Avaya May Be a Higher Flyer

03/08/2007 12:00 am EST

Focus:

John Buckingham

Editor, The Prudent Speculator

Ticker symbol AV

John Buckingham, president of Al Frank Asset Management, writes in the Prudent Speculator TechValue Report that Avaya, a spin-off from Lucent Technologies, has the right stuff to compete in the new world of Internet telephony.

Initially part of Lucent Technologies itself part of the original AT&T, Avaya (NYSE:
AV -$11.90) was separated from its parent and spun out to shareholders in September 2000. Back then a leader in messaging and structured cabling (network building), Avaya was also a dominant player in sales of enterprise voice communications and call center systems. Such setups were generally known as Private Branch Exchange (PBX) systems, which took a large bundle of lines from the local telecom services providers and created mini-telephone networks--for example, for a corporate office building.

Avaya was already transitioning to the Internet world by tacking on Internet Protocol (IP) enhancements to existing PBX installations and offering advanced “unified messaging” products, meant to pull together voice, fax, and e-mail messages into one easily managed solution. The company also was expanding its telecom gear and applications base to include local- and wide-area networking (LAN and WAN), selling triple-play (video, voice and data) switches and WAN VPN (virtual private network for secure remote connectivity) gear. But fierce competition and ever-evolving technical capabilities and requirements converged with an era-ending slowdown in communications spending.

Downturns often hurt [market leaders] the most. Adjusted for business departures, fiscal 2001 (ended September 30) revenue fell 9% to $6.79 billion. Happily, earnings actually grew to $0.66 per share that year, from $0.55 in 2000. Right at the beginning of its new public-company life, Avaya had embarked on its ”three Rs” strategy--restructuring, reinvestment, and revenue growth. Its focus on cost reduction, containment and overall profitability lifted the bottom line.

The next year, Avaya lost its legs in a hurricane's worth of headwinds. Revenue fell another 27% to $4.96 billion. This time, management couldn't control costs in an orderly fashion, and losses totaled $0.44 per share. By 2003, the unified-messaging-systems and connectivity-solutions businesses were gone, and an extreme focus on IP-based communications put Avaya on the road to recovery.

Though competition--particularly from communications equipment king Cisco Systems, remains brutal--Avaya has managed to maintain its leadership role in enterprise voice communications by parlaying its traditionally strong rapport with corporate-telecom- network specialists into growing brand trust among data-networking folks, who more and more control how enterprise communications traffic travels.

After six quarters of declines, earnings growth turned positive in the first quarter [of fiscal 2007], though revenue gains were a meager 2.5%. We think Avaya's differentiating focus on communications solutions that fit the customer's business model may set it apart from commodity offerings, and surprise us on the top line.

Meanwhile, the cash-rich balance sheet moderates relatively attractive earnings-based valuation metrics, currently 26x [trailing-12-months earnings]. Our current target Liquidity Goal and Fundamental Goal prices for AV shares are $24 and $20, respectively.

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