Avaya: An Underappreciated Transformation

Avaya’s (AVYA) transformation story remains on track – its Cloud, Alliance Partner & Subscriptions (CAPS) revenue stream continues to grow strongly, with subscription momentum all set to continue post-4Q as well. Looking past the planned step-up in product investments for FY21, I see the AVYA thesis playing out long term as it continues to unlock margin-accretive growth. Execution is a risk, but at the current ~5x EV/EBITDA multiple, the market might be exercising a little too much skepticism here.

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Subscription Momentum Drives A Strong 4Q Print

AVYA has a strong track record of beating expectations, and 4Q was more of the same – non-GAAP revenue of $757M (+4% YoY; +3% YoY on GAAP numbers) beat consensus, as the shift towards a subscription/cloud-first strategy remained on track. Case in point – the Software and Services revenue mix rose to 88% (vs. 83% in FY19), with recurring revenue also up to 63% (vs. 58% in FY19). The key positive, though, was CAPS revenue, which came in at 33% (vs. 15% in FY19) – beating the initial 30% CAPS target a year ahead of schedule, as AVYA’s transition to the cloud continues to gain traction.

Source: Investor Presentation

As a result, services revenue was unsurprisingly up 18.7% YoY at $488M, driven by the increased adoption of its subscription offering, offsetting declines in Product, which saw continued declines of 14.6% YoY to $269M on hardware-related headwinds. And with CAPS becoming an increasingly larger % of the mix, margins have been expanding as well – adjusted EBITDA margins in 4Q expanded ~2%pts YoY to 26.4%, with cost discipline and COVID-related savings also contributing.

Source: Earnings Release

Breaking Out the Cloud Portfolio

With AVYA’s new cloud KPI metric, OneCloud ARR (OneCloud subscription, ACO recurring, CCaaS, Spaces, CPaaS, Daas, and Private Cloud), which will be a leading indicator of cloud revenue over the next twelve months, investors should have a lot more visibility into the cloud opportunity. As of 4Q, key metrics have been strong – total contract value (TCV) came in at $181M, bringing the total to ~$400M since the 1Q20 launch. Annual recurring revenue (ARR) was also up to $191M in 4Q (vs. $35M in 4Q19 and $113M in 3Q20).

And the growth runway is extensive – AVYA expects OneCloud ARR to double to ~$400M by end-FY21, with a view to breaching the $1B mark by FY23. The added OneCloud disclosure is a step in the right direction, in my view, and continued progress on the cloud portfolio should go a long way toward disproving any lingering skepticism on the execution front.

Source: Investor Presentation

Looking Out for the ACO Ramp

Looking ahead to FY21, I think Avaya Cloud Office (ACO), which is currently a part of CAPS revenue, will be a key driver. While ACO is still in its early phase, with availability limited to the US since its late March launch, AVYA is looking to expand the roll-out to twelve countries by December. This largely reflects the initial traction for ACO, which has been strong and is tracking in line with internal expectations. And expect increasing momentum within ACO through FY21 as well – I think a ramp in ACO revenue to >$50M in FY21 (vs. ~$6M in FY20) is well within reach assuming execution goes according to plan. In addition to ACO traction, progress on Contact Center as a Service (CCaaS) conversions should also be supportive of the AVYA bull case.

Margin Pressure Ahead as Cloud Transition Continues

The FY21 guidance numbers were not particularly great – management assumes growth in the 0-1% YoY range to $2.875B to $2.925B, with EBITDA margins down to 23-24% and cash flow from operations as a % of revenue also set to be lower at 2-3% in FY21 (vs. 5% in FY20). The margin pressure mainly reflects the higher investment needs as AVYA looks to transition to the cloud – specifically, AVYA will incur increased cloud-related R&D and sales & marketing investments in FY21. Additionally, the company also sees travel-related expenses normalizing higher in 2H21.

Source: Investor Presentation

In reaction, the stock sold off post-4Q, although given AVYA’s recent track record of subsequent beats and raises, as well as the underlying growth potential for CAPS revenue, I see ample opportunity for upside to FY21 guidance. Given the guidance for “about a $300 million increase in CAPS revenue,” this would still imply ~$1.1B in CAPS revenue or a ~36% contribution in FY21 (~3%pts higher YoY). Much of this will be led by OneCloud subscription growth (targeted to double in FY21), though any upside from the ACO ramp could also re-rate the stock, in my view.

Undemanding Valuation for an Emerging Cloud Story

AVYA stock has performed well YTD, and rightly so – its transition to a software and cloud subscription-based model has seen early success, now contributing ~26% of FY20 sales. But the shift does come with higher investment needs, likely limiting the margin expansion potential through FY23 before the operating leverage benefits start to kick in.

That said, at the current ~5x EV/EBITDA, the bar isn’t high. The market seems to be exercising too much skepticism on the transformation, in my view, giving investors the opportunity to win both ways – from stronger earnings growth and a multiple re-rating. With cloud ARR set to hit ~5x current levels in FY23, driving overall revenue growth and improving the margin profile, I like the odds.

Downside risks include below par cloud growth on weaker ACO adoption trends, share losses as competition ramps up, as well as any weakness in the enterprise spending environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.