The State of Avaya

06/11/2004 12:00 am EST

Focus:

Sam Stovall

Chief Investment Strategist, CFRA Research

"Phone users across the globe are switching in rapidly growing numbers from traditional voice systems to telephony systems based on Internet protocol," says Sam Stovall in S&P's The Outlook. "We feel this transition represents a sizable opportunity."

"Avaya (AV NYSE) stands to be the big winner in the switch to IP telephony. Its strategy focuses on its customers' migration from traditional voice systems to IP telephony. We view its large installed customer base, global service organization, and end-to-end product offerings as significant strategic assets. Eventually, we expect the entire global installed base of 400 million phone lines to be converted to the IP platform. Assuming a reasonable technology transition period of ten years, that would imply the need to transfer roughly 40 million lines annually. As only seven million IP lines were shipped during 2003, we think that's a huge opportunity for growth.

"Additionally, Avaya is one of the few large equipment suppliers to offer a large in-house global-service organization. Given these strategic differentiators, we believe Avaya is best positioned to benefit from the large IP-telephony market opportunity. Due to successful restructuring efforts in recent years, we believe Avaya's business model will generate improved margins and profitability along with any incremental increase in revenue. Indeed, for fiscal 2005 (ending September), we estimate earnings per share nearly doubling, to 87 cents, from our fiscal 2004 estimate of 46 cents on modest 7% sales growth but an increasing percentage of next-generation products.

"Avaya trades at a discount to its networking peers, on most relative valuation metrics, including price-to-sales and enterprise value-to-sales. We believe these discounts reflect its core PBX business, which has a slower, more mature growth profile than the industry average. However, we expect the stock's valuation multiples to expand as Avaya successfully shifts its revenue mix to next-generation converged data products. We also believe that recent improvements in its balance sheet and cost structure justify valuation multiples closer to the peer average.

"We think the stock looks most attractive on an earnings basis. With a significantly smaller base of shares outstanding than its peers-and considerable tax-loss carryforwards that should reduce taxes payable-we believe Avaya is better able to create shareholder value. Aided by significant operating leverage, we see fiscal 2005 EPS increasing about 90% from the prior period, vs. an expected 35% average increase for its direct peers. The stock trades at 17 times our fiscal 2005 estimate of 87 cents, for a p-e-to-growth ratio of 1.4 based on our 12% long-term EPS growth rate- well below the industry average. Based on a blend of intrinsic value, as determined by our discounted cash flow model, and relative analysis, largely derived from the group average p-e-to-growth ratio, we arrive at our 12-month target price of $22. Avaya carries our highest investment recommendation of 5 STARS buy rating."

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