AS FILED WITH THE SEC ON August 8, 2006

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE

SECURITIES
EXCHANGE ACT OF 1934

For the
quarterly period ended June 30, 2006

OR

o TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF

THE
SECURITIES EXCHANGE ACT OF 1934

For the
transition period from _____________to _____________

Commission file number 001-11639

LUCENT TECHNOLOGIES INC.

|            |                
|----------- | ---------------
|A Delaware  | I.R.S. Employer
|Corporation | No. 22-3408857 

600 Mountain Avenue, Murray Hill, New Jersey 07974

Telephone Number: 908-582-8500

Indicate by
check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. 
Yes x  Noo

Indicate by
check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). 
Yes x  Noo

At July 31,
2006, 4,482,016,363 common shares were outstanding.

---



|         |                   
|-------- | ------------------
|<PAGE> 2 | Form 10-Q - Part I

INDEX

|                                |                                                                                                     |   
|------------------------------- | --------------------------------------------------------------------------------------------------- | --
|Part I  Financial Information: |                                                                                                    
|                                |                                                                                                     |   
|Item 1.                         | Financial Statements                                                                                |   
|                                |                                                                                                     |   
|                                | Consolidated
  Statements of Operations for the Three and Nine MonthsEnded June 30, 2006
  and 2005 | 3 
|                                |                                                                                                     |   
|                                | Consolidated Balance
  Sheets as of June 30, 2006 and September 30, 2005                            | 4 
|                                |                                                                                                     |   
|                                | Consolidated
  Statement of Changes in Shareowners Equity for the Nine MonthsEnded June
  30, 2006 | 5 
|                                |                                                                                                     |   
|                                | Consolidated
  Statements of Cash Flows for the Nine MonthsEnded June 30, 2006 and 2005             | 6 
|                                |                                                                                                     |   
|                                | Notes to Consolidated
  Financial Statements                                                        | 7 
|                                |                                                                                                     |   
|Item 2.                         | Managements
  Discussion and Analysis of Financial Condition and Results of Operations             | 21
|                                |                                                                                                     |   
|Item 3.                         | Quantitative and
  Qualitative Disclosures About Market Risk                                        | 38
|                                |                                                                                                     |   
|Item 4.                         | Controls and
  Procedures                                                                           | 39
|                                |                                                                                                     |   
|Part II  Other
  Information:  |                                                                                                    
|                                |                                                                                                     |   
|Item 1.                         | Legal Proceedings                                                                                   | 40
|                                |                                                                                                     |   
|Item 6.                         | Exhibits                                                                                            | 40

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|         |                   
|-------- | ------------------
|<PAGE> 3 | Form 10-Q - Part I

PART
1 - Financial Information Item 1. Financial
Statements LUCENT
TECHNOLOGIES INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in Millions, Except Per Share Amounts)
(Unaudited) Three months ended
  June 30,

Nine months ended
  June 30,2006

2005

2006

2005Revenues:Products

$
1,469

$
1,781

$
4,566

$
5,383Services


581


559


1,669


1,627Total revenues


2,050


2,340


6,235


7,010Costs:Products


779


908


2,358


2,832Services


432


380


1,261


1,167Total costs


1,211


1,288


3,619


3,999Gross margin


839


1,052


2,616


3,011Operating
  expenses:Selling, general
  and administrative


370


388


1,410


1,196Research and
  development


276


287


856


858In-process
  research and development


12





12


Business
  restructuring


7


6


4


(1
)Total operating
  expenses


665


681


2,282


2,053Operating income


174


371


334


958Other income,
  net


27


52


156


49Interest expense


82


85


247


259Income before
  income taxes


119


338


243


748Income taxes


40


(34
)

87


(65
)Net income

$
79

$
372

$
156

$
813Net income per
  share:Basic

$
0.02

$
0.08

$
0.03

$
0.18Diluted

$
0.02

$
0.07

$
0.03

$
0.17Weighted average
  common shares outstanding:Basic


4,479


4,433


4,465


4,419Diluted


4,519


5,326


4,511


5,039 See Notes to
Unaudited Consolidated Financial Statements.   <PAGE> 4
  Form 10-Q - Part ILUCENT TECHNOLOGIES INC. AND
SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in Millions, Except Per Share Amounts)
(Unaudited)

June 30,
  2006

September 30,
  2005ASSETSCash and cash
  equivalents

$
1,368

$
2,410Marketable
  securities


588


357Receivables, net


1,552


1,395Inventories


773


731Other current
  assets


1,001


690Total current
  assets


5,282


5,583Marketable
  securities


1,741


2,163Property, plant
  and equipment, net


1,229


1,295Prepaid pension
  costs


6,476


6,010Goodwill and
  other acquired intangibles, net


611


419Other assets


941


930Total assets

$
16,280

$
16,400LIABILITIESAccounts payable

$
702

$
769Payroll and
  benefit-related liabilities


958


1,095Debt maturing
  within one year


368


368Other current
  liabilities


1,780


1,588Total current
  liabilities


3,808


3,820Postretirement
  and postemployment benefit liabilities


4,571


4,751Pension
  liabilities


1,318


1,423Long-term debt


5,047


5,066Other
  liabilities


853


965Total
  liabilities


15,597


16,025Commitments and
  contingenciesSHAREOWNERS EQUITYPreferred stock
  par value $1.00 per share; authorized shares: 250; issued and outstanding:
  none





Common stock
  par value $.01 per share;
  authorized shares: 10,000; 4,483 issued and 4,482 outstanding shares as of
  June 30, 2006, and 4,457 issued and 4,447 outstanding shares as of September
  30, 2005


45


45Additional
  paid-in capital


23,645


23,513Accumulated
  deficit


(19,452
)

(19,608
)Accumulated
  other comprehensive loss


(3,555
)

(3,575
)Total
  shareowners equity


683


375Total
  liabilities and shareowners equity

$
16,280

$
16,400See Notes to
Unaudited Consolidated Financial Statements.

<PAGE> 5
  Form 10-Q - Part ILUCENT TECHNOLOGIES INC. AND
SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREOWNERS EQUITY
(Amounts in Millions)
(Unaudited)

Shares of
  Common
  Stock

Common
  Stock

Additional
  Paid-In
  Capital

Accumulated
  Deficit

Accumulated
  Other
  Comprehensive
  Loss

Total
  Shareowners
  EquityBalance as of
  September 30, 2005


4,447

$
45

$
23,513

$
(19,608
)
$
(3,575
)
$
375Net income











156





156Foreign currency
  translation adjustments














27


27Unrealized
  holding losses on investments














(7
)

(7
)Issuance of
  common stock related to employee benefit plans


24





44








44Stock-based
  compensation


2





60








60Release of
  Telica escrow shares


9





29








29Other








(1
)







(1
)Balance as of
  June 30, 2006


4,482

$
45

$
23,645

$
(19,452
)
$
(3,555
)
$
683See Notes to
Unaudited Consolidated Financial Statements.

<PAGE> 6
  Form 10-Q - Part ILUCENT TECHNOLOGIES INC. AND
SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Millions)
(Unaudited)

Nine Months ended 
  June 30,2006

2005Operating
  activities:Net income

$
156

$
813Adjustments to
  reconcile net income to net cash used in operating activities net of effects
  of acquisitions:Depreciation and
  amortization


397


457Recovery of bad
  debt and customer financing


(7
)

(75
)Deferred income
  taxes


38


(13
)Pension credit


(493
)

(730
)Stock-based
  compensation expense


63


30Other
  adjustments for non-cash items


(7
)

129Changes in
  operating assets and liabilities:Receivables


(112
)

128Inventories and
  contracts in process


(74
)

(57
)Accounts payable


(100
)

(155
)Deferred revenue


63


108Other operating
  assets and liabilities


(525
)

(935
)Net cash used in
  operating activities


(601
)

(300
)Investing
  activities:Capital
  expenditures


(131
)

(145
)Sales,
  maturities (purchases) of marketable securities


177


(925
)Acquisition of
  business


(200
)

Changes in
  restricted cash


(314
)

Other investing
  activities


(2
)

1Net cash used in
  investing activities


(470
)

(1,069
)Financing
  activities:Repayment of
  long-term debt


(15
)

(419
)Issuance of
  common stock


44


121Other financing
  activities


(4
)

4Net cash
  provided by (used in) financing activities


25


(294
)Effect of
  exchange rate changes on cash and cash equivalents


4


8Net decrease in
  cash and cash equivalents


(1,042
)

(1,655
)Cash and cash
  equivalents at beginning of year


2,410


3,379Cash and cash
  equivalents at end of period

$
1,368

$
1,724Income tax
  payments, net

$
(16
)
$
(89
)Interest
  payments

$
(208
)
$
(230
)See Notes to Unaudited
Consolidated Financial Statements.


|         |                   
|-------- | ------------------
|<PAGE> 7 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

1. BASIS OF
PRESENTATION

Lucent Technologies Inc.s (referred
to in this report as the Company, we, us, our or Lucent) unaudited
consolidated financial statements reflect all adjustments (consisting of normal
recurring accruals) that are considered necessary for a fair presentation of
consolidated results of operations, financial position and cash flows as of and
for the periods presented. Certain reclassifications were made to conform to the
current period presentation.

The unaudited consolidated financial
statements include all majority-owned subsidiaries over which we exercise
control. Investments where we exercise significant influence but do not control
(generally a 20% to 50% ownership interest), are accounted for under the equity
method of accounting. All material intercompany transactions and balances have
been eliminated.

We are required to make estimates
and assumptions that affect amounts reported in the unaudited consolidated
financial statements and footnotes. Actual results could be different from
estimated amounts. We believe that the more important estimates and related
assumptions that affect our financial condition and results of operations are
in the areas of revenue recognition, pension and postretirement benefits,
income taxes, legal contingencies, intangible assets, stock-based compensation,
employee incentive awards, receivables and customer financing, inventories,
business restructuring and warranties. Estimates and assumptions are
periodically reviewed, and the effects of any material revisions are reflected
in the period that they are determined to be necessary.

The results for the periods
presented are not necessarily indicative of the results for the full year and
should be read in conjunction with the audited consolidated financial
statements for the year ended September 30, 2005 included in our Current Report
on Form 8-K, filed on May 5, 2006.

2. MERGER AGREEMENT
WITH ALCATEL

On April 2, 2006, Lucent and Alcatel entered into an
  Agreement and Plan of Merger (the Merger Agreement), pursuant to
  which Lucent and Alcatel will combine their businesses through a merger. Under
  the terms of the Merger Agreement, each Lucent share will be converted into
  a right to receive 0.1952 of an American Depository Share (ADS) of Alcatel,
  with each Alcatel ADS representing one ordinary share of Alcatel. The completion
  of the merger, subject to various closing conditions, including obtaining the
  approval of Lucent and Alcatel shareholders and receiving certain approvals
  and decisions, is on target and expected to close by the end of calendar year
  2006. The merger is intended to qualify as a reorganization for federal income
  tax purposes. If the merger agreement is terminated under certain circumstances
  specified in the Merger Agreement, Lucent or Alcatel will be required to pay
  the other a termination fee of $250 million or $500 million, depending upon
  certain criteria. The terms of the Merger Agreement also include certain restrictions
  or limitations on future transactions of the Company prior to the closing of
  the merger, including acquisitions or dispositions, additional borrowings or
  customer financing, issuance of equity and changes in employee benefit plans.
  The terms of certain contracts, employee benefit arrangements and debt agreements
  have provisions which could result in changes to the terms or settlement amounts
  upon a change in control of Lucent.

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|         |                   
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|<PAGE> 8 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

3. PENSION AND
POSTRETIREMENT BENEFITS

The following tables summarize the
components of the pension and postretirement benefits.

|                                   |  |                             |      |                            |   |      |   |      |        |   |   |        |  
|---------------------------------- |  | --------------------------- | ---- | -------------------------- | - | ---- | - | ---- | ------ | - | - | ------ | -
|                                   |  | Pension benefits            |     
|                                   |  | Three months ended June 30, |      | Nine months ended June 30, |  
|(in millions)                      |  | 2006                        |      | 2005                       |   | 2006 |   | 2005 |       
|                                   |  |                             |      |                            |   |      |   |      |       
|Service cost                       |  | $                           | 39   |                            | $ | 40   |   | $    | 116    |   | $ | 119    |  
|Interest cost                      |  |                             | 411  |                            |   | 415  |   |      | 1,232  |   |   | 1,243  |  
|Expected return on plan assets     |  |                             | (682 | )                          |   | (724 | ) |      | (2,046 | ) |   | (2,172 | )
|Amortization of prior service cost |  |                             | 14   |                            |   | 20   |   |      | 43     |   |   | 62     |  
|Amortization of actuarial losses   |  |                             | 52   |                            |   | 5    |   |      | 160    |   |   | 14     |  
|                                   |  |                             |      |                            |   |      |   |      |        |   |   |        |  
|Subtotal                           |  |                             | (166 | )                          |   | (244 | ) |      | (495   | ) |   | (734   | )
|Settlements                        |  |                             |     |                            |   |     |   |      |       |   |   | 3      |  
|Termination benefits               |  |                             | 2    |                            |   |     |   |      | 2      |   |   | 1      |  
|                                   |  |                             |      |                            |   |      |   |      |        |   |   |        |  
|Benefit credit                     |  | $                           | (164 | )                          | $ | (244 | ) | $    | (493   | ) | $ | (730   | )
|                                   |  |                             |      |                            |   |      |   |      |        |   |   |        |  

|                                   |  |                             |     |                            |   |      |   |      |     |   |   |     |  
|---------------------------------- |  | --------------------------- | --- | -------------------------- | - | ---- | - | ---- | --- | - | - | --- | -
|                                   |  | Postretirement benefits     |    
|                                   |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)                      |  | 2006                        |     | 2005                       |   | 2006 |   | 2005 |    
|                                   |  |                             |     |                            |   |      |   |      |    
|Service cost                       |  | $                           | 2   |                            | $ | 2    |   | $    | 5   |   | $ | 6   |  
|Interest cost                      |  |                             | 79  |                            |   | 87   |   |      | 237 |   |   | 257 |  
|Expected return on plan assets     |  |                             | (17 | )                          |   | (25  | ) |      | (50 | ) |   | (74 | )
|Amortization of prior service cost |  |                             | (18 | )                          |   | (14  | ) |      | (53 | ) |   | (23 | )
|Amortization of actuarial losses   |  |                             | 14  |                            |   | 16   |   |      | 32  |   |   | 31  |  
|                                   |  |                             |     |                            |   |      |   |      |     |   |   |     |  
|Benefit cost                       |  | $                           | 60  |                            | $ | 66   |   | $    | 171 |   | $ | 197 |  
|                                   |  |                             |     |                            |   |      |   |      |     |   |   |     |  

4. STOCK-BASED
COMPENSATION

Effective October 1, 2005, we adopted
Statement of Financial Accounting Standards (SFAS) No. 123R, Share Based
Payment. We elected to use the modified prospective transition method,
therefore, prior period results were not restated. Prior to the adoption of
SFAS 123R, stock-based compensation expense related to stock options was not
recognized in the results of operations if the exercise price was at least
equal to the market value of the common stock on the grant date, in accordance
with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees. As a result, the recognition of stock-based compensation expense
was generally limited to the expense attributed to restricted stock unit awards
and stock option modifications, as well as the amortization of certain acquisition-related
deferred compensation.

SFAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized as compensation expense over the service period (generally the
vesting period) in the consolidated financial statements based on their fair
values. For options with graded vesting, we value the stock option grants and
recognize compensation expense as if each vesting portion of the award was a
separate award. Under the modified prospective method, awards that were
granted, modified, or settled on or after October 1, 2005 are measured and
accounted for in accordance with SFAS 123R. Unvested equity-classified awards
that were granted prior to October 1, 2005 will continue to be accounted for in
accordance with SFAS 123, except that all awards are recognized in the results
of operations over the remaining vesting periods. The impact of forfeitures
that may occur prior to vesting is also estimated and considered in the amount
recognized. In addition, the realization of tax benefits in excess of amounts
recognized for financial reporting purposes will be recognized as a financing
activity rather than an operating activity as in the past.

We have stock-based compensation
plans under which directors, officers and other eligible employees receive
stock options and other equity-based awards usually on an annual basis. The
plans provide for the grant of stock options, stock appreciation rights,
performance share awards, restricted stock awards and other stock unit awards.

---



|         |                   
|-------- | ------------------
|<PAGE> 9 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

Historically, stock options have been granted to broad
  groups of employees at most levels on a discretionary basis. Beginning in fiscal
  2006, employees at mid-level leadership and below are eligible to receive restricted
  stock units (RSUs) instead of stock options. Employees in more advanced leadership
  positions (approximately 1,100 employees) continue to be eligible to receive
  stock options. In addition, the long-term incentive award program was modified
  for the current three-year cycle beginning in fiscal 2006, to change the denomination
  of any targeted awards to performance shares for officers. Performance shares
  will also represent 25% of any targeted awards for all other participants. The
  administration of the Employee Stock Purchase Plan (ESPP) was also modified
  to reduce the discount from 15% to 5% and eliminate the lookback feature. As
  a result, the ESPP is no longer accounted for as compensatory beginning November
  1, 2005.

Stock options are generally granted
with an exercise price equal to the market value of a share of common stock on
the date of grant. Stock options also expire within five to 10 years and vest
within four years from the date of grant. Subsequent to December 2002, stock
option grants have a term of seven years with graded vesting of 25% per year.

Restricted stock unit awards
generally vest over three to four years. The initial broad-based RSU awards
granted during the first quarter of fiscal 2006 vest ratably over three years.

Performance share awards under the
long-term incentive award program are earned over three years. The number of
shares earned for the three-year performance cycle is based on achievement of
annual financial targets established at the beginning of each fiscal year in
the cycle. These awards are subject to fair value adjustments for any changes
in the underlying market value of our common stock, until the performance
levels have been determined at the end of each fiscal year.

The following table summarizes stock
option activity.

|                                       |  |                        |     |                                               |   |       | 
|-------------------------------------- |  | ---------------------- | --- | --------------------------------------------- | - | ----- | 
|                                       |  | Shares
  (in millions) |     | Weighted average
  exercise price
  per share |  
|                                       |  |                        |     |                                               |  
|Outstanding as of September 30,
  2005 |  |                        | 418 |                                               | $ | 10.50 | 
|                                      
|Granted/assumed                        |  |                        | 27  |                                               |   | 2.82  | 
|                                      
|Exercised                              |  |                        | (15 | )                                             |   | 1.64  | 
|                                      
|Forfeited/expired                      |  |                        | (71 | )                                             |   | 10.32 | 
|                                       |  |                        |     |                                               |   |       | 
|Outstanding as of June 30, 2006        |  |                        | 359 |                                               |   | 10.33 | 
|                                       |  |                        |     |                                               |   |       | 
|                                      
|Exercisable as of June 30, 2006        |  |                        | 268 |                                               | $ | 12.74 | 
|                                       |  |                        |     |                                               |   |       | 

The weighted average remaining term
for stock options outstanding and exercisable was 2.9 years and 2.0 years,
respectively, as of June 30, 2006. The aggregate intrinsic value for stock options
outstanding and exercisable was $70 million and $60 million, respectively, as
of June 30, 2006. The intrinsic value of stock options is calculated as the
amount by which the market price of our common stock exceeds the exercise price
of the option.

The following table summarizes
unvested restricted stock unit activity.

|                                  |  |                        |    |                                          |   |      | 
|--------------------------------- |  | ---------------------- | -- | ---------------------------------------- | - | ---- | 
|                                  |  | Shares
  (in millions) |    | Weighted average
  grant date fair value |  
|                                  |  |                        |    |                                          |  
|Unvested as of September 30, 2005 |  |                        | 3  |                                          | $ | 4.36 | 
|                                 
|Granted                           |  |                        | 10 |                                          |   | 2.83 | 
|                                 
|Vested                            |  |                        | (1 | )                                        |   | 4.50 | 
|                                  |  |                        |    |                                          |   |      | 
|Forfeited                         |  |                        | (1 | )                                        |   | 3.17 | 
|                                  |  |                        |    |                                          |   |      | 
|                                 
|Unvested as of June 30, 2006      |  |                        | 11 |                                          | $ | 3.00 | 
|                                  |  |                        |    |                                          |   |      | 

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|          |                   
|--------- | ------------------
|<PAGE> 10 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

Proceeds received from the exercise
of stock options were $26 million and $16 million during the nine months ended
June 30, 2006 and 2005, respectively. The intrinsic value related to the
exercise of stock options was $20 million and $15 million during the nine
months ended June 30, 2006 and 2005, respectively, of which the majority is
currently deductible for tax purposes. However, these tax benefits were not
realized due to net operating loss carryforwards.

The following table summarizes the
pro forma effect of stock-based compensation as if the fair value method of
accounting for stock compensation had been applied.

|                                                                                                         |  |                                    |      |                                   |   |      |  
|-------------------------------------------------------------------------------------------------------- |  | ---------------------------------- | ---- | --------------------------------- | - | ---- | -
|(in millions,
  except per share amounts)                                                                |  | Three months ended
  June 30, 2005 |      | Nine months ended
  June 30, 2005 |  
|                                                                                                         |  |                                    |      |                                   |  
|Net income, as reported                                                                                  |  | $                                  | 372  |                                   | $ | 813  |  
|Add: Stock-based employee compensation
expense included in as reported net income                        |  |                                    | 16   |                                   |   | 30   |  
|Deduct:
  Total stock-based employee compensation expense determined under the fair
  value based method |  |                                    | (73  | )                                 |   | (239 | )
|                                                                                                         |  |                                    |      |                                   |   |      |  
|Pro forma net income                                                                                     |  | $                                  | 315  |                                   | $ | 604  |  
|                                                                                                         |  |                                    |      |                                   |   |      |  
|Income per
  share applicable to common shareowners:                                                     |  |                                    |      |                                   |   |      |  
|As
  reported:                                                                                           |  |                                    |      |                                   |   |      |  
|Basic                                                                                                    |  | $                                  | 0.08 |                                   | $ | 0.18 |  
|Diluted                                                                                                  |  | $                                  | 0.07 |                                   | $ | 0.17 |  
|Pro forma:                                                                                               |  |                                    |      |                                   |   |      |  
|Basic                                                                                                    |  | $                                  | 0.07 |                                   | $ | 0.14 |  
|Diluted                                                                                                  |  | $                                  | 0.06 |                                   | $ | 0.13 |  

No tax benefits were attributed to
the stock-based compensation expense because a valuation allowance was
maintained for substantially all net deferred tax assets. We elected to adopt
the alternative method of calculating the historical pool of windfall tax
benefits as permitted by FASB Staff Position (FSP) No. SFAS 123R-c, Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment
Awards. This is a simplified method to determine the pool of windfall tax
benefits that is used in determining the tax effects of stock compensation in
the results of operations and cash flow reporting for awards that were
outstanding as of the adoption of SFAS 123R.

The following table summarizes the
components and classification of stock-based compensation expense.

|                                               |  |                                     |    |                                    |   |      |  |      |    |  |   |    | 
|---------------------------------------------- |  | ----------------------------------- | -- | ---------------------------------- | - | ---- |  | ---- | -- |  | - | -- | 
|                                               |  | Three
        months ended June 30, |    | Nine
        months ended June 30, |  
|                                               |  | 2006                                |    | 2005                               |   | 2006 |  | 2005 |   
|                                               |  |                                     |    |                                    |   |      |  |      |   
|Stock options                                  |  | $                                   | 17 |                                    | $ |     |  | $    | 52 |  | $ |   | 
|Restricted stock units                         |  |                                     | 2  |                                    |   | 4    |  |      | 9  |  |   | 11 | 
|Other                                          |  |                                     |   |                                    |   | 12   |  |      | 2  |  |   | 19 | 
|                                               |  |                                     |    |                                    |   |      |  |      |    |  |   |    | 
|Total stock-based compensation
        expense |  | $                                   | 19 |                                    | $ | 16   |  | $    | 63 |  | $ | 30 | 
|                                               |  |                                     |    |                                    |   |      |  |      |    |  |   |    | 
|Costs                                          |  | $                                   | 2  |                                    | $ |     |  | $    | 8  |  | $ |   | 
|Selling, general and administrative            |  |                                     | 11 |                                    |   | 15   |  |      | 35 |  |   | 28 | 
|Research and
        development               |  |                                     | 6  |                                    |   | 1    |  |      | 20 |  |   | 2  | 
|                                               |  |                                     |    |                                    |   |      |  |      |    |  |   |    | 
|Total stock-based compensation
        expense |  | $                                   | 19 |                                    | $ | 16   |  | $    | 63 |  | $ | 30 | 
|                                               |  |                                     |    |                                    |   |      |  |      |    |  |   |    | 

The fair value of stock options was
estimated using the Black-Scholes option-pricing model. This model requires the
input of subjective assumptions that will usually have a significant impact on
the fair value estimate. The assumptions for the current period grants were
developed based on SFAS 123R and SEC guidance contained in Staff Accounting
Bulletin (SAB) No. 107, Share-Based Payment. The following table summarizes
the assumptions used to compute the weighted average fair value of stock option
grants.

---



|          |                   
|--------- | ------------------
|<PAGE> 11 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

|                                                 |  |                             |      |                            |   |      |   |      |      |   |   |      |  
|------------------------------------------------ |  | --------------------------- | ---- | -------------------------- | - | ---- | - | ---- | ---- | - | - | ---- | -
|                                                 |  | Three months ended June 30, |      | Nine months ended June 30, |  
|                                                 |  | 2006                        |      | 2005                       |   | 2006 |   | 2005 |     
|                                                 |  |                             |      |                            |   |      |   |      |     
|Dividend yield                                   |  |                             | 0.0  | %                          |   | 0.0  | % |      | 0.0  | % |   | 0.0  | %
|Weighted average volatility                      |  |                             | 46.4 | %                          |   | 77.3 | % |      | 54.3 | % |   | 82.1 | %
|Risk-free interest rate                          |  |                             | 4.8  | %                          |   | 3.8  | % |      | 4.4  | % |   | 3.5  | %
|Expected holding period (in
  years)             |  |                             | 4.8  |                            |   | 3.8  |   |      | 4.8  |   |   | 3.8  |  
|Weighted average fair value of
  options granted |  | $                           | 1.26 |                            | $ | 1.42 |   | $    | 1.41 |   | $ | 2.34 |  

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | No dividend yield was assumed because we currently do not
  pay cash dividends on our common stock and have no plans to reinstate a
  dividend. An increase in the dividend yield will decrease stock compensation
  expense.                                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | The weighted average volatility for the current period was
  developed using equal weight from (a) implied volatilities of traded options
  and warrants to purchase the companys common stock at prices that
  approximate the options exercise price and have a life in excess of one
  year, and (b) historical volatility for periods equal to the expected life of
  the options. Prior to fiscal 2006, only historical volatility was considered.
  An increase in the weighted average volatility assumption will increase stock
  compensation expense.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | The risk-free interest rate was developed using the U.S.
  Treasury yield curve for periods equal to the expected life of the options on
  the grant date. An increase in the risk-free interest rate will increase
  stock compensation expense.                                                                                                                                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | The expected holding period for the current period grants
  was calculated using the average of the vesting period and the term of the
  option based on guidance contained in SAB 107. Prior to fiscal 2006, this
  assumption was developed after considering vesting schedules, life of the
  option, historical experience and estimates of future exercise behavior
  patterns. An increase in the expected holding period will increase stock
  compensation expense.                                                                                      

SFAS 123R requires the recognition
of stock-based compensation for the number of awards that are ultimately
expected to vest. As a result, for most awards, recognized stock compensation
was reduced for estimated forfeitures prior to vesting primarily based on
historical annual forfeiture rates of approximately 7%. Estimated forfeitures
will be reassessed in subsequent periods and may change based on new facts and
circumstances. Prior to October 1, 2005, actual forfeitures were accounted for
as they occurred for purposes of required pro forma stock compensation
disclosures.

As of June 30, 2006, approximately
$89 million of unrecognized stock compensation related to unvested awards (net
of estimated forfeitures) is expected to be recognized over a weighted-average
period of 1.5 years.

5. BUSINESS
RESTRUCTURING

|                                               |  |                        |   |                        |   |                     |   |       |     |   |   |     |  
|---------------------------------------------- |  | ---------------------- | - | ---------------------- | - | ------------------- | - | ----- | --- | - | - | --- | -
|(in millions)                                  |  | Employee
  separations |   | Contract
  settlements |   | Facility
  closings |   | Total |    
|                                               |  |                        |   |                        |   |                     |   |       |    
|Restructuring reserve as of September 30, 2005 |  | $                      | 1 |                        | $ | 1                   |   | $     | 145 |   | $ | 147 |  
|Revisions to prior year plans                  |  |                        |  |                        |   | (1                  | ) |       | 5   |   |   | 4   |  
|Utilization of reserves                        |  |                        |  |                        |   |                    |   |       | (31 | ) |   | (31 | )
|                                               |  |                        |   |                        |   |                     |   |       |     |   |   |     |  
|Restructuring reserve as of June 30, 2006      |  | $                      | 1 |                        | $ |                    |   | $     | 119 |   | $ | 120 |  
|                                               |  |                        |   |                        |   |                     |   |       |     |   |   |     |  

Facility closing reserves are for the
expected remaining future cash outlays associated with trailing lease
liabilities, lease termination payments and expected restoration costs in
connection with plans to reduce a significant number of leased facilities. The
remaining liability is expected to be paid over the remaining lease

---



|          |                   
|--------- | ------------------
|<PAGE> 12 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

terms and is reflected net of
expected sublease income of $71 million. Additional charges may be required in
the future if the expected sublease income is not realized.

6. SUPPLEMENTARY
BALANCE SHEET INFORMATION

|                                                                                             |  |                 |       |                      |   |       |  
|-------------------------------------------------------------------------------------------- |  | --------------- | ----- | -------------------- | - | ----- | -
|(in millions)                                                                                |  | June 30,
  2006 |       | September 30,
  2005 |  
|                                                                                             |  |                 |       |                      |  
|Completed
  goods                                                                            |  | $               | 527   |                      | $ | 580   |  
|Work in
  process                                                                            |  |                 | 51    |                      |   | 39    |  
|Raw
  materials                                                                              |  |                 | 195   |                      |   | 112   |  
|                                                                                             |  |                 |       |                      |   |       |  
|Inventories,
  net of reserves of $658 as of June 30, 2006 and $712 as of September 30, 2005 |  | $               | 773   |                      | $ | 731   |  
|                                                                                             |  |                 |       |                      |   |       |  
|                                                                                             |  |                 |       |                      |   |       |  
|Costs and
  recognized income not yet billed                                                 |  | $               | 295   |                      | $ | 208   |  
|Billings
  in excess of costs and recognized income                                          |  |                 | (269  | )                    |   | (220  | )
|                                                                                             |  |                 |       |                      |   |       |  
|Contracts
  in process reflected in other current assets (liabilities)                       |  | $               | 26    |                      | $ | (12   | )
|                                                                                             |  |                 |       |                      |   |       |  
|                                                                                             |  |                 |       |                      |   |       |  
|Restricted cash                                                                              |  | $               | 353   |                      | $ | 41    |  
|Deferred income taxes                                                                        |  |                 | 242   |                      |   | 237   |  
|Prepaid expenses                                                                             |  |                 | 211   |                      |   | 206   |  
|Non-trade receivables                                                                        |  |                 | 129   |                      |   | 117   |  
|Income tax receivables, including related
interest                                           |  |                 | 43    |                      |   | 85    |  
|Contracts in process                                                                         |  |                 | 26    |                      |   |      |  
|Other                                                                                        |  |                 | (3    | )                    |   | 4     |  
|                                                                                             |  |                 |       |                      |   |       |  
|Other current assets                                                                         |  | $               | 1,001 |                      | $ | 690   |  
|                                                                                             |  |                 |       |                      |   |       |  
|                                                                                             |  |                 |       |                      |   |       |  
|Marketed software                                                                            |  | $               | 261   |                      | $ | 254   |  
|Internal use software                                                                        |  |                 | 104   |                      |   | 120   |  
|Restricted cash                                                                              |  |                 | 139   |                      |   | 137   |  
|Deferred income taxes                                                                        |  |                 | 77    |                      |   | 78    |  
|Investments                                                                                  |  |                 | 61    |                      |   | 65    |  
|Non-trade receivables                                                                        |  |                 | 20    |                      |   | 20    |  
|Retainage receivables                                                                        |  |                 | 4     |                      |   | 8     |  
|Other                                                                                        |  |                 | 275   |                      |   | 248   |  
|                                                                                             |  |                 |       |                      |   |       |  
|Other assets                                                                                 |  | $               | 941   |                      | $ | 930   |  
|                                                                                             |  |                 |       |                      |   |       |  
|                                                                                             |  |                 |       |                      |   |       |  
|Deferred revenue                                                                             |  | $               | 599   |                      | $ | 529   |  
|Winstar litigation reserve                                                                   |  |                 | 284   |                      |   |      |  
|Warranty                                                                                     |  |                 | 141   |                      |   | 188   |  
|Contracts in process                                                                         |  |                 |      |                      |   | 12    |  
|Business restructuring                                                                       |  |                 | 28    |                      |   | 44    |  
|Other                                                                                        |  |                 | 728   |                      |   | 815   |  
|                                                                                             |  |                 |       |                      |   |       |  
|Other current liabilities                                                                    |  | $               | 1,780 |                      | $ | 1,588 |  
|                                                                                             |  |                 |       |                      |   |       |  
|                                                                                             |  |                 |       |                      |   |       |  
|Deferred income taxes                                                                        |  | $               | 244   |                      | $ | 205   |  
|Deferred compensation                                                                        |  |                 | 58    |                      |   | 112   |  
|Business restructuring                                                                       |  |                 | 91    |                      |   | 102   |  
|Environmental                                                                                |  |                 | 58    |                      |   | 72    |  
|Warranty                                                                                     |  |                 | 68    |                      |   | 69    |  
|Minority interests                                                                           |  |                 | 29    |                      |   | 63    |  
|Other, including contingencies                                                               |  |                 | 305   |                      |   | 342   |  
|                                                                                             |  |                 |       |                      |   |       |  
|Other liabilities                                                                            |  | $               | 853   |                      | $ | 965   |  
|                                                                                             |  |                 |       |                      |   |       |  

---



|          |                   
|--------- | ------------------
|<PAGE> 13 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

7. GOODWILL AND
OTHER ACQUIRED INTANGIBLE ASSETS

The following table summarizes the
changes in the carrying value of goodwill and other acquired intangible assets.

|                         |  |                                                  |    |                                  |   |                              |  |          |     |       |   |                                        |  |   |     |  |   |     |  
|------------------------ |  | ------------------------------------------------ | -- | -------------------------------- | - | ---------------------------- |  | -------- | --- | ----- | - | -------------------------------------- |  | - | --- |  | - | --- | -
|                         |  | Goodwill                                         |    |                                  |   |                             
|                         |  |                                                  |    |                                  |   |                             
|(in millions)            |  | Mobility
  Access and
  Applications
  Solutions |    | Multimedia
  Network
  Solutions |   | Converged
  Core
  Solutions |  | Services |     | Total |   | Other
  acquired
  intangible
  assets | 
|                         |  |                                                  |    |                                  |   |                              |  |          |     |       |   |                                        | 
|As of September 30, 2005 |  | $                                                | 32 |                                  | $ | 86                           |  | $        | 154 |       | $ | 102                                    |  | $ | 374 |  | $ | 45  |  
|Telica escrow release    |  |                                                  |   |                                  |   |                             |  |          | 20  |       |   | 9                                      |  |   | 29  |  |   |    |  
|Riverstone acquisition   |  |                                                  |   |                                  |   | 90                           |  |          |    |       |   |                                       |  |   | 90  |  |   | 89  |  
|Amortization             |  |                                                  |   |                                  |   |                             |  |          |    |       |   |                                       |  |   |    |  |   | (16 | )
|                         |  |                                                  |    |                                  |   |                              |  |          |     |       |   |                                        |  |   |     |  |   |     |  
|As of June 30, 2006      |  | $                                                | 32 |                                  | $ | 176                          |  | $        | 174 |       | $ | 111                                    |  | $ | 493 |  | $ | 118 |  
|                         |  |                                                  |    |                                  |   |                              |  |          |     |       |   |                                        |  |   |     |  |   |     |  

During February 2006, nine million
shares of our common stock, valued at $29 million, were released from an escrow
account established for possible post-closing claims related to the Telica
acquisition. The escrow agreement expired and there were no pending claims
against the escrow.

The following table summarizes the
estimated future amortization expense of other acquired intangible assets.

|               |  |        |     | 
|-------------- |  | ------ | --- | 
|(in millions)  |  |        |    
|Fiscal Year:   |  | Amount |    
|               |  |        |    
|Remainder 2006 |  | $      | 10  | 
|2007           |  |        | 38  | 
|2008           |  |        | 36  | 
|2009           |  |        | 22  | 
|2010           |  |        | 12  | 
|               |  |        |     | 
|Total          |  | $      | 118 | 
|               |  |        |     | 

8. RIVERSTONE
ACQUISITION

On April 27, 2006, we acquired
certain net assets of Riverstone Networks Inc., a supplier of carrier-grade
Ethernet routers, for $207 million in cash plus $3 million for direct costs of
the acquisition. The purchase price included $10 million of cash that is held
in escrow. The escrow is expected to be released upon the favorable resolution
of certain indemnifications during the fourth quarter of fiscal 2006.

The purchase price in excess of the
estimated fair value of tangible net assets acquired was allocated to goodwill
($90 million), identifiable intangible assets ($89 million) and in-process
research and development (IPR&D) ($12 million). The identifiable intangible
assets were attributed to developed technology and customer relationships that
are amortized over their expected useful lives from 1 to 4 years. IPR&D
represents technology that has not reached technological feasibility and has no
alternative future use. The value of IPR&D was determined using an income
approach that included an excess earnings analysis reflecting the appropriate
cost of capital for each project. These estimated future cash flows considered
estimates of revenues, gross margin, operating expenses and income taxes and
were consistent with historical pricing, cost and expense levels for similar
products. The weighted average discount rate utilized to discount the cash
flows of identifiable intangible assets was 22%. The discount rates were
determined after consideration of our weighted average cost of capital, as well
as other factors, including the estimated useful life of each project and the
uncertainty of technological advances that were known at the time and the stage
of completion of each project. A 25% discount rate was used to derive the
present value of the cash flows for IPR&D due to the higher inherent risks
of completing the projects. The goodwill and identifiable intangible assets
will be deductible for tax purposes.

The operating results of Riverstone
were included in our consolidated results since the date of acquisition. Pro
forma results were not presented because the effect of the acquisition was not
material.

---



|          |                   
|--------- | ------------------
|<PAGE> 14 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

9. COMPREHENSIVE
INCOME

The components of other
comprehensive income are summarized below. Foreign currency translation
adjustments are generally not adjusted for income taxes, as they relate to
indefinite investments in non-U.S. subsidiaries.

|                                                 |  |                             |    |                            |   |      |   |      |     |   |   |     |  
|------------------------------------------------ |  | --------------------------- | -- | -------------------------- | - | ---- | - | ---- | --- | - | - | --- | -
|                                                 |  | Three months ended June 30, |    | Nine months ended June 30, |  
|(in millions)                                    |  | 2006                        |    | 2005                       |   | 2006 |   | 2005 |    
|                                                 |  |                             |    |                            |   |      |   |      |    
|Net income                                       |  | $                           | 79 |                            | $ | 372  |   | $    | 156 |   | $ | 813 |  
|Minimum pension liability adjustment             |  |                             |   |                            |   |     |   |      |    |   |   | (4  | )
|Foreign currency translation adjustments         |  |                             | 21 |                            |   | (21  | ) |      | 27  |   |   | 26  |  
|Unrealized holding gains (losses) on investments |  |                             | (2 | )                          |   | 9    |   |      | (7  | ) |   | (3  | )
|                                                 |  |                             |    |                            |   |      |   |      |     |   |   |     |  
|Comprehensive income                             |  | $                           | 98 |                            | $ | 360  |   | $    | 176 |   | $ | 832 |  
|                                                 |  |                             |    |                            |   |      |   |      |     |   |   |     |  

10. EARNINGS PER
COMMON SHARE (EPS)

Basic EPS is calculated by dividing
net income by the weighted average number of common shares outstanding during
the period. Diluted EPS is calculated by dividing net income, adjusted to
exclude preferred dividends and accretion, conversion costs, redemption costs
and interest expense related to the potentially dilutive securities, by the
weighted average number of common shares outstanding during the period, plus
any additional common shares that would have been outstanding if potentially
dilutive common shares had been issued during the period.

The following table summarizes the
computation of basic and diluted EPS.

|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|------------------------------------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- | - | ---- | ----- |  | - | ----- | 
|                                                  |  | Three months ended June 30, |       | Nine months ended June 30, |  
|(in millions,
  except per share amounts)         |  | 2006                        |       | 2005                       |   | 2006  |   | 2005 |      
|                                                  |  |                             |       |                            |   |       |   |      |      
|Net income                                        |  | $                           | 79    |                            | $ | 372   |   | $    | 156   |  | $ | 813   | 
|Adjustment for dilutive securities on net income: |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|7.75% convertible securities                      |  |                             |      |                            |   | (1    | ) |      |      |  |   | 1     | 
|2.75% convertible securities                      |  |                             |      |                            |   | 11    |   |      |      |  |   | 34    | 
|8.00% convertible securities                      |  |                             |      |                            |   | 11    |   |      |      |  |   |      | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|Net income  diluted                              |  | $                           | 79    |                            | $ | 393   |   | $    | 156   |  | $ | 848   | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|Weighted average shares outstanding  basic       |  |                             | 4,479 |                            |   | 4,433 |   |      | 4,465 |  |   | 4,419 | 
|Effect of dilutive securities:                    |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|Stock options                                     |  |                             | 40    |                            |   | 49    |   |      | 44    |  |   | 62    | 
|Warrants                                          |  |                             |      |                            |   | 1     |   |      | 2     |  |   | 14    | 
|7.75% convertible securities                      |  |                             |      |                            |   | 10    |   |      |      |  |   | 10    | 
|2.75% convertible securities                      |  |                             |      |                            |   | 622   |   |      |      |  |   | 534   | 
|8.00% convertible securities                      |  |                             |      |                            |   | 211   |   |      |      |  |   |      | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|Weighted average shares outstanding  diluted     |  |                             | 4,519 |                            |   | 5,326 |   |      | 4,511 |  |   | 5,039 | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|                                                  |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|EPS:                                              |  |                             |       |                            |   |       |   |      |       |  |   |       | 
|Basic                                             |  | $                           | 0.02  |                            | $ | 0.08  |   | $    | 0.03  |  | $ | 0.18  | 
|Diluted                                           |  | $                           | 0.02  |                            | $ | 0.07  |   | $    | 0.03  |  | $ | 0.17  | 

The following table summarizes the
potential shares of common stock that were excluded from diluted earnings per
share, because the effect of including these potential shares would be
antidilutive.

---



|          |                   
|--------- | ------------------
|<PAGE> 15 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|-------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ----- | -------------------------- |  | ---- |  | ---- | ----- |  |  | --- | 
|                                                                                                                                                   |  | Three months ended June 30, |       | Nine months ended June 30, | 
|(in millions)                                                                                                                                      |  | 2006                        |       | 2005                       |  | 2006 |  | 2005 |      
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |      
|2.75%
  convertible securities                                                                                                                     |  |                             | 641   |                            |  |     |  |      | 617   |  |  |    | 
|8.00%
  convertible securities                                                                                                                     |  |                             | 191   |                            |  | 44   |  |      | 190   |  |  | 251 | 
|7.75%
  convertible securities                                                                                                                     |  |                             | 228   |                            |  | 228  |  |      | 228   |  |  | 228 | 
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|Total
  potentially dilutive shares                                                                                                                |  |                             | 1,060 |                            |  | 272  |  |      | 1,035 |  |  | 479 | 
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|Securities
  excluded from diluted earnings per share because the exercise price was
  greater than the average market price of the common shares: |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|Warrants                                                                                                                                           |  |                             | 199   |                            |  |     |  |      |      |  |  |    | 
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 
|Stock
  options                                                                                                                                    |  |                             | 268   |                            |  | 315  |  |      | 281   |  |  | 292 | 
|                                                                                                                                                   |  |                             |       |                            |  |      |  |      |       |  |  |     | 

11. OPERATING
SEGMENTS

Network Solutions Group consists of
the following operating segments: Mobility Access Solutions, Applications
Solutions, Multimedia Network Solutions and Converged Core Solutions.
Applications Solutions is aggregated with Mobility Access Solutions because its
results are not material and do not meet the requirements for being reported
separately. Applications Solutions was previously reported with our wireless
business. Multimedia Network Solutions consists primarily of optical, data and
access products. Converged Core Solutions consists primarily of voice
networking products, including circuit switching, personal handyphone systems and
next-generation switching products. The Network Operations Software reporting
unit that was previously reported within the wireline business was transferred
to Lucent Worldwide Services (Services). Services provides deployment,
maintenance, professional and managed services in support of our product
offerings and multivendor networks. Other changes to the previous reporting
structure included the elimination of certain internal revenue sharing
arrangements between our wireless and wireline businesses, the internal
transfer of certain organizations and revised allocations of employee benefit
costs that are more closely aligned with actual benefit costs for active
employees. The prior period segment results were revised to conform to the new
reporting structure. In addition, the revenues attributed to products and
services were revised in the Consolidated Statements of Operations to conform
to the new reporting structure. The accounting policies of the reportable
segments are the same as those applied in the consolidated financial
statements.

Performance measurement and resource
allocation for the reportable segments are based on many factors. The primary
financial measures include the revenues, costs and expenses directly controlled
by each reportable segment and exclude the following:

| |   |                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Global sales organization expenses.                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Certain costs related to shared services, such as general
  corporate functions, which are managed on a common basis in order to realize
  economies of scale and efficient use of resources.                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Certain employee compensation and benefits, including
  stock-based compensation, differences between actual and budgeted employee
  benefit costs, differences between actual and budgeted employee incentive
  awards, as well as most of the impacts related to pension, postretirement and
  postemployment benefits.
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Bad debt and customer financing expenses and recoveries.                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Business restructuring.                                                                                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Revenues and expenses associated with licensing and
  protecting intellectual property rights.                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                          
| |  | Certain other general and miscellaneous costs and expenses
  not directly used in assessing the performance of the operating segments.                                                                                                                                                                                   

---



|          |                   
|--------- | ------------------
|<PAGE> 16 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|--------------------------------------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- | - | ---- | ----- | - | - | ----- | -
|                                                    |  | Three months ended June 30, |       | Nine months ended June 30, |  
|(in millions)                                       |  | 2006                        |       | 2005                       |   | 2006  |   | 2005 |      
|                                                    |  |                             |       |                            |   |       |   |      |      
|Revenues:                                           |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|MobilityAccess and Applications
  Solutions         |  | $                           | 827   |                            | $ | 1,187 |   | $    | 2,774 |   | $ | 3,576 |  
|Multimedia Network Solutions                        |  |                             | 454   |                            |   | 367   |   |      | 1,237 |   |   | 1,093 |  
|Converged Core Solutions                            |  |                             | 147   |                            |   | 189   |   |      | 443   |   |   | 614   |  
|Services                                            |  |                             | 581   |                            |   | 559   |   |      | 1,669 |   |   | 1,627 |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|Reportable segments                                 |  |                             | 2,009 |                            |   | 2,302 |   |      | 6,123 |   |   | 6,910 |  
|Intellectual property                               |  |                             | 37    |                            |   | 31    |   |      | 97    |   |   | 73    |  
|Other                                               |  |                             | 4     |                            |   | 7     |   |      | 15    |   |   | 27    |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|Revenues                                            |  | $                           | 2,050 |                            | $ | 2,340 |   | $    | 6,235 |   | $ | 7,010 |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|Operating income:                                   |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|MobilityAccess and Applications
  Solutions         |  | $                           | 228   |                            | $ | 438   |   | $    | 916   |   | $ | 1,297 |  
|Multimedia Network Solutions                        |  |                             | 26    |                            |   | 15    |   |      | 113   |   |   | 19    |  
|Converged Core Solutions                            |  |                             | 20    |                            |   | 34    |   |      | 36    |   |   | 20    |  
|Services                                            |  |                             | 84    |                            |   | 106   |   |      | 219   |   |   | 240   |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|Reportable segments                                 |  |                             | 358   |                            |   | 593   |   |      | 1,284 |   |   | 1,576 |  
|Global sales organization                           |  |                             | (111  | )                          |   | (117  | ) |      | (330  | ) |   | (382  | )
|Shared services such as general corporate functions |  |                             | (269  | )                          |   | (264  | ) |      | (815  | ) |   | (810  | )
|Unallocated compensation and benefits               |  |                             | 214   |                            |   | 146   |   |      | 484   |   |   | 573   |  
|Bad debts and customer financings                   |  |                             | 2     |                            |   | 53    |   |      | 7     |   |   | 75    |  
|Business restructuring                              |  |                             | (7    | )                          |   | (6    | ) |      | (4    | ) |   | 1     |  
|Winstar litigation charge                           |  |                             |      |                            |   |      |   |      | (278  | ) |   |      |  
|Other                                               |  |                             | (13   | )                          |   | (34   | ) |      | (14   | ) |   | (75   | )
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  
|Operating income                                    |  | $                           | 174   |                            | $ | 371   |   | $    | 334   |   | $ | 958   |  
|                                                    |  |                             |       |                            |   |       |   |      |       |   |   |       |  

Two customers accounted for 25% and
11% of consolidated revenues during the three months ended June 30, 2006 and
29% and 11% of consolidated revenues during the nine months ended June 30,
2006. Two customers accounted for 31% and 13% of consolidated revenues during
the three months ended June 30, 2005 and 29% and 13% of consolidated revenues
during the nine months ended June 30, 2005.

12. COMMITMENTS AND
CONTINGENCIES

Legal Proceedings

We are subject to legal proceedings,
lawsuits, and other claims, including proceedings by government authorities. In
addition, we may be subject to liabilities of some of our former affiliates
under separation agreements with them. Legal proceedings are subject to uncertainties,
and the outcomes are difficult to predict. Consequently, unless otherwise
indicated, we are unable to estimate the ultimate aggregate amounts of monetary
liability or ranges of possible losses with respect to our pending litigation
matters as of June 30, 2006. The resolution of these matters could have a
material impact on our consolidated results of operations, financial position
and cash flows. Charges of $8 million and $295 million were recognized during
the three and nine months ended June 30, 2006, including charges resulting from
the Winstar judgment discussed below.

Winstar

We were a defendant in an adversary
proceeding originally filed in U.S. Bankruptcy Court in Delaware by Winstar and
Winstar Wireless, Inc. in connection with the bankruptcy of Winstar and various
related entities. The trial for this matter concluded in June 2005. The trial
pertained to breach of contract and other claims against us, for which the
trustee for Winstar was seeking compensatory damages of approximately $60 million,
as well as costs and expenses associated with litigation. The trustee was also
seeking recovery of a payment Winstar made to us in December 2000 of
approximately $190 million plus interest. On December 21, 2005, the judge
rendered his decision and the verdict resulted in a judgment against Lucent for
approximately $244

---



|          |                   
|--------- | ------------------
|<PAGE> 17 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

million, plus statutory interest and
other costs. As a result, we recognized a $278 million charge (including
related interest and other costs of approximately $34 million) in the first
quarter of fiscal 2006 and an additional $6 million charge for post-judgment
interest during the nine months ended June 30, 2006. In addition, $311 million
of cash was used to collateralize a letter of credit that was issued during the
second quarter of fiscal 2006 in connection with this matter. This judgment is
under appeal with the U.S. District Court for the District of Delaware.
Additional charges for post-judgment interest will be recognized in subsequent
periods until this matter is resolved.

Government
Investigations

During August 2003, the U.S.
Department of Justice (DOJ) and the SEC informed us that they had each
commenced an investigation into possible violations of the Foreign Corrupt
Practices Act (FCPA) with respect to our operations in Saudi Arabia. These
investigations followed allegations made by National Group for Communications
and Computers Ltd. (NGC) in an action filed against us on August 8, 2003, which
is described below. In April 2004, we reported to the DOJ and the SEC that an internal
FCPA compliance audit and an outside counsel investigation found incidents and
internal control deficiencies in our operations in China that potentially
involve FCPA violations. We are cooperating with those agencies. We believe
these incidents and deficiencies did not have a material effect on our results
of operations. However, we cannot determine whether this continuing
investigation will affect our future business operations in China. The
investigation is continuing with respect to both China and Saudi Arabia.

During the third quarter of fiscal
2005, we received subpoenas on two different matters, requesting specific
documents and records. One of the subpoenas relates to a DOJ investigation of
potential antitrust and other violations by various participants in connection
with the federal E-Rate program. The subpoena requires us to produce documents
before a grand jury of the U.S. District Court in Georgia. The second subpoena
was from the Office of Inspector General, U.S. General Services Administration
and relates to a federal investigation into certain sales to the federal
government of telecommunications equipment and related maintenance services.
During April 2006, the California Department of Justice served us with
discovery requests related to sales to California governmental agencies of
telecommunications equipment and related maintenance services. It is too early
for us to determine whether any of these matters will have a material effect on
our business, financial position, results of operations or cash flows.

Employment and
Benefits Related Cases

We have implemented various actions
to address the rising costs of providing retiree health care benefits and the
funding of our pension plans. These actions have led to the filing of cases
against us and may lead to the filing of additional cases. Purported class
action lawsuits have been filed against us in connection with the elimination
of the death benefit from our U.S. management pension plan in early 2003. Three
such cases have been consolidated into a single action pending in the U.S.
District Court in New Jersey, captioned In
Re Lucent Death Benefits ERISA Litigation. The elimination of this
benefit reduced our future pension obligations by approximately $400 million.
The benefit was paid out of the pension plan assets to certain qualified
surviving dependents, such as spouses or dependent children of management
retirees. The case alleges that we wrongfully terminated this death benefit and
requests that it be reinstated, along with other remedies. We have filed a
motion to dismiss, which is pending. Another such case, Chastain, et al. v. AT&T, was filed in the U.S. District Court in
the
Western District of Oklahoma. The Chastain
case also involves claims related to changes to retiree health care benefits.
In October 2005, a purported class action was filed by Peter A. Raetsch,
Geraldine Raetsch and Curtis Shiflett, on behalf of themselves and all others
similarly situated, in the U.S. District Court for the District of New Jersey.
The plaintiffs allege that Lucent failed to maintain health care benefits for
retired management employees as required by the Internal Revenue Code, the
Employee Retirement Income Security Act, and the Lucent pension and medical
plans. We have filed a motion to dismiss, which is pending.

The Equal Employment Opportunity
Commission (EEOC) filed a purported class action lawsuit against us,

---



|          |                   
|--------- | ------------------
|<PAGE> 18 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

EEOC v. Lucent
Technologies Inc., in the U.S. District Court in California. The case alleges gender
discrimination in connection with the provision of service credit to a class of
present and former Lucent employees who were out of work because of maternity
prior to 1980 and seeks the restoration of lost service credit prior to April
29, 1979, together with retroactive pension payment adjustments, corrections of
service records, back pay and recovery of other damages and attorneys fees and
costs.

Other Matters

On April 3,
2006, a putative class action entitled Resnick
v. Lucent Technologies Inc., et al was filed against us and members of
our board of directors in the Superior Court of New Jersey, Law Division, Union
County. The named plaintiffs propose to represent a class of Lucents public
shareholders and claim that, among other things, the proposed merger with
Alcatel is the product of breaches of duty by Lucents board of directors in
that they allegedly failed to maximize shareholder value in the transaction.
Along with other relief, the complaint seeks an injunction against the closing
of the proposed merger. We believe the action is without merit and that we have
substantial defenses to the claims.

On May 12, 2006, a putative class action entitled AR
  Maley Trust v. Lucent Technologies Inc., et al was filed against us and the
  current members of our board of directors in the United States District Court
  for the Southern District of New York. The first amended complaint was filed
  on June 23, 2006. The named plaintiff proposes to represent a class of our public
  shareholders and claims that, among other things, the proposed merger with Alcatel
  constitutes a breach of duty in that defendants allegedly failed to maximize
  shareholder value with the transaction. Along with other relief, the complaint
  seeks an injunction against the closing of the proposed merger. We believe the
  action is without merit and that we have substantial defenses to the claims.

On August 8, 2003, NGC filed an
action in the U.S. District Court for the Southern District of New York against
us, certain former officers and employees, our subsidiary, Lucent Technologies
International Inc., certain unaffiliated individuals and an unaffiliated
company, alleging violations of the Racketeer Influenced Corrupt Organizations
Act (RICO) and other improper activities. These allegations relate to
activities in Saudi Arabia in connection with certain telecommunications
contracts involving Lucent, the Kingdom of Saudi Arabia and other entities. The
complaint seeks damages in excess of $63 million, which could be tripled under
RICO. The allegations in this complaint appear to arise out of certain
contractual disputes between NGC and Lucent that are the subject of a separate
case that NGC previously filed against us in U.S. District Court in New Jersey
and other related proceedings brought by NGC in Saudi Arabia. On March 1, 2006,
the District Court in New York granted our motion to dismiss the case in its
entirety. NGC has filed a notice of appeal. Some of the claims brought by NGC
in the New Jersey action have been dismissed, but that case and the other
claims in Saudi Arabia are still pending.

Separation
Agreements

We are party to various agreements
that were entered into in connection with the separation of Lucent and former
affiliates, including AT&T, Avaya, Agere Systems and NCR Corporation.
Pursuant to these agreements, we and the former affiliates have agreed to
allocate certain liabilities related to each others business, and have agreed
to share liabilities based on certain allocations and thresholds. We are not
aware of any material liabilities to our former affiliates as a result of the
separation agreements that are not otherwise reflected in our unaudited
consolidated financial statements. Nevertheless, it is possible that potential
liabilities for which the former affiliates bear primary responsibility may
lead to contributions by us.

Guarantees and
Indemnification Agreements

We divested certain businesses and
assets through sales to third-party purchasers and spin-offs to our common
shareowners. In connection with these transactions, certain direct or indirect
indemnifications are provided to the buyers or other third parties doing
business with the divested entities. These indemnifications include secondary
liability for certain leases of real property and equipment assigned to the
divested entity and certain

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|          |                   
|--------- | ------------------
|<PAGE> 19 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

specific indemnifications for
certain legal and environmental contingencies, as well as vendor supply
commitments. The time durations of such indemnifications vary but are standard
for transactions of this nature.

We remain secondarily liable for
approximately $140 million of lease obligations as of June 30, 2006, that were
assigned to Avaya, Agere and purchasers of other businesses that were divested.
The remaining terms of these assigned leases and our corresponding guarantees
range from one month to 14 years. The primary obligor under assigned leases may
terminate or restructure the lease obligation before its original maturity and
thereby relieve us of our secondary liability. We generally have the right to
receive indemnity or reimbursement from the assignees and have not reserved for
losses on this form of guarantee.

We are party to a tax-sharing
agreement to indemnify AT&T and are liable for tax adjustments that are
attributable to our lines of business, as well as a portion of certain other
shared tax adjustments during the years prior to our separation from AT&T.
We have similar agreements with Avaya and Agere. Certain tax adjustments have
been proposed or assessed subject to these tax-sharing agreements. The outcome
of these other matters is not expected to have a material adverse effect on our
consolidated results of operations, consolidated financial position or
near-term liquidity.

We license to our customers software
and rights to use intellectual property that might provide the licensees with
an indemnification against any liability arising from third-party claims of
patent, copyright or trademark infringement. We cannot determine the maximum
amount of losses that we could incur under this type of indemnification,
because we often may not have enough information about the nature and scope of
an infringement claim until it has been submitted to us.

We indemnify our directors and
certain of our current and former officers for third-party claims alleging
certain breaches of their fiduciary duties as directors or officers. Certain
costs incurred for providing such indemnification may be recovered under
various insurance policies. We are unable to reasonably estimate the maximum
amount that could be payable under these arrangements since these exposures are
not capped and due to the conditional nature of our obligations and the unique
facts and circumstances involved in each agreement. Historically, payments made
under these agreements have not had a material effect on our business,
financial condition, results of operations or cash flows.

Warranty reserves are established
for costs that are expected to be incurred after the sale and delivery of a
product or service under specific product or service warranty provisions. These
reserves are established when it is probable that customers will make claims
and when a reasonable estimate of costs can be made. The reserves are
determined as a percentage of revenues based on the actual trend of historical
charges incurred over various periods. In addition, any significant or infrequent
issues are specifically identified and reserved. The following table summarizes the activity related to warranty
reserves.

|                             |  |      |     |      |   |     |  
|---------------------------- |  | ---- | --- | ---- | - | --- | -
|(in millions)                |  | 2006 |     | 2005 |  
|                             |  |      |     |      |  
|Reserve as of September 30   |  | $    | 257 |      | $ | 297 |  
|Accruals for warranties, net |  |      | 48  |      |   | 42  |  
|Payments                     |  |      | (96 | )    |   | (54 | )
|                             |  |      |     |      |   |     |  
|Reserve as of June 30        |  | $    | 209 |      | $ | 285 |  
|                             |  |      |     |      |   |     |  

Environmental
Matters

Our current and historical
operations are subject to a wide range of environmental laws. In the United
States, these laws often require parties to fund remedial action regardless of
fault. We have remedial and investigatory activities underway at numerous
current and former facilities.

Environmental reserves of $90
million have been established for environmental liabilities that can be reasonably
estimated as of June 30, 2006. These reserves are not discounted to present
value. We have receivables of $19 million with respect to environmental matters
due from third-party indemnitors as of June 30, 2006. Receivables are recorded
only if the indemnitors have agreed to pay the claims and management believes

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|          |                   
|--------- | ------------------
|<PAGE> 20 | Form 10-Q - Part I

Notes to Consolidated Financial Statements
(Unaudited)

collection of the receivables is
reasonably assured. Environmental matters did not have a significant impact on
our consolidated results of operations, financial position and cash flows for
all periods presented.

Reserves for estimated losses from
environmental remediation are, depending on the site, based on analyses of many
interrelated factors, including:

| |   |                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------
| |  | The extent and degree of contamination and the nature of
  required remedial actions.                                                          
| |   |                                                                                                                                                
| |  | The timing and various types of environmental
  expenditures, such as investigatory, remedial, capital and operations, and
  maintenance costs.
| |   |                                                                                                                                                
| |  | Applicable legal requirements defining remedial goals and
  methods.                                                                           
| |   |                                                                                                                                                
| |  | Progress and stage of existing remedial programs in
  achieving remedial goals.                                                                
| |   |                                                                                                                                                
| |  | Innovations in remedial technology and expected trends in
  environmental costs and legal requirements.                                        
| |   |                                                                                                                                                
| |  | The number, participation level and financial viability of
  other potentially responsible parties.                                            
| |   |                                                                                                                                                
| |  | The timing and likelihood of potential recoveries or
  contributions from other third parties.                                                 
| |   |                                                                                                                                                
| |  | Historical experience.                                                                                                                         
| |   |                                                                                                                                                
| |  | The degree of certainty and reliability of all the factors
  considered.                                                                       

It is often difficult to estimate
the future impact of environmental matters, including potential liabilities,
due to the above factors and the lengthy time periods involved in resolving
them, which may be up to 30 years or longer. Although we believe that our
reserves are currently adequate, there can be no assurance that the amount of
capital expenditures and other expenses that will be required for remedial
actions and compliance with applicable environmental laws will not exceed the
amounts reflected in reserves or will not have a material adverse effect on our
consolidated financial condition, results of operations or cash flows. Any
possible loss or range of possible loss that may be incurred in excess of
amounts provided for as of June 30, 2006 cannot be reasonably estimated.

13. RECENT
PRONOUNCEMENTS

During June 2006, the Financial Accounting Standards
  Board (FASB) issued FASB Interpretation No. 48, Accounting
  for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,
  which clarifies the accounting for uncertainty in income taxes. This Interpretation
  prescribes a recognition threshold and measurement attribute for the financial
  statement recognition and measurement of a tax position taken or expected to
  be taken in a tax return. This Interpretation also provides guidance on derecognition,
  classification, interest and penalties, accounting in interim periods, disclosure,
  and transition. This Interpretation is effective for fiscal years beginning
  after December 15, 2006. We are currently evaluating the effects, if any, that
  this Interpretation may have on our consolidated financial statements.

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|          |                   
|--------- | ------------------
|<PAGE> 21 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis
of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

This quarterly report, including the Managements Discussion and
Analysis of Financial Condition and Results of Operations (MD&A), contains
statements regarding future performance, events or developments, including the
proposed transaction between Lucent and Alcatel, the expected timetable for
completing the proposed transaction and other statements about Lucent
managements future expectations, beliefs, goals, plans or prospects that are
based on current expectations, estimates, forecasts and projections about
Lucent, as well as Lucents future performance and the industries in which it
operates, in addition to managements assumptions. These statements constitute
forward-looking statements within the meaning of the U.S. Private Securities
Litigation Reform Act of 1995. Words such as expects, anticipates,
targets, goals, projects, intends, plans, believes,
seeks, estimates,
variations of such words and similar expressions are intended to identify such
forward-looking statements which are not statements of historical facts. These
forward-looking statements are not guarantees of future performance and involve
certain risks, uncertainties and assumptions that are difficult to assess.
Therefore, actual outcomes and results may differ materially from what is
expressed or forecasted in such forward-looking statements. These risks and
uncertainties are based upon a number of important factors including, among
others: our ability to operate effectively in a highly competitive industry
with many participants; our ability to keep pace with technological advances
and correctly identify and invest in the technologies that become commercially
accepted; our reliance on a small number of key customers; the ability to
consummate the proposed transaction with Alcatel; difficulties and delays in
achieving synergies and cost savings; potential difficulties in meeting
conditions set forth in the definitive merger agreement entered into by Lucent;
fluctuations in the telecommunications market; the pricing, cost and other
risks inherent in long-term sales agreements; exposure to the credit risk of
customers; reliance on a limited number of contract manufacturers to supply
products we sell; the social, political and economic risks of our global
operations; the costs and risks associated with pension and postretirement
benefit obligations; the complexity of products sold; changes to existing regulations
or technical standards; existing and future litigation; difficulties and costs
in protecting intellectual property 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, refer to
Lucents Form 10-K for the year ended September 30, 2005 as well as other
filings by Lucent with the U.S Securities and Exchange Commission (the SEC).
Except as required under the US federal securities laws and the rules and
regulations of the SEC, we disclaim any intention or obligation to update any
forward-looking statements after the distribution of this quarterly report,
whether as a result of new information, future events, developments, changes in
assumptions or otherwise.

EXECUTIVE SUMMARY

We design and deliver the systems, software and services that drive
next generation communications networks. Supported 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 new revenue-generating
opportunities for our customers, while enabling them to quickly deploy and
better manage their networks. Our customer base includes communications service
providers, governments and enterprises worldwide.

There has been consolidation among certain service providers as they
look to expand their scope and scale while improving cost efficiencies. This
industry dynamic presents both challenges and opportunities for equipment
vendors. One potential challenge may come in the form of rationalized capital
spending in the future. In addition, integration activities may delay new
network deployments. However, we anticipate that there will also be
opportunities, as carriers will require assistance integrating these large,
complex networks. Also, depending on the service providers involved, some of
the consolidation could enable certain vendors to extend their reach into
customers 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 to next-generation networks. As a result we have been
focusing on certain high-growth areas, such as services, Internet protocol (IP)
multimedia subsystem (IMS), broadband access, optical and next generation
mobile high-speed data. As this transformation progresses, our customers are
increasingly focused on deploying new IP-

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|          |                   
|--------- | ------------------
|<PAGE> 22 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis
of Financial Condition and Results of Operations

based, revenue-generating services that will differentiate their
businesses and build customer loyalty. However, the actual trialing, testing
and deployment of these new technologies will take time. This is a long-term
technology transition, which will create opportunities for us and our customers
in growth areas such as mobile high-speed data, broadband access, metro optical
networking and voice over Internet protocol (VoIP) solutions, as well as in
professional and managed services. We are working to turn these technologies
and opportunities into cost-effective offers for our customers.

Within this environment, certain service providers are currently
investing to meet growing capacity demands. These demands are being driven by
the coverage requirements, subscriber growth and traffic increases that place
demands on networks of all kinds. In addition, service providers have increased
investments in the systems, software and technologies that enable
next-generation converged services that cut across wireline and wireless, as
well as voice, video and data. There is 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 platform that gives our customers the flexibility to build
the types of networks and offer the types of services required to best meet the
demand for converged broadband services. We combined our mobility and wireline
businesses into a single unit, the Network Solutions Group. This change is
enabling us to improve our efficiency, market approach and cost structure. We
are also focused on the following actions:

| |   |                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The implementation
  of a services-led software strategy that combined the network operations software
  business with the Services business, which is expected to bring better
  alignment, 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-growth areas where we have strong technology, market
or customer advantages. We believe that focusing on these areas allow us to
serve our customers better and provides us with the best opportunity to
profitably grow the business.

Our revenues are subject to fluctuation as a result of changes in
customer spending patterns and short-term capital requirements, as well as the
timing of customer acceptances. Revenues during the nine months of fiscal 2006
were lower than the comparable prior year period, primarily due to lower sales
in the U.S. and APaC region, including China and to a lesser extent, India.

Our EV-DO Rev A solution is expected to be commercially available in
late September. Assuming that our EV-DO-Rev A and HSDPA rollouts remain on
track, we expect that mobility deployments in North America will enable us to
make the fourth quarter our highest quarterly revenue period for fiscal 2006 by
a significant margin.

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 network build-outs as well as the general
availability of products and software releases may also impact future revenues.
As a result of this uncertainty, it is difficult to make accurate forecasts of
near- and long-term results and cash flow. In addition, because a limited
number of customers account for a significant amount of our revenue, our
results are subject to fluctuation due to changes in spending by one or more of
these customers.

---



|          |                   
|--------- | ------------------
|<PAGE> 23 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis
of Financial Condition and Results of Operations

The following table includes certain financial information.

|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|-------------------------------------------- |  | --------------------------- | ----- | -------------------------- | - | ------ | - | ---- | ------ | ---- | - | ------ | - | - | ----- | - | - | ----- | --
|                                             |  | Three months ended June 30, |       | Nine months ended June 30, |  
|(in millions)                                |  | 2006                        |       | 2005                       |   | change |   | 2006 |        | 2005 |   | change |  
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |  
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Mobility
  Access and Applications Solutions |  | $                           | 827   |                            | $ | 1,187  |   |      | (30    | %)   | $ | 2,774  |   | $ | 3,576 |   |   | (22   | %)
|Multimedia
  Network Solutions               |  |                             | 454   |                            |   | 367    |   |      | 24     | %    |   | 1,237  |   |   | 1,093 |   |   | 13    | % 
|Converged
  Core Solutions                   |  |                             | 147   |                            |   | 189    |   |      | (22    | %)   |   | 443    |   |   | 614   |   |   | (28   | %)
|Services                                     |  |                             | 581   |                            |   | 559    |   |      | 4      | %    |   | 1,669  |   |   | 1,627 |   |   | 3     | % 
|Other                                        |  |                             | 41    |                            |   | 38     |   |      | 8      | %    |   | 112    |   |   | 100   |   |   | 12    | % 
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Revenues                                     |  | $                           | 2,050 |                            | $ | 2,340  |   |      | (12    | %)   | $ | 6,235  |   | $ | 7,010 |   |   | (11   | %)
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Gross
  margin                               |  | $                           | 839   |                            | $ | 1,052  |   | $    | (213   | )    | $ | 2,616  |   | $ | 3,011 |   | $ | (395  | ) 
|Gross
  margin rate                          |  |                             | 41    | %                          |   | 45     | % |      | (4 pts | )    |   | 42     | % |   | 43    | % |   | (1 pt | ) 
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Operating expenses                           |  | $                           | 665   |                            | $ | 681    |   | $    | (16    | )    | $ | 2,282  |   | $ | 2,053 |   | $ | 229   |   
|Percentage of revenue                        |  |                             | 32    | %                          |   | 29     | % |      | 3 pts  |      |   | 37     | % |   | 29    | % |   | 8 pts |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Operating income                             |  | $                           | 174   |                            | $ | 371    |   | $    | (197   | )    | $ | 334    |   | $ | 958   |   | $ | (624  | ) 
|Other income, net                            |  |                             | 27    |                            |   | 52     |   |      |        |      |   | 156    |   |   | 49    |   |   |       |   
|Interest expense                             |  |                             | 82    |                            |   | 85     |   |      |        |      |   | 247    |   |   | 259   |   |   |       |   
|Income taxes                                 |  |                             | 40    |                            |   | (34    | ) |      |        |      |   | 87     |   |   | (65   | ) |   |       |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   
|Net
  income                                 |  | $                           | 79    |                            | $ | 372    |   | $    | (293   | )    | $ | 156    |   | $ | 813   |   | $ | (657  | ) 
|                                             |  |                             |       |                            |   |        |   |      |        |      |   |        |   |   |       |   |   |       |   

As discussed in more detail throughout our MD&A:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Mobility Access
  and Applications Solutions revenues decreased primarily due to lower CDMA
  sales in the U.S. and China. Multimedia Network Solutions revenues increased
  due to higher sales of data and optical products. Converged Core Solutions
  revenues decreased due to lower sales of legacy circuit switching and
  Personal Handyphone Systems (PHS), as declines in these product sales
  continue to outpace growth in spending on next generation technologies.
  Services revenues increased due to higher deployment services.                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | The gross margin
  rate decreased in both of the current periods presented. The decrease in
  gross margin rate was primarily driven by the unfavorable impact of lower
  revenues, competitive pricing pressures, a lower net pension and
  postretirement benefit credit (net pension credit) and revised estimates
  related to long-term contracts in certain periods, partially offset by the
  favorable impact of lower accruals for employee incentive awards. The
  decrease in gross margin rate was more significant during the three-month
  period primarily due to an unfavorable product and geographic mix.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Operating expenses
  increased from the nine-month comparable prior-year period primarily due to
  the Winstar litigation charge of $278 million recognized during the first
  quarter of fiscal 2006 and a lower net pension credit offset in part by lower
  accruals for employee incentive awards.                                                                                                                                                                                                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | The net pension
  credit was $104 million and $322 million during the three and nine months
  ended June 30, 2006, a decrease of $74 million and $211 million,
  respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Operating income
  was favorably impacted by $150 million and $192 million as a result of lower
  accruals for employee incentive awards during the three and nine-month
  periods due to lower than targeted performance in the current periods.                                                                                                                                                                                                                                                                                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | In addition to
  interest income realized in both periods, other income included charges
  related to changes in the estimated fair value of the warrants issued as part
  of the global settlement of our shareowner litigation during the first
  quarter of fiscal 2005 and interest income related to income tax settlements.                                                                                                                                                                                                                                                                                          

---



|          |                   
|--------- | ------------------
|<PAGE> 24 | Form 10-Q - Part I

Item 2. Managements
Discussion and Analysis of Financial Condition and Results of Operations

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Income taxes were
  primarily attributed to non-U.S. earnings and to U.S. deferred taxes
  associated with retiree benefits. We expect to recognize
  approximately $160 million of income taxes during fiscal 2006, including
  non-cash U.S. deferred taxes of approximately $100 million. The balance is
  attributable to non-U.S. income taxes. During the three and nine months ended
  June 30, 2005, income tax benefits and interest income were recognized due to
  the favorable resolution of certain prior period tax matters.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | Cash and cash
  equivalents and marketable securities decreased $1.2 billion to $3.7 billion
  during the nine months ended June 30, 2006, primarily due to the timing of
  annual and long-term employee incentive award payments, additional use of
  working capital, legal settlements and cash used to collateralize a letter of
  credit that was issued in connection with the Winstar judgment and for the
  Riverstone acquisition.                                                                                               

APPLICATION
OF CRITICAL ACCOUNTING ESTIMATES

Our unaudited consolidated financial statements are based on the selection
of accounting policies and the application of significant accounting estimates,
some of which require management to make significant assumptions. Actual
results could differ materially from the estimated amounts. We believe that
some of the more critical estimates and related assumptions that affect our
financial condition and results of operations are in the areas of revenue
recognition, pension and postretirement benefits, income taxes, legal
contingencies and intangible assets. We
discuss our critical accounting estimates with our Audit and Finance Committee
of the Board of Directors at least annually. For more information on critical
accounting estimates, refer to the MD&A included in our Form 8-K for the
year ended September 30, 2005, filed on May 5, 2006.

SFAS 123R was adopted on October 1, 2005.
Refer to Note 4 to our unaudited consolidated financial statements for further
information. There were no other accounting policies adopted during the nine
months ended June 30, 2006 that had a
material effect on our financial condition and results of operations.

CONSOLIDATED RESULTS
OF OPERATIONS - THREE AND NINE MONTHS ENDED
JUNE 30, 2006 VERSUS THREE AND NINE MONTHS ENDED JUNE 30, 2005

Revenues

|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  
|---------------------------------------------------------- |  | ----------------------------------- | ----- |  |  | ---- | ---------------------------------- | - | ----- |  | ---- | --- | - | - | ----- | ---- |  | --- | - | - | ----- |  |  | --- | -
|                                                           |  | Three
        months ended June 30, |       |  |  |      | Nine
        months ended June 30, |   |       |  |     
|(in millions)                                              |  | 2006                                |       |  |  | 2005 |                                    |   |       |  | 2006 |     |   |   |       | 2005 |  |     |   |  
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |  
|Mobility
        Access and Applications Solutions         |  | $                                   | 827   |  |  | 40   | %                                  | $ | 1,187 |  |      | 51  | % | $ | 2,774 |      |  | 44  | % | $ | 3,576 |  |  | 51  | %
|Multimedia
        Network Solutions (MNS)                 |  |                                     | 454   |  |  | 22   | %                                  |   | 367   |  |      | 16  | % |   | 1,237 |      |  | 20  | % |   | 1,093 |  |  | 16  | %
|Converged
        Core Solutions (CCS)                     |  |                                     | 147   |  |  | 7    | %                                  |   | 189   |  |      | 8   | % |   | 443   |      |  | 7   | % |   | 614   |  |  | 9   | %
|Services                                                   |  |                                     | 581   |  |  | 29   | %                                  |   | 559   |  |      | 24  | % |   | 1,669 |      |  | 27  | % |   | 1,627 |  |  | 23  | %
|Intellectual
        property                              |  |                                     | 37    |  |  | 2    | %                                  |   | 31    |  |      | 1   | % |   | 97    |      |  | 2   | % |   | 73    |  |  | 1   | %
|Other                                                      |  |                                     | 4     |  |  |     |                                    |   | 7     |  |      |    |   |   | 15    |      |  |    |   |   | 27    |  |  |    |  
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  
|Revenues                                                   |  | $                                   | 2,050 |  |  | 100  | %                                  | $ | 2,340 |  |      | 100 | % | $ | 6,235 |      |  | 100 | % | $ | 7,010 |  |  | 100 | %
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  
|U.S.                                                       |  | $                                   | 1,270 |  |  | 62   | %                                  | $ | 1,523 |  |      | 65  | % | $ | 4,109 |      |  | 66  | % | $ | 4,422 |  |  | 63  | %
|Other
        Americas (Canada, Caribbean & Latin America) |  |                                     | 169   |  |  | 8    | %                                  |   | 180   |  |      | 7   | % |   | 512   |      |  | 8   | % |   | 530   |  |  | 8   | %
|EMEA
        (Europe, Middle East & Africa)                |  |                                     | 393   |  |  | 19   | %                                  |   | 318   |  |      | 14  | % |   | 984   |      |  | 16  | % |   | 973   |  |  | 14  | %
|APaC
        (Asia Pacific & China)                        |  |                                     | 218   |  |  | 11   | %                                  |   | 319   |  |      | 14  | % |   | 630   |      |  | 10  | % |   | 1,085 |  |  | 15  | %
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  
|Revenues                                                   |  | $                                   | 2,050 |  |  | 100  | %                                  | $ | 2,340 |  |      | 100 | % | $ | 6,235 |      |  | 100 | % | $ | 7,010 |  |  | 100 | %
|                                                           |  |                                     |       |  |  |      |                                    |   |       |  |      |     |   |   |       |      |  |     |   |   |       |  |  |     |  

Revenues decreased by 12% and 11% during the three and nine months
ended June 30, 2006, primarily within the Mobility Access and Applications
Solutions and CCS segments. Refer to the segment discussion later in this
MD&A for information on changes in revenues by segment and product.

The decrease in the U.S. during the three
months ended June 30, 2006 was primarily due to
lower Mobility Access and Applications Solutions revenues driven by lower sales
to our two largest customers. The decrease in APaC was primarily due to lower
CDMA sales in China driven by further delays in the issuance of 3G licenses and
the continuing reduction in PHS sales in China. The decrease in Other Americas
was due to lower sales in Canada. The increase in EMEA was primarily due to
higher data networking products sales.

---



|          |                   
|--------- | ------------------
|<PAGE> 25 | Form 10-Q - Part I

Item 2. Managements
Discussion and Analysis of Financial Condition and Results of Operations

The revenue decrease in the U.S. and non-U.S. regions
  during the nine months ended June 30, 2006 was primarily due
  to similar reasons noted above and to a lesser extent, our limited participation
  in highly competitive market opportunities in India.

Changes in foreign currency rates did not
have a material impact to our consolidated revenues during the interim fiscal
2006 periods.

Gross
Margin

|                    |  |                             |     |                            |   |       |   |      |       |   |   |       |  
|------------------- |  | --------------------------- | --- | -------------------------- | - | ----- | - | ---- | ----- | - | - | ----- | -
|                    |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)       |  | 2006                        |     | 2005                       |   | 2006  |   | 2005 |      
|                    |  |                             |     |                            |   |       |   |      |      
|Gross margin        |  | $                           | 839 |                            | $ | 1,052 |   | $    | 2,616 |   | $ | 3,011 |  
|Gross
  margin rate |  |                             | 41  | %                          |   | 45    | % |      | 42    | % |   | 43    | %

Our gross margin rate is subject to fluctuation due to changes in
volume, geographic, product and service mix, the impact of inventory-related or
warranty charges and revisions to estimates related to long-term contracts.
Changes in estimates related to long-term contracts could occur throughout the
execution of a project as a result of changes in previously expected costs,
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 period that 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 emerging markets and our ability
to continue realizing cost reductions. We operate in highly competitive markets
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 have reduced our relative revenue levels from prior periods,
our gross margin has not been significantly impacted due to our ability to
realize cost reductions.

The following factors impacted changes in our gross margin rate from
the comparable three and nine month prior year periods:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The impact of a
  lower net pension credit decreased the gross margin rate by one percentage
  point.                                                                                                                                                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | The impact of
  lower accruals for employee incentive awards increased the gross margin rate
  by two percentage points and one percentage point, respectively.                                                                                                                                                                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | The impact of
  revised estimates related to long-term contracts in certain periods decreased
  the gross margin rate by one percentage point.                                                                                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | The impact of less
  absorption of fixed costs due to lower volume decreased the gross margin rate
  by one percentage point.                                                                                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Historically, our
  gross margin rates are generally higher in our wireless business as compared
  to our wireline and services businesses, and higher in the U.S. as compared
  to non-U.S. regions. The impact of changes in the percentage of U.S. revenues
  to the consolidated revenues and other factors including pricing and product
  mix accounted for most of the remaining changes in the gross margin rate.

---



|          |                   
|--------- | ------------------
|<PAGE> 26 | Form 10-Q - Part I

Item 2. Managements
Discussion and Analysis of Financial Condition and Results of Operations

Operating Expenses

|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |   |   |       |   |   |      |  
|--------------------------------------------------------------------------------------------- |  | --------------------------- | --- | -------------------------- | - | ------ | - | ---- | --- | ---- | - | ------ | - | - | ----- | - | - | ---- | -
|                                                                                              |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)                                                                                 |  | 2006                        |     | 2005                       |   | change |   | 2006 |     | 2005 |   | change |  
|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |  
|Marketing and sales (M&S)                                                                     |  | $                           | 217 |                            | $ | 235    |   | $    | (18 | )    | $ | 660    |   | $ | 715   |   | $ | (55  | )
|General and administration (G&A)                                                              |  |                             | 147 |                            |   | 202    |   |      | (55 | )    |   | 463    |   |   | 544   |   |   | (81  | )
|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |   |   |       |   |   |      |  
|Selling, general and administrative (SG&A)
  expenses, excluding the following three
  items: |  |                             | 364 |                            |   | 437    |   |      | (73 | )    |   | 1,123  |   |   | 1,259 |   |   | (136 | )
|Winstar
  litigation                                                                          |  |                             |    |                            |   |       |   |      |    |      |   | 278    |   |   |      |   |   | 278  |  
|Recovery
  of bad debts and customer financings                                               |  |                             | (2  | )                          |   | (53    | ) |      | 51  |      |   | (7     | ) |   | (75   | ) |   | 68   |  
|Amortization
        of other acquired intangible assets                                      |  |                             | 8   |                            |   | 4      |   |      | 4   |      |   | 16     |   |   | 12    |   |   | 4    |  
|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |   |   |       |   |   |      |  
|SG&A                                                                                          |  |                             | 370 |                            |   | 388    |   |      | (18 | )    |   | 1,410  |   |   | 1,196 |   |   | 214  |  
|Research and development (R&D)                                                                |  |                             | 276 |                            |   | 287    |   |      | (11 | )    |   | 856    |   |   | 858   |   |   | (2   | )
|IPR&D                                                                                         |  |                             | 12  |                            |   |       |   |      | 12  |      |   | 12     |   |   |      |   |   | 12   |  
|Business restructuring                                                                        |  |                             | 7   |                            |   | 6      |   |      | 1   |      |   | 4      |   |   | (1    | ) |   | 5    |  
|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |   |   |       |   |   |      |  
|Operating expenses                                                                            |  | $                           | 665 |                            | $ | 681    |   | $    | (16 | )    | $ | 2,282  |   | $ | 2,053 |   | $ | 229  |  
|                                                                                              |  |                             |     |                            |   |        |   |      |     |      |   |        |   |   |       |   |   |      |  

Operating expenses increased from the nine-months comparable prior year
period mainly due to the Winstar litigation charges. Refer to Note 12 to our
unaudited consolidated financial statements for further discussion on this
matter.

SG&A

Excluding the impact of bad debt and customer financing
  and amortization of other acquired intangible assets, SG&A decreased by
  $73 million during the three months ended June 30, 2006. Reductions
  of $18 million are primarily attributed to lower average workforce levels and
  discretionary spending. Lower accruals for employee incentive awards of $60
  million (including the impact of sales compensation), lower stock-based compensation
  expense of $4 million and lower litigation charges of $18 million also contributed
  to the decrease.

The impact of these items more
than offset a $23 million lower net pension and postretirement benefit credit
and $4 million in less favorable settlements for non-income tax matters and
other disputes.

Excluding the impact of the Winstar litigation charge,
  bad debt and customer financing and amortization of other acquired intangible
  assets, SG&A decreased by $136 million during the nine months ended June
  30, 2006. Reductions of $72 million were primarily attributed to lower average
  workforce levels and discretionary spending. Lower accruals for employee incentive
  awards of $88 million (including lower sales compensation), lower litigation
  charges of $30 million and more favorable settlements of non-income tax matters
  and other disputes of $17 million also contributed to the decrease.

The impact of these items more
than offset a $64 million lower net pension and postretirement benefit credit
and $7 million of higher stock-based compensation expense.

R&D

Our R&D programs are focused on enhancing, expanding and evolving
our broad portfolio of leading edge technologies and reshaping our product
portfolio to capture convergence opportunities. In addition, our R&D
investment also supports Bell Labs long-term research programs in such areas as
computer science, materials science and bioengineering. We believe our current
R&D spending levels and 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 of software that will be sold, leased or otherwise
marketed are capitalized when technological feasibility has been established.
The amortization of these costs was reflected as a cost component in
determining our gross margin. Unamortized software development costs determined
to be in excess of the net realizable value of the product are expensed
immediately and reflected in R&D if such determination is made prior to
when the product is available for general release to the customer.

---



|          |                   
|--------- | ------------------
|<PAGE> 27 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

|                  |  |                             |    |                            |   |      |  |      |     |  |   |     | 
|----------------- |  | --------------------------- | -- | -------------------------- | - | ---- |  | ---- | --- |  | - | --- | 
|                  |  | Three months ended June 30, |    | Nine months ended June 30, |  
|(in millions)     |  | 2006                        |    | 2005                       |   | 2006 |  | 2005 |    
|                  |  |                             |    |                            |   |      |  |      |    
|Costs capitalized |  | $                           | 59 |                            | $ | 64   |  | $    | 178 |  | $ | 179 | 
|                  |  |                             |    |                            |   |      |  |      |     |  |   |     | 
|Amortization      |  |                             | 57 |                            |   | 65   |  |      | 165 |  |   | 200 | 

R&D decreased by $11 million during the three months ended June 30,
2006. The decrease was primarily attributed to the effect of lower accruals for
fiscal 2006 employee incentive awards of $51 million.

The impact of this item more than offset a $28 million lower net pension
credit, $5 million of higher stock-based compensation expense and $7 million
higher headcount related expense and discretionary spending which resulted from
the Riverstone acquisition.

R&D decreased by $2 million during the nine months ended June 30, 2006.
The decrease was primarily attributed to the effect of lower accruals for
fiscal 2006 employee incentive awards of $66 million as well as lower average
workforce levels and less discretionary spending of $35 million.

The impact of these items more than offset an $81 million lower net
pension credit and $18 million of higher stock-based compensation expense.

IPR&D

IPR&D charges of $12
million resulted from the Riverstone acquisition. IPR&D represents
technology that has not reached technological feasibility and has no
alternative future use. Refer to Note 8 to our unaudited consolidated financial
statements for information regarding the purchase price allocation.

Business restructuring

We have essentially completed our restructuring actions but continue to
evaluate the remaining restructuring reserves at the end of each reporting
period. There may be additional charges or reversals, primarily related to
estimates of facility closing costs, including expected sublease income. Actual
costs have differed from estimated amounts in the past. Refer to Note 5 to our
unaudited consolidated financial statements for details on the changes in our
business restructuring reserves.

Pension, Postretirement and Postemployment
Benefits

We maintain defined benefit pension plans covering the majority of
employees and retirees, as well as postretirement benefit plans for retirees
that include health care, dental benefits and life insurance coverage.
Additionally, we offer various postemployment benefits to certain employees after
employment but before retirement, including disability benefits, severance pay
and workers compensation. Refer to Note 3 to our unaudited consolidated
financial statements for further information.

|                                                |  |                             |      |                            |   |      |   |      |      |   |   |      |  
|----------------------------------------------- |  | --------------------------- | ---- | -------------------------- | - | ---- | - | ---- | ---- | - | - | ---- | -
|                                                |  | Three months ended June 30, |      | Nine months ended June 30, |  
|(in millions)                                   |  | 2006                        |      | 2005                       |   | 2006 |   | 2005 |     
|                                                |  |                             |      |                            |   |      |   |      |     
|Pension
  benefit credit                        |  | $                           | (164 | )                          | $ | (244 | ) | $    | (493 | ) | $ | (730 | )
|Postretirement benefit cost                     |  |                             | 60   |                            |   | 66   |   |      | 171  |   |   | 197  |  
|                                                |  |                             |      |                            |   |      |   |      |      |   |   |      |  
|Net
  pension and postretirement benefit credit |  | $                           | (104 | )                          | $ | (178 | ) | $    | (322 | ) | $ | (533 | )
|                                                |  |                             |      |                            |   |      |   |      |      |   |   |      |  
|                                                |  |                             |      |                            |   |      |   |      |      |   |   |      |  
|Postemployment
  benefit cost                   |  | $                           | 26   |                            | $ | 20   |   | $    | 68   |   | $ | 54   |  
|                                                |  |                             |      |                            |   |      |   |      |      |   |   |      |  

Approximately two-thirds of the net credit is reflected in operating
expenses, with the balance in costs used to determine gross margin. The
decrease in the net credit was primarily due to lower expected return on plan
assets and higher amortization of actuarial losses resulting from:

---



|          |                   
|--------- | ------------------
|<PAGE> 28 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

| |   |                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Reductions in the
  market-related value of plan assets due to the impact of actual losses
  incurred on plan assets during fiscal 2002 and 2001.
| |   |                                                                                                                                                  
| |  | Changes in
  mortality assumptions as of September 30, 2005.                                                                                     

The net pension credit is expected to decrease by approximately $300
million during fiscal 2006, primarily due to the factors discussed above.
Changes in actuarial assumptions could also significantly impact the net credit
in the future.

Globally, based on preliminary estimates for certain asset classes, the
fair market value of assets held in pension trusts was approximately $34
billion as of June 30, 2006. Almost all of these assets are related to the U.S.
pension plans.

During the third quarter of fiscal 2006, the allocation of U.S. pension
plan assets was changed as part of a routine periodic review. The overall
pension plan asset portfolio now reflects a balance of investments split about
50/50 between equity and fixed-income securities compared to the previous split
of about 75 percent equity and 25 percent fixed income. We believe this action
was prudent 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 occupational pension plan whose beneficiaries
  include formerly represented retirees. Assets in this pension plan are currently
  well in excess of liabilities, and the plan fiduciaries, acting in accordance
  with advice from an independent external asset allocation advisor, determined
  that a higher allocation to fixed income 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 return on plan assets will decrease by about one
percentage point during fiscal 2007. The fiscal 2007 net pension credit will be
impacted by this change as well as by other important factors such as the
discount rate, which will be driven by prevailing interest rates at September
30, 2006 and differences between our actuarial assumptions and actual results
for this fiscal year. We currently expect a reduction in the fiscal 2007 net
pension credit of approximately $225 million as a result of these changes and
factors. Actual result may differ from these preliminary expectations.

Stock-Based Compensation Expense

SFAS 123R was adopted on October 1, 2005, which now requires among
other items, the recognition of stock option expense in the results of
operations. The modified prospective transition method was elected, therefore
prior period results were not restated. Stock-based compensation expense was
$19 million and $16 million during the three months ended June 30, 2006 and
2005, respectively, and $63 million and $30 million during the nine months
ended June 30, 2006 and 2005, respectively.

Stock-based compensation expense recognized in the results of
operations during the three and nine months ended June 30, 2006 was $54 million
and $176 million lower than the pro forma amount determined under the fair
value-based method and disclosed in accordance with SFAS 123 for the respective
comparable prior year periods. This reduction was primarily due to the
amortization of previously unvested awards over the original vesting periods
and lower fair value amounts attributed to the more recent awards. There were
no significant modifications to existing awards or acceleration of vesting
periods during fiscal 2005 and the nine months ended June 30, 2006.

Refer to Note 4 to our unaudited consolidated financial statements for
more information on stock-based compensation.

---



|          |                   
|--------- | ------------------
|<PAGE> 29 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

Other Income, net

|                                                  |  |                             |     |                            |   |      |   |      |     |   |   |     |  
|------------------------------------------------- |  | --------------------------- | --- | -------------------------- | - | ---- | - | ---- | --- | - | - | --- | -
|                                                  |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)                                     |  | 2006                        |     | 2005                       |   | 2006 |   | 2005 |    
|                                                  |  |                             |     |                            |   |      |   |      |    
|Legal (settlements) recoveries                    |  | $                           | 18  |                            | $ | 17   |   | $    | 18  |   | $ | (68 | )
|Winstar post-judgment interest                    |  |                             | (3  | )                          |   |     |   |      | (6  | ) |   |    |  
|Interest on tax matters                           |  |                             | 1   |                            |   | 20   |   |      | 3   |   |   | 79  |  
|Interest income                                   |  |                             | 44  |                            |   | 29   |   |      | 133 |   |   | 83  |  
|Minority Interest                                 |  |                             | (4  | )                          |   | (20  | ) |      | 31  |   |   | (35 | )
|Gain (loss) on sale of
  investments, net         |  |                             | (3  | )                          |   | 1    |   |      | (12 | ) |   | (1  | )
|Other-than-temporary
  write-downs of investments |  |                             | (5  | )                          |   | (5   | ) |      | (7  | ) |   | (16 | )
|Merger related expenses                           |  |                             | (8  | )                          |   |     |   |      | (11 | ) |   |    |  
|Miscellaneous, net                                |  |                             | (13 | )                          |   | 10   |   |      | 7   |   |   | 7   |  
|                                                  |  |                             |     |                            |   |      |   |      |     |   |   |     |  
|Other income, net                                 |  | $                           | 27  |                            | $ | 52   |   | $    | 156 |   | $ | 49  |  
|                                                  |  |                             |     |                            |   |      |   |      |     |   |   |     |  

Legal (settlements) recoveries during the three and
  nine months ended June 30, 2006 was related to a third party indemnification
  associated with the previously settled consumer products leasing lawsuit. The
  legal settlement charge during the nine months ended June 30, 2005 was primarily
  related to the changes in fair market value of warrants issued in connection
  with the global settlement of our shareowner lawsuit of $71 million (offset
  by recoveries from fiduciary insurance companies of $17 million during the third
  quarter of fiscal 2005) and to a lesser extent other litigation settlements
  of $14 million.

Interest on tax matters was primarily related to our favorable resolution
of income tax audits, including the favorable resolution of certain tax issues
under tax sharing agreements with AT&T, Avaya and Agere.

The increase in interest income was primarily due to higher average
marketable securities balances and higher interest rate yields.

One of our joint ventures recognized a loss during the nine months
ended June 30, 2006 resulting in a minority interest share of the losses. The
loss recognized by the joint venture during the nine months ended June 30, 2006
included internal pricing adjustments related to certain prior periods.

Merger related expenses included third party professional fees that are
directly attributable to the pending merger transaction with Alcatel.

Interest Expense

Interest expense decreased by $3 million and $12 million during the
three and nine months ended June 30, 2006, respectively, due to the early
extinguishment of convertible securities and other debt obligations.

Income Taxes

|                                                               |  |                             |    |                            |   |      |   |      |    |   |   |      |  
|-------------------------------------------------------------- |  | --------------------------- | -- | -------------------------- | - | ---- | - | ---- | -- | - | - | ---- | -
|                                                               |  | Three months ended June 30, |    | Nine months ended June 30, |  
|(in millions)                                                  |  | 2006                        |    | 2005                       |   | 2006 |   | 2005 |   
|                                                               |  |                             |    |                            |   |      |   |      |   
|U.S.
  deferred taxes                                          |  | $                           | 26 |                            | $ |     |   | $    | 42 |   | $ |     |  
|Favorable
  resolution of prior period tax audits              |  |                             | (9 | )                          |   | (56  | ) |      | (9 | ) |   | (111 | )
|Non-U.S.
  and state income taxes attributed to pre-tax income |  |                             | 23 |                            |   | 22   |   |      | 54 |   |   | 46   |  
|                                                               |  |                             |    |                            |   |      |   |      |    |   |   |      |  
|Income
  taxes                                                 |  | $                           | 40 |                            | $ | (34  | ) | $    | 87 |   | $ | (65  | )
|                                                               |  |                             |    |                            |   |      |   |      |    |   |   |      |  

The
realization of our deferred tax assets is dependent upon the existence of
taxable income during future periods. During fiscal 2004 and 2005, most of our pretax
income in the U.S. was generated from a pension credit that is not currently
taxable. As a result, even though we exited a cumulative loss position during
the fourth quarter of fiscal 2005, there was not sufficient positive evidence
to conclude that it was more likely than not that the U.S. deferred tax assets
would be realized. Therefore, we have continued to maintain a valuation
allowance on our net U.S. deferred tax assets.

---



|          |                   
|--------- | ------------------
|<PAGE> 30 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

However,
the expected future tax consequences of deferred tax liabilities generated
primarily from our pension credit continues to be relied upon to support the
deferred tax assets of other retiree benefits. This resulted in not providing
taxes attributable to U.S. income during fiscal 2005, as valuation allowances
were reversed to the extent of increases in deferred tax liabilities. We expect
that the U.S. deferred taxes associated with retiree benefits will be in a net
liability position as of September 30, 2006.

Our
assumptions regarding the future tax consequences of retiree benefits might
change for various reasons, including changes in legislation, actual return on
plan assets, Section 420 transfers, or changes in plan design. Such changes
could impact our valuation allowance assessment and necessitate additional
charges. In addition, we have deferred tax assets attributed to additional
minimum pension liabilities that were established through direct charges to
equity. If these liabilities were to reverse in future periods, charges to our
results of operations will be required for the related deferred tax impacts.
The potential deferred tax charges associated with these liabilities were $1.3
billion as of September 30, 2005.

During the
prior periods, certain
income tax benefits were recognized due to the favorable settlement of audit
matters related to the years 1990 through 2002, including matters with a
previously merged company and the settlement of certain matters under tax sharing
agreements with AT&T, Avaya and Agere. We also recognized interest income
related to these settlements, which is included in other income.

We expect
to recognize approximately $160 million of income tax expense during fiscal
2006, including non-cash impacting U.S. deferred taxes of approximately $100
million to offset the anticipated net liability position described above. The
remaining amounts are attributable to non-U.S. income taxes. The expected
remaining tax expense will be recognized in the fourth quarter of fiscal 2006
and could change as a result of a number of variables, including our assessment
of the future realization of deferred tax assets.

Results of Operations
by Segment

MobilityAccess
and Applications Solutions

|                 |  |                             |     |                            |   |        |  |      |      |      |   |        |  |   |       |  |   |      |   
|---------------- |  | --------------------------- | --- | -------------------------- | - | ------ |  | ---- | ---- | ---- | - | ------ |  | - | ----- |  | - | ---- | --
|                 |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)    |  | 2006                        |     | 2005                       |   | change |  | 2006 |      | 2005 |   | change | 
|                 |  |                             |     |                            |   |        |  |      |      |      |   |        | 
|U.S.             |  | $                           | 655 |                            | $ | 898    |  |      | (27  | %)   | $ | 2,253  |  | $ | 2,668 |  |   | (16  | %)
|NonU.S.         |  |                             | 172 |                            |   | 289    |  |      | (40  | %)   |   | 521    |  |   | 908   |  |   | (43  | %)
|                 |  |                             |     |                            |   |        |  |      |      |      |   |        |  |   |       |  |   |      |   
|Total revenues   |  | $                           | 827 |                            | $ | 1,187  |  |      | (30  | %)   | $ | 2,774  |  | $ | 3,576 |  |   | (22  | %)
|                 |  |                             |     |                            |   |        |  |      |      |      |   |        |  |   |       |  |   |      |   
|                 |  |                             |     |                            |   |        |  |      |      |      |   |        |  |   |       |  |   |      |   
|Segment
  income |  | $                           | 228 |                            | $ | 438    |  | $    | (210 | )    | $ | 916    |  | $ | 1,297 |  | $ | (381 | ) 
|                 |  |                             |     |                            |   |        |  |      |      |      |   |        |  |   |       |  |   |      |   

Three months ended June 30, 2006 versus June
30, 2005

Mobility Access and Applications Solutions revenues
  reflected a $346 million decrease in Mobility Access Solutions and $14 million
  decrease in Applications Solutions. U.S. revenues decreased primarily 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 large high-speed data network build-outs are nearing completion. Expansion
  and upgrades for these high-speed data network build outs, combined with similar
  deployments by other customers, will continue to drive our CDMA revenues in
  the U.S. These two customers accounted for 62% and 68% of total Mobility Access
  and Applications Solutions revenues during the third quarter of fiscal 2006
  and 2005, respectively. Including these two customers, the five largest Mobility
  Access and Applications Solutions customers accounted for 84% and 82% of total
  Mobility Access and Applications Solutions revenues during the third quarter
  of fiscal 2006 and 2005, respectively. Non-U.S. revenues decreased primarily
  due to lower CDMA sales in China driven by the delay of 3G licenses and to a
  lesser extent, lower UMTS data card and applications sales in EMEA and our selective
  participation in highly competitive market opportunities in India.

Approximately 86% of Mobility Access and Applications Solutions
revenues are currently generated from CDMA technology. We expect revenues
related to a large UMTS contract in the U.S. will continue to grow during the
fourth quarter of fiscal 2006. We are conducting third-generation UMTS / W-CDMA
trials in China.

---



|          |                   
|--------- | ------------------
|<PAGE> 31 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

Consolidation has occurred with several large U.S. wireless service
providers and may have impacted capital spending in certain situations. These
events may continue to present opportunities for us to assist in integration
efforts or to expand our products/services or technologies in certain networks
where they were not previously utilized. However, events may impact our future
revenue trends as these service providers assess potential technology
migrations to common platforms or leverage excess capacity. In addition, the
timing of awards of licenses and spectrum to service providers 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 revenue among a limited number of customers and the resulting
exposure to their spending patterns and the general availability of next
generation products. Our EV-DO Rev A solution is expected to be commercially
available in late September.

R&D investment in Mobility Access and Application Solutions is
focused primarily on CDMA and UMTS next generation technologies and includes
expenses associated with UMTS product trials with certain customers. This
investment continues to support our leadership position in spread-spectrum
technology and our development of high-speed mobile data solutions.

Segment income decreased due to a $207 million decrease in gross margin
and a $3 million increase in operating expenses. The decrease in gross margin
was primarily due to lower sales volume.

Nine months ended June 30, 2006 versus June
30, 2005

Mobility Access and Applications Solutions revenues decreased due to a
$783 million decrease in Mobility Access Solutions and $19 million decrease in
Applications Solutions. U.S. revenues decreased primarily due to lower CDMA
sales to our two largest customers. These two customers accounted for 67% and
66% of total Mobility Access and Applications Solutions revenues during the
nine months ended June 30, 2006 and 2005, respectively. Including these two
customers, the five largest Mobility Access and Applications Solutions
customers accounted for 82% and 81% of total Mobility Access and Applications
Solutions revenues during the nine months ended June 30, 2006 and 2005,
respectively. Non-U.S. revenues decreased primarily due to lower CDMA sales in
China driven by the delay of 3G licenses and to a lesser extent, lower UMTS
data card sales in EMEA and our selective participation in highly competitive
market opportunities in India.

Segment income decreased primarily due to a $377 million decrease in
gross margin and a $4 million increase in operating expenses. The decrease in
gross margin was primarily due to lower sales volume.

Multimedia Network Solutions (MNS)

|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|-------------------- |  | --------------------------- | --- | -------------------------- | - | ------ |  | ---- | -- | ---- | - | ------ | ----- | - | -- | ----- | - | -- | -- | - | 
|                     |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)        |  | 2006                        |     | 2005                       |   | change |  | 2006 |    | 2005 |   | change |      
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |      
|Data
  and Access    |  | $                           | 240 |                            | $ | 163    |  |      | 47 | %    |   | $      | 574   |   | $  | 516   |   |    | 11 | % | 
|Optical
  networking |  |                             | 214 |                            |   | 204    |  |      | 5  | %    |   |        | 663   |   |    | 577   |   |    | 15 | % | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|Total
  revenues     |  | $                           | 454 |                            | $ | 367    |  |      | 24 | %    |   | $      | 1,237 |   | $  | 1,093 |   |    | 13 | % | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|U.S.                 |  | $                           | 169 |                            | $ | 150    |  |      | 13 | %    |   | $      | 537   |   | $  | 424   |   |    | 27 | % | 
|NonU.S.             |  |                             | 285 |                            |   | 217    |  |      | 31 | %    |   |        | 700   |   |    | 669   |   |    | 5  | % | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|Total revenues       |  | $                           | 454 |                            | $ | 367    |  |      | 24 | %    |   | $      | 1,237 |   | $  | 1,093 |   |    | 13 | % | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |    |   | 
|Segment
  income     |  | $                           | 26  |                            | $ | 15     |  | $    | 11 |      | $ | 113    |       | $ | 19 |       | $ | 94 |   
|                     |  |                             |     |                            |   |        |  |      |    |      |   |        |       |   |    |       |   |    |   

Three months ended June 30, 2006 versus June
30, 2005

MNS revenues increased by $87 million. U.S. revenues increased primarily
due to higher data networking sales. Non-U.S. revenues increased primarily from
higher data networking sales in Europe, partially offset by lower data and
access sales in APaC. Five customers accounted for 42% and 45% of MNS revenues
during the third quarter of fiscal 2006 and 2005, respectively.

---



|          |                   
|--------- | ------------------
|<PAGE> 32 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

R&D investment in MNS supports a broad array of current and next
generation technologies, including metro optical and broadband networking
solutions.

Segment income increased due to a $33 million increase in gross margin
that was partially offset by a $22 million increase in operating expenses. The
higher gross margin resulted from an increase in the gross margin rate and
higher revenues. The increase in the gross margin rate was due to a more
favorable product mix and lower incurred costs and software amortization. The
increase in operating expenses was primarily due to expenses related to the
Riverstone acquisition including in-process R&D, intangible asset
amortization and additional headcount related expenses.

Nine months ended June 30, 2006 versus June
30, 2005

MNS revenues increased by $144 million. U.S. revenues increased
primarily due to higher optical networking sales. Non-U.S. revenues increased
primarily from higher data and access sales in Europe, partially offset by
lower sales of all MNS products in APaC. Five customers accounted for 42% and
40% of MNS revenues during the nine months ended June 30, 2006 and 2005,
respectively.

Segment income increased due to an $80 million increase in gross margin
and a $14 million decrease in operating expenses. The higher gross margin
resulted from an increase in the gross margin rate and higher revenues. The
increase in the gross margin rate was primarily due to a more favorable product
mix and lower inventory related charges. The decrease in operating expenses was
primarily due to lower R&D spending attributed to lower average employee
workforce levels and discretionary spending, partially offset by expenses
related to the Riverstone acquisition noted above.

Converged Core Solutions (CCS)

|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |     |  |   |     |   
|---------------- |  | --------------------------- | --- | -------------------------- | - | ------ |  | ---- | --- | ---- | - | ------ |  | - | --- |  | - | --- | --
|                 |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)    |  | 2006                        |     | 2005                       |   | change |  | 2006 |     | 2005 |   | change | 
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        | 
|U.S.             |  | $                           | 84  |                            | $ | 106    |  |      | (21 | %)   | $ | 249    |  | $ | 311 |  |   | (20 | %)
|NonU.S.         |  |                             | 63  |                            |   | 83     |  |      | (24 | %)   |   | 194    |  |   | 303 |  |   | (36 | %)
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |     |  |   |     |   
|Total revenues   |  | $                           | 147 |                            | $ | 189    |  |      | (22 | %)   | $ | 443    |  | $ | 614 |  |   | (28 | %)
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |     |  |   |     |   
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |     |  |   |     |   
|Segment
  income |  | $                           | 20  |                            | $ | 34     |  | $    | (14 | )    | $ | 36     |  | $ | 20  |  | $ | 16  |   
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |     |  |   |     |   

Three months ended June 30, 2006 versus June
30, 2005

CCS revenues declined by $42 million. The decline in U.S. revenues was
attributed to circuit switching products. Lower non-U.S. sales were attributed
to lower PHS sales in China. Five customers accounted for 47% and 57% of CCS
revenues during the third quarter of fiscal 2006 and 2005, respectively.

Circuit switching revenues declined by $24 million to $73 million. PHS
revenues declined by $24 million to $26 million. Traditional circuit switching
product sales have been declining at a faster rate than the growth in next
generation technologies. This decline is more prevalent in the U.S. PHS sales
declined as service providers in China curtailed their spending in preparation
for transitioning to 3G networks. CCSs remaining revenues consisted primarily
of sales of next generation switching 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 revenues will be impacted by our
success in offering a product portfolio that effectively addresses customer needs.
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, including IP Multi-Media Subsystem and VoIP.

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|          |                   
|--------- | ------------------
|<PAGE> 33 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

Segment income decreased due to an
$18 million decrease in gross margin that was partially offset by a $4 million
decrease in operating expenses. The decrease in gross margin was due to lower revenues.Nine months ended June 30, 2006 versus June
30, 2005

CCS revenues declined by $171 million. The decline in U.S. revenues was
attributed to circuit switching products. Lower non-U.S. sales were attributed
to lower PHS sales in China. Five customers accounted for 47% and 57% of CCS
revenues during the nine months ended June 30, 2006 and 2005, respectively.

Circuit switching revenues declined by $77 million
  to $226 million. PHS revenues declined by $103 million to $74 million. The reasons
  for the decline in circuit switching and PHS are similar to the reasons noted
  above. CCSs remaining revenues consisted primarily of sales of next generation
  products and refurbished equipment.

Segment income increased primarily due to an $18 million decrease in
operating expense. The decrease in operating expense was due to lower R&D
spending attributed to lower average employee workforce levels and higher
SG&A expense from a legal settlement in the prior year period.

Services

|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |       |  |   |     |  
|---------------- |  | --------------------------- | --- | -------------------------- | - | ------ |  | ---- | --- | ---- | - | ------ |  | - | ----- |  | - | --- | -
|                 |  | Three months ended June 30, |     | Nine months ended June 30, |  
|(in millions)    |  | 2006                        |     | 2005                       |   | change |  | 2006 |     | 2005 |   | change | 
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        | 
|U.S.             |  | $                           | 321 |                            | $ | 331    |  |      | (3  | %)   | $ | 958    |  | $ | 920   |  |   | 4   | %
|NonU.S.         |  |                             | 260 |                            |   | 228    |  |      | 14  | %    |   | 711    |  |   | 707   |  |   | 1   | %
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |       |  |   |     |  
|Total revenues   |  | $                           | 581 |                            | $ | 559    |  |      | 4   | %    | $ | 1,669  |  | $ | 1,627 |  |   | 3   | %
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |       |  |   |     |  
|                
|Segment
  income |  | $                           | 84  |                            | $ | 106    |  | $    | (22 | )    | $ | 219    |  | $ | 240   |  | $ | (21 | )
|                 |  |                             |     |                            |   |        |  |      |     |      |   |        |  |   |       |  |   |     |  

Three months ended June 30, 2006 versus June
30, 2005

Services revenues increased by $22 million. U.S. revenues decreased
primarily due to lower government revenues as a result of the completion of a
project in Iraq partially offset by an increase in deployment services related
to a UMTS contract. Non-U.S. revenues increased primarily from higher
maintenance and deployment revenues in Europe. Five customers accounted for 45%
and 49% of Services revenues during the third quarter of fiscal 2006 and 2005,
respectively.

Segment income decreased due to a $30 million decrease in gross margin
that was partially offset by an $8 million decrease in operating expenses. The
decrease in gross margin was driven by a lower gross margin rate attributed
primarily to services and geographic mix. The decrease in operating expense was
primarily attributed to lower average workforce levels.

Nine months ended June 30, 2006 versus June
30, 2005

Services revenues increased by $42 million. U.S. revenues increased due
to multi-vendor maintenance contracts, managed services and deployment services
related to a UMTS contract, offset by lower government revenues. Non-U.S.
revenues were essentially flat. The increase in revenues in EMEA and Other
Americas were offset by the decrease in revenues in APaC. Five customers
accounted for 47% and 46% of Services revenues during the nine months of fiscal
2006 and 2005, respectively.

Professional services revenues decreased by $50 million primarily due
to lower government revenues.

Segment income decreased due to a $52 million decrease in gross margin
that was partially offset by a $31 million decrease in operating expenses due
to similar reasons described in the three-month discussion above.

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|          |                   
|--------- | ------------------
|<PAGE> 34 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

LIQUIDITY
AND CAPITAL RESOURCES

Cash, cash equivalents and marketable securities decreased by $1.2
billion to $3.7 billion during the nine months ended June 30, 2006 primarily
due to the payment of fiscal 2005 employee incentive awards, additional working
capital and cash used to collateralize a letter of credit that was issued in
connection with the Winstar judgment and for the Riverstone acquisition.
Summarized cash flow information and key working capital metrics are as
follows.

|                                                      |  |                                    |      |      |   |        |   |   |      |  
|----------------------------------------------------- |  | ---------------------------------- | ---- | ---- | - | ------ | - | - | ---- | -
|                                                      |  | Nine
        months ended June 30, |     
|(in millions)                                         |  | 2006                               |      | 2005 |   | change |  
|                                                      |  |                                    |      |      |   |        |  
|Net income                                            |  | $                                  | 156  |      | $ | 813    |   | $ | (657 | )
|Non-cash items                                        |  |                                    | (9   | )    |   | (202   | ) |   | 193  |  
|Changes in
        working capital                    |  |                                    | (223 | )    |   | 24     |   |   | (247 | )
|Other changes                                         |  |                                    | (525 | )    |   | (935   | ) |   | 410  |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|Operating
        activities                          |  | $                                  | (601 | )    | $ | (300   | ) | $ | (301 | )
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|Investing activities                                  |  | $                                  | (470 | )    | $ | (1,069 | ) | $ | 599  |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|Financing
        activities                          |  | $                                  | 25   |      | $ | (294   | ) | $ | 319  |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|                                                      |  |                                    |      |      |   |        |   |   |      |  
|Days sales outstanding in accounts
        receivable |  |                                    | 68   |      |   | 50     |   |   | 18   |  
|Inventory
        turnover                            |  |                                    | 6.3  |      |   | 5.7    |   |   | 0.6  |  
|Days sales outstanding in working
        capital     |  |                                    | 46   |      |   | 25     |   |   | 21   |  

Operating Activities

Our operating results and resulting cash flows have generally been
impacted during the past few years due to changes in revenue levels, cost
reductions and other factors discussed throughout this MD&A. The following
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 as the pension credit and depreciation and
amortization. In addition, a charge related to the changes in the fair value of
warrants issued in connection with the global settlement of our shareowner
lawsuit impacted non-cash items during fiscal 2005.

Changes in working capital requirements include changes in receivables,
inventories and contracts in process, accounts payable and deferred revenue.
Working capital requirements are impacted by the timing of cash collections,
customer billings and accounts payable disbursements. We periodically sell
certain non-U.S. receivables with extended payment terms where it is cost
effective to do so. We sold $80 million and $172 million of receivables during
the nine months ended June 30, 2006 and 2005, respectively. This impact is
reflected in the changes in receivables. Receivables with extended billing
terms were $326 million and $225 million as of June 30, 2006 and September 30,
2005, respectively.

The timing of certain payments will also impact our cash flow. For
example, while employee incentive awards are accrued throughout the fiscal
year, they are generally paid during the first quarter of the subsequent fiscal
year. Annual incentive awards of approximately $350 million were paid during
the first quarter of fiscal 2006. In addition, approximately $100 million was
paid under a three-year long-term incentive program (2003-2005 cycle) during
the first quarter of fiscal 2006. This long-term incentive program was
introduced for approximately 1,100 employees in advanced leadership positions
during fiscal 2003.

Changes in other operating assets and liabilities (reflected above as
other changes) during the nine months ended June 30, 2006 included the
payment of fiscal 2005 incentive awards, capitalized software of $178 million,
legal settlement payments of $100 million, funding of $49 million for deferred
compensation and non-qualified pension benefits related to certain current and
retired officers, partially offset by the impact of $284 million of

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|          |                   
|--------- | ------------------
|<PAGE> 35 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

reserves (including $6 million of post judgment interest) provided for
as a result of the Winstar judgment. Changes reflected in the comparable
prior-year period included the payment of fiscal 2004 employee incentive awards
of $600 million, the final payment related to our shareowner lawsuit settlement
of $215 million, cash outlays for our restructuring program of $55 million,
capitalized software of $179 million, partially offset by $201 million of
proceeds from our welfare benefits trusts as a reimbursement for prior period
management health care contributions. Cash flow from operating activities also
included net tax payments of $10 million and $156 million (including related
interest) during the nine months ended June 30, 2006 and 2005, respectively.

Investing Activities

Investing activities included net sales and
maturities of $177 million and net purchases of $925 million of marketable
securities during the nine months ended June 30, 2006 and
2005, respectively. We may continue to purchase and sell marketable
securities in an attempt to improve our investment returns. During the third
quarter of fiscal 2006, we used $200 million of cash (including $3 million of
acquisition related fees) to purchase certain net assets of Riverstone
Networks, a supplier of carrier-grade Ethernet routers for the
telecommunications industry. Changes in restricted cash included $311 million
of cash used to collateralize a letter of credit issued in connection with the
Winstar judgment during the second quarter of fiscal 2006 and $10 million of
cash held in escrow that will be paid to Riverstone upon the favorable
resolution of certain acquisition related contingencies. The remaining cash
used in investing activities was for capital expenditures, including internal
use software.

Financing Activities

Cash used in connection with the early extinguishment of
certain debt obligations was $15 million and $419 million during the nine
months endedJune
30, 2006 and 2005, respectively. Cash provided from the
issuance ofcommon
shares for certain employee benefit plans was $44 million and $121 million
during the nine months ended June 30, 2006 and 2005, respectively.

We are currently authorized by our board of directors to extinguish
certain of our convertible securities and other debt obligations prior to
maturity. During the past few years, we retired convertible securities and
certain other debt obligations in exchange for shares of our common stock and
cash, in separate, multiple and privately-negotiated transactions. We may only
use cash in similar transactions in the future pending completion of the merger
transaction with Alcatel.

Future Capital Requirements and Funding
Sources

We do not expect that our operations will generate cash on a sustainable
basis until our pre-tax income exceeds the amount of net non-cash income items,
which have been driven primarily by our pension credit. Our pension credit was
$973 million and $493 million during fiscal 2005 and the nine months ended June
30, 2006, respectively. Our cash requirements during the next few years are
primarily related to funding our operations, retiree health care obligations,
capital expenditures, potential acquisitions, debt obligations and related
interest and other matters discussed below.

Debt obligations relating to the 7.25% notes of $368 million matured
and were paid during July 2006. We also have the right to redeem $486 million
of 8% convertible securities for cash after August 14, 2006. These securities
are redeemable at the option of the holders on August 2, 2007 whereby we have
the right to satisfy the redemption with cash, shares of our common stock, or a
combination of both.

We believe our cash and cash equivalents of $1.4 billion and marketable
securities of $2.3 billion as of June 30, 2006 are sufficient to fund our cash
requirements for fiscal 2006 as well as the following few years. However, we
cannot provide assurance that our actual cash requirements will not be greater
than we currently expect. If sources of liquidity are not available or if we
cannot generate sufficient cash flow from operations, we might be required to
obtain additional sources of funds through additional operating improvements,
capital market transactions, asset sales or financing from third parties, or a
combination thereof. We cannot provide

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|          |                   
|--------- | ------------------
|<PAGE> 36 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

assurance that these 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 $120 million, primarily for lease obligations over the remaining
lease terms, net of expected sublease rental income of $71 million. The cash
requirement could increase in the future if the expected sublease income is not
realized.

We currently do not expect to make contributions to
  our qualified U.S. pension plans through fiscal 2007. We are unable to provide
  an estimate of future funding requirements beyond fiscal 2007 for our U.S. pension
  plans. Based on our actuarial projections and current law, we believe it is
  unlikely that any required contributions would have a material effect on our
  liquidity during fiscal 2008 through fiscal 2010. Legislative changes were recently
  passed by the U.S. Congress that would impact U.S. pension plans, if signed
  into law by the President (the Pension Protection Act of 2006). The Act contains
  Section 420 Amendments that we have been pursuing as discussed in more detail
  below. The Act would also alter the manner in which liabilities and asset values
  are determined for the purpose of calculating required pension contributions
  and the timing and manner in which required contributions to under-funded pension
  plans would be made. The funding requirements for our U.S. pension plans could
  be affected by these proposed changes, if they are adopted. No assurances can
  be given that the Act will be signed into law or that the technical corrections
  discussed below will be made.

Annual contributions to our non-qualified and non-U.S. pension plans
are expected to be approximately $60 million in each of the next five fiscal
years.

We currently provide retiree health care benefits for our retirees in
the United States, including 46,000 management retirees and 68,000 formerly
represented retirees as well as an additional 68,000 dependents of retirees.
The obligations and plan assets for management and formerly represented
retirees are accounted for separately. Historically, retiree health care
benefits were funded through plan assets set aside in trusts and transfers of
excess pension assets. There are currently no plan assets available in these
trusts to fund the obligations of the management retirees. There are
approximately $232 million of assets in trusts as of June 30, 2006, that are available to fund the
obligations of the formerly represented retirees.

We are permitted to transfer pension plan assets that are in excess of
125% of pension plan obligations under Section 420 of the Internal Revenue Code
to fund annual retiree health care benefits. Our cumulative Section 420 transfers
were $1.9 billion, although no transfers were made within the management
retiree plan since fiscal 2002 or within the formerly represented retiree plan
since fiscal 2003. There were approximately $2.2 billion of pension plan assets that would be eligible for Section 420 transfers in our formerly represented retiree plan as of the most recent valuation (January 1, 2006). The funding levels for our management retiree pension plans were below the required thresholds that would allow for Section 420 transfers. If a Section 420 transfer is made, we are required to
maintain a certain level of cost per participant for a period of five years
beginning with the year of transfer. As a result, although these excess pension
asset transfers can help fund retiree health care benefits, they limit our
ability to implement cost reductions in the future.

Together with our unions, we are seeking legislative
  changes to allow an employer to fund more than one years retiree health
  care benefits through a Section 420 transfer and permit the terms of an enforceable
  collective bargaining agreement to serve as an alternative to the maintenance
  of cost requirements described above. Although Section 420 legislative changes
  were included in the Act, additional changes are being pursued as technical
  corrections that are related to minimum pension funding thresholds following
  a collectively bargained Section 420 transfer. If the Act is signed into law
  and we are successful in obtaining the technical corrections, we believe that
  a majority of the funding required for formerly represented retirees (assuming
  the present level and structure of benefits) could be addressed through Section
  420 transfers based on current actuarial assumptions. However, no assurances
  can be given that we will be successful in these efforts or that other legislative
  changes will not be adopted that will adversely affect the amount of pension
  plan assets that would be available for Section 420 transfers.

Our collective bargaining agreements with our unions currently provide that if the legislative changes that we are seeking are not obtained by
September 1, 2006, our obligation to fund a $400 million trust for represented
retiree health care by 2012 will terminate, and we can change the level of the

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|          |                   
|--------- | ------------------
|<PAGE> 37 | Form 10-Q - Part I

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

subsidy for represented retiree health care at our sole discretion
beginning January 1, 2007, subject to the maintenance of cost requirements that
expire on September 30, 2007.

Assuming the present level and structure of benefits,
  our expected cash requirements for funding retiree health care benefits and
  other postretirement benefits are expected to be $254 million during fiscal
  2006 and are expected to increase to $431 million, $526 million, $502 million
  and $474 million during the next four consecutive fiscal years due to the depletion
  of plan assets held in trusts. These amounts exclude potential Section 420 transfers,
  but include the expected annual Medicare Part D subsidies of approximately $50
  million in fiscal 2007 and $80 million annually thereafter. These expected funding
  requirements are subject to change.

Our existing credit facility that provides us the ability to issue
letters of credit will expire on September 30, 2006. We are in discussions with
our banks to amend or extend these agreements. If we fail to obtain a new
credit facility we may be required to use cash as collateral to guarantee our
performance or payment to third parties.

Customer financing commitments

We may provide or commit to additional
customer financings on a limited basis. We carefully review requests for
customer financing on a case-by-case basis. Such review assesses the credit
quality of the individual borrowers and the structure of the transactions. We
also assess our ability to sell or transfer the undrawn commitments and drawn
borrowings to unrelated third parties. Our net exposure for customer financing
commitments was not material as of June 30, 2006.

Credit
ratings

Our credit ratings are below investment grade. Any credit downgrade
affects our ability to enter into and maintain certain contracts on favorable terms
and increases our cost of borrowing. Our credit ratings as of August 8, 2006,
are as follows:

|                        |  |                  |  |                                  |  |                                                                  |  |                            
|----------------------- |  | ---------------- |  | -------------------------------- |  | ---------------------------------------------------------------- |  | ---------------------------
|Rating Agency           |  | Long-term
  debt |  | 8.00%
  convertible
  securities |  | Liability to
  subsidiary trust
  issuing preferred
  securities |  | Last change                
|                        |  |                  |  |                                  |  |                                                                  |  |                            
|Standard &
  Poors (a) |  | B                |  | CCC+                             |  | CCC                                                              |  | Upgraded March 10,
  2004  
|Moodys (b)             |  | B1               |  | B3                               |  | B3                                                               |  | Upgraded May 16,
  2005    
|Fitch (c)               |  | BB-              |  | B                                |  | B                                                                |  | Upgraded October
  26, 2005



|    |                                                                    
|--- | -------------------------------------------------------------------
|   
|(a) | Outlook changed to
  Watch Positive on March 24, 2006.             
|    |                                                                    
|(b) | Rating placed
  under review for possible upgrade on April 3, 2006.
|    |                                                                    
|(c) | Outlook changed to
  Watch Positive on April 3, 2006.              

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|          |                   
|--------- | ------------------
|<PAGE> 38 | Form 10-Q - Part I

Item 3.
Quantitative and Qualitative Disclosures About Market Risk

RISK MANAGEMENT

We are exposed to market risk from
changes in foreign currency exchange rates, interest rates and equity prices.
We manage our exposure to risk from changing exchange rates and interest rates
through the use of derivative financial instruments, coupled with other
strategies. Our risk management objective is to minimize the effects of
volatility on our cash flows by identifying the assets, liabilities or
forecasted transactions exposed to these risks and hedging them. Hedges may be
achieved either by forward or option contracts, swap derivatives, or terms
embedded into certain contracts that affect the ultimate amount of cash flows
under the contract. The gains and losses on these exposures are generally
offset by reciprocal changes in the value of the hedging instruments when used
because there is a high correlation between the hedging instruments and the
underlying exposures. We use derivative financial instruments as risk management
tools and not for trading 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 are therefore subject
to market risk for changes in foreign exchange rates. We use foreign exchange
forward and option contracts to minimize exposure to the risk of the eventual
net cash inflows and outflows resulting from foreign currency denominated
transactions with customers, suppliers and non-U.S. subsidiaries. Our objective
is to hedge all types of foreign currency risk to preserve our cash flows, but
we generally do not expect to designate these derivative instruments as hedges
under current accounting standards unless the benefits of doing so are
material. Cash inflows and outflows denominated in the same foreign currency
are netted on a legal entity basis or at the corporate level. The corresponding
net cash flow exposure is appropriately hedged. To the extent that the forecasted
cash flow exposures are overstated or understated or if there is a shift in the
timing of the anticipated cash flows during periods of currency volatility, we
may experience unanticipated currency gains or losses. We do not hedge our net
investment in non-U.S. entities because we view those investments as long-term
in nature.

Interest rate risk

We are exposed to various forms of
interest rate risk. The fair value of our fixed-rate available-for-sale
marketable securities and the interest income earned on our cash and cash
equivalents may fluctuate as interest rates change. In addition, if interest
rates are low, we may forgo the opportunity to obtain more favorable interest
rates on borrowings due to our fixed-rate debt obligations. Our objective is to
mitigate the variability of cash inflows and outflows resulting from interest
rate fluctuations by maintaining a balanced mix of fixed- and floating-rate
debt and investments. We mitigate our interest rate risk by entering into
interest rate swaps on a portion of our debt obligations to make them
variable-rate debt instruments and by including fixed-rate assets in our
investment portfolio. We also expect that these types of transactions will
reduce our overall cost of borrowing and increase investment returns over the
long-term.

As of June 30, 2006, we had interest
rate swaps where we received fixed interest rates (5.5% and 7.25%) and paid
floating rates based upon the three-month LIBOR rate plus agreed upon spreads
(ranging from 1.72% to 2.89%) on notional amounts aggregating $400 million. As
of June 30, 2006, the three-month LIBOR rate was 5.48%. We do not foresee any
significant changes in our interest rate risk management strategy or in our
exposure to interest rate fluctuations.

Equity price risk

Our investment portfolio includes
equity investments in publicly held companies that are classified as
available-for-sale and other strategic equity holdings in privately held
companies and venture funds. These securities are exposed to price fluctuations
and are generally concentrated in high-technology industries. The carrying
values of our available-for-sale equity securities and privately held
securities were $2 million and $59 million as of June 30, 2006, respectively.
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 privately held companies.

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|          |                   
|--------- | ------------------
|<PAGE> 39 | Form 10-Q - Part I

Item 4. Controls
and Procedures

We periodically review the design
and effectiveness of our disclosure controls and internal control over
financial reporting worldwide, including compliance with various laws and
regulations that apply to our operations both inside and outside the United
States. We make modifications to improve the design and effectiveness of our
disclosure controls and internal control structure, and may take other
corrective action, if our reviews identify a need for such modifications or
actions. In designing and evaluating the disclosure controls and procedures and
internal control of financial reporting, we recognize that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives.

An evaluation was carried out under
the supervision and with the participation of our management, including the
Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the
effectiveness of our disclosure controls and procedures. Based on that
evaluation, the CEO and CFO have concluded that as of the end of the period
covered by this report, our disclosure controls and procedures are effective to
provide reasonable assurance that information required to be disclosed by us in
reports that we file or submit under the Securities Exchange Act of 1934 is
recorded, processed, summarized and timely reported as provided in the
Securities and Exchange Commission rules and forms. No changes occurred during
the three months ended June 30, 2006 in our internal control over financial
reporting that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.

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|          |                    
|--------- | -------------------
|<PAGE> 40 | Form 10-Q - Part II

Part II  Other Information

Item 1. Legal
Proceedings

Information about legal proceedings
is set forth in Note 12 to the unaudited consolidated financial statements
included in this report.

Item
6. Exhibits

See Exhibit
Index on page 42 for a description of the documents that are filed as Exhibits
to this report on Form 10-Q or incorporated by reference herein.

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|          |          
|--------- | ---------
|<PAGE> 41 | Form 10-Q

SIGNATURES

Pursuant to the
requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.

|                     |  |                            |                                | 
|-------------------- |  | -------------------------- | ------------------------------ | 
|                     |  | Lucent
  Technologies Inc.
|                     |  | Registrant                
|                     |  |                           
|Date: August 8, 2006 |  |                            |                               
|                     |  |                            |                               
|                     |  |                            | /s/ David W. Hitchcock         | 
|                     |  |                            |                                | 
|                     |  |                            | David W. Hitchcock            
|                     |  |                            | Corporate Controller          
|                     |  |                            | (Principal Accounting Officer)

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|          |          
|--------- | ---------
|<PAGE> 42 | Form 10-Q

Exhibit Index

|        |                                                                                                                                                                         
|------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31(i).1 | Certification of Patricia F. Russo required by Rule
  13a-14(a) (17 C.F.R. 240.13a-14(a)).                                                                              
|        |                                                                                                                                                                         
|31(i).2 | Certification of John A. Kritzmacher required by Rule
  13a-14(a) (17 C.F.R. 240.13a-14(a)).                                                                            
|        |                                                                                                                                                                         
|32      | Certification of Patricia F. Russo and John A. Kritzmacher
  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
  Sarbanes-Oxley Act of 2002.

---