.0%. Product revenue increases, particularly related to converged voice applications and a benefit from foreign currency, were offset by the expected reduced sales of traditional products and a decline in our rental base in Germany. The $30 million increase in large communication systems revenue was the result of increased demand for enterprise gateways and other equipment. Small communications systems revenues decreased by $31 million due to continued declines of our sales of traditional products and our rental base. Converged voice applications revenues increased by $30 million due to increased demand for applications, especially IP messaging and contact center applications, offset by declines in demand for traditional messaging products.
The following table sets forth operating income of the GCS segment:
|
| Nine Months Ended June 30, |
| |||||||||||||||||||
|
|
|
|
|
| Percent of Revenue |
|
|
| |||||||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||||
|
| Dollars in millions |
| |||||||||||||||||||
Operating income |
|
| $ | 85 |
|
| $ | 111 |
|
| 4.1 | % |
|
| 5.5 | % |
| $ | (26 | ) | -23.4 | % |
The $26 million decline in operating income was primarily due to higher costs associated with our warehousing issues, increases in R&D investment and the benefit of $11 million from a change in the Company’s vacation policy for the first nine months of fiscal 2006, partially offset by the impact of increases in sales volume.
45
Avaya Global Services
The following table sets forth revenue by similar class of services within the AGS segment:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Mix |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
Product Support Services |
| $ | 1,231 |
| $ | 1,215 |
|
| 69 | % |
|
| 69 | % |
| $ | 16 |
| 1.3 | % |
Consulting and Systems Integration |
| 294 |
| 290 |
|
| 16 | % |
|
| 17 | % |
| 4 |
| 1.4 | % | |||
Global Managed Services |
| 259 |
| 251 |
|
| 15 | % |
|
| 14 | % |
| 8 |
| 3.2 | % | |||
Other |
| — |
| 2 |
|
| 0 | % |
|
| 0 | % |
| (2 | ) | -100.0 | % | |||
Total AGS revenue |
| $ | 1,784 |
| $ | 1,758 |
|
| 100 | % |
|
| 100 | % |
| $ | 26 |
| 1.5 | % |
Overall AGS revenue increased by $26 million, or 1.5%, due to increases in product support services, as well as a benefit from foreign currency.
Product support services revenues increased by $16 million compared to the third quarter of fiscal 2006, particularly in the international regions. Consulting and systems integration revenues increased by $4 million due to an increase in professional services in the U.S. Global managed services revenues increased by $8 million due to higher customer termination fees and favorable foreign currency, which were partially offset by reductions in scope related to our Germany rental base, cancellations of contracted services and price erosion on new contracts.
The following table sets forth operating income of the Avaya Global Services segment:
|
| Nine Months Ended June 30, |
| |||||||||||||||||
|
|
|
|
|
| Percent of Revenue |
|
|
|
|
| |||||||||
|
| 2007 |
| 2006 |
| 2007 |
| 2006 |
| Change |
| |||||||||
|
| Dollars in millions |
| |||||||||||||||||
Operating income |
| $ | 172 |
| $ | 135 |
|
| 9.6 | % |
|
| 7.7 | % |
| $ | 37 |
| 27.4 | % |
The $37 million increase in operating income is primarily due to the shift in mix of contract maintenance and implementation revenues, lower inventory-related costs, reduced costs resulting from prior restructuring actions and improved efficiencies and expense controls. These items were partially offset by expected increases in employee benefit costs. Operating income for the first nine months of fiscal 2006 included a benefit of $10 million from the change in our vacation policy.
Corporate/Other Unallocated Amounts
|
| Nine Months Ended June 30, |
| |||||||||
|
| 2007 |
| 2006 |
| Change |
| |||||
|
| Dollars in millions |
| |||||||||
Operating loss |
| $ | (16 | ) | $ | (58 | ) | $ | 42 |
| 72 | % |
For the first nine months of fiscal 2007, the operating loss in Corporate/Other Unallocated Amounts is primarily attributable to $29 million of net restructuring charges and $8 million of Merger-related costs, partially offset by $8 million in gains on the sale of real estate and the $8 million benefit from non-income tax audit settlements in several jurisdictions. The operating loss for the nine months of fiscal 2006 was primarily related to a $29 million impairment charge primarily associated with certain internal-use software assets, $42 million of net restructuring charges, and certain real estate expenses. These costs were partially offset by lower accruals for employee incentive awards and a $22 million benefit from the favorable resolution of non-income tax audits in several jurisdictions.
46
Liquidity and Capital Resources
During the first nine months of fiscal 2007, we generated positive cash flow from operations of $424 million. We also received $110 million in connection with the issuance of common stock under our employee stock purchase plan and stock compensation plans. This source of cash was partially offset by $94 million of cash used during the first nine months of fiscal 2007 to repurchase shares in connection with our 2005 and 2007 share repurchase plans. In addition, we used $15 million and $147 million of cash to acquire Traverse and Ubiquity, respectively, and used $150 million of cash for capital expenditures and software development costs. Cash and cash equivalents increased by $158 million to $1,057 million as of June 30, 2007 from $899 million as of September 30, 2006.
Sources and Uses of Cash for the Nine Months Ended June 30, 2007
A condensed statement of cash flows for the first nine months of fiscal 2007 and 2006 follows:
|
| Nine months ended June 30, |
| ||||||||
|
| 2007 |
| 2006 |
| ||||||
|
| Dollars in millions |
| ||||||||
Net cash provided by (used for): |
|
|
|
|
|
|
|
|
| ||
Operating activities |
|
| $ | 424 |
|
|
| $ | 456 |
|
|
Investing activities |
|
| (304 | ) |
|
| (139 | ) |
| ||
Financing activities |
|
| 13 |
|
|
| (250 | ) |
| ||
Effect of exchange rate changes on cash and cash equivalents |
|
| 25 |
|
|
| 5 |
|
| ||
Net increase in cash and cash equivalents |
|
| 158 |
|
|
| 72 |
|
| ||
Cash and cash equivalents at beginning of year |
|
| 899 |
|
|
| 750 |
|
| ||
Cash and cash equivalents at end of period |
|
| $ | 1,057 |
|
|
| $ | 822 |
|
|
Operating Activities
Our net cash provided by operating activities was $424 million for the first nine months of fiscal 2007, compared to $456 million in the first nine months of fiscal 2006. The lower amount of cash provided by operating activities compared to the prior year was primarily driven by higher employee incentive payments. The first nine months of fiscal 2007 included payment of employee incentives based on fiscal 2006 performance. The first nine months of fiscal 2006 included payments of lower discretionary awards based on fiscal 2005 performance. This change in the level of incentive payments resulted in an approximately $70 million increase in cash usage in the first nine months of fiscal 2007 compared with the same period of fiscal 2006.
Accounts Receivable, Net—The following summarizes our accounts receivable, net and related metrics:
|
| June 30, |
| September 30, |
|
|
| |||||||
|
| 2007 |
| 2006 |
| Change |
| |||||||
|
| Dollars in millions |
| |||||||||||
Accounts receivable, gross |
|
| $ | 928 |
|
|
| $ | 928 |
|
| $ | — |
|
Allowance for doubtful accounts |
|
| (59 | ) |
|
| (57 | ) |
| (2 | ) | |||
Accounts receivable, net |
|
| $ | 869 |
|
|
| $ | 871 |
|
| $ | (2 | ) |
Allowance for doubtful accounts as a percent of accounts receivable, gross |
|
| 6.4 | % |
|
|
6.1 | % |
| +0.3 pts |
| |||
Past due receivables as a percent of accounts receivable, gross |
|
| 18.5 | % |
|
|
17.8 | % |
| +0.7 pts |
|
47
|
| For the three months ended |
|
|
| ||||||
|
| June 30, |
| September 30, |
|
|
| ||||
|
| 2007 |
| 2006 |
| Change |
| ||||
Days sales outstanding (DSO) |
|
| 61 days |
|
|
| 57 days |
|
| +4 days |
|
The accounts receivable balance as of June 30, 2007 was substantially flat when compared to September 30, 2006. The increase in DSO was the result of current quarter sales occurring later in the quarter when compared to the three months ended September 30, 2006 as well as the increase in the deferred revenue balance as of June 30, 2007.
Inventory—The following summarizes our inventory and inventory turnover:
|
| June 30, |
| September 30, |
|
|
| |||||
|
| 2007 |
| 2006 |
| Change |
| |||||
|
| Dollars in millions |
| |||||||||
Finished goods |
| $ | 300 |
|
| $ | 281 |
|
| $ | 19 |
|
Raw materials |
| 4 |
|
| 4 |
|
| — |
| |||
Total inventory |
| $ | 304 |
|
| $ | 285 |
|
| $ | 19 |
|
Inventory turnover |
| 8.9 times |
|
| 10.2 times |
|
| -1.3 times |
|
Inventory increased by $19 million since the beginning of the fiscal year and inventory turnover declined due to changes in the mix of product demand as well as in anticipation of seasonally strong demand for our products in the fourth fiscal quarter.
Accounts Payable—The following summarizes our accounts payable:
|
| June 30, |
| September 30, |
|
|
| |||||||
|
| 2007 |
| 2006 |
| Change |
| |||||||
|
| Dollars in millions |
| |||||||||||
Accounts payable |
|
| $ | 395 |
|
|
| $ | 418 |
|
| $ | (23 | ) |
Days payable outstanding |
|
| 52 |
|
|
| 51 |
|
| +1 day |
| |||
Accounts payable decreased in the first nine months of fiscal 2007 due to lower spending levels and the timing of payments during the quarter.
Investing Activities
Net cash used for investing activities was $304 million in the first nine months of fiscal 2007, compared with $139 million in the same period last year. Activities in the current period include $162 million for the acquisitions of Ubiquity and Traverse, $79 million for capital expenditures and $71 million for capitalized software development costs.
Cash used in the same period of fiscal 2006 included $83 million for capital expenditures and $53 million for capitalized software development costs.
Financing Activities
Net cash provided by financing activities was $13 million in the first nine months of fiscal 2007, compared with cash used of $250 million in the same period last year. Activities in the current period primarily include $110 million of cash received in connection with the issuance of common stock under our employee stock purchase plan and stock compensation plans, partially offset by $94 million of cash used to repurchase our common stock pursuant to our share repurchase plans.
48
Cash used in the same period of fiscal 2006 consisted primarily of $256 million to repurchase our common stock and $14 million to repay our senior notes partially offset by $20 million of cash received in connection with the issuance of common stock under employee stock purchase plan and the exercise of options under our stock compensation plans.
Future Cash Requirements and Sources of Liquidity
Impact of Proposed Merger
We expect the proposed Merger to be completed in the fall of 2007, subject to receipt of shareholder approval and customary regulatory approvals, as well as satisfaction of other customary closing conditions.
We will incur indebtedness and utilize cash in order to complete the proposed Merger. As a result, our future cash requirements, sources of liquidity and uncertainties regarding our liquidity may change after the completion of the Merger. Because the proposed Merger is not complete, the discussion in this section does not consider the impact of proposed costs which will only be incurred upon consummation of the proposed Merger, nor does it consider the incurrence of the related indebtedness contemplated by the Merger.
Future Cash Requirements
Our primary future cash requirements will be to fund capital expenditures, restructuring payments, employee benefit obligations and Merger-related costs.
Specifically, we expect our primary cash requirements for the remainder of fiscal 2007 to be as follows:
· Capital expenditures—We expect to spend approximately $75 million for capital expenditures and capitalized software development costs during the fourth quarter of fiscal 2007.
· Restructuring payments—We expect to make payments of approximately $20 million during the remainder of fiscal 2007 for employee separation costs and lease termination obligations associated with restructuring actions we have taken to date. If we take any further actions to reduce costs and expenses, we would expect to make additional payments throughout the remainder of fiscal 2007.
· Employee benefit obligations—We estimate that we will pay $2 million each for U.S. and non-U.S. pension benefits for the remainder of fiscal 2007. We also estimate that we will make payments of $5 million for retiree medical benefits that are not pre-funded during the remainder of fiscal 2007.
· Merger-related costs—We have incurred $8 million for Merger-related costs during the third quarter of fiscal 2007, and we expect to incur an additional $15 million during the remainder of fiscal 2007. Payment of these costs is not dependent on the successful completion of the Merger. Substantially all accrued Merger-related costs are expected to be paid after closing of the Merger, which we expect to complete in the fall of 2007.
Future Sources of Liquidity
We expect our primary source of cash during the remainder of fiscal 2007 to be positive net cash provided by operating activities. We expect that growth in profitable revenues and continued focus on accounts receivable, inventory management and cost containment will enable us to continue to generate positive net cash from operations.
We and a syndicate of lenders are currently party to a $400 million revolving credit facility, which expires in May 2011. The Merger Agreement limits Avaya’s ability without the Sponsors’ consent during the period from the date of the Merger Agreement until the closing of the Merger to, among other things,
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incur indebtedness over certain thresholds. For more information regarding the credit facility, see Note 7 “Financing Arrangements” to our Consolidated Financial Statements.
Based on past performance and current expectations, we believe that our existing cash and cash equivalents of $1,057 million and our net cash provided by operating activities will be sufficient to meet our future cash requirements described above. Our ability to meet these requirements will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
Uncertainties Regarding Our Liquidity
If we do not generate sufficient cash from operations, face unanticipated cash needs such as the need to fund significant strategic acquisitions or do not otherwise have sufficient cash and cash equivalents, we may need to incur debt or issue equity. In order to meet our cash needs we may, from time to time, borrow under our credit facility or issue other long- or short-term debt or equity, if the market and the terms of our existing debt instruments permit us to do so.
We believe the following uncertainties exist regarding our liquidity:
· Ability to Increase Revenue—Our ability to generate net cash from operating activities has been a primary source of our liquidity. If our revenues were to decline, our ability to generate net cash from operating activities in a sufficient amount to meet our cash needs could be adversely affected.
· Acquisitions—We may from time to time in the future make acquisitions. Such acquisitions may require significant amounts of cash or may result in increased debt service requirements to the extent we assume or incur debt in connection with such acquisitions.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value because of their short-term maturity and variable rates of interest.
We conduct our business on a multi-national basis in a wide variety of foreign currencies. We are therefore subject to the risk associated with foreign currency exchange rates and interest rates that could affect our results of operations, financial position and cash flows. We manage our exposure to these market risks through our regular operating and financing activities and, when deemed appropriate, through the use of derivative financial instruments. We use derivative financial instruments to reduce earnings and cash flow volatility associated with foreign exchange rate changes. Derivative financial instruments are used as risk management tools and not for speculative or trading purposes. As of June 30, 2007 and September 30, 2006, the estimated fair values of our foreign currency forward contracts were a gain of $3 million and a loss of $2 million, respectively. The gain was included in other current assets, while the loss was included in other current liabilities. The estimated fair values of these forward contracts were based on market quotes obtained through independent pricing sources.
Debt Ratings
Our ability to obtain external financing and the related cost of borrowing is affected by our debt ratings, which are periodically reviewed by the major credit rating agencies. As of June 30, 2007, we had a long-term corporate family rating of Ba3 with ratings under review for possible downgrades from Moody’s and a corporate credit rating of B+ with ratings on the credit watch with negative implications from Standard & Poor’s. These ratings are not recommendations to buy, sell or hold securities. The ratings are subject to change or withdrawal at any time by the respective credit rating agencies. Each credit rating should be evaluated independently of any other ratings.
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Credit Facility
Our credit facility contains affirmative and restrictive covenants that we must comply with, as described in Note 7, “Financing Arrangements” to our Consolidated Financial Statements. As of June 30, 2007, we were in compliance with all of the covenants included in the credit facility.
There are currently $27 million of letters of credit issued under the credit facility. There are no other outstanding borrowings under the facility and the remaining availability is $373 million as of June 30, 2007. We believe the credit facility provides us with an important source of backup liquidity.
Critical Accounting Policies and Estimates
The preparation of the Consolidated Financial Statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to establish accounting policies that contain estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. These policies include:
· Revenue recognition;
· Collectibility of accounts receivable;
· Inventories;
· Deferred tax assets and tax liabilities;
· The measurement of long-lived assets, including goodwill, the impairment of which would impact operating expenses;
· Restructuring programs;
· Pension and post-retirement benefits costs;
· Commitments and contingencies; and
· Accounting for stock options.
We have other important accounting policies and practices; however, once adopted, these other policies either generally do not require us to make significant estimates or assumptions or otherwise only require implementation of the adopted policy and not a judgment as to the policy itself. We base our estimates on our historical experience and also on assumptions that we believe are standard and reasonable. Despite our intention to establish accurate estimates and assumptions, actual results could differ from those estimates for various reasons including those described in “Forward Looking Statements.”
During the nine months ended June 30, 2007, management believes there have been no significant changes to the items that we disclosed as our critical accounting polices and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended September 30, 2006.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
See Avaya’s Annual Report on Form 10-K filed with the SEC on December 8, 2006. As of June 30, 2007, there has been no material change in this information.
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Item 4. Controls and Procedures.
a) Evaluation of Disclosure Controls and Procedures.
As of the end of the period covered by this report, our management, under the supervision and with the participation of the principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on this evaluation, our principal executive officer and principal financial officer have concluded (1) that the disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and (2) that the disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
b) Changes in Internal Control Over Financial Reporting.
There were no changes in our internal control over financial reporting during the third quarter of fiscal 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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See Note 13, “Commitments and Contingencies” to the Consolidated Financial Statements.
(Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)
We provide the following cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our businesses. We note these factors for investors as permitted by the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These are factors that we think could cause our actual results to differ materially from expected and historical results. However, it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.
It should also be noted that we may not be able to complete the proposed Merger on the terms summarized elsewhere in this Form 10-Q or on other acceptable terms, or at all, due to a number of factors, including the failure to satisfy customary closing conditions. The risks and uncertainties described below do not contemplate or give effect to potential risks associated with the proposed Merger, including any potential adverse reaction of our customers, suppliers, distributors and other business partners to the proposed Merger.
The risks and uncertainties discussed in more detail below include, but are not limited to:
· price and product competition, including from competitors who may offer products and applications similar to those we offer as part of another offering, and from current leaders in information technology which benefit from the convergence of enterprise voice and data networks;
· rapid or disruptive technological development, including the effects of the technology shift from traditional TDM to IP telephony;
· dependence on new product development;
· customer demand for our products and services, including risks specifically associated with the services business and, in particular, the maintenance and rental and managed services lines of business, primarily due to renegotiations of customer contracts and changes in scope, pricing erosion and cancellations;
· supply issues related to our outsourced manufacturing operations, logistics, distribution or components;
· risks related to inventory, including warranty costs, obsolescence charges, excess capacity, material and labor costs, and our distributors’ decisions regarding their own inventory levels;
· general industry and market conditions and growth rates and general domestic and international economic conditions including interest rate and currency exchange rate fluctuations;
· the economic, political and other risks associated with international sales and operations, including increased exposure to currency fluctuations and to European economies as a result of a large percentage of our business being conducted in Europe;
· the ability to successfully integrate acquired companies, which may require significant management time and attention;
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· the ability to attract and retain qualified employees;
· control of costs and expenses, including difficulties in completing restructuring actions in a timely and efficient manner due to labor laws and required approvals;
· U.S. and non-U.S. government regulation; and
· the ability to form and implement alliances.
Below is a detailed discussion of certain risks affecting our business. The categorization of risks set forth below is meant to help you better understand the risks facing our business and is not intended to limit your consideration of the possible effects of these risks to the listed categories. Any adverse effects related to the risks discussed below may, and likely will, adversely affect many aspects of our business.
Risks Related To Our Revenue and Business Strategy
A key component of our strategy is our focus on the development and sale of advanced communications products and applications and related services, including IP communications solutions, and this strategy may not be successful.
A key component of our strategy is our focus on the development and sale of IP communications solutions and other advanced communications products and applications and related services. Our product offerings include IP communications and traditional voice communications systems, multi-media contact center infrastructure and applications in support of customer relationship management, unified communications applications and appliances, such as IP telephone sets. These offerings are part of what we refer to as “Intelligent Communications,” which is about embedding communications solutions into our customers’ business processes to help them transform their businesses and innovate their business models.
In order to execute our strategy successfully, we must continue to:
· expand our current customer base by selling our advanced communications products, applications and services to enterprises that have not previously purchased our products and applications;
· make sales to our existing customers that incorporate our advanced communications products, applications and services;
· train our sales staff and distribution partners to sell new types of products, applications and services and improve our marketing of such products, applications and services;
· research and develop IP communications solutions and other advanced communications products and applications;
· increase the performance and reliability of new products and ensure that the performance and reliability of these products meet our customers’ expectations;
· acquire key technologies through licensing, development contracts, alliances and acquisitions;
· train our services employees and channel partners to service new products and applications, and take other measures to ensure we can deliver consistent levels of service globally to our multinational customers;
· enhance our services organization’s ability to service more complex, multi-vendor IP networks, versus traditional closed, proprietary TDM networks, and in general ensure that there is a sufficient level of service technicians with IP skills;
· develop relationships with new types of channel partners who are capable of both selling more advanced products and extending our reach into new and existing markets; and
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· establish presence in key geographic markets.
Our investments are targeted around achieving our strategic vision of Intelligent Communications. Our vision may fail to predict our customers’ business needs or changes in technological trends, which may adversely affect our operating results. If we do not successfully execute our strategy, our operating results may be adversely affected.
The market opportunity for advanced communications products, applications and services, including IP communications solutions, may not develop in the ways that we anticipate.
The demand for our products can change quickly and in ways that we may not anticipate because the market is characterized by rapid, and sometimes disruptive, technological developments, evolving industry standards, frequent new product introductions and enhancements, changes in customer requirements and a limited ability to accurately forecast future customer orders. Our operating results may be adversely affected if the market opportunity for advanced communications products, applications and services, including IP telephony solutions, does not develop in the ways that we anticipate. The ratio of revenue attributable to IP telephony solutions versus traditional voice communication systems is expected to increase as more and more companies convert to IP telephony solutions. However, IP lines currently constitute a small percentage of global installed enterprise lines and if IP does not gain widespread acceptance in the marketplace as an alternative replacement option for enterprise communications systems our overall revenue and operating results may be adversely affected. Even if we are successful in increasing our revenue from sales of IP communications solutions, if revenue from traditional enterprise voice communications systems and services declines faster than revenue from IP communications solutions increases, our overall revenue and operating results may be adversely affected. We cannot predict whether:
· the demand for advanced communications products, applications, and services, including IP solutions, will grow as quickly as we anticipate;
· current or future competitors or new technologies will cause the market to evolve in a manner different than we expect;
· other technologies will become more accepted or standard in our industry; or
· we will be able to maintain a leadership or profitable position as this opportunity develops.
We face intense competition from our current competitors and, as the enterprise communications and information technology markets evolve, may face increased competition from companies that do not currently compete directly against us.
Historically, our GCS segment has competed against other providers of enterprise voice communications solutions such as Nortel Networks Corporation, Siemens AG, Alcatel-Lucent and NEC Corporation. As we focus on the development and marketing of advanced communications solutions, such as IP solutions, we face intense competition from these providers of voice communications solutions as well as from data networking companies such as Cisco Systems, Inc. and 3Com Corp. The GCS segment also faces competition in the small and medium business market from many competitors, including Cisco, Nortel, Alcatel-Lucent, NEC, Matsushita Electric Corporation of America, Inter-Tel, Incorporated, 3Com, and Mitel Networks Corp., although the market for these products is fragmented. Our AGS segment competes with companies like those above offering services with respect to their own product offerings, as well as many consulting and systems integration firms and network service providers.
In addition, because the market for our products is subject to rapid technological change, as the market evolves we may face competition in the future from companies that do not currently compete in the enterprise communications market, including companies that currently compete in other sectors of the information technology, communications and software industries or communications companies that serve
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residential rather than enterprise customers. In particular, as the convergence of enterprise voice and data networks becomes more widely deployed by enterprises, the business, information technology and communication applications deployed on converged networks become more integrated. We may face increased competition from current leaders in information technology infrastructure, information technology, personal and business applications and the software that connects the network infrastructure to those applications, such as the alliance entered into between Microsoft Corp. and Nortel. We may also face competition from companies that seek to sell remotely hosted services or software as a service directly to the end customer. Competition from these potential market entrants may take many forms, including offering products and applications similar to those we offer as part of another offering. In addition, these technologies continue to move from a proprietary environment to an open standards-based environment.
Several of these existing competitors have, and many of our future competitors may have, greater financial, personnel, research and other resources, more well-established brands or reputations and broader customer bases than we and, as a result, these competitors may be in a stronger position to respond quickly to potential acquisitions and other market opportunities, new or emerging technologies and changes in customer requirements. Some of these competitors may have customer bases that are more geographically balanced than ours and, therefore, may be less affected by an economic downturn in a particular region. Competitors with greater resources also may be able to offer lower prices, additional products or services or other incentives that we cannot match or do not offer. Industry consolidations such as the merger between Alcatel and Lucent Technologies Inc. may also create competitors with broader and more geographic coverage, with the ability to reach enterprises through service provider customers.
In addition, existing customers of data networking companies that compete against us may be inclined to purchase enterprise communications solutions from their current data networking vendor rather than from us. Also, as communications and data networks converge, we may face competition from systems integrators that traditionally have been focused on data network integration. We cannot predict with precision which competitors may enter our markets in the future, what form such competition may take or whether we will be able to respond effectively to the entry of new competitors into our markets or the rapid evolution in technology and product development that has characterized our markets. In addition, in order to effectively compete with any new market entrant, we may need to make additional investments in our business or use more capital resources than our business currently requires or reduce prices, which may adversely affect our profitability.
Our revenues are dependent on general economic conditions and the willingness of enterprises to make capital investments.
One factor that significantly affects our operating results is the impact of economic conditions on the willingness of enterprises to make capital investments, particularly in enterprise communications technology and related services. Although general economic conditions have improved in recent years, we believe that enterprises continue to be concerned about sustained economic growth and they have tried to maintain or improve profitability through cost control and constrained capital spending. Because it is not certain whether enterprises will increase spending on enterprise communications technology significantly in the near term, we could experience continued pressure on our ability to increase our revenue. Our ability to grow revenue is also affected by other factors, such as competitive pricing pressures and price erosion, see Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Trends and Uncertainties Affecting Our Results—Trends and Uncertainties Affecting Our Revenue—Technology transition,” “—Competitive environment’’ and “—Pressures on services business.”
If these or other conditions limit our ability to grow revenue or cause our revenue to decline and we cannot reduce costs on a timely basis or at all, our operating results will be adversely affected.
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Risks Related To Our Operations
We rely on outsourced product manufacturers, distributors and warehousing agents for our products and various issues with respect to the delivery of our products could arise which could adversely impact both our revenue and our costs.
We have outsourced substantially all of our manufacturing operations and we may experience significant disruption to our operations by outsourcing too much of our manufacturing. Our ability to realize the intended benefits of our manufacturing outsourcing initiative depends on the willingness and ability of our contract manufacturers to produce our products. If a contract manufacturer terminates its relationship with us or is unable to fill our orders on a timely basis or in accordance with our quality requirements, we may be unable to deliver the affected products to meet our customers’ orders, which could delay or decrease our revenue or otherwise have an adverse effect on our operations. In fiscal 2006 we experienced these types of disruptions and delays and they impacted our ability to meet timelines for certain of our customer requirements. In addition, we periodically review our product manufacturing operations and consider appropriate changes as necessary. Although we endeavor to appropriately manage any disruption in transitioning from one contract manufacturer to another contract manufacturer, we may experience significant disruption to our operations during any contract manufacturer transition, and did experience such a disruption recently while making this type of transition.
As we continue to seek to optimize our end-to-end supply chain, we have outsourced various logistics functions. We rely on third-party logistics (3PL) service providers to provide certain services for our business, including warehousing, physical distribution, repairs and returns processing. If a logistics service provider does not meet our service level and quality requirements, we may be unable to fulfill our customers’ orders or meet certain customer support obligations in a timely and accurate manner, which could delay or decrease our revenue or otherwise have an adverse effect on our revenue and our costs. In the fourth quarter of fiscal 2006 and first quarter of fiscal 2007, we moved certain warehousing and physical distribution operations to a different 3PL service provider at a new facility. That provider and facility provide our 3PL needs in North America and certain 3PL needs outside of North America. There were disruptions and delays in delivery of certain products from this facility in the first quarter of fiscal 2007. Additionally, there was an adverse impact on our costs at this facility throughout the first half of fiscal 2007. We and the 3PL service provider operating this facility continue to work to promote stability in the 3PL operations there. We have been making improvements as we progress through this transition. However, we cannot assure you that this issue will not continue to have an adverse effect on our revenue and increase our costs.
We also rely on outside sources for the supply of the components of our products and for the finished products that we purchase from third parties. In some cases certain components are only available from a single source or from a limited number of suppliers. Delays or shortages associated with these components could cause significant disruption to our operations. We have in the past experienced component shortages that have affected our operations and we may in the future experience these shortages. Shortages could be a result of manufacturing or capacity issues at our outsourced manufacturers or suppliers or strong demand for certain products for which we have not made adequate forecasts. Our operating results could be adversely affected if shortages or delays persist or if the price of the necessary components increases or the components become unavailable at reasonable prices or at all.
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For more information concerning the risks associated with our contract manufacturers operating internationally, please see “—Risks Related To Our Operations—As our international business has grown significantly in the last fiscal year, changes in economic or political conditions in a specific country or region could negatively affect our revenue, costs, expenses and financial condition.”
If we are unable to integrate acquired businesses into ours effectively, our operating results may be adversely affected. Even if we are successful, the integration of these businesses has required, and will likely continue to require, significant resources and management attention.
We may not be able to successfully integrate acquired businesses into ours, and therefore we may not be able to realize the intended benefits from an acquisition. If we fail to successfully integrate these acquisitions or if they fail to perform as we anticipated, our existing businesses and our revenue and operating results could be adversely affected. If the due diligence of the operations of these acquired businesses performed by us and by third parties on our behalf were inadequate or flawed, or if we later discover unforeseen financial or business liabilities, the acquired businesses may not perform as expected. Additionally, acquisitions could result in difficulties assimilating acquired operations and products and the diversion of capital and management’s attention away from other business issues and opportunities. To the extent that the Company expands internationally through acquisitions and fails to identify and respond to cross-cultural employee issues appropriately, it may fail to retain employees acquired through those acquisitions, which may negatively impact its integration efforts. Acquisitions could also have a negative impact on our results of operations if it is subsequently determined that goodwill or other acquired intangible assets are impaired, thus resulting in an impairment charge in a future period. Finally, acquisitions often necessitate restructurings in order to optimize the operational performance of the combined entity and to control costs and expenses. These restructurings are more difficult due to labor laws and required approvals when the acquired business is a company operating in multiple and/or non-U.S. jurisdictions, which may hinder completion of restructuring actions in a timely and efficient manner and delay anticipated cost savings.
We are dependent on our intellectual property. If we are not able to protect our proprietary rights or if those rights are invalidated or circumvented, our business may be adversely affected.
We believe that developing new products and technology is critical to our success. As a leader in technology and innovation in the telecommunications services, applications and services industries, we are dependent on the maintenance of our current intellectual property rights and the establishment of new intellectual property rights. We generally protect our intellectual property through patents, trademarks, trade secrets, copyrights, confidentiality and nondisclosure agreements and other measures. We cannot assure you that patents will be issued from pending applications that we have filed or that our patents will be sufficient to protect our key technology. Although we have been granted many patents, have obtained other intellectual property rights and continue to file new patent applications and seek additional proprietary rights, there can be no assurances made that any of our patents, patent applications or our other proprietary rights will not be challenged, invalidated, or circumvented. In addition, our business is global and the level of protection of our proprietary technology will vary by country, particularly in countries that do not have well-developed judicial systems or laws that adequately protect intellectual property rights and any actions taken in these countries may have results that are different than if such actions were taken under the laws of the United States. Patent litigation and other challenges to our patents and other proprietary rights are costly and unpredictable and may result in preventing us from marketing and selling a product in a particular geographic area. Patent filings by third parties, whether made before or after the date of our filings, could render our intellectual property less valuable. Competitors and others may also misappropriate our intellectual property, disputes as to ownership of intellectual property may arise and our intellectual property may otherwise fall into the public domain. If
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we are unable to protect our proprietary rights, we may be at a disadvantage to others who did not incur the substantial time and expense required to create the products that we have created.
The failure to maintain adequate security over our information systems could adversely affect our operating results.
We rely on the security of our information systems, among other things, to protect our proprietary information and information of our customers. Information technology system failures, including a breach of our data security, could disrupt our ability to function in the normal course of business by potentially causing, among other things, delays in the fulfillment or cancellation of customer orders, disruptions in the manufacture or shipment of products, or an unintentional disclosure of customer or our information. Additionally, if we do not maintain adequate security procedures over our information systems, we may be subject to consequences such as computer hacking, cyber-terrorism or other unauthorized attempts by third parties to access our or our customers’ proprietary information. Even if we are able to maintain procedures that are adequate to address current security risks, unauthorized users may be able to develop new techniques that will enable them to successfully circumvent our current security procedures. The failure to protect our proprietary information could seriously harm our business and future prospects or expose us to claims by our customers, employees or others that we did not take the appropriate measures to adequately protect their proprietary information. We have taken steps to address these concerns for our information systems by implementing network security and internal control measures. However, an information system failure or data security breach of ours or a third-party vendor could have a material adverse effect on our operating results.
As our international business has grown significantly in the last two fiscal years, changes in economic or political conditions in a specific country or region could negatively affect our revenue, costs, expenses and financial condition.
We conduct significant sales and customer support operations in countries outside of the United States and also depend on non-U.S. operations of our contract manufacturers and our distribution partners. For the first nine months of fiscal 2007 and 2006, we derived 44% and 42% of our revenue, respectively, from sales outside the United States. Our future international operating results, including our ability to import our products to, export our products from, or sell our products in various countries, could be materially adversely affected by a variety of uncontrollable and changing factors. These factors include political conditions, economic conditions, legal and regulatory constraints, currency regulations, health or similar issues, natural disasters and other matters in any of the countries or regions in which we currently operate or intend to operate in the future. Currently, we have concerns about weakness and uncertainty in European economies, including high unemployment levels and low economic growth forecasts, particularly in Germany where we have a high concentration of our business.
Other factors which may impact our international operations include foreign trade, environmental, monetary and fiscal policies, laws, regulations and other activities of foreign governments, agencies and similar organizations, and risks associated with having facilities located in countries which have historically been less stable than the United States. For example, the EU has enacted the RoHS and WEEE directives, which are discussed in Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key Trends and Uncertainties Affecting Our Results—Manufacturing and Logistics.”
Additional risks inherent in our international operations generally include, among others, the costs and difficulties of managing international operations, adverse tax consequences, including imposition of withholding or other taxes on payments by subsidiaries, and greater difficulty in enforcing intellectual property rights. Our effective tax rates in the future could be adversely affected if the geographical distribution of our earnings and losses is unfavorable, by changes in the valuation of our deferred tax assets
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or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. The various risks inherent in doing business in the United States generally also exist when doing business outside of the United States, and may be exaggerated by the difficulty of doing business in numerous sovereign jurisdictions due to differences in culture, laws and regulations.
Fluctuations in foreign currency exchange rates could negatively impact our operating results.
Since a significant portion of our business is conducted outside the United States, we face exposure to movements in currency exchange rates. Foreign currency exchange rates and fluctuations may have an impact on our revenue, costs or cash flows from our international operations, which could adversely affect our financial performance. Our primary currency exposures are to the euro, British pound, Indian rupee and Canadian dollar. These exposures may change over time as business practices evolve and as the geographic mix of our business changes. For example, as our business grows in emerging markets, we may see an increase in our exposure to emerging market currencies, which can have high volatility. An increase in the value of the U.S. dollar could increase the real cost to our customers of our products in those markets outside the United States, and a weakened U.S. dollar could increase the cost of local operating expenses and procurement of raw materials. We may from time to time enter into foreign exchange forward contracts to reduce the short-term impact of foreign currency fluctuations, however, any attempts to hedge against foreign currency fluctuation risks may be unsuccessful and result in an adverse impact to our operating results.
Risks Related to Contingent Liabilities
We may incur liabilities as a result of our obligation to indemnify, and to share certain liabilities with, Lucent in connection with our spin-off from Lucent in September 2000.
Pursuant to the Contribution and Distribution Agreement, Lucent contributed to us substantially all of the assets, liabilities and operations associated with its enterprise networking businesses and distributed all of the outstanding shares of our common stock to its stockholders. The Contribution and Distribution Agreement, among other things, provides that, in general, we will indemnify Lucent for all liabilities including certain pre-distribution tax obligations of Lucent relating to our businesses and all contingent liabilities primarily relating to our businesses or otherwise assigned to us. In addition, the Contribution and Distribution Agreement provides that certain contingent liabilities not directly identifiable with one of the parties will be shared in the proportion of 90% by Lucent and 10% by us. The Contribution and Distribution Agreement also provides that contingent liabilities in excess of $50 million that are primarily related to Lucent’s businesses shall be borne 90% by Lucent and 10% by us and contingent liabilities in excess of $50 million that are primarily related to our businesses shall be borne equally by the parties.
Please see Note 13, “Commitments and Contingencies,” to our Consolidated Financial Statements for a description of certain matters involving Lucent for which we have assumed responsibility under the Contribution and Distribution Agreement.
We cannot assure you that Lucent will not submit a claim for indemnification or cost sharing to us in connection with any future matter. In addition, our ability to assess the impact of matters for which we may have to indemnify or share the cost with Lucent is made more difficult by the fact that we do not control the defense of these matters.
We may be subject to litigation and infringement claims, which could cause us to incur significant expenses or prevent us from selling our products or services.
From time to time, we receive notices from third parties asserting that our proprietary or licensed products, systems and software infringe their intellectual property rights. We cannot assure you that the number of these notices will not increase in the future and that others will not claim that our proprietary or
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licensed products, systems and software are infringing their intellectual property rights or that we do not in fact infringe those intellectual property rights. We may be unaware of intellectual property rights of others that may cover some of our technology. Irrespective of the merits of these claims, if someone claimed that our proprietary or licensed systems and software infringed their intellectual property rights, any resulting litigation could be costly and time consuming and would divert the attention of management and key personnel from other business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. These matters may result in any number of outcomes for us, including entering into licensing agreements, redesigning our products to avoid infringement, being enjoined from selling products that are found to infringe, paying damages if products are found to infringe, and indemnifying customers from claims as part of our contractual obligations. Royalty or license agreements may be very costly or we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to significant damages or an injunction against us or our proprietary or licensed systems. A successful claim of patent or other intellectual property infringement against us could materially adversely affect our operating results. We have made and will likely continue to make investments to license and/or acquire the use of third party intellectual property rights and technology as part of our strategy to manage this risk, but we cannot assure you that we will be successful. We may also be subject to additional notice and other requirements to the extent we incorporate open source software into our applications.
In addition, third parties have claimed, and may in the future claim, that a customer’s use of our products, systems or software infringes the third party’s intellectual property rights. Under certain circumstances, we may be required to indemnify our customers for some of the costs and damages related to such an infringement claim. Any indemnification requirement could have a material adverse effect on our business and our operating results.
If the distribution does not qualify for tax-free treatment, we could be required to pay Lucent or the Internal Revenue Service a substantial amount of money.
Lucent has received a private letter ruling from the Internal Revenue Service stating, based on certain assumptions and representations, that the distribution would not be taxable to Lucent. Nevertheless, Lucent could incur a significant tax liability if the distribution did not qualify for tax-free treatment because any of those assumptions or representations were not correct.
We could be liable for all or a portion of any taxes owed for the following reasons. First, as part of the distribution, we and Lucent entered into the Tax Sharing Agreement, which generally allocates between Lucent and us the taxes and liabilities relating to the failure of the distribution to be tax-free. Under the Tax Sharing Agreement, if the distribution fails to qualify as a tax-free distribution because of an issuance or an acquisition of our stock or an acquisition of our assets, or some other actions of ours, then we will be solely liable for any resulting taxes to Lucent.
Second, aside from the Tax Sharing Agreement, under U.S. Federal income tax laws, we and Lucent are jointly and severally liable for Lucent’s U.S. Federal income taxes resulting from the distribution being taxable. This means that even if we do not have to indemnify Lucent under the Tax Sharing Agreement, we may still be liable for all or part of these taxes if Lucent fails to pay them. These liabilities of Lucent could arise from actions taken by Lucent over which we have no control, including an issuance or acquisition of stock (or acquisition of assets) of Lucent.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
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Item 3. Defaults Upon Senior Securities.
None.
We make available free of charge, through our investor relations’ website, http://investors.Avaya.com, our Form 10-K, Form 10-Q and Form 8-K reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
As disclosed in the Company’s Annual Proxy Statement on Schedule 14A filed with the SEC on December 22, 2006, Mark Leslie, one of the Company’s directors, had previously advised the Board of Directors that he received a “Wells Notice” that the SEC may commence a civil enforcement action against him in connection with his previous services while an employee of Veritas Software Corporation (now Symantec Corporation) in 2000 and 2001. The relevant transactions predated Mr. Leslie’s tenure as a Director of the Company, and the SEC’s inquiry is not directed at, and does not concern, the Company or any other member of the Board of management. On July 2, 2007, the SEC announced that is has filed civil fraud charges in the United States District Court for the Northern District of California against five former executives at Veritas, including Mr. Leslie. The SEC’s complaint alleges that Mr. Leslie, among others, artificially inflated and/or manipulated Veritas’ reported financial results and misled Veritas’ independent auditors in connection with two transactions with AOL in September 2000.
Exhibit Number |
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2.1 |
| Agreement and Plan of Merger, dated as of June 4, 2007, by and among Avaya Inc., Sierra Holdings Corp. and Sierra Merger Corp.(1) | ||
3.1 |
| Restated Certificate of Incorporation of Avaya Inc.(2) | ||
3.2 |
| Amended and Restated By-laws of Avaya Inc., as amended on July 18, 2002.(3) | ||
10.1 |
| Form of Severance Agreement for Senior Officers.* | ||
10.2 |
| Form of Amendment to Severance Agreement for Senior Officers.* | ||
10.3 |
| Avaya Inc. Deferred Compensation Plan, as amended.* | ||
31.1 |
| Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.* | ||
31.2 |
| Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.* | ||
32.1 |
| Certification of Principal Executive Officer pursuant to18 U.S.C. Section 1350.* | ||
32.2 |
| Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350.* |
* Filed herewith.
(1) Incorporated by reference from Exhibit 2.1 to Avaya’s Current Report on Form 8-K filed with the SEC on June 5, 2007.
(2) Incorporated by reference from Exhibit 3.1 to Amendment No. 1 to Avaya’s Registration Statement on Form 10 (Reg. No. 1-15951) filed with the SEC on August 9, 2000.
(3) Incorporated by reference from Exhibit 3.1 to Avaya’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, filed with the SEC on August 14, 2002.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AVAYA INC. | ||
| By: | /s/ AMARNATH K. PAI |
|
| Amarnath K. Pai |
August 6, 2007 |
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