Exhibit13**LUCENT TECHNOLOGIES FINANCIAL REVIEW 2006**       Management’s Discussion and Analysis of Financial Condition and Results of Operations    Forward-Looking Statements F-2  Executive Summary F-2  Application of Critical Accounting Estimates F-5  Consolidated Results of Operations F-11  Results of Operations by Segment F-21  Liquidity and Capital Resources F-25  Quantitative and Qualitative Disclosures About Market Risk F-31       Five-Year Summary of Selected Financial Data F-33Report on Internal Control Over Financial Reporting F-34Report of Independent Registered Public Accounting Firm F-35       Consolidated Financial Statements    Consolidated Statements of Operations F-37  Consolidated Balance Sheets F-38  Consolidated Statements of Changes in Shareowners’ Equity (Deficit) F-39  Consolidated Statements of Cash Flows F-40       Notes to Consolidated Financial Statements    1. Summary of Significant Accounting Policies F-41  2. Merger with Alcatel F-45  3. Business Restructuring F-45  4. Business Acquisitions F-47  5. Supplementary Financial Information F-48  6. Earnings Per Common Share F-49  7. Accumulated Other Comprehensive Loss F-50  8. Income Taxes F-51  9. Debt Obligations and Early Extinguishment of Debt F-54  10. Employee Benefit Plans F-57  11. Stock Compensation Plans F-63  12. Operating Segments F-67  13. Financial Instruments F-69  14. Commitments and Contingencies F-73  15. Subsequent Events F-78  16. Quarterly Information (Unaudited) F-79
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**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****FORWARD-LOOKING STATEMENTS**This Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)contains forward-looking statements that are based on future performance, events or developments,including other statements about Lucent’s managements’ future expectations, beliefs, goals, plansor prospects that are based on current expectations, estimates, forecasts and projections aboutLucent, as well as Lucent’s future performance and the industries in which it operates, in additionto management’s assumptions. These statements constitute forward-looking statements within themeaning of the U.S. Private Securities Litigation Reform Act of 1995. Words such as “expects,”“anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,”“estimates,” or variations of such words and similar expressions are intended to identify suchforward-looking statements which are not statements of historical facts. These forward-lookingstatements are not guarantees of future performance and involve certain risks, uncertainties andassumptions that are difficult to assess. Therefore, actual outcomes and results may differmaterially from what is expressed or forecasted in such forward-looking statements. These risksand uncertainties are based upon a number of important factors including, among others:difficulties and delays in achieving synergies and cost savings from our merger with Alcatel; ourability to retain key employees due to uncertainties associated with the merger; our ability tooperate effectively in a highly competitive industry with many participants; our ability to keeppace with technological advances and correctly identify and invest in the technologies that becomecommercially accepted; our reliance on a small number of key customers; fluctuations in thetelecommunications market; fluctuations in our working capital requirements and cash flows; thepricing, cost and other risks inherent in our long-term sales agreements; impairment of goodwill orother acquired intangibles; exposure to the credit risk of our customers; reliance on a limitednumber of contract manufacturers to supply products we sell; the social, political and economicrisks of our foreign operations; the costs and risks associated with our pension and postretirementbenefit obligations; the complexity of our products; changes to existing regulations or technicalstandards; existing and future litigation; difficulties and costs in protecting intellectualproperty rights and exposure to infringement claims by others; and compliance with environmental,health and safety laws. For a more complete list and description of such risks and uncertainties,see the reports filed by us with the Securities and Exchange Commission (the SEC). Except asrequired under the federal securities laws and the rules and regulations of the SEC, we disclaimany intention or obligation to update publicly any forward-looking statements after thedistribution of this MD&A, whether as a result of new information, future events, changes inassumptions or otherwise.**EXECUTIVE SUMMARY**We design and deliver the systems, software and services that drive next-generation communicationsnetworks. Backed by Bell Labs research and development, we use our strengths in mobility, optical,access, data and voice networking technologies, as well as services, to create newrevenue-generating opportunities for our customers, while enabling them to quickly deploy andbetter manage their networks. Our customer base includes communications service providers,governments and enterprises worldwide.There has been some consolidation among service providers as they look to expand their scope andscale while improving cost efficiencies. This industry dynamic presents both challenges andopportunities for equipment vendors. One potential challenge may come in the form of rationalizedcapital spending in the future. In addition, integration activities may delay new networkdeployments. However, we anticipate that there will also be opportunities, as carriers willrequire assistance integrating these large, complex networks. Also, depending on the serviceproviders involved, some of the consolidation could enable certain vendors to extend their reach tocustomers that were previously focused on different technologies or areas.We continue to believe the telecom industry is in the early stages of a multiyear transformation tonext-generation networks. As a result we have been focusing on certain high-growth areas, such asservices, Internet protocol (IP) multimedia subsystem (IMS), broadband access, optical andnext-generation mobile
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high-speed data. As this transformation progresses, our customers are increasingly focused ondeploying new IP-based, revenue-generating services that will differentiate their businesses andbuild customer loyalty. However, the actual trialing, testing and deployment of these newtechnologies will take time. This is a long-term technology transition, which will createopportunities for us and our customers in growth areas such as mobile high-speed data, broadbandaccess, metro optical networking and voice over Internet protocol (VoIP) solutions, as well as inprofessional and managed services. We are working to turn these technologies and opportunitiesinto cost-effective offers for our customers.Within this environment, certain service providers are currently investing to meet growing capacitydemands. These demands are being driven by the coverage requirements, subscriber growth andtraffic increases that place demands on networks of all kinds. In addition, service providers haveincreased investments in the systems, software and technologies that enable next-generationconverged services that cut across wireline and wireless, as well as voice, video and data. Thereis also a growing interest in content such as games, music and entertainment.To meet these challenges, we have been adapting our product portfolio around a common IMS platformthat gives our customers the flexibility to build the types of networks and offer the types ofservices required to best meet the demand for converged broadband services. We combined ourmobility and wireline businesses into a single unit, the Network Solutions Group. This change isenabling us to improve our efficiency, market approach and cost structure. We are also focused onthe following actions: **•** The implementation of a services-led software strategy that combined the networkoperations software business with the Services business, which is expected to bring betteralignment, focus and efficiency.  **•** The optimization of our supply chain network, including the consolidation of our EMS(electronic manufacturing service) providers from four to two.  **•** The continuation of business process simplification efforts across the Company,including corporate center functions.These actions allow us to more effectively focus our efforts and resources on pursuing high-growthareas where we have strong technology, market or customer advantages. We believe that focusing onthese areas will allow us to serve our customers better and provide us with the best opportunity toprofitably grow the business.Capital spending in our target markets can change rapidly and can vary over short periods of time.In addition, the timing of customer orders, deployments and acceptances for large networkbuild-outs as well as the general availability of products and software releases may also impactfuture revenues. As a result of this uncertainty, it is difficult to make accurate forecasts ofnear- and long-term results and cash flow. In addition, because a limited number of customersaccounts for a significant amount of our revenue, our results are subject to fluctuation due tochanges in spending by one or more of these customers. Exposure to this type of fluctuation ismost prevalent in our Mobility Access and Applications Solutions segment.
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The following table includes certain financial information.                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change Mobility Access & Applications Solutions $4,051  $4,660   (13%) $4,166   12%Multimedia Network Solutions (MNS)  1,677   1,563   7%  1,498   4%Converged Core Solutions (CCS)  600   850   (29%)  1,215   (30%)Services  2,313   2,220   4%  2,044   9%Intellectual property  130   113   15%  72   57%Other  25   35   (29%)  50   (30%)                  Revenues $8,796  $9,441   (7%) $9,045   4%                  Gross margin $3,735  $4,124  $(389) $3,779  $345 Gross margin rate  42%  44%  (2pts)   42%  2 pts                                        Operating expenses $3,066  $2,863  $203  $2,560  $303 Percentage of revenue  35%  30%  5 pts   28%  2 pts                   Operating income $669  $1,261  $(592) $1,219  $42 Other income, net  224   114       240     Interest expense  324   341       396     Income taxes  42   (151)      (939)                      Net income $527  $1,185      $2,002                       As discussed in more detail throughout our MD&A: **•** During fiscal 2006, Mobility Access and Applications Solutions revenues decreasedprimarily due to lower CDMA sales particularly in the APaC region. CCS revenues decreaseddue to lower sales of legacy circuit switching and Personal Handyphone Systems (PHS), asdeclines in these product sales continue to outpace growth in spending on next-generationtechnologies. Services revenues increased due to higher deployment services.  **•** During fiscal 2005, Mobility Access and Applications Solutions revenues continued toincrease due to deployment of EVDO and CDMA network expansion in the U.S., as certain ofour large customers increase network investment for high-speed mobile data services anddeploy additional capacity to support subscriber growth. MNS revenues increased due tohigher optical networking sales. CCS revenues decreased due to lower sales of legacycircuit switching and PHS as declines in these product sales continue to outpace growth inspending on next-generation technologies. Services revenues increased due to higherprofessional services and government contracts.  **•** Among other factors, the gross margin rate decreased during fiscal 2006 as a result ofunfavorable mix and lower sales volume. The gross margin rate increased during fiscal2005 as a result of a more favorable mix. The impact of competitive pricing pressurescontinued to be offset by cost reductions in all periods presented.  **•** Fiscal 2006 operating expenses increased primarily due to the Winstar litigation chargeand a lower pension credit offset in part by lower accruals for employee incentive awards.Fiscal 2005 operating expenses increased primarily due to lower recoveries of bad debt andcustomer financing, additional selling expenses to support the Global Sales Organizationand Services growth initiatives and higher charges related to various litigation matters.  **•** The net pension and postretirement benefit credit (net pension credit) was $429million, $718 million and $868 million during fiscal 2006, 2005 and 2004, respectively, and is expected to decline byapproximately $150 million during fiscal 2007.  **•** Valuation allowances were maintained on substantially all of our net deferred taxassets. As a result, federal and certain state and non-U.S. income taxes attributable topre-tax income were
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   not provided during fiscal 2006, 2005 and 2004. However, income tax benefits wererecognized primarily as a result of valuation allowance reversals related to certaincarryback claims and other potential sources of taxable income, including an $816 millionfederal net operating loss carryback claim recognized during fiscal 2004 and additionalbenefits from the favorable resolution of certain income tax audit matters.  **•** Cash and cash equivalents and marketable securities were $3.4 billion and $4.9 billionas of September 30, 2006 and 2005, respectively. During fiscal 2006, cash and marketablesecurities were used to repay long-term debt of $383 million, collateralize a letter ofcredit issued in connection with the Winstar judgment of $311 million and for theRiverstone acquisition of $206 million.**APPLICATION OF CRITICAL ACCOUNTING ESTIMATES**Our consolidated financial statements are based on the selection of accounting policies and theapplication of accounting estimates, some of which require management to make significantassumptions. Actual results could differ materially from the estimated amounts. We believe thatsome of the more important estimates and related assumptions that affect our financial conditionand results of operations are in the areas of revenue recognition, pension and postretirementbenefits, income taxes, legal contingencies and intangible assets.During the fourth quarter of fiscal 2006, we elected to early adopt Statement of FinancialAccounting Standards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans.” SFAS No. 123R, “Share-BasedPayment”, was adopted on October 1, 2005. There were no other accountingpolicies adopted during fiscal 2006 that had a material effect on our financial condition orresults of operations. Refer to Note 1 to our consolidated financial statements for oursignificant accounting policies.**Revenue recognition**Most of our sales are generated from complex contractual arrangements that require significantrevenue recognition judgments in determining the units of delivery and related values, as well asdetermining whether acceptance milestones have been achieved. These judgments are particularlyimportant in the areas of multiple-element arrangements, the application of software revenuerecognition rules and contract accounting and the assessment of collectibility.Revenues from contracts with multiple-element arrangements, such as those including products soldwith installation and integration services, are recognized as the revenue for each unit ofaccounting is earned, based on the relative fair value of each unit of accounting as determined byinternal or third-party analyses of market-based prices. A delivered element is considered aseparate unit of accounting if it has value to the customer on a standalone basis, if there isobjective and reliable evidence of the fair value of undelivered elements in the arrangement, andif delivery or performance of undelivered elements is considered probable and substantially underour control.Many of our products are integrated with software that is embedded in our hardware at delivery. Inthose cases where indications are that software is more than incidental and was a significantfactor in the customer’s purchasing decision, such as where the transaction includes softwareupgrades or enhancements, we apply software revenue recognition rules to determine the amount andtiming of revenue recognition. In multiple element arrangements where software is considered morethan incidental, fair value of an undelivered element is determined using vendor-specific objectiveevidence.The percentage-of-completion method of accounting is used for sales generated from certaincontracts, primarily those related to customized network solutions and network build-outs withdurations of at least six months. We make important judgments in estimating revenue and cost andin measuring progress toward completion. These judgments underlie our determinations regardingoverall contract value, contract profitability and timing of revenue recognition. Revenue and costestimates are revised
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periodically based on changes in circumstances. Revenues recognized under thepercentage-of-completion method of accounting have increased during recent fiscal years,representing 26%, 25% and 24% of total revenues during fiscal 2006, 2005 and 2004, respectively.The threshold for contracts that qualify for the percentage-of-completion method of accounting waslowered to $5 million from $20 million, which resulted in $44 million of additional revenuerecognized during fiscal 2005.The assessment of collectibility is critical in determining whether revenues should be recognized.As part of the revenue recognition process, we determine whether trade and notes receivable arereasonably assured of collection based on various factors. Revenue and related costs are deferredif we are uncertain as to whether the receivable can be collected. Revenue is deferred but costsare recognized when we determine that the collection or sale of the receivable is unlikely.Deferredrevenue was $540 million and $529 million as of September 30, 2006 and 2005,respectively.**Pension and postretirement benefits**Our results of operations include the impact of significant pension and postretirement benefitsthat are measured using actuarial valuations. Inherent in these valuations are key assumptions,including assumptions about discount rates, expected return on plan assets and expectedparticipation rates in retirement health care plans. These assumptions are updated on an annualbasis at the beginning of each fiscal year or more frequently upon the occurrence of significantevents. Changes in the related pension and postretirement benefit costs or credits may occur inthe future due to changes in the assumptions. Our net pension credit was $429 million, $718million and $868 million during fiscal 2006, 2005 and 2004. Approximately two-thirds of these amounts are allocated to operatingexpenses, with the balance in costs used to determine gross margin. This allocation is based on arecent comparison of salaries that are related to costs and those that are related to operatingexpenses. Refer to our “Consolidated Results of Operations” section of this MD&A for a furtherdiscussion of changes in the net pension credit and the related impact on our results.The expected rate of return on pension plan assets used to develop our pension credit was 8.5%,8.5% and 8.75% during fiscal 2006, 2005 and 2004, respectively, and is determined at the beginningof the period. Changes in the rate were generally due to lower expected future returns based onstudies performed by our external investment advisors. Similar changes were made to our expectedrate of return on postretirement plan assets due to lower expected future returns, as well as forchanges in the mix of assets held. A lower expected rate of return reduces our net pension creditand profitability. We plan to use an expected rate of return of 8.5% for the management plan and6.75% for the occupational plans during fiscal 2007 which will result in a weighted average rate ofabout 7.63%. The fiscal 2007 expected rate of return for theoccupational plans reflects a significant change in theallocation of plan assets as more assets are invested in fixed income securities rather than equitysecurities.The discount rate used to determine our pension credit was 5.5%, 5.5% and 5.75% during fiscal 2006,2005 and 2004, respectively. The discount rate is determined at the beginning of the period. Weplan to use a discount rate of 5.75% during fiscal 2007. Changes in the discount rate were due toincreased long-term interest rates. The discount rate is also somewhat volatile because it isdetermined based upon the prevailing rate as of the measurement date. Similar adjustments weremade to the discount rate used to determine our postretirement benefit cost. The discount rateused to determine the postretirement health care benefit costs is slightly lower due to a shorterexpected duration of postretirement health care obligations as compared to pension planobligations. A higher discount rate decreases the plan obligations and increases our net pensioncredit and profitability for those plans where actuarial losses are being amortized. Otherwise, ahigher discount rate decreases our net pension credit and profitability.The expected rate of return on pension plan assets and the discount rate as well as theamortization of actuarial gains and losses were determined in accordance with consistentmethodologies, as described in Note 10 to our consolidated financial statements.
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Mortality assumptions were updated as of September 30, 2005, using actual company experience duringthe most recent four years for retirees and the RP2000 Mortality Table for all other participants.This resulted in an increase in the management pension obligation of approximately $500 million anda decrease in the occupational pension obligation of approximately $200 million during fiscal 2005.Additionally, this change reduced the fiscal 2006 net pension credit by approximately $50 million.Holding all other assumptions constant, a 0.5% increase or decrease in the discount rate would haveincreased or decreased the fiscal 2006 net pension credit by approximately $30 million and $45million, respectively. The impact of changes in the discount rate is different if the resultingactuarial gains or losses are subject to amortization. A 0.5% increase or decrease in the expectedreturn on plan assets would have increased or decreased the fiscal 2006 net pension credit byapproximately $165 million. In addition, a 0.5% increase or decrease in the discount rate wouldhave decreased or increased the fiscal 2006 pension obligation by approximately $1.4 billion andthe postretirement obligation by approximately $240 million.There have been several recent developments related to retiree health care benefits, includingchanges in benefits, cost sharing and legislation, such as Medicare Part D of the MedicarePrescription Drug Improvement and Modernization Act of 2003. These legislative changes and recentexperience with participation rates for management retiree plans have required us to assess theexpected future participation rates of certain retirees in the existing plans. Generally, weassume that approximately 3% to 5% of all retirees subject to cost sharing will opt out of ourplans on an annual basis. The impact of these participation rates favorably impacted our annualnet pension credit and profitability by approximately $30 million during fiscal 2006. The impactof differences between actual and assumed experience will affect our net pension credit andprofitability in the future through the amortization of actuarial gains or losses.We have taken various actions to reduce our share of retiree health care costs during recentperiods, including the shifting of certain costs to our retirees. Our retiree health careobligations are determined using the terms of the current plans. Health care benefits foremployees who retired prior to March 1, 1990 are not subject to annual dollar caps on the Company’sshare of future benefit costs. The benefit obligation associated with this retiree groupapproximated 60% of the total retiree health care obligation. Management employees who retired onor after March 1, 1990 have paid amounts above their caps since 2001. The obligation related toplans covering formerly represented retirees who retired on or after March 1, 1990 assumed thatannual dollar caps are effective and were enforced beginning November 1, 2004. We either waived orincreased these caps in two prior negotiations. Our collective bargaining agreements were ratifiedduring December 2004, and will expire on May 26, 2012.The collective bargaining agreements address retiree health care benefits, among other items. Weagreed to continue to subsidize these benefits up to the established cap level consistent with ourcurrent actuarial assumptions. Except for costs attributable to an implementation period thatended on February 1, 2005, costs that are in excess of this capped level are being borne by theretirees in the form of premiums and plan design changes. We also agreed to establish a $400million trust that is being funded by us over eight years and managed jointly by trustees appointedby the Company and the unions. The trust is being used to mitigate the cost impact on retirees ofpremiums or plan design changes. The agreements also acknowledge that retiree health care benefitswill no longer be a subject of bargaining between the Company and the unions.As a result of these changes, our required obligation for retiree health care benefits increased bythe net present value of the $400 million of committed contributions to the trust during fiscal2005. This incremental cost is being amortized over the contract period. We also considered thesubstantive plan requirements of SFAS No. 106 and have determined that our obligation for retireehealth care benefits is appropriately stated based on our past practice of shifting certain coststo retirees and on the actions that are contemplated as a result of the new agreements. The netpresent value of the required contributions to the new trust is approximately one-third of theamount of the costs that are expected to be in excess of the capped level during the contractperiod.
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The discount rate used to determine the minimum pension liability was 5.75%, 5.5% and 5.5% as ofSeptember 30, 2006, 2005 and 2004, respectively. Changes in the discount rate were due to thereasons described above. Market conditions and interest rates significantly affect the futureassets and liabilities of our pension plans. The minimum pensionliability was eliminated upon the adoption of SFAS 158. Referto Note 10 to our consolidated financial statements foradditional information.The estimated accumulated benefit obligation related to the U.S. management employees’ pension planand several other smaller pension plans exceeded the fair value of the plan assets as of September30, 2005 and 2004. Changes in the minimum pension liability increased our shareowners’ equity by$46 million and $150 million during fiscal 2005 and 2004, respectively. Prior to adopting SFAS158, additional minimum pension liabilities were reduced by $3.2 billion through a direct credit toaccumulated other comprehensive loss. The reduction of these liabilities resulted from plan assetperformance and a higher discount rate used to determine the obligation.**Income taxes**Changes in valuation allowances favorably impacted our results of operations by $229 million, $357million and $1.2 billion during fiscal 2006, 2005 and 2004, respectively. Our valuation allowancefor net deferred tax assets was $7.2 billion and $7.3 billion as of September 30, 2006 and 2005,respectively.We have significant deferred tax assets, resulting from tax credit carryforwards, net operatingloss carryforwards and deductible temporary differences that may reduce taxable income in futureperiods. We also have significant deferred tax liabilities resulting from taxable temporarydifferences that may result in taxable amounts in future periods. Valuation allowances have beenestablished and maintained for deferred tax assets based on a “more likely than not” threshold.Refer to Note 8 to our consolidated financial statements for further components of the deferred taxassets and liabilities and related valuation allowances.The realization of deferred tax assets depends upon the existence of sufficient taxable incomewithin the carryback or carryforward periods under the tax law for each tax jurisdiction. We haveconsidered the following possible sources of taxable income when assessing the realization of thedeferred tax assets: **•** Future taxable income exclusive of reversing temporary differences and carryforwards.  **•** Future reversals of existing taxable temporary differences.  **•** Taxable income in prior carryback years.  **•** Tax planning strategies.We have not relied upon future taxable income exclusive of temporary differences and carryforwardsfor the realization of U.S. deferred tax assets during recent periods. Reliance on this source isdifficult when there is negative evidence such as cumulative losses in recent years, even if incomeis reported in the current period. Cumulative losses weigh heavily in the overall assessment. Wedetermine cumulative losses on a rolling twelve-quarter basis. We are no longer in a cumulativeloss position in the U.S. as of September 30, 2006. Income forecasts were considered inconjunction with other positive and negative evidence, including our current financial performance,our market environment and other factors. Although U.S. profits were generated in recent periodsand we are no longer in a cumulative loss position in the U.S., a substantial amount of the profitswere generated from a pension credit that is not currently taxable. As a result, we concluded thatthere was not sufficient positive evidence to enable us to conclude that it was more likely thannot that the net U.S. deferred tax assets would be realized. Therefore, we have maintained avaluation allowance on our net U.S. deferred tax assets. This assessment will continue to beundertaken in the future. Our results of operations might be favorably impacted in the future byreversals of valuation allowances if we are able to demonstrate sufficient positive evidence thatour deferred tax assets will be realized.We have assumed that all of our deferred tax liabilities will ultimately generate taxable income orreduce potential tax deductions. Most of these deferred tax liabilities are related to prepaidpension costs that result primarily from pension credits that are not currently taxable. The taximpacts for pension, retiree health care and other retiree benefits are usually driven by fundingrequirements. Valuation allowances
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were reversed in recent periods as a result of reductions in net deferred tax assets driven bypension credits. These reversals have resulted in more reliance on the expected reversal oftaxable temporary differences for the realization of deferred tax assets, rather than valuationallowances. We have limited this potential source of future taxable income to the extent of therelated deferred tax assets for retiree benefits after considering potential funding scenarios andactions such as Section 420 transfers. We expect that the deferred taxes associated with retireebenefits will be in a net liability position by approximately $125 million as of September 30,2007, which would result in a corresponding deferred tax charge during fiscal 2007, beginning inthe first quarter.Our assumptions regarding the future tax consequences of retiree benefits might change for variousreasons, including changes in legislation, actual return on plan assets, Section 420 transfers, orchanges in plan design. Such changes could impact our valuation allowance assessment andnecessitate additional charges. In addition, the funded status of our pension, retiree healthcare and other retiree benefits is required to be recognized in the balance sheet as a result ofadopting SFAS 158. The cumulative direct charges in equity to reflect the funded status of thesebenefits were $3.8 billion as of September 30, 2006. If these amounts were to reverse in futureperiods, charges to our results of operations will be required for the related deferred taximpacts. The potential deferred tax charges associated with these liabilities were $1.5 billion asof September 30, 2006.During the fourth quarter of fiscal 2003, we filed a net operating loss carryback claim related tothe carryback of our fiscal 2001 federal net operating loss to 1996, a year in which we filed ourfederal income tax return as part of the AT&T consolidated group. We reached a tentative agreementwith the Internal Revenue Service (IRS) on September 1, 2004 that allowed for a tax refund of $816million (plus statutory interest to the date of payment), subject to approval by the CongressionalJoint Committee on Taxation. The tax benefit related to the claim was not recognized at that timeor prior to that time, because it was related to a complex matter and there was no assurance thatthe approval from the Joint Committee would be obtained. On November 8, 2004, we received writtenconfirmation from the IRS that the Joint Committee had approved our tentative agreement with theIRS and that our agreement with the IRS was final. We were required to reassess the realization ofour net operating loss carryforwards as of September 30, 2004, because the Joint Committee’s finalapproval was received prior to the issuance of our consolidated financial statements. As a result,an $816 million income tax benefit and $45 million of interest income was recognized during thefourth quarter of fiscal 2004 from the reversal of valuation allowances. An additional $41 millionof interest income was recognized during fiscal 2005. The $902 million refund was received duringthe fourth quarter of fiscal 2005.We assess the realization of deferred tax assets in each jurisdiction in a manner similar to thatdiscussed above. We reversed $29 million and $81 million of valuation allowances related tonon-U.S. tax jurisdictions during fiscal 2006 and 2005, respectively. We determined that it wasmore likely than not that these net deferred tax assets were realizable based upon actual financialperformance and future income projections and certain other factors for those jurisdictions. Wewere not in a cumulative loss position in these jurisdictions at the time of the reversals.We assess the likelihood of the ultimate determination of various contingent tax liabilities thatarise in many different tax jurisdictions. These tax matters can be complex in nature anduncertain as to the ultimate outcome. We establish reserves for tax contingencies when we believean unfavorable outcome is likely to occur and the liability can be reasonably estimated, similar toaccounting for other contingencies. Although we believe these positions are fully supportable, weconsider the likelihood of potential challenges and the sustainability of such challenges uponexamination. Changes in our tax reserves have occurred and are likely to continue to occur as ourassessments change based on current facts and circumstances, such as further developments andprogress of tax examinations in various jurisdictions. The net impact of the reassessments of suchchanges, primarily from the finalization of tax audits, resulted in the recognition of income taxbenefits of $18 million, $130 million and $142 million during fiscal 2006, 2005 and 2004,respectively.
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**Legal contingencies**We are subject to proceedings, lawsuits and other claims, including proceedings under laws andgovernment regulations related to securities, environmental, labor, product and other matters.These contingencies are often resolved over long periods of time. We assess the likelihood of anyadverse judgments in or outcomes to these contingencies, as well as potential ranges of possiblelosses. Reserves are established when it is probable that a liability has been incurred or anasset has been impaired and the amount of the loss can be reasonably estimated based on a detailedanalysis of each individual issue, often with the assistance of outside legal counsel. We alsodetermine whether disclosures are required for each contingency based on this assessment. Thereare several hundred contingencies that are currently being assessed. Most of these contingenciesare not currently reserved because we have determined that it is not probable that a loss has beenincurred. New developments, such as a change in settlement strategy or an adverse court ruling,may change our assessment as to the likely outcome or potential range of possible losses. Our mostsignificant reserves are related to environmental matters that are discussed in Note 14 to ourconsolidated financial statements along with our other significant matters.**Intangible assets**Our intangible assets include goodwill and other acquired intangibles of $607 million, developmentcosts for software to be sold, leased or otherwise marketed of $242 million and internal usesoftware development costs of $97 million as of September 30, 2006. As a result of the Riverstoneacquisition in fiscal 2006, goodwill and other acquired intangible assets of $186 million wererecorded. Refer to Note 4 to our consolidated financial statements for information related to thepurchase price allocation.Goodwill is not amortized but is tested for impairment annually, or more often, if an event orcircumstance indicates that an impairment loss may have been incurred. Other intangible assets areamortized on a straight-line basis over their estimated useful lives and reviewed for impairmentwhenever events such as product discontinuances, plant closures, product dispositions or otherchanges in circumstances indicate that the carrying amount may not be recoverable. The annualgoodwill impairment tests completed during the fourth quarter of fiscal 2006, 2005 and 2004 did notresult in an impairment loss.As of September 30, 2006, goodwill and acquired intangible assets of $607 million are assigned toreporting units, including $240 million to the data networking reporting unit within the MNSsegment, which includes Riverstone-related products, and $174 million to the next-generationconverged core solutions reporting unit within the CCS segment, which includes Telica-relatedproducts. The estimated fair value of the reporting units used in the most recent impairment testwas determined using projected cash flows over a seven-year period discounted at a range of 10% to25% plus a terminal value. The carrying amounts for the data networking reporting unit andnext-generation converged core solutions reporting unit exceeded the estimated fair value withoutconsidering the terminal value. If the expected results for these two reporting units are notrealized, particularly the next-generation converged core solutions reporting unit, which generatedlosses in fiscal 2006 and 2005, impairment charges may be required in the future.Software development costs related to UMTS technology were expensed as incurred during fiscal 2006,2005 and 2004.
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**CONSOLIDATED RESULTS OF OPERATIONS****Revenues**                           Years ended September 30, (in millions) 2006      2005      2004     Mobility Access & Applications Solutions $4,051   46% $4,660   49% $4,166   46%Multimedia Network Solutions (MNS)  1,677   19%  1,563   17%  1,498   17%Converged Core Solutions (CCS)  600   7%  850   9%  1,215   13%Services  2,313   26%  2,220   24%  2,044   23%Intellectual property  130   2%  113   1%  72   1%Other  25   —   35   —   50   —                       Revenues $8,796   100% $9,441   100% $9,045   100%                       U.S. $5,881   67% $5,936   63% $5,517   61%Other Americas (Canada, Caribbean &Latin America)  703   8%  728   8%  537   6%EMEA (Europe, Middle East & Africa)  1,354   15%  1,337   14%  1,292   14%APaC (Asia Pacific & China)  858   10%  1,440   15%  1,699   19%                      Revenues $8,796   100% $9,441   100% $9,045   100%                      Fiscal 2006 vs. 2005Revenues decreased by 7% during fiscal 2006. The decrease was primarily driven by lower MobilityAccess and Applications Solutions and CCS revenues. Refer to the segment discussion later in thisMD&A for information on changes in revenues by segment and product.The revenue decrease in the U.S. during fiscal 2006 was primarily due to lower sales from our twolargest customers. Sales to these two customers decreased by approximately $280 million andaccounted for 40% of our consolidated sales during fiscal 2006. The decrease in Other Americas wasdue to lower sales in Canada. The increase in EMEA was primarily due to higher sales in datanetworking products and services, partially offset by lower sales in Mobility products. Thedecrease in APaC was primarily due to lower CDMA sales in China driven by further delays in theissuance of 3G licenses, the continuing reduction in PHS sales in China and to a lesser extent, ourlimited participation in highly competitive market opportunities in India. Revenues from customersin China represented 4% and 9% of consolidated revenues during fiscal 2006 and 2005, respectively,and are expected to continue to decline due to further delays in the issuance of 3G licenses andthe continuing reduction in PHS sales and other unfavorable conditions.Our revenues are subject to fluctuation as a result of changes in customer spending patterns andshort-term capital requirements, as well as the timing of customer acceptances. Changes in foreigncurrency rates did not have a material impact to our consolidated revenues during fiscal 2006.Fiscal 2005 vs. 2004 Revenues increased by 4% during fiscal 2005. The increase was primarily driven by higher MobilityAccess and Applications Solutions revenues, particularly in the U.S., and to a lesser extent, byhigher Services revenues. Converged Core Solutions revenues continued to decline.The increase in the U.S. was due to higher spending by our two largest customers to upgrade theirCDMA wireless networks and deploy additional capacity to support subscriber growth. Sales to thesetwo customers increased by approximately $500 million and accounted for 36% of our consolidatedsales during fiscal 2005. The increase in Other Americas was due to higher CDMA sales in Venezuelaand various product sales in Canada. The increase in EMEA was primarily due to higher sales ofcertain wireline products and services, as well as favorable foreign currency impacts in Europe.The decline in APaC was primarily due to lower voice networking sales in China, primarily in PHSsales, and the timing of CDMA network deployments in Korea, as well as the completion of a majorCDMA project in India
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during fiscal 2004. Revenues from customers in China represented 9% and 10% of consolidatedrevenues during fiscal 2005 and 2004, respectively.**Gross Margin**               Years ended September 30,(in millions) 2006 2005 2004Gross margin $3,735  $4,124  $3,779 Gross margin rate  42%  44%  42%The cost of materials, components and manufacturing that are sourced from third parties are themost significant items used in determining our gross margin. These costs are negotiated throughsupply agreements and fluctuate with changes in sales volume. Employee-related costs, such assalaries and related benefits associated with services, logistics and warehousing and other directsupply chain functions, are also included. Employee-related costs will not usually fluctuate basedon changes in sales volume. However, employee-related costs may change as a result of actions toalign our resources to market conditions, annual salary or wage increases or changes in employeebenefits, including those related to pension or health care costs for active employees andretirees. A portion of employee-related costs are subject to collective bargaining agreements.To a lesser extent, amortization of software development costs, certain other overhead itemsrelated to IT and facility related costs, as well as charges associated with warranty and inventoryvalues, are also used in determining gross margin. In assessing the ultimate realization ofinventories, we make judgments as to future demand requirements and compare these with the currentor committed inventory levels. Reserve requirements generally increase when projected demandrequirements decrease due to market conditions, technological and product life cycle changes andlonger than expected usage periods. It is possible that changes in inventory reserves may berequired if there is a rapid change in the demand for our products due to fluctuations in marketconditions or to new technological developments. Most of the costs used in determining grossmargin are included in our reportable segments.Our gross margin rate is subject to fluctuation due to changes in volume, geographic, product andservice mix, the impact of significant inventory-related or warranty charges and revisions toestimates related to long-term contracts. Changes in estimates related to long-term contractscould occur throughout the execution of a project as a result of changes in previously expectedcosts, contract change orders or the resolution of project contingencies, among other items.Changes in the expected profitability for a contract are reflected in results during the periodthat they are determined, based on the project’s percentage of completion to date. As a result,the cumulative effect of any changes would be reflected in the results of the current period.Our gross margin rate may also be impacted by other factors, such as competitive pricing pressures,the initial impact of sales of certain next-generation products, our efforts to enter emergingmarkets and our ability to continue realizing cost reductions. We operate in highly competitivemarkets that are subject to pricing pressures for various reasons, including technological changes,new entrants and supply and demand fluctuations. Although we believe that these impacts havereduced our relative revenue levels from prior periods, our gross margin has not been significantlyimpacted due to our ability to realize cost reductions.The following factors impacted our consolidated gross margin rate during fiscal 2006: **•** The impact of a lower net pension credit decreased the gross margin rate by onepercentage point.  **•** The impact of lower accruals for employee incentive awards increased the gross marginrate by one percentage point.  **•** Historically, our gross margin rate is generally higher in our wireless business ascompared to our wireline and services businesses, and higher in the U.S. as compared tonon-U.S. regions. The
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   unfavorable impact of the lower percentages of Mobility Access and Applications Solutionsrevenues to the consolidated revenues and other factors including pricing and product mixaccounted for a decrease of approximately two percentage points in the gross margin rate.The following factors impacted our consolidated gross margin rate during fiscal 2005: **•** The consolidated gross margin rate increased due to lower employee incentive awards anddecreased due to a lower net pension and postretirement benefit credit. The net impact ofthese items increased the consolidated gross margin rate by one percentage point.  **•** The net impact of higher provisions for slow moving and obsolete inventories, customerand supplier contract settlements, warranty expenses, and certain customer obligationsdecreased the consolidated gross margin rate by one percentage point.  **•** Historically, our gross margin rate is generally higher in our wireless business than inour wireline and services businesses, and higher in the U.S. than in non-U.S. regions. Thefavorable impact of the higher percentage of Mobility Access and Applications Solutions andU.S. revenues on the consolidated revenues, cost reductions and revised estimates relatedto long-term contracts was offset by other factors including pricing and product mix. Thenet effect of these items increased the consolidated gross margin rate by approximately twopercentage points from the comparable prior year period.**Operating Expenses**                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change Marketing and sales (M&S) $891  $955  $(64) $903  $52 General and administration (G&A)  628   794   (166)  620   174                 Selling, general and administrative (SG&A)expenses, excluding the following three items:  1,519   1,749   (230)  1,523   226 Winstar litigation  278   —   278   —   — Provision for (recovery of) bad debts andcustomer financings  4   (69)  73   (230)  161 Amortization of other acquired intangibleassets  27   16   11   3   13                 SG&A  1,828   1,696   132   1,296   400 Research and development (R&D)  1,177   1,177   —   1,270   (93)Merger related expenses  45   —   45   —   — In-process research and development (IPR&D)  12   —   12   14   (14)Business restructuring  4   (10)  14   (20)  10                 Operating expenses $3,066  $2,863  $203  $2,560  $303                 Salaries and related employee benefits associated with product development, selling andadministrative functions are the most significant costs included in operating expenses. Theseemployee-related expenses do not fluctuate significantly with short-term changes in revenue levels.However, employee related expenses may change as a result of salary increases or changes inrelated benefits, as well as changes in workforce levels. Salary increases are generally providedto employees on an annual basis and were increased by approximately 3 percent effective in December2005. Changes in the funding levels of short- and long-term employee incentive awards may alsoimpact trends between various periods. Operating expenses are also reflected net of a creditattributed to pension, postretirement and postemployment benefits that are discussed in more detailthroughout this MD&A. Changes in this net credit will impact the trends between various periods.To a lesser extent, third-party consulting fees and certain other overhead items, such asinformation technology- and facility-related costs are also included in operating expenses. Mostof the SG&A expenses are included in our Global Sales Organization and shared services, such asgeneral corporate functions. In contrast, most of the R&D expenses are directly associated withresearch and product development for our wireline and wireless products and included in ourreportable segments.
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Operating expenses increased during fiscal 2006, primarily due to the Winstar litigation charges.The impact of annual salary increases and a lower net pension and postretirement benefit creditalso contributed to the increase. However, this impact was offset by lower accruals for employeeincentive awards due to lower than targeted performance in the current year period and slightlylower average workforce levels. The net effect of these compensation and benefit matters impactedM&S, G&A and R&D trends. Our reportable segment results were not impacted by the changes in thenet pension and postretirement benefit credit or changes in the funding of employee incentiveawards.***SG&A***Fiscal 2006 vs. 2005SG&A decreased by 13% in fiscal 2006, excluding the impact of the Winstar litigation charge, baddebt and customer financing and amortization of other acquired intangible assets. Reductions of$126 million were primarily attributed to lower average workforce levels and lower overhead fromthe general corporate centers and the global sales organization. Lower accruals for employeeincentive awards of $115 million (including lower sales compensation) and lower litigation chargesof $100 million also contributed to the decrease.The impact of these items more than offset an $87 million lower net pension and postretirementbenefit credit, $16 million of higher stock-based compensation expense and less favorablesettlements of non-income tax matters and other disputes of $8 million. SG&A charges related tovarious litigation matters were $14 million and $114 million during fiscal 2006 and 2005,respectively.Fiscal 2005 vs. 2004SG&A increased by 15% in fiscal 2005, excluding the impact of bad debts and customer financings andamortization of other acquired intangibles. Changes in SG&A included the impact of compensationand benefit matters discussed above and higher selling expenses to support the global salesorganization and Services growth initiatives, including the government market.During fiscal 2005, SG&A included approximately $10 million of lower employee incentive awards andapproximately $50 million of a lower net pension credit. SG&A charges related to variouslitigation matters were $114 million and $34 million during fiscal 2005 and 2004, respectively.***Provision for (Recovery of) Bad Debts and Customer Financings***Net recoveries during fiscal 2005 and 2004 were due to the favorable settlement or sale of certainfully reserved notes receivable and accounts receivable and significantly lower bad debt andcustomer financing exposure. These settlements generally occur as a result of the resolution ofwork-outs and consummation of bankruptcy proceedings. The charges for bad debt and customerfinancings were $20 million, $14 million and $24 million during fiscal 2006, 2005 and 2004,respectively.A considerable amount of judgment is required in assessing the realization of trade receivables andnotes receivable, including the current creditworthiness of each customer and the related aging ofpast due balances. Reserves for trade receivables are determined by using percentages applied tocertain categories of aged receivables. Specific accounts are also evaluated when we become awareof information indicating that a customer may not be able to meet its financial obligations due toa deterioration of its financial condition, lower credit ratings or bankruptcy. Reserverequirements are based on the best facts available to us and are re-evaluated and adjusted asadditional information is received. Typically, reserves are reduced only when agings improve orcustomer settlement proceeds are recovered. Recoveries are generally the result of directnegotiations with the customer, resolutions in bankruptcy or legal actions. Additional charges orrecoveries may occur in the future.
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***R&D***Our R&D investment is focused on enhancing, expanding and evolving our broad portfolio of leadingedge technologies and reshaping our product portfolio to capture convergence opportunities. Inaddition, our R&D investment also supports Bell Labs long-term research programs in such areas ascomputer science, materials science and bioengineering. We believe our current R&D spending levelsand plans are aligned with current and expected market opportunities.R&D costs are charged to expense as incurred. However, the costs incurred for the development ofcomputer software that will be sold, leased or otherwise marketed are capitalized whentechnological feasibility has been established. The amortization of these costs is reflected as acost component in determining our gross margin. Unamortized software development costs determinedto be in excess of the net realizable value of the product are expensed immediately and reflectedin R&D if such determination is made prior to when the product is available for general release tocustomers.               Years ended September 30,(in millions) 2006 2005 2004Cost capitalized $230  $232  $258 Amortization  230   262   281 Fiscal 2006 vs. 2005R&D expenses were flat in fiscal 2006. Lower accruals for fiscal 2006 employee incentive awardswere $97 million. Lower average workforce levels and less discretionary spending of $37 millionwere primarily from the Services organization. The impact of these items was offset by a $111million lower net pension credit and $23 million of higher stock-based compensation expense.Fiscal 2005 vs. 2004R&D decreased by 7% in fiscal 2005, primarily due to changes in compensation and benefit matters aswell as to recent cost-reduction actions in our wireline business. During fiscal 2005, R&Dincluded approximately $135 million of lower employee incentive awards and approximately $55million of a lower net pension credit.***Merger related expenses***Merger related expenses included proxy material costs and third party professional fees that aredirectly attributable to the merger transaction with Alcatel.***IPR&D***IPR&D charges resulted from the Riverstone acquisition during fiscal 2006 and the Telicaacquisition during fiscal 2004. IPR&D represents technology that has not reached technologicalfeasibility and has no alternative future use. Refer to Note 4 to our consolidated financialstatements for information regarding the purchase price allocation.***Goodwill Impairment and Amortization of Other Acquired Intangible Assets***The increase in the amortization of other acquired intangible assets were related to theacquisition of Riverstone and Telica, respectively. Refer to the “Application of CriticalAccounting Estimates” for further discussion.
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***Business Restructuring***               Years ended September 30, (in millions) 2006  2005  2004           Employee separations $—  $(5) $(14)Contract settlements  (1)  (2)  (15)Facility closings  5   (3)  12 Other  —   —   (3)          Restructuringcosts (reversals)  4   (10)  (20)Asset write-downs  —   —   1 Net gains on sales  —   —   (1)          Net charges(reversals) $4  $(10) $(20)          During fiscal 2001, we committed to and began implementing a restructuring program to realignresources to focus on the large telecommunications service provider market. We assessed ourproduct portfolio and associated R&D and then streamlined the rest of our operations to supportthose reassessments. We eliminated some marginally profitable or non-strategic product lines,merged certain technology platforms, consolidated development activities, eliminated managementpositions and many duplications in marketing functions and programs, centralized our sales supportfunctions and sold or leased certain of our manufacturing facilities and made greater use ofcontract manufacturers. We sold or disposed of the assets related to the eliminated product lines,closed facilities and reduced the employee workforce on a global basis.The restructuring actions have been completed. However, the related reserves reflected manyestimates, including those pertaining to employee separation costs, inventory, contractualobligations, facility exit costs and proceeds from asset sales. The individual plan’s reserverequirement under our restructuring program was reassessed at the end of each reporting period.Actual experience has been and may continue to be different from these estimates. Reversals orcharges related to revisions of our estimates for certain restructuring plans initiated in priorperiods were primarily due to the following: **•** Reversals of employee separation charges were primarily due to differences in theactual versus assumed demographics of separated employees, including age, length ofservice and salaries.  **•** The net contract settlement reversals were the result of settlements of certaincontractual obligations and purchase commitments for amounts lower than originallyestimated.  **•** Charges or reversals related to facility closings were primarily due to revisedestimates of costs and expected sublease rental income on certain properties resultingfrom changes in the commercial real estate market.The remaining reserve requirements are related to leases on exited facilities as of September 30,2006. Facility exit costs of $113 million are expected to be paid over the remaining lease termsand are reflected net of expected sublease rental income of $68 million. Expected marketconditions for commercial real estate are received from real estate brokers for most facilities andare considered in estimating the sublease rental income. Additional charges or reversals may berequired if the expected amount of sublease rental income changes in the future or if othercircumstances change.
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**Pension, Postretirement and Postemployment Benefits**               Years ended September 30, (in millions) 2006  2005  2004           Pension benefit credit $(660) $(973) $(1,111)Postretirement benefit cost  231   255   243           Net pension and postretirement benefitcredit $(429) $(718) $(868)                       Postemployment benefit cost $91  $72  $40           We maintain defined benefit pension plans covering the majority of employees and retirees, as wellas postretirement benefit plans for U.S. retirees that include health care, dental benefits andlife insurance coverage. Additionally, we offer various postemployment benefits to certainemployees after employment but before retirement, including disability benefits, severance pay andworkers’ compensation.The pension credit is determined under complex rules using actuarial assumptions. The rulesprovide for various smoothing techniques under which gains and losses are spread over futureperiods. The largest component of the pension credit is the expected return on plan assets. Thisamount is partially offset by the assumed interest cost on the benefit obligations, the servicecosts and amortization of unrecognized gains and losses. Our pension plans are well funded. Thefair value of pension plan assets was $35.1 billion and exceeded the related benefit obligation by$5.2 billion as of September 30, 2006. Significant pension actuarial assumptions for fiscal 2006expense include an 8.5% expected rate of return on plan assets and a 5.5% discount rate used indetermining the interest cost. This 3% rate differential is a significant reason why we recognizea pension credit. The postretirement benefit costs are determined in a similar manner. However,most of these benefit obligations are unfunded, and therefore the interest costs on the benefitobligations exceed the expected return on plan assets.Approximately two-thirds of the netcredit is reflected in operating expenses, with the balance in costs used to determine grossmargin.The decrease in the net pension and postretirement benefit credit during fiscal 2006 was primarilydue to: **•** Reductions in the market-related value of plan assets due to the impact of actual lossesincurred on plan assets during fiscal 2002 and 2001.  **•** Changes in mortality assumptions as of September 30, 2005.The decrease in the net pension and postretirement benefit credit during fiscal 2005 was primarilydue to: **•** Reduction in the market-related value of plan assets due to the impact ofactual losses incurred on plan assets during fiscal 2002 and 2001.  **•** Reduction in the expected rate of return on pension plan assets.  **•** Impact of the collective bargaining agreements that were ratified in December 2004.However, these items were partially offset by the impact of the following items: **•** Reduction in the discount rate.  **•** Full year recognition of the prescription drug benefit under Medicare Part D ofthe Medicare Prescription Drug Improvement and Modernization Act of 2003 (the MedicareModernization Act) and expected reduction in plan participation rates as a result of recentexperience and the Medicare Modernization Act.During the third quarter of fiscal 2006, the allocation of U.S. pension plan assets was changed aspart of a routine periodic review. The overall pension plan asset portfolio now reflects a balanceof investments split about 50/50 between equity and fixed income securities compared to theprevious split of about 75 percent equity and 25 percent fixed income. We believe this action wasprudent given the demographics, funded status and future obligations for our pension plans.The shift in asset allocation from equities to fixed income securities related to the occupationalpension
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plan whose participants include formerly represented retirees. Assets in this pension plan arecurrently well in excess of liabilities, and the plan fiduciaries, acting in accordance with advicefrom an independent external asset allocation advisor, determined that a higher allocation to fixedincome securities would be in the best interests of the plan participants.As a result of this change in asset allocation, we currently anticipate the expected rate of returnon plan assets will decrease by about one percentage point during fiscal 2007. The fiscal 2007 netpension credit will be impacted by this change as well as by other important factors such as a 25basis point increase in the discount rate, driven by prevailing interest rates at September 30,2006 and differences between our actuarial assumptions and actual results for this fiscal year. Wecurrently expect a reduction in the fiscal 2007 net pension credit of approximately $150 million asa result of these changes and factors. Actual result may differ from these preliminaryexpectations.Refer to Note 10 to our consolidated financial statements and the “Application of CriticalAccounting Estimates” for further information.**Stock-Based Compensation Expense**SFAS 123R was adopted on October 1, 2005 and requires among other items, the recognition of stockoption expense in the results of operations. The modified prospective transition method waselected, therefore prior period results were not restated. Stock-based compensation expense was$85 million and $35 million during fiscal 2006 and 2005, respectively.Stock-based compensation expense recognized in the results of operations during fiscal 2006 was$182 million lower than the pro forma amount determined under the fair value-based method anddisclosed in accordance with SFAS 123 for fiscal 2005. This reduction was primarily due to theamortization of previously unvested awards over the original vesting periods and lower fair valueamounts attributed to the more recent awards. There were no significant modifications to existingawards or acceleration of vesting periods during fiscal 2006 and 2005.Refer to Note 11 to our consolidated financial statements for more information on stock-basedcompensation.**Other Income, Net**               Years ended September 30, (in millions) 2006  2005  2004           Interest income $177  $121  $89 Interest income on tax refunds and settlements  3   88   135 Legal (settlements) recoveries  18   (65)  (84)SEC settlement  —   —   (25)Winstar post-judgment interest  (9)  —   — Minority interest  34   (30)  (6)Other-than-temporary write-down of investments  (8)  (20)  (22)Gain (loss) on sale of investments  (14)  (4)  75 Loss on extinguishment of convertible securities and debt, net  —   (11)  (7)Other, net  23   35   85           Other income, net $224  $114  $240           Fiscal 2006The increase in interest income was primarily due to higher average marketable securities balancesand higher interest rate yields.Legal (settlements) recoveries during fiscal 2006 were related to a third party indemnificationassociated
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with the previously settled consumer products leasing lawsuit. Refer to Note 14 to ourconsolidated financial statements for more information on legal settlements.One of our joint ventures recognized a loss during fiscal 2006. The loss recognized by the jointventure during fiscal 2006 included internal pricing adjustments related to certain prior periods.Fiscal 2005Charges of $54 million related to the shareowner lawsuit settlement were recognized, including $71million related to changes in fair market value of warrants prior to their issuance in December2004, net of $17 million of recoveries from fiduciary insurance carriers. The remaining legalsettlement charges of $11 million were primarily related to parties that opted out of our globalsettlement and a supplier claim.Interest income on tax refunds and settlements was due primarily to the favorable resolution ofcertain prior-year federal income tax audits and to the recognition of a federal net operating losscarryback claim under tax-sharing agreements with AT&T, Avaya and Agere. Refer to Note 8 to ourconsolidated financial statements for further information on these tax matters.Minority interest is primarily attributable to a joint venture located in China that manufacturescertain of our products.Fiscal 2004Charges of $56 million related to the shareowner lawsuit settlement were recognized, including $91million related to changes in the estimated fair value of the warrants that were expected to beissued, $5 million related to changes in the fair value of our common stock that was deposited intoescrow and subsequently sold and $40 million of recoveries from fiduciary insurance carriers. Theremaining legal settlement charges of $28 million were primarily related to Y2K claims under ourseparation agreement with Avaya and a prior year sale of our consumer products business.We reached an agreement with the SEC and paid a $25 million fine in connection with the SEC’sinvestigation into our revenue recognition issues previously identified in November and December of2000. The final judgment and consent decree to settle the investigation with the SEC was enteredinto in May 2004.Interest income on tax settlements was due primarily to the favorable resolution of certain prioryear federal income tax audits and the recognition of a federal net operating loss carryback claimunder tax sharing agreements with AT&T, Avaya and Agere.The gain on sale of an investment was primarily related to the maturity of a forward contract forthe sale of Corning common stock we owned. The shares of Corning were obtained in connection withthe sale of certain joint ventures associated with the optical fiber business in fiscal 2002.**Interest Expense**Fiscal 2006 vs. 2005Interest expense decreased by $17 million to $324 million during fiscal 2006, primarily due toextinguishment of convertible securities and certain other debt obligations.Fiscal 2005 vs. 2004Interest expense decreased by $55 million to $341 million during fiscal 2005, primarily due to theextinguishment of convertible securities and certain other debt obligations.
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**Income Taxes**               Years Ended September 30, (in millions) 2006  2005  2004           Carryback claims $—  $(19) $(844)Favorable resolution of prior-period tax audits  (18)  (130)  (142)Reversal of non-U.S. valuation allowances  (29)  (81)  (17)Non-U.S. and state income taxes attributed to pre-taxincome  89   79   64           Income taxes $42  $(151) $(939)          Valuation allowances were reversed due to the recognition of certain net operating loss carrybackclaims, including a claim of $816 million that was recognized during fiscal 2004 that was relatedto the carryback of our fiscal 2001 federal net operating loss to 1996, a year in which we filedour federal income tax return as part of the AT&T consolidated group. The other carryback claimsrecognized were primarily related to taxes paid in prior years by our former foreign salescorporation and previously merged companies, including a $21 million tax refund (including interestof $2 million) received during the first quarter of fiscal 2006. This tax refund was notpreviously recognized until the fourth quarter of fiscal 2005 due to the uncertainty of receivingthe refund from an unaffiliated third party. Interest income related to these claims was $43million and $45 million during fiscal 2005 and 2004, respectively.Certain income tax benefits were recognized due to the favorable settlement of audit mattersrelated to the years 1990 through 2005, including matters with a previously merged company and thesettlement of certain matters under tax-sharing agreements with AT&T, Avaya and Agere. We alsorecognized interest income related to these settlements of $45 million and $90 million duringfiscal 2005 and 2004, respectively.Valuation allowances related to certain non-U.S. tax jurisdictions that exited a cumulative lossposition were reversed based on our assessment that it was more likely than not that those deferredtax assets will be realizable based on income projections and certain other factors for thosejurisdictions.The realization of our deferred tax assets is dependent upon the existence of taxable income duringfuture periods. During fiscal 2004, 2005, and 2006, most of our pretax income in the U.S. wasgenerated from a pension credit that is not currently taxable. As a result, even though we exiteda cumulative loss position during the fourth quarter of fiscal 2005, we have concluded that therewas not sufficient positive evidence to enable us to conclude that it was more likely than not thatthe U.S. deferred tax assets would be realized. Therefore, we have continued to maintain avaluation allowance on our net U.S. deferred tax assets.However, the expected future tax consequences of deferred tax liabilities generated primarily fromour pension credit continue to be relied upon to support the deferred tax assets of other retireebenefits. This resulted in not providing taxes attributable to U.S. income during fiscal 2006,2005 and 2004 as valuation allowances were reversed to the extent of increases in deferred taxliabilities. We expect that the U.S. deferred taxes associated with retiree benefits will be in anet liability position as of September 30, 2007.We currently expect to recognize non-cash impacting U.S. deferred taxes of approximately $125million for the above item during fiscal 2007. Expected U.S. deferred tax expense will berecognized throughout the year and is likely to change during fiscal 2007 as a result of a numberof variables, including our assessment of the future realization of deferred tax assets.Refer to the “Application of Critical Accounting Estimates” in this MD&A and Note 8 to ourconsolidated financial statements for more detail regarding income taxes.
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**RESULTS OF OPERATIONS BY SEGMENT****Mobility Access and Applications Solutions**                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change                 U.S. $3,360  $3,481   (3%) $2,992   16%Non-U.S.  691   1,179   (41%)  1,174   —                   Total revenues $4,051  $4,660   (13%) $4,166   12%                  Gross margin %  55%  54% 1 pt  51% 3 pts                  Segment income $1,422  $1,704  $(282) $1,290  $414                   Return on sales  35%  37% (2 pts)  31% 6 pts                  Fiscal 2006 vs. 2005Mobility Access and Applications Solutions revenues reflected a $627 million decrease in MobilityAccess Solutions and an $18 million increase in Applications Solutions. U.S. revenues decreasedprimarily due to a slow-down in spending on some of our current-generation wireless solutions,including lower CDMA sales to our two largest customers as certain initial stages of largehigh-speed data network build-outs are nearing completion. Expansion and upgrades for thesehigh-speed data network build-outs, combined with similar deployments by other customers, willcontinue to drive our CDMA revenues in the U.S. These two customersaccounted for 64%and 62% of total Mobility Access and Applications Solutions revenues during fiscal 2006 and 2005,respectively. Including these two customers, the five largest Mobility Access and ApplicationsSolutions customers accounted for 82% and 79% of total Mobility Access and Applications Solutionsrevenues during fiscal 2006 and 2005, respectively. The decline in revenues from the two largestcustomers was offset by additional revenues related to a large UMTS contract in the U.S. Non-U.S.revenues decreased primarily due to lower CDMA sales in China driven by the delay of 3G licensesand to a lesser extent, lower UMTS data card sales in EMEA and our selective participation inhighly competitive market opportunities in India.Approximately 89% of Mobility Access and Applications Solutions revenues are currently generatedfrom CDMA technology. We expect revenues related to a large UMTS contract in the U.S. willcontinue to grow during fiscal 2007. We are conducting third-generation UMTS / W-CDMA trials inChina.Consolidation has occurred with several large U.S. wireless service providers and may have impactedcapital spending in certain situations. These events may continue to present opportunities for usto assist in integration efforts or to expand our products/services or technologies in certainnetworks where they were not previously utilized. However, events may impact our future revenuetrends as these service providers assess potential technology migrations to common platforms orleverage excess capacity. In addition, the timing of awards of licenses and spectrum to serviceproviders and the technologies that ultimately will be deployed in certain markets, such as China,may also impact future revenue.Future quarterly revenue trends may be volatile as a result of the high concentration of revenueamong a limited number of customers and the resulting exposure to their spending patterns and thegeneral availability of next-generation products.R&D investment in Mobility Access and Application Solutions is focused primarily on CDMA and UMTSnext-generation technologies and includes expenses associated with UMTS product trials with certaincustomers. This investment continues to support our leadership position in spread-spectrumtechnology and our development of high-speed mobile data solutions.Segment income decreased primarily due to a $285 million decrease in gross margin and slightlyoffset by a $3 million decrease in operating expenses. The decrease in gross margin was primarilydue to lower sales volume.
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Fiscal 2005 vs. 2004Mobility Access and Applications Solutions revenues increased $494 million. U.S. revenuesincreased primarily due to higher sales to Verizon Wireless and Sprint Nextel as they executedtheir EVDO deployment and CDMA network investment for high-speed mobile data services andadditional network capacity. These two customers accounted for 62% and 60% of Mobility Access andApplications Solutions revenues during fiscal 2005 and 2004, respectively. Including these twocustomers, five customers accounted for 79% and 77% of Mobility Access and Applications Solutionsrevenues during fiscal 2005 and 2004, respectively. Non-U.S. revenues increased primarily in OtherAmericas due to higher CDMA sales in Brazil, Venezuela and Canada. These increases were partiallyoffset by lower revenues in APaC resulting from the timing of obtaining customer acceptance for aCDMA project in India in the prior period. Approximately 91% of fiscal 2005 Mobility Access andApplications Solutions revenues were derived from CDMA technology.Segment income increased due to a $382 million increase in gross margin and a $32 million decreasein operating expenses. The increase in gross margin was primarily due to higher sales volume andto a lesser extent, a three-percentage point improvement in the gross margin rate due to a morefavorable geographic mix.**Multimedia Network Solutions (MNS)**                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change Data and access $777  $725   7% $727   — Optical networking  900   838   7%  771   9%                  Total revenues $1,677  $1,563   7% $1,498   4%                  U.S. $717  $623   15% $631   (1%)Non-U.S.  960   940   2%  867   8%                  Total revenues $1,677  $1,563   7% $1,498   4%                  Gross margin %  30%  31%  (1pt)  35%  (4 pts)                  Segment income $127  $112  $15  $167  $(55)                  Return on sales  8%  7% 1pt   11% (4 pts)                  Fiscal 2006 vs. 2005MNS revenues increased by $114 million. U.S. revenues increased primarily due to higher opticalnetworking sales. Non-U.S. revenues increased primarily from higher data and access sales inEurope, partially offset by lower sales of all MNS products in APaC. Five customers accounted for41% and 39% of MNS revenues during fiscal 2006 and 2005, respectively.R&D investment in MNS supports a broad array of current and next-generation technologies, includingmetro optical and broadband networking solutions.Segment income increased due to a $32 million increase in gross margin which was partially offsetby a $17 million increase in operating expenses. The higher gross margin was driven by higherrevenues. The increase in operating expenses was primarily due to higher expenses related to theRiverstone acquisition including in-process R&D, intangible asset amortization and additionalheadcount related expenses.Fiscal 2005 vs. 2004MNS revenues increased by $65 million. The increase in non-U.S. regions primarily resulted fromhigher sales in optical networking products and certain data and access products in Europe. Fivecustomers accounted for 39% and 43% of MNS’s revenues during fiscal 2005 and 2004, respectively.
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Segment income decreased due to a $52 million decrease in gross margin and a $3 million increase inoperating expenses. The lower gross margin was due to a four-percentage point decrease in thegross margin rate. The gross margin rate decreased due to unfavorable product mix andhigher-inventory related charges and as well as certain reserve reversals and settlementsrecognized during the prior period.**Converged Core Solutions (CCS)**                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change U.S. $334  $422   (21%) $644   (34%)Non-U.S.  266   428   (38%)  571   (25%)                  Total revenues $600  $850   (29%) $1,215   (30%)                  Gross margin %  43%  30%  13 pts   32%  (2 pts)                  Segment income $70  $36  $34  $223  $(187)                  Return on sales  12%  4%  8 pts   18%  (14 pts)                  Fiscal 2006 vs. 2005CCS revenues declined by $250 million. The decline in U.S. revenues was attributed to circuitswitching products. Lower non-U.S. sales were attributed to lower PHS sales in China. Fivecustomers accounted for 48% and 56% of CCS revenues during fiscal 2006 and 2005, respectively.Circuit switching revenues declined by $94 million to $309 million. PHS revenues declined by $141million to $103 million. Traditional circuit switching product sales have been declining at afaster rate than the growth in next-generation technologies. This decline is more prevalent in theU.S. PHS sales declined as service providers in China curtailed their spending in preparation fortransitioning to 3G networks . CCS’s remaining revenues consisted primarily of sales ofnext-generation products and refurbished equipment.Although customer-spending levels for CCS products may not change significantly in the aggregate,the mix of what is purchased is likely to continue to change or fluctuate. Our future revenueswill be impacted by our success in offering a product portfolio that effectively addresses customerneeds. CCS revenues may continue to decline due to the transition to next-generation networks.R&D investment in CCS supports a broad array of current and next-generation technologies, includingIMS and VoIP.Segment income increased primarily due to a $30 million decrease in operating expenses. Thedecrease in operating expense was due to lower R&D spending attributed to lower average employeeworkforce levels and higher SG&A expense from a legal settlement in the prior year period.Fiscal 2005 vs. 2004CCS revenues declined by $365 million. The decline in the U.S. revenue was attributed to legacycircuit switching products. Lower non-U.S. sales were attributed to lower PHS sales in China.Five customers accounted for 56% and 58% of CCS revenues during fiscal 2005 and 2004, respectively.Circuit switching revenues declined by $155 million to $403 million. PHS revenues declined by $138million to $244 million. Traditional circuit switching product sales have been declining at afaster rate than the growth rate of next-generation technologies. This decline was mostsignificant in the U.S., where certain customers shifted their spending to other areas, such asfiber-to-the-premise and broadband access, in response to competitive factors from cable serviceproviders. PHS sales declined as service providers in China curtailed their spending inpreparation for transitioning to 3G networks. CCS’s remaining revenues consisted primarily ofsales of next-generation products and refurbished equipment.
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Segment income decreased due to a $134 million decrease in gross margin and a $53 million increasein operating expenses. The lower gross margin was due to a two-percentage point decrease in thegross margin rate. The gross margin rate decreased due to the impact of lower sales volume andunfavorable product mix. Operating expenses increased primarily due to additional R&D expense innext-generation technologies driven by the Telica acquisition.**Services**                       Years ended September 30, (in millions) 2006  2005  Change  2004  Change U.S. $1,317  $1,263   4% $1,128   12%Non-U.S.  996   957   4%  916   4%                  Total revenues $2,313  $2,220   4% $2,044   9%                  Gross margin %  25%  29%  (4 pts)  28%  1 pt                   Segment income $314  $344  $(30) $302  $42                   Return on sales  14%  15% (1 pt)  15%  —                   Fiscal 2006 vs. 2005Services revenues increased by $93 million. U.S. revenues increased primarily due to a large UMTScontract, offset by lower government revenues. Non-U.S. revenues increased due to higher revenuesin all regions except APaC including China. Five customers accounted for 47% and 46% of Servicesrevenues during fiscal 2006 and 2005, respectively.Deployment services increased by $110 million primarily related to a large UMTS contract. Managedservices increased by $22 million. These increases were partially offset by lower professionalservices revenues of $45 million primarily due to lower government revenues.Segment income decreased due to a $70 million decrease in gross margin that was partially offset bya $40 million decrease in operating expenses. The decrease in gross margin was due to the lowergross margin rate primarily driven by a large UMTS contract. The decrease in operating expense wasprimarily attributed to lower average workforce levels.Fiscal 2005 vs. 2004 Services revenues increased by $176 million. Revenues increased in the U.S. and in the non-U.S.regions, primarily in Other Americas and EMEA. Five customers accounted for 46% and 41% ofServices revenues during fiscal 2005 and 2004, respectively.Professional services increased by $241 million primarily due to government contracts, including aproject in Iraq, and services for wireless customers. Deployment services decreased by $64 milliondue to a decrease in sales of wireline products that required installation, as well as a decline inservices related to preparing sites for placement of wireless network equipment.Segment income increased due to a $66 million increase in gross margin that was offset by a $24million increase in operating expenses. The higher gross margin resulted from an increase in thegross margin rate and higher revenues. The gross margin rate increased by one-percentage point asa result of lower average employee workforce levels. Operating expenses increased due to highersales and marketing expenses incurred to further expand worldwide service offerings.
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**LIQUIDITY AND CAPITAL RESOURCES**Cash, cash equivalents and marketable securities were approximately $3.4 billion and $4.9 billionas of September 30, 2006 and 2005, respectively. As discussed in more detail below, the fiscal2006 cash flows included payment of fiscal 2005 employee incentive awards, additional workingcapital and cash used to repay debt, to collateralize a letter of credit issued in connection withthe Winstar judgment and for the Riverstone acquisition. Summarized annual cash flow informationand key working capital metrics are as follows:             (in millions) 2006  2005  2004 Net income $527  $1,185  $2,002 Non-cash items  (46)  (361)  (587)Changes in working capital  (422)  (133)  18 Other changes  (531)  26   (799)          Operating activities $(472) $717  $634                        Investing activities $(268) $(1,268) $(869)                       Financing activities $(340) $(421) $(239)                       Days sales outstanding in accountsreceivable  57   52   51 Inventory turnover  7.9   7.2   6.9 Days sales outstanding in working capital  44   30   23 **Operating Activities**Our operating results and resulting cash flows have fluctuated during the past few years due tochanges in revenue levels, cost reductions and other factors discussed throughout this MD&A. Thefollowing discussion is intended to further explain differences between net income and cash flow.Non-cash items include items that are not expected to generate or require the use of cash, such asthe pension credit and depreciation and amortization. In addition, charges or credits related tothe changes in the fair value of warrants issued in connection with the global settlement of ourshareowner lawsuit impacted the non-cash items through the first quarter of fiscal 2005.Changes in working capital requirements include changes in receivables, inventories and contractsin process, accounts payable and deferred revenue. Working capital requirements are impacted bythe timing of cash collections, customer billings and accounts payable disbursements. The increasein the days sales outstanding in working capital during fiscal 2006 was driven primarily by anincrease in accounts receivable and contracts in process and a reduction in accounts payable. Weperiodically sold certain non-U.S. accounts receivable with extended payment terms where it wascost effective to do so. We sold $135 million and $226 million of receivables during the fiscalyears ended September 30, 2006 and 2005, respectively. This impact is reflected in the changes inreceivables. Receivables with extended payment terms were $251 million and $225 million as ofSeptember 30, 2006 and September 30, 2005, respectively.Generally, working capital requirements will increase or decrease with changes in quarterly revenuelevels. In addition, working capital requirements might be impacted by changes in payment terms,the timing of attaining billing milestones and collections performance.The timing of certain payments will also impact our cash flow. For example, while employeeincentive awards are accrued throughout the fiscal year, they are generally paid during the firstquarter of the subsequent fiscal year. Annual incentive awards of approximately $350 million werepaid during the first quarter of fiscal 2006. In addition, approximately $100 million was paidunder a three-year long-term incentive program (2003-2005 cycle) during the first quarter of fiscal2006. This long-term incentive
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program was introduced for approximately 1,100 employees in advanced leadership positions duringfiscal 2003. Annual incentive awards related to fiscal 2006 of $110 million and long-termincentive awards of $80 million are expected to be paid during the first quarter of fiscal 2007.Fiscal 2006 other changes included capitalized software of $230 million, legal settlement paymentsof $104 million, funding of $49 million for deferred compensation and non-qualified pensionbenefits related to certain current and retired officers. The impact of these items was partiallyoffset by the impact of $287 million of reserves (including $9 million of post judgment interest)provided for as a result of the Winstar judgment.Fiscal 2005 other changes included the impact of changes in tax-related assets and liabilities of$627 million, primarily due to tax refunds that were accrued for in fiscal 2004 and proceeds of$201 million from a welfare benefits trust as reimbursement for management health carecontributions that were made during fiscal 2004. Offsetting these impacts were a $215 millionpayment related to our shareowner lawsuit settlement, cash outlays for restructuring of $69 millionand capitalized software of $232 million, as well as higher accruals for employee incentive awardsduring fiscal 2004 that were paid during fiscal 2005.Fiscal 2004 other changes included an $861 million tax refund that was received during fiscal 2005,cash outlays for restructuring of $227 million and capitalized software of $258 million. Partiallyoffsetting these impacts were certain insurance and customer settlements and customer financingrecoveries of approximately $600 million.**Investing Activities**Fiscal 2006 investing activities included net sales and maturities of marketable securities of $418million. Although we have the ability and intent to hold these marketable securities untilmaturity, we may continue to purchase and sell marketable securities in an attempt to improve ourinvestment returns. We also used $206 million of cash to purchase certain net assets of RiverstoneNetworks, a supplier of carrier-grade Ethernet routers for the telecommunications industry.Changes in restricted cash included $312 million of cash used to collateralize a letter of creditissued in connection with the Winstar judgment. The remaining cash used in investing activitieswas for capital expenditures of $195 million, including internal-use software of $42 million.Fiscal 2005 investing activities included net purchases of marketable securities of $1.0billion and capital expenditures of $221 million, of which $60 million was for internal-usesoftware.Fiscal 2004 investing activities included net purchases of marketable securities of $821 millionand capital expenditures of $157 million, of which $54 million was for internal use software.Partially offsetting these cash outflows were cash proceeds of $63 million from the sale of certainmanufacturing and real estate facilities in the U.S. and China.**Financing Activities**We are currently authorized by our board of directors to extinguish certain of our convertiblesecurities and other debt obligations prior to maturity. During the past few years, we retiredconvertible securities and certain other debt obligations in exchange for shares of our commonstock and cash, in separate, multiple and privately-negotiated transactions.Fiscal 2006 financing activities included $383 million of cash to repay or repurchase certain debtobligations including $368 million related to our 7.25% notes that matured during July 2006. Wealso received net proceeds of $46 million from the issuance of 26 million common shares primarilyfor certain employee benefit plans.Fiscal 2005 financing activities included $547 million of cash to repay or repurchase certain debtobligations and convertible securities. We also received net proceeds of $126 million from theissuance of 48 million
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common shares primarily for certain employee benefit plans.Fiscal 2004 financing activities included $500 million of cash to repay or repurchase certain debtobligations and convertible securities, including $249 million under our recapitalization programand $216 million of variable interest notes related to our Insured Special Purpose Trust. We alsoreceived net proceeds of $276 million from the issuance of 91 million common shares for certainemployee benefit plans.**Cash Management**Achieving optimal returns on our cash balance involves concentrating domestic cash in a primaryaccount with our lead bank in order to make efficient investment decisions in various instrumentsand maturities. Short-term domestic cash is invested daily in money market funds. Strategic short-and long-term domestic cash is outsourced to various fund managers and the portfolio consists ofinvestment-grade debt securities such as treasury notes, corporate bonds, high-quality asset-backedsecurities and government agency bonds, with various maturities. International cash is invested ininternational money market funds, time deposits and other bank accounts. Approximately 74% of ourcash, cash equivalents and marketable securities were held domestically as of September 30, 2006.**Future Capital Requirements and Funding Sources**We do not expect that our operations will generate cash on a sustainable basis until our pre-taxincome exceeds the amount of net non-cash income items, which have been driven primarily by ourpension credit. Our pension credit was $660 million, $973 million and $1.1 billion during thefiscal years ended September 30, 2006, 2005 and 2004, respectively. Our cash requirements duringthe next few years are primarily related to funding our operations, retiree health careobligations, capital expenditures, potential acquisitions, debt obligations and related interestand other matters discussed below. We have the right to redeem $486 million of 8% convertiblesecurities for cash after August 14, 2006. These securities are redeemable at the option of theholders on August 2, 2007 whereby we have the right to satisfy the redemption with cash, shares ofour common stock, or a combination of both.We believe our cash and cash equivalents of $1.3 billion and marketable securities of $2.1 billionas of September 30, 2006 are sufficient to fund our cash requirements for fiscal 2007 as well asthe following few years. However, we cannot provide assurance that our actual cash requirementswill not be greater than we currently expect. If sources of liquidity are not available or if wecannot generate sufficient cash flow from operations, we might be required to obtain additionalsources of funds through additional operating improvements, capital market transactions, assetsales or financing from third parties, or a combination thereof. We cannot provide assurance thatthese additional sources of funds will be available or, if available, would have reasonable terms.The remaining cash requirements for our restructuring program are expected to be $114 million,primarily for lease obligations over the remaining lease terms, net of expected sublease rentalincome of $68 million. The cash requirement could increase in the future if the expected subleaseincome is not realized.Our U.S. pension plans meet the requirements of ERISA’s current funding rules, and we do not expectto make contributions to our qualified U.S. pension plans through fiscal 2008. We also currentlybelieve that it is unlikely that any required contributions would have a material effect on ourliquidity through fiscal 2011. Annual contributions to our non-qualified and non-U.S. pensionplans are expected to be approximately $60 million in each of the next five fiscal years.On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006. Theprincipal changes under this legislation relate to the way assets and liabilities are valued todetermine required pension contributions. This legislation also impacts the timing and manner ofrequired contributions to under-funded pension plans. The Pension Protection Act contains Section420 Amendments that we were pursuing as discussed in more detail below.
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Wecurrently provide retiree health care benefits for our retirees in the U.S., including 44,000management retirees and 66,000 formerly represented retirees as wellas an additional 64,000dependents of retirees. The obligations and plan assets for management and formerly representedretirees are accounted for separately. Historically, retiree health care benefits were fundedthrough plan assets set aside in trusts and transfers of excess pension assets. There arecurrently no plan assets available in these trusts to fund the obligations of the managementretirees. There are $104 million of assets in trusts as of September 30, 2006, that are availableto fund the obligations of the formerly represented retirees.We are permitted to transfer pension plan assets that are in excess of 125% of pension planobligations under Section 420 of the Internal Revenue Code to fund annual retiree health carebenefits. Our cumulative Section 420 transfers were $1.9 billion, although no transfers were madewithin the management retiree plan since fiscal 2002 or within the formerly represented retireeplan since fiscal 2003. There were approximately $2.2 billion of pension plan assets that would beeligible for a conventional Section 420 transfer in our formerly represented retiree plan as of themost recent valuation (January 1, 2006). The funding levels for our management retiree pensionplans were below the required thresholds that would allow for Section 420 transfers. If aconventional Section 420 transfer is made, we are required to maintain a certain level of cost perparticipant for a period of five years beginning with the year of transfer.The Pension Protection Act allows an employer to fund more than one year’s retiree health carebenefits through a Section 420 transfer and permit the terms of an enforceable collectivebargaining agreement to serve as an alternative to the maintenance of cost requirements describedabove. Under this new type of transfer, pension assets in excess of 120% of obligations would beavailable to fund retiree health care costs. There were approximately $2.8 billion of pension planassets that would be eligible for a collectively bargained Section 420 transfer as of the mostrecent valuation (January 1, 2006). However, additional changes are being pursued as technicalcorrections that are related to minimum pension funding thresholds of 120% following a collectivelybargained Section 420 transfer that would facilitate our ability to provide a collectivelybargained level of retiree health care benefits.With suitable legislation, we believe it is likely that almost all of the funding required forformerly represented retirees (assuming the present level and structure of benefits) could beaddressed through Section 420 transfers based on current actuarial assumptions. However, noassurances can be given that we will be successful in these efforts or that other legislativechanges will not be adopted that will adversely affect the amount of pension plan assets that wouldbe available for Section 420 transfers.Our collective bargaining agreements with our unions currently provide that if suitable legislationis not obtained by June 30, 2007, our obligation to fund a $400 million trust for representedretiree health care by 2012 will terminate, and we can change the level of the subsidy forrepresented retiree health care at our sole discretion beginning January 1, 2008, subject to themaintenance of cost requirements that expire on September 30, 2007.We are planning to make a collectively bargained Section 420 transfer during December 2006 of nomore than $550 million for formerly represented retirees to cover costs from October 1, 2006through December 31, 2007.Assuming the present level and structure of benefits, our expected cash requirements for fundingretiree health care benefits and other postretirement benefits areexpected to be $126 millionduring fiscal 2007 and are expected to increase to $315 million, $489 million, $469 million and$443 million during the next four consecutive fiscal years due to the depletion of plan assets heldin trusts. These amounts include the collectively bargained Section 420 transfer discussed aboveand the expected annual Medicare Part D subsidy of approximately $70 million. These expectedfunding requirements are subject to change.
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**Contractual Obligations and Other Commercial Commitments and Contingencies**Our contractual obligations as defined by the SEC’s rules and regulations are presented in thetable below. However, our expected cash flow cannot be entirely assessed based on such obligationssince they are subject to changes based on future events. Many of our outsourced manufacturingagreements are linked to future sales forecasts and will vary based on customer demands.Furthermore, we have other cash requirements that are not included in the table. Theserequirements are related to our normal operations that are not based on “commitments”, such aspurchases of services on an “as needed” basis, employee compensation, and other items. The mostsignificant factor affecting our future cash flows is our ability to earn and collect cash from ourcustomers.**Contractual obligations**                       Payments due during the years ending September 30, (in millions) Total  2007  2008 and 2009  2010 and 2011  2012 and thereafter Long-term debt (a) $5,081  $486  $202  $750  $3,643 Interest on long-term debt (a)  3,577   285   488   448   2,356 Operating leases (b)  775   147   207   147   274 Unconditional purchase obligations(c)  553   486   65   2   —                 Total (d) (e) $9,986  $1,404  $962  $1,347  $6,273                  (a) The long-term debt principal amounts exclude $31 million of fair value basisadjustments and unamortized discounts. Refer to Note 9 to our consolidated financialstatements for additional information related to long-term debt and convertible securities,including early redemption features. (b) The contractual obligations under operating leases excludeapproximately $150 million of potentiallease obligations that were assigned to Avaya, Agere and other entities for which we remainsecondarily liable. The operating lease obligations for facilities reserved under ourrestructuring program of $127 million are included in the table. (c) Unconditional purchase obligations include all commitments to purchase goods orservices that are noncancelable or would impose a penalty if the agreements were cancelledprior to expiration. In these situations, the amount of the penalty was included in the“2007” column in the table above. Amounts exclude obligations included in accounts payableas of September 30, 2006. (d) Certain other long-term liabilities of $775 million are excluded in the above tablebecause they do not represent contractual obligations as defined by the SEC’s rules. Theseliabilities are primarily contingencies related to tax, litigation and insurance matters,long-term employee compensation and non-cash items, such as deferred income taxes andminority interest. The estimated future cash payments for these items are expected to be$279 million during fiscal years 2008 through 2009, $100 million during fiscal years 2010through 2011, and $143 million during 2012 and thereafter. Other long-term liabilitiesrelated to facility reserves in connection with our restructuring plans are included in theoperating leases caption. (e) Obligations related to pensions, postretirement health and welfare benefits andpostemployment benefit obligations are excluded from the table. Refer to Note 10 to ourconsolidated financial statements and the above discussion for a summary of our expectedcontributions to these plans.**Other commercial commitments**                       Amounts expiring during the years ending September 30, (in millions) Total  2007  2008 and 2009  2010 and 2011  2012 and thereafter Letters of credit (a) $493  $454  $27  $1  $11 Undrawn customercommitments 11   —  6  5   — Approved but not availablecustomer commitments 26   —   —   —  26                 Total $530  $454  $33  $6  $37                 
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(a) Refer to Note 13 to our consolidated financial statements for further information.**Customer Financing Commitments**We may provide or commit to additional customer financings on a limited basis. We are focusing onthe larger service providers that typically have less demand for such financing. We carefullyreview requests for customer financing on a case-by-case basis. Such reviews assess the creditquality of the individual borrowers, their respective business plans and market conditions. Wealso assess our ability to sell or transfer the undrawn commitments and drawn borrowings tounrelated third parties. Our net exposure for customer financing commitments was not material asof September 30, 2006. Refer to Note 13 of our consolidated financial statements for additionalinformation.**Credit Ratings**Our credit ratings are below investment grade. Any credit downgrade affects our ability to enterinto and maintain certain contracts on favorable terms and increases our cost of borrowing. Ourcredit ratings as of December 14, 2006, are as follows:               Liability to        subsidiary trust      8.00% convertible issuing  Rating Agency Long-term debt securities preferred securities Last change         Standard & Poor’s(a)(b) B+ B B- Upgraded December 5, 2006Moody’s (c) Ba3 B2 B2 Upgraded December 11, 2006Fitch (d)         (a) Long-term corporate rating upgraded to BB- with Positive Outlook on December 5, 2006. (b) All long-term ratings removed from CreditWatch, except the senior unsecured debt ratings,which remain on CreditWatch with positive implications on December 5, 2006. (c) Moody’s withdrew Lucent’s corporate family rating ofB1 on December 11, 2006. (d) Fitch withdrew Lucent’s ratings on December 8, 2006.
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**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**We are exposed to market risk from changes in foreign currency exchange rates, interest rates andequity prices. We manage our exposure to risk from changing exchange rates and interest ratesthrough the use of derivative financial instruments, coupled with other strategies. Our riskmanagement objective is to minimize the effects of volatility on our cash flows by identifying theassets, liabilities or forecasted transactions exposed to these risks and hedging them. Hedges maybe achieved either by forward or option contracts, by swap derivatives or by terms embedded intocertain contracts that affect the ultimate amount of cash flows under the contract. The gains andlosses on these exposures are generally offset by reciprocal changes in the value of the hedginginstruments when used because there is a high correlation between the hedging instruments and theunderlying exposures. We use derivative financial instruments as risk management tools and not fortrading or speculative purposes. Generally, price risk on equity holdings is not hedged.**Foreign Currency Risk**As a multinational company, we conduct our business in a wide variety of currencies and aretherefore subject to market risk for changes in foreign exchange rates. We use foreign exchangeforward and option contracts to minimize exposure to the risk of the eventual net cash inflows andoutflows resulting from foreign currency denominated transactions with customers, suppliers andnon-U.S. subsidiaries. Our objective is to hedge all types of foreign currency risk to preserveour cash flows, but we generally do not expect to designate these derivative instruments as hedgesunder current accounting standards unless the benefits of doing so are material. Cash inflows andoutflows denominated in the same foreign currency are netted on a legal entity basis or at thecorporate level. The corresponding net cash flow exposure is appropriately hedged. To the extentthat the forecasted cash flow exposures are overstated or understated or if there is a shift in thetiming of the anticipated cash flows during periods of currency volatility, we may experienceunanticipated currency gains or losses. We do not hedge our net investment in non-U.S. entitiesbecause we view those investments as long-term in nature.Our primary net foreign currency exposures included the euro, British pound, Canadian dollar,Korean won and Mexican peso. The fair value of foreign exchange contracts is subject to changes inforeign currency exchange rates.We use theMonte Carlo simulation model to calculate Value at Risk (VAR). This model estimates the potential lossin fair value of foreign currency forwards and options over a defined period of time within acertain confidence level by randomly generating different foreign currency exchange ratesrepeatedly and then applying those exchange rates to our outstanding forwards and options. As aresult of our foreign currency VAR calculations, we estimated with 95 percent confidence that thefair value of our foreign currency derivatives would not decline by more than $10 million and $9million over a quarterly period during fiscal 2006 and 2005, respectively. Consistent with thenature of the economic hedge, any changes in the value of the forwards and options would be offsetby reciprocal changes in the underlying exposure.**Interest Rate Risk**We are exposed to various forms of interest rate risk. Refer to Note 13 to our consolidatedfinancial statements for further information related to interest rate risk.
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The impacts of a sensitivity analysis we performed under a model that assumes a hypothetical 100basis point increase in interest rates are as follows:                       Hypothetical     Hypothetical      decrease in fair     decrease in fair  Fair value as of value as of Fair value as of value as of(in millions) September 30, 2006 September 30, 2006 September 30, 2005 September 30, 2005**Assets:**                Short-term marketable securities $630  $3  $357  $2 Long-term marketable securities  1,476   22   2,163   34 Interest rate swaps  —   —   —   — **Liabilities:**                Debt maturing within one year  490   —   372   3 Long-term debt (includingliability to subsidiary trustissuing preferred securities)  4,383   292   5,144   303 Interest rate swaps  6   4   5   7 Our sensitivity analysis excludes customer finance notes because a significant portion of theprincipal balances and related receivables for accrued interest are fully-reserved.**Equity Price Risk**Our investment portfolio includes equity investments in publicly held companies that are classifiedas available-for-sale and other strategic equity holdings in privately held companies and venturefunds. These securities are exposed to price fluctuations and are generally concentrated inhigh-technology industries. The carrying values of our available-for-sale equity securities andprivately held securities were $2 million and $59 million, respectively, as of September 30, 2006.We generally do not hedge our equity price risk due to hedging restrictions imposed by the issuers,illiquid capital markets or our inability to hedge non-marketable equity securities in privatelyheld companies. An adverse movement in equity prices on our available-for-sale equity securitieswould not have a material impact due to their immaterial carrying values as of September 30, 2006and 2005. The impact of an adverse movement in equity prices on our holdings in privately heldcompanies cannot be easily quantified, as our ability to realize returns on investments depends onthe enterprises’ ability to raise additional capital or derive cash inflows from continuingoperations or through liquidity events such as initial public offerings, mergers or private sales.The process of determining the fair values of our privately held equity investments inherentlyrequires certain assumptions and subjective judgments. These valuation assumptions and judgmentsinclude consideration of: (1) the investee’s earnings and cash flow position, cash flowprojections, and rate of cash consumption; (2) recent rounds of equity infusions by us and otherinvestors; (3) the strength of the enterprise’s management; and (4) valuation data provided by theenterprise that may be compared with data for peers. Investment impairment charges were $8million, $20 million and $22 million during fiscal 2006, 2005 and 2004, respectively. Similarcharges may be required in the future if declines in the fair value of investments are determinedto be other-than-temporary.
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**FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA**