Description

AV was separated from Lucent (LU) in September, 2000 through a 1:12 distribution. The timing of the spinoff could not have been worse (or better, depending on your perspective). Since the spinoff, Lucent, a very widely held stock, has issued earnings warnings and disclosed problems related to accounting irregularities and its customer financing practices. Add AV’s label as a “low growth” business to the terrible publicity of its former parent and you have a recipe for indiscriminate dumping of AV shares. AV began trading at $21, but has since nose-dived to its current price. There are only 2 investment banks covering AV.

The company is a provider of communications systems and software to businesses and call centers. The core traditional phone systems business (representing about 40% of sales) is expected to grow at only 1%, but the company’s overall market is growing at 11%. AV is currently trading at a forward P/E (Sep 01) and EV/Sales of only 8.7X and 0.5X. To me, the pricing of MITEL’s (MLT) communications division, a direct comp for AV’s core business, provides a good indicator of AV’s low valuation. The MLT communications division had annualized sales and operating loss of C$620M and (C$14M). MLT recently agreed to sell the division for C$350M or 0.6X sales. AV, on the other hand, had FY 00 adjusted ongoing sales and EBIT of $7,435M and $308M. Keep in mind that MLT’s communications division is a very small and cheap AV comp. (The Form 10 lists several competitors for its different business segments, including Alcatel, Cisco, and Nortel.)

The only way to really get your hands around this investment opportunity is to read the voluminous Form 10, FY 00 results, and the transcript of the Q400 conference call. But here are some of the merits: Management has put in place a large scale restrucutirng program, including the disposal of real estate, outsourcing of most manufacturing, and reduction of G&A. The objective is to achieve an operating margin of 10-12%. AV took a related $684M restructuring charge (most of it will be cash charges) in Q400 and expects a two-year payback on the charge. On Oct 1, Warburg Pincus made a $400M convertible preferred stock investment at approx. $24 per share (which is not reflected in the Q400 balance sheet). AV is the undisputed #1 in its core phone systems business and has a tremendous R&D capability from Bell Labs. AV expects to achieve 16% sales growth in 3-4 years based on the transition to its high growth segments i.e. IP telephony, unified messaging and CRM. The company showed significant improvement in its receivables management in FY 00, resulting in better cash flow. AV has a fat gross margin (about 44%) and low leverage.

Risks: The company experienced “softness” in its traditional telephony products sales in Q400, resulting in a 19% decline in the segment’s Q400 sales(7% decline for FY00); much of the YOY decrease could be attributed to the Y2K ramp up in FY 99 as well as a realignment of the sales force to focus on AV's high growth segments. Then again, the company’s high growth products -- where AV is not a market leader -- may not stand up to the competition. AV’s employee stock options are well underwater.

In FY 00, before any of the restructuring kicked in, AV had ongoing adjusted FY 00 Sales, EBIT, and Capital Employed of $7,435M, $308M, and $1,505M, for an ROCE of 20.5%. I expect that the company will have a much improved operating margin and ROCE going forward. The consensus FY01 and FY02 EPS estimates are $1.27 and $1.82. Too high given the slowing economy and Q4 softness in sales of AV’s traditional telephony products ? Maybe. But I believe the current valuation gives no credit whatsoever to the restructuring that is underway, and allows for a significant margin for error.

Catalyst