Avaya Holdings Corp.
Q3 2019 Earnings Call Transcript

Published: 13 Aug 2019

[Operator:]

Good morning. My name is Marcella, and I will be your conference operator today. At this time, I would like to welcome everyone to the Avaya Third Quarter Fiscal 2019 Financial Results Conference Call and Webcast. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. [Operator Instructions] Thank you.Mr. Mike McCarthy, Vice President of Investor Relations, you may begin your conference.

[Michael McCarthy:]

Welcome to Avaya's Q3 fiscal year 2019 investor call. Jim Chirico, our President and CEO; and Kieran McGrath, our Senior VP and CFO, will lead this morning's call and share with you some prepared remarks before taking your questions.Shefali Shah, our Senior Vice President, Chief Administrative Officer and GC; Chris McGugan, Senior Vice President of Solutions and Technology, are also here for this morning's call.The earnings release, and investor slides referenced on this morning's call are accessible on the Investor page of our website, as well as our 8-K filed today with the SEC and should aid in your understanding of Avaya's financial results. We will reference our non-GAAP financial measures and specifically note that all sequential and year-over-year comparisons reference non-GAAP numbers, except where otherwise noted. A reconciliation of such measures to GAAP is included in the earnings release and investor slides, which are available on the Investor page of our website.We may make some forward-looking statements that are based on our current expectations, forecasts and assumptions, which remain subject to risks and uncertainties that could cause actual results to differ materially. Information about risks and uncertainties may be found in our most recent filings with the SEC, including our Form 10-K and subsequent Form 10-Q reports. It is Avaya's policy not to reiterate guidance, and we undertake no obligations to update or revise forward-looking statements in the event facts or circumstances change, except as otherwise required by law.I will now turn the call over to Jim.

[Jim Chirico:]

Thanks, Mike. Good morning, everyone, and thank you for joining us. Before discussing our third quarter, I’d like to provide two updates. First is an update on the process we are conducting with J.P. Morgan, at this time we are in advanced discussions with multiple parties on a range of strategic transactions to maximize shareholder value. We expect to bring this process to a conclusion within the next 30 days.Second, I’d like to address a goodwill impairment charge that we took this quarter. In short, the recent decline in our stock price and our year-to-date performance prompted an interim goodwill impairment test resulting in a $657 million non-cash charge. Kieran will provide additional context around this charge.Let me start with our results. In the third quarter of fiscal 2019, we delivered revenues of $720 million. Gross margins of 60.8%, adjusted EBITDA of $167 million and we generated $52 million in cash flow from operations. Software and services as a percent of revenue increased to 83.6% and recurring revenue was 59.3%.Importantly, our financial results were above the midpoint of the range demonstrating progress across our business. In particular, I mentioned on our last call, two product transition issues that impacted our performance. I am really happy with the way the company tackled each one of them and the progress that we made.First, we addressed the operational execution issues impacting the transition of our new endpoints. The momentum generated by our new J Series phones has exceeded expectations and sales were up significantly quarter-over-quarter.Second, in the contact center, we successfully achieved a technical deliverable associated with our partner offer and it went GA at the end of June. We have already booked three new deals associated with this solution; have a pipeline of another 20 opportunities, and we’ve launched marketing campaigns into our install base and sales and partner enablement activities are underway. I consider these two issues behind us.Turning to the details of the quarter, we have discussed our strategic growth levers on previous calls, and we are seeing success across all four. First in our core business, we continue to see progress on a number of fronts. As I mentioned, our new endpoints are gaining traction.In total, revenue from the new device portfolio increased meaningfully, both sequentially and year-over-year more than just showing a successful transition, these modern, refresh devices also provide new features and capabilities to our customers including the ability to deliver custom applications via android OS, industry-specific solutions, such as our hospitality endpoints and Open SIP Phones to connect to any IP-based system, just to name a few.In our contact center omni-channel offering, we continue to see improved traction following the release of our 3.6 version of the platform. Bookings increased for the third consecutive quarter and pipeline conversion rates are also increasing. Together, contributions from the new products in our core portfolio continues to increase, proves that our customer-led focus is making a difference.One more point about the improvements in our core. Customers are showing their confidence in Avaya and our innovative capabilities. A clear indicator of this is the health of our upgrade advantage offer. UA is a recurring subscription that entitles customers to upgrade in the future. Renewal rates for this offer returned to historic highs last quarter demonstrating customers’ commitment in Avaya.Second, let me turn to Cloud. Total cloud seats came in at 3.6 million for the quarter. In public cloud, we saw seat growth of over a 170% year-over-year and 24% sequentially. We added nearly 70,000 public cloud seats driven by the continued strength of our powered by NX CaaS Solutions. This brought our public seat count to over 360,000.Equally noteworthy, total contract value or TCV for this solution has more than doubled since the first quarter of the fiscal year. These solutions provide our customers excellent reliability and high ROI. This value proposition is driving strong growth across the U.S. and international markets, particularly in Brazil and the UK.In Q3, we booked 30 million in private cloud-enabled by our ReadyNow solutions. We continued to see impressive demand for ReadyNow across our customer base, which has generated about 75 million TCV since launch. We have recently expanded this capability to The Netherlands, Japan, Australia, Mexico, Brazil and Canada by the end of the calendar year. I am particularly pleased by the continued traction of ReadyNow.Just one example of our recent win, a U.S.-based healthcare provider in the Mid-Atlantic chose to transition to ReadyNow in a deal representing over $10 million in TCV. This customer will implement ReadyNow to support nearly 5,000 UC seats and 650 contact center agents, supplemented with our collaboration and workforce engagement solutions.Once fully implemented, Avaya will displace the West Cloud IVR, the Televox patient appointment reminder, WebEx, Skype and GoToMeeting. Thirdly, in the area of emerging tech, we continue to add value for our customers across multiple segments and delivery models through our reference in mobility and artificial intelligence.In mobility, we began to rollout our call deflection security capability. This allows voice calls to be natively converted into digital interaction before the call connects providing users with greater flexibility and how to maximize their customer experience during these interactions. We are currently implementing this capability into one of the largest logistics management companies in the U.S.An existing customer with more than 25,000 seats, we have also begun to trial with four additional customers. Two BPOs that manage over 60,000 seats and two other enterprise customers with 25,000 and 40,000 seats respectively.We have also initiated proof-of-concept in trials with six existing enterprise-class customers working to upgrade their contact centers by providing them with sentiment and intent analysis designed to improve both the agent and the agent supervisor experience. To-date, our team has processed over 1 million minutes of call analysis using this feature.Our partnership with Afiniti continues to gain traction and we are rolling out 30 new deployments at 15 different companies including some of the industry’s largest BPOs. Our investment in innovation coupled with our customer-driven focus continues to be recognized by third-party analysts. This quarter, IDC recognized Avaya’s leadership in their 2019 Worldwide Unified Communications and Collaboration MarketScape.Lastly in the area of services, we continue to see positive signs in our APCS managed cloud business and especially in the area of maintenance services where revenues were flat to last quarter. Maintenance like our UA offering is a measure of customer long-term commitment to the company.I’d like to share another key area of services’ success. We launched a modernization program called Loyalty Together over a year ago. The purpose of the program is to bring customers at around older releases of CM and CS1K solutions where we have one of our largest maintenance headwinds to a more current level.Last quarter alone, we upgraded 68,000 lines of CS1K and 191,000 lines of CM to the latest version. This not only locks in these customers, but more importantly, gets them current on technology to take full advantage of the spectrum of solutions we can offer. It also pulls through additional services revenues for Avaya and our partners.Success with this program has been a significant contributor to the overall renewal rates and stabilization of our maintenance revenue.Let me share a few more datapoints on how we are successfully competing in the market. In the third quarter, we added roughly 1400 new customers and signed 68 transactions with a TCV over $1 million. This included six deals over $5 million, and one deal over $10 million. Our 1400 new customers this quarter underscores our ability to win new business from our competitors and demonstrates we are delivering compelling value to our customers.Importantly, we maintained our TCV balance of approximately $2.4 billion. Our ability to win multi-million dollar commitments from large organizations across both private and public sector is unique in the industry. This momentum has carried into the fourth quarter. In July and August, we won two landmark contracts with the U.S. Federal government.The first is a 10-year deal with the social security administration worth up to $400 million and it’s to modernize the entire UC and CC infrastructure supporting more than a 100,000 UC ports, 1600 field officers and 12,000 contact center agents.The second is an award to provide secure, fed ramp certified cloud services FedRamp Certified Cloud services across several agencies that could be worth up to several hundred million dollars. Not only do these represent some of the largest wins in the history of Avaya, but more importantly, these service proof points regarding our strategy.The sound investments we are making in innovation and our product portfolio and in our ability to execute. It is also important to note that both of these opportunities were won in partnership with major service providers underscoring the important role SPs and SIs play as part of the broader Avaya channel ecosystem.As I had said previously, we’ve increased our focus and investment in SPs and SIs and it’s beginning to bear fruit. As our third quarter results demonstrate, we are improving our competitiveness winning in the marketplace and are making great progress in the cloud both in private and public. We continue to remain laser-focused on delivering value to our customers and we continue to show signs of pivoting the business to capitalize on our revamped product portfolio.Now, I’ll turn it over to Kieran.

[Kieran McGrath:]

Thank you, Jim, and good morning, everyone. Before we begin, I'd like to mention that all references to financial metrics are non-GAAP unless otherwise indicated. Additionally, please note that we have posted supplementary commentary on our quarterly financial results, as well as any relevant tables and GAAP to non-GAAP reconciliations on our Investor Relations website.Before I discuss our third quarter performance in greater detail, I would like to address the goodwill impairment charge that was disclosed in our earnings press release this morning. Following the sustained decline in our stock price during the third quarter, combined with our year-to-date financial results, the fiscal 2019 reset and the resulting implications to our long range forecast, we determined that a triggering event had occurred and consequently performed an interim goodwill impairment test.As part of the goodwill impairment test, we compare the fair values of our reporting units to their respective carrying amounts, as well as their allocated goodwill that was established as part of first start accounting in December of 2017.Based on the analysis, we determined that the carrying amount for one of the reporting units within our products and solutions segment exceeded its estimated fair value due to our revised outlook. As a result, we’ve recorded a non-cash goodwill impairment charge of $657 million.Further, due to the ongoing review of strategic alternatives, we are not currently in a position to update our long-term outlook at this time. We will provide this information after the conclusion of the process. Our previous expectations that were set at the company’s Investor Day last December are no longer applicable and should not be relied upon given our fiscal 2019 reset.Turning to our third quarter financial results, non-GAAP was in line with our expectations at $720 million, compared to $755 million in the year ago period. Software and services were approximately 84% of non-GAAP revenue while recurring revenue was 59% of non-GAAP revenue. The mix of software and services, as well as recurring revenues improved over the prior year.Cloud was approximately 11% the non-GAAP revenues and was consistent with the prior quarter. Third quarter non-GAAP product revenue was $298 million, compared to $322 million in the year ago period. In our UC portfolio, we saw improved demand for our software solutions driven by both new and capacity transactions offset by a lower contribution from endpoints and gateways.In CC, we saw signs of stabilization in the quarter, as we realized the benefit from updated product releases.Third quarter non-GAAP services revenue was $422 million, compared to $433 million in the year ago period. The year-over-year decline in services revenue was again driven primarily by lower maintenance revenue. However, our overall maintenance renewal rate continued to trend upward in the third quarter helping keep maintenance revenues roughly flat on a sequential basis.While we expect maintenance revenues to remain a headwind to our overall growth outlook, particularly as we migrate customers to our cloud solutions, we are encouraged by the underlying improvements in our maintenance business.Geographically, the U.S. accounted for 55% of our revenue while EMEA, Asia-Pacific and Americas International represented 25%, 12% and 8% of our revenues, respectively.Turning to our profitability metrics, non-GAAP gross margin was 60.8% in the third quarter, compared to 61.9% in the year ago period. Non-GAAP product gross margin was 63.8%, compared to 65.5% in the prior year. Product gross margins benefited from an improved software mix.However, this was more than offset by an unfavorable mix in our hardware portfolio due to larger than mix of servers delivered in the period. Non-GAAP services margin was 58.8%, compared to 59.1% in the prior year.Third quarter non-GAAP operating income was $145 million representing a non-GAAP operating margin of 20.1% and adjusted EBITDA was $167 million representing an adjusted EBITDA margin of 23.2%. Despite lower gross margins, we were able to realize efficiencies across our expenses that helped keep our operating and adjusted EBITDA margins largely unchanged compared to the prior year.Further, we generated $52 million in cash flow from operations, and $15 million in free cash flow. As we mentioned last quarter, we are continuing to see an uptick in capital investments for the continued buildout of our ReadyNow infrastructure to support the solution’s global rollout.Additionally, we ended the third quarter with $729 million in cash and cash equivalents on our balance sheet. Our cash balance decreased modestly on a sequential basis due to an investment in a public sector UCaaS provider with FedRamp security requirement capabilities.Turning to our fourth quarter outlook, we anticipate non-GAAP revenue of between $738 million to $758 million. Our non-GAAP operating margin is expected to be between 22% and 23% and our adjusted EBITDA margin is expected to be between 25% and 26%. We expect our fourth quarter weighted average shares outstanding to be roughly 111 million shares.Turning to our full year outlook. As we highlighted during last quarter’s earnings conference call, our full year guidance consider a few assumptions around the awards and expected revenue recognition of a large contract with a government agency. As Jim mentioned in his prepared remarks, this transaction worth approximately $400 million in TCV over ten years with the sole security administration was awarded at the beginning of our fiscal fourth quarter.While we are pleased that there is no further ambiguity around the timing of the award, there are still some uncertainties around the timing of revenue recognition due to final contracting and issuance of Pos. As such, the low-end of our fiscal fourth quarter revenue guidance continues to contemplate a scenario where we would not recognize any revenue from the SSA contract in the current fiscal year.As such, for the full year, we now anticipate non-GAAP revenues to be in the range of $2.92 billion to $2.94 billion with cloud expected to represent approximately 11% of our revenue. We expect our non-GAAP operating margin for the full year to be between 21% and 22% and our adjusted EBITDA margin to be approximately 24%. We expect our cash flow from operations to be approximately 7% of our revenue.Finally, we expect our full year weighted average shares outstanding to be approximately 111 million shares.Operator, we are now ready to take questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of Raimo Lenschow from Barclays. Your line is open.

[Michael McGuire:]

Hey this is Mike McGuire on for Raimo. Congrats on the quarter guys. You called out and said that two large wins on the federal side in Q4, but can you give a little bit more detail, I guess, into your, like, overall federal pipeline, how that looks kind of going into this quarter and then, on the second question I had – this is more for Kieran, on the public cloud seats, you saw impressive growth again, but can you kind of touch on the timing between converting those seats and the seat growth into more revenues and percent of revenue has kind of remained flat at that 11% for a little while. Thanks again guys.

[Jim Chirico:]

Yes, sure. Hi, Mike. Jim. Thank you very much. Yes, on your first question, actually the government business, it was actually doing quite well. If you remember back in – I think it was December, we signed – or got certification on FedRamp, which has really generated and really lifted the momentum around opportunities for us in the government space coupled with the investment we just made in the last quarter with a partner of ours to further drive additional cloud opportunities and cloud certification in the government.So, we are seeing a significant uplift. In this quarter, obviously, it being the end of the fiscal year for the government is typically a rather large quarter as compared to the other three quarters, but throughout the fiscal year. But, we can’t get into pipeline and opportunities, but I can tell you that, both at a federal level and state and local, the government business is really showing signs of strength and we expect that to continue with the investments that we made as we go into 2020.As far as overall cloud, I’ll turn it over to Kieran to provide some additional color both on the private side as well as on the public side of the business.

[Kieran McGrath:]

So, Mike, to your point, first and foremost on the public cloud activity, we actually saw nice growth, again relatively small dollar amounts in aggregate with good quarter-on-quarter growth in our public cloud seats to go along with that 70,000 seat expansion. As we talked about before, we pay these rebates upfront and we take them all at a point in time.What will happen is, as we go through time and we start to build up a nice recurring revenue base, obviously, the rebates are one-time in nature only and then you start to get the rebounding effect. So we were up strong double-digits just on a quarter-on-quarter basis just on the public cloud along with the 70,000 seats in aggregate.Again, and that’s on the – and that basis have to take into account the impact of those items, the rebate items. When you talk about the ReadyNow and our private cloud, as we mentioned before, the time to – from a booking perspective to revenue recognition, really hinders on the complexity of actually the deployment that the client is engaged with us on.As Jim pointed out in his example in his script, once again we see another big signing this quarter with another great complex – a very complex deployment. We are – we have all t he infrastructure in place as you can see from our CapEx numbers as well. So, we really expect that the growth rate is going to dramatically accelerate for the ReadyNow private cloud aspects when we are in fiscal 2020.

[Michael McGuire:]

Great. Thanks guys.

[Operator:]

Your next question comes from the line of Lance Vitanza from Cowen. Your line is open.

[Lance Vitanza:]

Hi, thanks guys and congratulations on a nice quarter. Couple questions, the first is, could you remind me what’s the typical seasonal revenue pattern you’d expect as you move from Q2 to Q3 and revenue grew sequentially I am trying to put the modest gain into context.

[Kieran McGrath:]

Seven year average was actually flat, it was down actually ten to a point and we were up about almost a point on a quarter-on-quarter basis. So, historically…

[Lance Vitanza:]

Okay.

[Kieran McGrath:]

It would have been flat basically. And then as we look from Q3 to Q4, our average is – excuse me, around between 3% and 4% growth, between 3Q and 4Q.

[Lance Vitanza:]

Okay. That’s great. On the gross margin pressure, now you talked a little bit about this in the prepared remarks, but, was that in line with your business plan? I mean, it seems to some extent that we perhaps should expect continued gross margin pressure given that you are seeking to ramp the revenues, but could you talk a little bit about that and where you would expect gross margins to trend just generally if not qualitatively if not quantitatively?

[Kieran McGrath:]

Sure, sure. So, let me tackle this in a couple of different manners. The first is in aggregate, on a quarter-on-quarter basis, we did see a reduction of about seven tenths of a point versus Q2. That was really all specifically driven by one engagement that we have in Germany, it’s a very complex – we’ve actually been working on it for quite some time.But now we are starting to drive the cost. We expect to start to recognize revenue on those at this particular engagement in Q4. So, it was really a significant amount of cost incurred in the quarter. We’ll start to see the revenue next quarter and that really was responsible to the entire Q3 versus Q2 margin decline.On a year-on-year basis, I would say, if you look, we were down about little over a point, about 1.1 points on year-on-year basis. That’s the same transaction that we talked about drives about half of that value. The other half was actually driven by some promotions that we’ve been driving it.As Jim might have described this Loyalty Together, which is a way that we are able to migrate some of our customers and some of the legacy Nortel and older versions of our UC or a product on to the – on to more recent versions. And what we did was, we had some promotions around some of the devices that we sent out to the customers.That we started that in Q2 of last year, but quite frankly, it sort of peaked in the last couple of quarters, and I think we are kind of stable in that as we go forward. That will become less and less of a headwind. When we think about, where I think your question was going was, what do we expect that the implications from having more cloud in our business.Certainly, there is going to be some headwinds from ReadyNow initially just at the very early stages I’ll tell you really achieved some level of scale.We would hope to put that behind us really quickly after we get through next year. In aggregate, still being a reasonably small part of the total business. Honestly, I don’t think we could – I don’t think we really see a big headwind to margin in aggregate as we look out into the next year as we shift more to cloud.

[Lance Vitanza:]

Okay. Great. And speaking of cloud, just a couple questions there, can you talk at all about what you are seeing in monthly revenue per seat? And then also, how much do the upfront – I think you talked about this last quarter, there is an upfront netting in public cloud of the channel partner fees that net against gross revenues and that – as you grow, as quarter-to-quarter as the number of cloud seats that you are adding expands, and that actually intensifies the pressure a little bit, and I am wondering if you could give us a sense for how much that impacted performance or the reported results in Q3?

[Kieran McGrath:]

Yes, I think it’s probably fair if I think about third quarter year-to-date is probably been a headwind that that half of what our revenue has been. So we would have seen about double the amount of our public cloud revenue this year with the exception of the rebates that we’ve been taking. So, as you say…

[Lance Vitanza:]

And the rebates you are basically, you are sort of frontloading the entire programs worth of fees in t he period in which you turn the revenues on, how long typically when you are setting up these programs? Are these sort of one-year programs, multi-year programs?

[Kieran McGrath:]

Yes, usually, I mean, usually, we take these one-time. Right now, we’ve been trying to take them under one year programs and we’ve seen different types. Obviously, we offer a lot of different models on wholesale across our UCaaS and our CCaaS or SCaaS type offerings. But in general, one year is what we see.

[Lance Vitanza:]

Okay. Thanks very much for the time guys.

[Kieran McGrath:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Nandan Amladi from Guggenheim Partners. Your line is open.

[Nandan Amladi:]

Hi, good morning. Thanks for taking my questions. So, you touched a little bit on this, but how is the reaction been from the partner community on the strategic alternatives process in these past few months?

[Jim Chirico:]

Yes. Hi. This is Jim here. Great question. Look, as we – to be honest, the team has done a really nice job. I mean, if you take a look at, not only from our partner community but also if you take a look at the customer base, I think our sales organization has done a phenomenal job keeping our partners abreast to the situation focusing obviously on what we need to do, deliver the solutions, deliver the technology in order to make them competitive.We have seen – when there is areas and times of uncertainty, the teams have stepped up and have actually done a great job. We’ve kind of been through obviously a situation where we had uncertainty before. But I think they’ve actually prevailed and have done an excellent job staying focused on – at the task at hand and really driving the right solutions to our partner basing community and our customer base.So, we’ve seen a little bit of disruption. We talked about that last quarter. I would say, it’s still there. But it certainly isn’t to where it was in the June quarter, simply because of the timing and number one the team has had an opportunity to continue to operate and everybody understands sort of the environment.I would also say that, if you take a look at the government wins, and you take a look at just the overall number of wins that we’ve had greater than $1 million and the way the business momentum is picking up shows great support for the company and really shows great support for the outlook and more importantly, the roadmap.Once again, we will point out as that SSA win was a competitive displacement as well. So, not only was it significant in size, but we displaced Cisco and - in order to win that deal. So, again, further proof points in our overall product, our overall execution and more importantly the confidence within the company. So, it’s still there.As we said, we expect that within the next 30 days, we will bring it to conclusion, but I think the teams have done an excellent job working through it.

[Nandan Amladi:]

And a quick – thank you for that. A quick follow-up if I might. On the R&D front, we are starting to see some consolidation happen in the CPaaS space and I think on your product roadmap that is different than what we saw at Insight?

[Chris McGugan:]

Hi, Nandan, it is Chris McGugan.

[Nandan Amladi:]

Hi, Chris.

[Chris McGugan:]

We continue to invest in our CPaaS platform. We have a nice book of business both in the U.S. market and in Canada and so we are seeing consolidation across the market space and have built the technology that we have embedded in our solution stack. We are going to make it deeper and grained with some of our premise technology to enable a cloud access into our premise with CPaaS. So you’ll see that as we go into the end of the year.

[Nandan Amladi:]

Thank you.

[Operator:]

Your next question comes from the line of Meta Marshall from Morgan Stanley. Your line is open.

[Erik Lapinski:]

Hi, this is Erik for Meta. Thanks for taking our question. We are just wondering, are there certain verticals or customer types where you are seeing more traction with your public cloud seats?

[Jim Chirico:]

There isn’t any one particular vertical differentiated from another to be honest with you. We were seeing obviously the traction of public cloud is our IP office powered by solution. And we're seeing that obviously – if you take a look at it from a geography perspective, it’s actually doing well across all geographies, whether it’s in Latin America, U.S., UK, Europe, as well.So, not so much, I’ll say vertically dependent. It’s more of a – it’s more driven from our partner community and driven across the board. So, obviously it’s an SMB play for intensive purposes, low end of the mid-market. But I wouldn’t say that’s just one vertical per se that that is really driving it. It’s more broad based across our partner base.

[Erik Lapinski:]

Thank you. That makes sense. And then if I could just another one, are there – do you have any kind of update on the strategic alternatives that you are considering? Maybe the options there?

[Jim Chirico:]

Yes, look, in fairness, and I trust you all can understand, the only comment that we can make at this time is basically what we’ve said and the fact that we are in advanced discussions with multiple parties on a range of strategic transactions to maximize shareholder value and we expect that we will have a conclusion to this process within the next 30 days.So, I can imagine that there are probably many questions about the process in where we are and expected outcomes and so on and so forth. But, I trust you all can understand that these are the only comments we can make at this time.

[Erik Lapinski:]

Thank you.

[Operator:]

Your next question comes from the line of Rod Hall from Goldman Sachs. Your line is open.

[Balaji Krishnamurthy:]

Thanks. This is Balaji on for Rod. If I look to clarify on your Q4 guidance, you mentioned that the government contracts are not being contemplated at the low-end. But in terms of the range of $20 million, how much of that would you expect to be driven by the government contracts?

[Kieran McGrath:]

So, very consistent with what we talked about last quarter when we said the low-end really did not have any of these mega government contract deals and the high-end did. All is a delta between the low-end and the high-end is related to these government contracts and the SSA deal in particular.And it really has to do with just, that we have the award, now we’ve got to go through the contracting with the partner that we are using and then obviously the issuance of Pos. We also think that based upon looking at the award originally, we’ll probably see more of that revenue come to us at a ratable model, more as a sort of a longer term private cloud hosting on our part as well, which is better for us as we think about our long-term business as well we’d like to have a more ratable.But we will have the possibility of some upfront point in time UC product both of some software and a device perspective. And hopefully, we will be able to get some of that done in time for Q4, if not, it rolls into – goes into next year.

[Balaji Krishnamurthy:]

Got it. In terms of the geographical trends, it looks like EMEA stepped down pretty meaningfully this quarter. Any color there?

[Kieran McGrath:]

In any given quarter, one particular deal, one particular large deal like we might have had in the quarter before, can heavily colors that quarter. Honestly, the EMEA team I think were, from a revenue rec perspective hurt us, but actually, it’s pretty well on the booking side of it. So, it has more to do with the size of one particular transaction in any quarter or another can impact it.I think we’d say the sort of the same thing in AI for a couple of larger deals given some of the government issues that have been going on especially in next call in Brazil.The impact is then some stability hit there, we’d expect that to bounce back nicely in Q4. We were happy with the U.S,, which saw a pretty significant quarter-on-quarter increase. Again a lot of that was as we work through some of those device issues that we talked about.

[Balaji Krishnamurthy:]

Okay. And if I could just sneak in one more. The R&D – not R&D, the product gross margins, it looks like the Q4 tends to be a pretty strong quarter, at least in the last couple of years that was the case. If you could comment on, whether there is some underlying drivers that caused that? And if you expect some of the trends in Q4 here?

[Kieran McGrath:]

Yes, I’d say a couple of things, one is, you are right. In aggregate, I would expect to see a bounce back in close to 63% for the quarter just based upon historical trends. In general, what we see especially because of the federal government, outside of the large SSA deal that we are talking about in Q4 tends to be a larger quarter for us with the government we do tend to ship more products.The only thing that might be different is, we never quite know how much of it’s going to be software which is obviously going to have a very, very high gross profit margin versus maybe more of a device, which won’t be quite as healthy. So, there will be some dynamics around that. But I think you are right. I would expect to see a bounce back in margins in total and in the products in Q4.

[Balaji Krishnamurthy:]

Great. Thank you so much.

[Operator:]

[Operator Instructions] Your next question comes from the line of Asiya Merchant from Citigroup. Your line is open.

[Asiya Merchant:]

Great. Thank you very much and congratulations on a good quarter, as well. Kieran, I think at the last earnings call you mentioned something about being able to provide more bookings and billings on a more quarterly basis. So we kind of could see what the book-to-bill ratio is. Is that something that you are able to provide at this point?

[Kieran McGrath:]

Yes, so, not at this point. I mean, clearly, as move out to the time as we want to start to be able to demonstrate and provide the proof points of us as a software and cloud company, we clearly recognize that. My hope is to begin that in the new fiscal year.

[Asiya Merchant:]

Okay. And then, if I look at ASC606 impact and kind of – a little bit more of an apples-to-apples compare it inside excluding the 606 on a 605 basis, the decline is accelerating. Is that an unfair comparison again, as I look at those numbers, basically just looking at what you reported on a non-GAAP basis taking out the ASC606 impact and then comparing it to what it was last year?

[Kieran McGrath:]

In reality, it’s the exact same explanations that I gave you last quarter. As we think about the sort of drag that we are seeing from a 605 perspective, for those contracts that were actually put into retained earnings, we don’t get to recognize those if we had to recognize them, obviously we need to complete customer sign-off.The contracts, if we go back to – if we go back to the beginning of the year and we took this out of backlog and put it into retained earnings, these contracts were by and large heavily professional services contract with a lot of CC content inside of them. These CC contracts tend to be the most heavily customized, the most complex.It’s driving about half that point – half of the decline on a year-over-year basis as we’ve discussed the last time. So, really not much of a change. All I would say is that, right now, we’ve got about 40% of these deals that are 98% or higher, just waiting the final signature sign-off from the customer, so that we can actually bill it from a rep – from a cash perspective.And then, obviously, for this 605, 606 comparison, we'd be able to include to the normalization perspective. But in terms of any change, honestly, it’s the exact same description that I had last quarter and quite frankly I am a little disappointed that I didn’t make more progress in getting more sign-off and customer acceptance.But again, these are pretty complex deals the customers are taking a very long view on. I would hope that this starts to become less was a drag on us, and we are seeing some of this rollover into our cash, as well, we are effecting these from a working capital perspective.So, we’ve got a full core press on now to try and get these things signed off and billed on a much more timely basis. Just so I can start to reduce this drag from a working capital perspective.

[Asiya Merchant:]

Great. And if I can squeeze in one more. Your CapEx requirements that were illustrated on the slide seems to have picked up again into the third quarter 2019 from $100 million to $120 million. If you can explain what’s driving the increase in the CapEx requirement? Is it a function of going towards more private clouds, et cetera? Just so that we can understand as we look forward and model is the shift to cloud driving incremental CapEx and how we should think about that runway rate going into next year?

[Kieran McGrath:]

Right. So, it’s a great question and I would say two things. One is, there is no doubt that ReadyNow in particular, especially as Jim described the rollout, not just in the U.S., but around the world you are seeing an initial increase to start to build out all of our infrastructure.I would say, as we go forward through time, there will promptly be between $20 million to $30 million a year, it’s what we’ve modeled out that we will need for ReadyNow assuming the growth rates that we have projected over the longer time. We also do have some cost from an IT perspective as we have been putting in some additional tools internally to help ourselves move more towards a more of a cloud-oriented company.So, a lot of our different tools even need some level of capitalization taking place with some of the tools that are employing just or how I account for – for how I do 606. So those things like that that I think will flow behind us. I really do think over the long haul of $100 million a year is about the right CapEx number.I do think this year is a little anomalous just because we have the combination of the ramp of ReadyNow, as well as some of this IT tooling for internal IT tools to help us manage the business a little bit more efficiently. I think we’ve put down behind us and we are sort of back on that $100 million runrate longer term.

[Asiya Merchant:]

Okay. And then, the cash that you guys having, the strategic review is underway, but any color you can provide on how the Board is making about $700 million plus the cash that sits on your balance sheet?

[Kieran McGrath:]

Honestly I think, as we said before, I hate to keep giving the same answer, but we probably need to wait for the review since the play out. I think prior to the review taking out, we have always said that the Board did envisioned us having that amount of cash for an extended period of time. So, nothing would have changed from that perspective in terms of the Board’s view. But in terms of the exact disposition of it, I do think we need to look the process play out here over the next 30 days.

[Asiya Merchant:]

Okay. Thank you.

[Kieran McGrath:]

Thank you.

[Operator:]

Your next question comes from the line of Mike Latimore from Northland Capital. Your line is open.

[Mike Latimore:]

Hey. Thanks, I guess, on the cash topic, can you give any guidance on cash taxes sort of next fiscal year?

[Kieran McGrath:]

I don’t want to get ahead of myself in terms of we’ll provide the fiscal 2020 guidance as we exit Q4. At this point in time, I really don’t have anything to say in terms of long-term cash taxes.I don't think it's going to be all that different than what we had advised back in December of last year, maybe modestly, while we are maybe 10-ish million lower as we go through time. But I don’t have an updated view of it just yet that I am ready publish.

[Mike Latimore:]

Very good. Thanks. And then on the – obviously, good trends in public and private clouds. How is the – kind of just general churn in the business? Anything notable from a churn perspective?

[Kieran McGrath:]

From a cloud perspective, most of the deals that we are signing are actually multi-year deals, two years. So we really haven’t experienced any churn to speak of yet in this particular space. If I move away from the cloud, as Jim mentioned in his comments, and I mentioned minus 12, our renewal rates overall for our business from both a maintenance perspective, as well as our upgrade advantage subscription continued to improve and certainly bouncing back from where we were back in chapter 11.

[Jim Chirico:]

Yes, just to add to that, Mike, that, in ReadyNow, we are seeing a nice transition from if you will, GSS maintenance revenues to the cloud solutions. So that’s advantageous to ways, one, just from an overall dollar per seat count and then secondly, obviously from a stickiness perspective embeds us deeper in with our customer base.So, on a positive side, that churn is actually progressing well and some better economics if you will from a company perspective. I think, secondly to that point, is the work that the team is doing in activities around what we call Loyalty Together, as I mentioned and really bringing up releases greater than two releases old and bringing those up to current technology levels, but also doing better than we had anticipated. As Kieran pointed out, we are doing some promos associated with that.But getting folks up to the latest release is obviously helping us in our overall maintenance and renewal rates which are back to all-time high. So, I think from an overall churn perspective, there is certainly some positives that we are seeing in the business. We are seeing our maintenance stabilizing, which is obviously very, very important for us.So – and we look forward to seeing ReadyNow continue to grow as we go through the rest of this, obviously, fiscal year, which is our next six weeks, but certainly as we get into 2020 and beyond.

[Mike Latimore:]

Great. And then, on these two very large deals that you announced, how does that flow into backlog? Should we assume backlog is up materially on these? Or can you just help on the calculation?

[Kieran McGrath:]

Yes, so, we would expect to see, as you can imagine, the way the government tends the contract, they tend to break things up into smaller periods and usually depending on the specific terms, the government always has the right for an annual out. So, usually, again, having seen the exact terms here that will be finally negotiated, but usually book them a year at a time, is what we tended to see.So, I would expect, in Q4, we start to see the benefits of some of these bookings is out enabling us from a TCV perspective. But probably not to the entire $400 million amount more like just the annual portion of that.

[Mike Latimore:]

Kieran, it makes sense. Thanks.

[Operator:]

There are no further questions at this time. I'll turn the call over to Mike McCarthy.

[Michael McCarthy:]

Thanks, Marcella. And thanks everyone, for joining us this morning. We will look forward to speaking with you shortly. Have a good afternoon.

[Operator:]

This concludes today's conference call. You may now disconnect.