**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

x                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended June 30, 2007**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                   to                   **

**CommissionFile Number 001-15951**

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**AVAYA INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     |   | **22-3713430**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **211 Mount Airy Road  Basking Ridge, New Jersey**               |   | **07920**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

 

**(908) 953-6000**

(Registrant’s telephonenumber, including area code)

**None**

(Former name, formeraddress and former fiscal year, if changed since last report)

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes  x    No  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated  filer  x |   | Accelerated filer  o |   | Non-accelerated filer  o |
|---------------------------------------|--------|--------------------------------|--------|------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  o     No  x

Asof July 31, 2007, 456,934,358 shares of Common Stock, $.01 par value ofAvaya Inc. were outstanding.

 

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**TABLEOF CONTENTS**
| Item                                        | ** **   | ** **                                                                                  | ** ** | ** ** | **Description** | ** ** | ** ** | **Page** |
|---------------------------------------------|--------------|---------------------------------------------------------------------------------------------|------------|------------|-----------------|------------|------------|----------|
| **PART I—FINANCIAL  INFORMATION** |         |                                                                                        |       |
| 1.                                          |         | Financial Statements (unaudited)                                                            |       | 3          |            |
| 2.                                          |         | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       | 29         |            |
| 3.                                          |         | Quantitative and Qualitative  Disclosures About Market Risk                                 |       | 51         |            |
| 4.                                          |         | Controls and Procedures                                                                     |       | 52         |            |
| **PART II—OTHER  INFORMATION**    |         |                                                                                        |       |
| 1.                                          |         | Legal Proceedings                                                                           |       | 53         |            |
| 1A.                                         | *** *** | Risk Factors                                                                                |       | 53         |            |
| 2.                                          | *** *** | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       | 61         |            |
| 3.                                          |         | Defaults  Upon Senior Securities                                                            |       | 62         |            |
| 5.                                          |         | Other  Information                                                                          |       | 62         |            |
| 6.                                          |         | Exhibits                                                                                    |       | 62         |            |
|                                        |         | Signatures                                                                                  |       | 63         |            |

 

This Quarterly Report on Form 10-Q containstrademarks, service marks and registered marks of Avaya Inc. and itssubsidiaries and other companies, as indicated. Unless otherwise provided inthis Quarterly Report on Form 10-Q, trademarks identified by ® and TMare registered trademarks or trademarks, respectively, of Avaya Inc. or itssubsidiaries. All other trademarks are the properties of their respectiveowners.

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**PART I   FINANCIALINFORMATION**

**Item1.   *Financial Statements*.**

**AVAYAINC.**

**CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**

| ** **                                   | ** ** | **Three months ended** | ** ** | **Nine months ended**                                                 | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **June 30,**                | ** ** | **June 30,**                                                               | ** ** |
| ** **                                   | ** ** | ** **                       | ** ** | **   2007   **                                    | ** ** | **   2006   ** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                   | ** ** | ** **                       | ** ** | **Dollars in millions, except per share amounts** | ** ** |
| REVENUE                                      |       |                             |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Sales of products                            |       |                             | $          | 626                                                                             |       |   |   | $ | 636 |   |   | $ | 1,884 |   | $ | 1,820 |   |
| Services                                     |       |                             | 507        |                                                                            |       |   | 507 |   |   | 1,525 |   | 1,503 |   |
| Rental and  managed services                 |       |                             | 143        |                                                                            |       |   | 154 |   |   | 441 |   | 461 |   |
|                                         |       |                             | 1,276      |                                                                            |       |   | 1,297 |   |   | 3,850 |   | 3,784 |   |
| COSTS                                        |       |                             |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Sales of products                            |       |                             | 302        |                                                                            |       |   | 304 |   |   | 892 |   | 856 |   |
| Services                                     |       |                             | 312        |                                                                            |       |   | 335 |   |   | 960 |   | 976 |   |
| Rental and  managed services                 |       |                             | 65         |                                                                            |       |   | 70 |   |   | 204 |   | 197 |   |
|                                         |       |                             | 679        |                                                                            |       |   | 709 |   |   | 2,056 |   | 2,029 |   |
| GROSS MARGIN                                 |       |                             | 597        |                                                                            |       |   | 588 |   |   | 1,794 |   | 1,755 |   |
| OPERATING EXPENSES                           |       |                             |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Selling, general  and administrative         |       |                             | 402        |                                                                            |       |   | 423 |   |   | 1,184 |   | 1,207 |   |
| Research and  development                    |       |                             | 104        |                                                                            |       |   | 115 |   |   | 332 |   | 318 |   |
| Restructuring  charges, net                  |       |                             | 13         |                                                                            |       |   | 22 |   |   | 29 |   | 42 |   |
| Merger-related  costs                        |       |                             | 8          |                                                                            |       |   | — |   |   | 8 |   | — |   |
| TOTAL OPERATING  EXPENSES                    |       |                             | 527        |                                                                            |       |   | 560 |   |   | 1,553 |   | 1,567 |   |
| OPERATING INCOME                             |       |                             | 70         |                                                                            |       |   | 28 |   |   | 241 |   | 188 |   |
| Other income, net                            |       |                             | 10         |                                                                            |       |   | 5 |   |   | 23 |   | 16 |   |
| Interest expense                             |       |                             | (1         | )                                                                               |       |   | — |   |   | (1 | ) | (3 | ) |
| INCOME BEFORE INCOME TAXES                   |       |                             | 79         |                                                                            |       |   | 33 |   |   | 263 |   | 201 |   |
| Provision for (benefit from) income taxes    |       |                             | 24         |                                                                            |       |   | (11 | ) |   | 80 |   | 48 |   |
| **NET INCOME**                               | ** ** | ** **                       | **$**      | **55**                                                                          |       | ** ** | ** ** | **$** | **44** |   | ** ** | **$** | **183** | ** ** | **$** | **153** | ** ** |
| **Earnings Per Common Share—Basic:**    | ** ** | ** **                       | **$**      | **0.12**                                                                        |       | ** ** | ** ** | **$** | **0.10** |   | ** ** | **$** | **0.40** | ** ** | **$** | **0.33** | ** ** |
| **Earnings  Per Common Share—Diluted:** | ** ** | ** **                       | **$**      | **0.12**                                                                        |       | ** ** | ** ** | **$** | **0.10** |   | ** ** | **$** | **0.40** | ** ** | **$** | **0.32** | ** ** |

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.

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**AVAYAINC.**

**CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

| ** **                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | **June 30, 2007**                                                       | ** ** | **September 30, 2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | **Dollars in millions,   except per share amounts** | ** ** |
| **ASSETS**                                                                                                                                                                                                                          | ** ** |       | ** ** | ** **                                                                        |       |                             | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                                                                     |       |       |       |                                                                              |       |                             |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                           |       |       | $          | 1,057                                                                             |       |                             |       | $ | 899 |   |   |
| Accounts receivable, less allowances of $59 million  and $57 million  as of June 30, 2007 and September 30, 2006, respectively                                                                                            |       |       | 869        |                                                                              |       |                             | 871        |   |   |
| Inventory                                                                                                                                                                                                                           |       |       | 304        |                                                                              |       |                             | 285        |   |   |
| Deferred income taxes, net                                                                                                                                                                                                          |       |       | 177        |                                                                              |       |                             | 153        |   |   |
| Other current assets                                                                                                                                                                                                                |       |       | 212        |                                                                              |       |                             | 151        |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                                               |       |       | 2,619      |                                                                              |       |                             | 2,359      |   |   |
| Property, plant and equipment, net                                                                                                                                                                                                  |       |       | 626        |                                                                              |       |                             | 668        |   |   |
| Deferred income taxes, net                                                                                                                                                                                                          |       |       | 700        |                                                                              |       |                             | 787        |   |   |
| Intangible assets                                                                                                                                                                                                                   |       |       | 275        |                                                                              |       |                             | 263        |   |   |
| Goodwill                                                                                                                                                                                                                            |       |       | 1,121      |                                                                              |       |                             | 941        |   |   |
| Other assets                                                                                                                                                                                                                        |       |       | 222        |                                                                              |       |                             | 182        |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                                   | ** ** |       | **$**      | **5,563**                                                                         | ** ** |                             |       | **$** | **5,200** | ** ** |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                       | ** ** |       | ** ** | ** **                                                                        |       |                             | ** ** | ** ** |   |
| Current  liabilities:                                                                                                                                                                                                               |       |       |       |                                                                              |       |                             |       |   |   |
| Accounts payable                                                                                                                                                                                                                    |       |       | $          | 395                                                                               |       |                             |       | $ | 418 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                                     |       |       | 400        |                                                                              |       |                             | 377        |   |   |
| Deferred revenue                                                                                                                                                                                                                    |       |       | 327        |                                                                              |       |                             | 286        |   |   |
| Business restructuring reserve                                                                                                                                                                                                      |       |       | 70         |                                                                              |       |                             | 98         |   |   |
| Other current liabilities                                                                                                                                                                                                           |       |       | 228        |                                                                              |       |                             | 249        |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                          |       |       | 1,420      |                                                                              |       |                             | 1,428      |   |   |
| Benefit obligations                                                                                                                                                                                                                 |       |       | 1,372      |                                                                              |       |                             | 1,321      |   |   |
| Deferred income taxes, net                                                                                                                                                                                                          |       |       | 79         |                                                                              |       |                             | 77         |   |   |
| Other liabilities                                                                                                                                                                                                                   |       |       | 266        |                                                                              |       |                             | 288        |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                                      |       |       | 1,717      |                                                                              |       |                             | 1,686      |   |   |
| Commitments and contingencies                                                                                                                                                                                                       |       |       |       |                                                                              |       |                             |       |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                       | ** ** |       | ** ** | ** **                                                                        |       |                             | ** ** | ** ** |   |
| Series A junior participating preferred stock,  par value $1.00 per  share, 7.5 million shares authorized; none issued and outstanding                                                                                         |       |       | —     |                                                                              |       |                             | —     |   |   |
| Common stock, par value $0.01 per share, 1.5 billion  shares  authorized, 457,182,852 and 452,203,778 issued (including  1,060,315 and 461,429 treasury shares) as of June 30, 2007 and  September 30, 2006, respectively |       |       | 5          |                                                                              |       |                             | 5          |   |   |
| Additional paid-in-capital                                                                                                                                                                                                          |       |       | 2,713      |                                                                              |       |                             | 2,637      |   |   |
| Retained earnings                                                                                                                                                                                                                   |       |       | 331        |                                                                              |       |                             | 148        |   |   |
| Accumulated other comprehensive loss                                                                                                                                                                                                |       |       | (609       | )                                                                                 |       |                             | (698       | ) |   |
| Less: Treasury stock at cost                                                                                                                                                                                                        |       |       | (14        | )                                                                                 |       |                             | (6         | ) |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                    |       |       | 2,426      |                                                                              |       |                             | 2,086      |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                | ** ** |       | **$**      | **5,563**                                                                         | ** ** |                             |       | **$** | **5,200** | ** ** |   |

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.

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**AVAYAINC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

| ** **                                                                           | ** ** | **Nine months ended**   | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                           | ** ** | **June 30,**                 | ** ** |
| ** **                                                                           | ** ** | **  2007  **  | ** ** | **  2006  ** | ** ** |
| ** **                                                                           | ** ** | **Dollars in millions** | ** ** |
| **OPERATING  ACTIVITIES:**                                                           |       |                              |       |   |   |   |   |
| Net income                                                                           |       | $                                 | 183        |   |   | $ | 153 |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:   |       |                              |       |   |   |   |   |
| Depreciation and amortization                                                        |       | 221                               |       |   | 202 |   |   |
| Share-based compensation                                                             |       | 28                                |       |   | 22 |   |   |
| Deferred income taxes, net                                                           |       | 55                                |       |   | 24 |   |   |
| Impairment charges                                                                   |       | —                            |       |   | 29 |   |   |
| Reversal of liabilities related to tax settlements                                   |       | (8                                | )          |   | (25 | ) |   |
| Gain resulting from sale of real estate                                              |       | (8                                | )          |   | — |   |   |
| Restructuring charges, net                                                           |       | 29                                |       |   | 42 |   |   |
| Unrealized losses on foreign currency exchange                                       |       | 19                                |       |   | 11 |   |   |
| Adjustments for other non-cash items, net                                            |       | 5                                 |       |   | 7 |   |   |
| Changes in operating assets and liabilities, net of  effects of acquired businesses: |       |                              |       |   |   |   |   |
| Accounts receivable                                                                  |       | 14                                |       |   | 40 |   |   |
| Inventory                                                                            |       | (9                                | )          |   | (4 | ) |   |
| Accounts payable                                                                     |       | (28                               | )          |   | (12 | ) |   |
| Payroll and benefit obligations                                                      |       | 38                                |       |   | 42 |   |   |
| Business restructuring reserve                                                       |       | (83                               | )          |   | (56 | ) |   |
| Deferred revenue                                                                     |       | 57                                |       |   | 29 |   |   |
| Other assets and liabilities                                                         |       | (89                               | )          |   | (48 | ) |   |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES                                           |       | 424                               |       |   | 456 |   |   |
| **INVESTING  ACTIVITIES:**                                                           |       |                              |       |   |   |   |   |
| Capital expenditures                                                                 |       | (79                               | )          |   | (83 | ) |   |
| Capitalized software development costs                                               |       | (71                               | )          |   | (53 | ) |   |
| Acquisitions of businesses, net of cash acquired                                     |       | (162                              | )          |   | — |   |   |
| Proceeds from sale of real estate                                                    |       | 13                                |       |   | 2 |   |   |
| Other investing activities, net                                                      |       | (5                                | )          |   | (5 | ) |   |
| NET CASH USED FOR  INVESTING ACTIVITIES                                              |       | (304                              | )          |   | (139 | ) |   |
| **FINANCING  ACTIVITIES:**                                                           | ** ** | ** **                        | ** ** |   |   |   |   |
| Issuance of common stock                                                             |       | 110                               |       |   | 20 |   |   |
| Repurchase of common stock                                                           |       | (94                               | )          |   | (256 | ) |   |
| Capital lease payments                                                               |       | (3                                | )          |   | (14 | ) |   |
| NET CASH PROVIDED  BY (USED FOR) FINANCING ACTIVITIES                                |       | 13                                |       |   | (250 | ) |   |
| Effect of  exchange rate changes on cash and cash equivalents                        |       | 25                                |       |   | 5 |   |   |
| Net increase in  cash and cash equivalents                                           |       | 158                               |       |   | 72 |   |   |
| Cash and cash  equivalents at beginning of fiscal year                               |       | 899                               |       |   | 750 |   |   |
| Cash and cash  equivalents at end of period                                          |       | $                                 | 1,057      |   |   | $ | 822 |   |   |

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these Statements.

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**AVAYA INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

**1.**                 Background andBasis of Presentation

***Background***

Unless otherwise indicatedby the context in this Quarterly Report on Form 10-Q, “we,” “us,” “our,” “theCompany” and “Avaya” refer to Avaya Inc. and its consolidated subsidiaries. Weare a leading provider of communications solutions that help enterprisestransform their businesses by intelligently connecting customers, employees andbusiness partners with enhanced business processes. Our enterprisecommunications solutions offerings are comprised of a product portfolio thatincludes infrastructure hardware, application software, phone appliances and acomprehensive portfolio of enterprises services focused on IT andcommunications solutions. We support our broad customer base with comprehensiveglobal service offerings that enable our customers to plan, design, implement,monitor and manage their communications systems and/or converged networks. Theterm “traditional” with respect to “voice communications,” “enterprise voicecommunications,” “telephony,” “voice telephony,” “voice systems,” or “TDM,”refers to circuit-based enterprise voice communications.

***Basis of Presentation***

The accompanying unaudited interim ConsolidatedFinancial Statements as of June 30, 2007 and for the three and nine monthsended June 30, 2007 and 2006, have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“U.S. GAAP”) for interim financial statements and therules and regulations of the U.S. Securities and Exchange Commission (“theSEC”) for interim financial statements, and should be read in conjunction withour Consolidated Financial Statements and other financial information for thefiscal year ended September 30, 2006, which were included in our AnnualReport on Form 10-K filed with the SEC on December 8, 2006. Thesignificant accounting policies used in preparing these unaudited interimConsolidated Financial Statements are the same as those described in Note 2 toour Annual Report on Form 10-K filed with the SEC on December 8,2006. In our opinion, the unaudited interim Consolidated Financial Statementsreflect all adjustments, consisting of normal and recurring adjustments,necessary for a fair statement of the financial condition, results ofoperations and cash flows for the periods indicated.

Certain prior year amounts have beenreclassified to conform to the current year presentation. Theconsolidated results of operations for the interim periods reported are notnecessarily indicative of the results to be experienced for the entire fiscalyear.

***Merger Agreement with Silver Lake Partners and TPGPartners***

On June 4, 2007, Avaya entered into an Agreement and Plan of Merger(the “Merger Agreement”) with Sierra Holdings Corp., a Delaware corporation (“Parent”),and Sierra Merger Corp., a Delaware corporation and wholly owned subsidiary ofParent (“Merger Sub”). Under the terms of the Merger Agreement, Merger Sub willbe merged with and into the Company, with the Company continuing as thesurviving corporation and a wholly owned subsidiary of Parent (the “Merger”). Parentwas formed by two private equity funds, Silver Lake Partners III, L.P. and TPGPartners V, L.P. (collectively, the “Sponsors”), solely for the purpose ofentering into the Merger Agreement and consummating the Merger. The MergerAgreement provides for a purchase price of $17.50 per share of Avayacommon stock (the “Merger Consideration”), or approximately $8.21 billion inthe aggregate (excluding fees and expenses in connection with the Merger ofapproximately $0.28 billion).

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The proposed transaction is expected to be completedin the fall of 2007, subject to receipt of shareholder approval and customaryregulatory approvals, as well as satisfaction of other customary closingconditions. There is no financing condition to the obligations of the Sponsorsto consummate the transaction, and equity and debt commitments sufficient tofund the Merger Consideration have been delivered to Parent. The Company filedits preliminary proxy statement with the SEC on July 18, 2007 and filedits Hart-Scott-Rodino notification with the Federal Trade Commission and theDepartment of Justice on June 15, 2007. TheDepartment of Justice and the Federal Trade Commission granted earlytermination of the Hart-Scott-Rodino waiting period effective June 28,2007. The date for the special meeting of shareholders to vote on adoption ofthe Merger Agreement is September 28, 2007, and the record date related tothis meeting is August 9, 2007.

During the three monthsended June 30, 2007, the Company incurred third-party costs associatedwith the Merger of $8 million (approximately $4.6 million after tax, or $0.01per diluted share) consisting primarily of investment banking and legal feesdirectly related to the proposed Merger.

**2.**                 RecentAccounting Pronouncements

**SFAS 159**

In February 2007, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities” (“SFAS 159”) which permits companies the option, atspecified election dates, to measure financial assets and liabilities at theircurrent fair value, with any corresponding changes in fair value from period toperiod recognized in the income statement. Additionally, SFAS 159establishes presentation and disclosure requirements designed to facilitatecomparisons between companies that choose different measurement attributes forsimilar assets and liabilities. SFAS  159 is effective for theCompany beginning in fiscal 2009. The Company is currently evaluatingthe impact that adoption of SFAS 159 may have on its Consolidated FinancialStatements.

**SFAS 158**

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Post Retirement Plans—an amendment of FASB Statements No. 87,88, 106 and 132(R)” (“SFAS 158”). SFAS 158 improves reporting ofobligations for pensions and other post-retirement benefits byrecognizing the over-funded or under-funded status of plans as an asset orliability. The pronouncement does not change how plan assets and benefitobligations are measured under FAS 87 and FAS 106 nor does it change theapproach for measuring annual benefit cost reported in earnings. Instead, iteliminates the provisions that permit plan assets and obligations to bemeasured as of a date not more than three months prior to the balance sheetdate, instead requiring measurement as of the reporting date. In addition, thepronouncement requires previously unrecognized items, such as actuarial gainsor losses and unrecognized prior service costs or credits to be recognized onthe balance sheet as a component of other comprehensive income (loss). TheCompany will adopt the provisions of SFAS 158 by the end of fiscal 2007. Theestimated impact of adopting this new standard depends upon several factors,including the market discount rate at September 30, 2007 and the actualreturn on plan assets. The Company estimates an increase in the liability forbenefit obligations recognized on the September 30, 2007 ConsolidatedBalance Sheet of approximately $150 to $180 million with an additionto accumulated other comprehensive loss. This range is an estimate and issubject to change pending the funded status of the plans as of the measurementdate, which is September 30, 2007. The Company is also assessing thepotential impact that adoption of SFAS 158 may have on the Company’spostemployment liabilities established under SFAS No. 112, “Employers’Accounting for Postemployment Benefits.”

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**SFAS 157**

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS157 defines fair value and establishes a framework for measuring fair valueunder U.S. GAAP. The pronouncement describes fair value as being based on ahypothetical transaction to sell an asset or transfer a liability at a specificmeasurement date, as considered from the perspective of a market participantwho holds the asset or owes the liability. In addition, fair value should beviewed as a market-based measurement, not an entity-specific measurement. Thereforefair value should be determined based on the assumptions that marketparticipants would use in pricing an asset or liability, including all risksassociated with that asset or liability. SFAS 157 will be effective for theCompany beginning in fiscal 2009. The adoption of SFAS 157 is not expected tohave a material impact on the Company’s Consolidated Financial Statements.

**SAB 108**

In September 2006, the SEC issued SAB 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB 108”). In SAB 108, the SEC staff established anapproach that requires quantification of financial statement misstatementsbased on the effect of the misstatements on each of the Company’s financialstatements and the related financial statement disclosures. This model iscommonly referred to as a “dual approach” because it requires quantification oferrors under both the iron curtain (year-end balance sheet effect) and therollover (current-year effect on consolidated statements of operations)methods, along with the evaluation of all relevant qualitative factors.

SAB 108 permits existingpublic companies to initially apply its provisions either by (i) restatingprior financial statements as if the “dual approach” had always been used or (ii) recordingthe “cumulative effect” of initially applying the “dual approach” asadjustments recorded to the opening balance of retained earnings. Use of the “cumulativeeffect” transition method requires detailed disclosure of the nature and amountof each individual error being corrected through the cumulative adjustment andhow and why it arose. We expect to initially apply the provisions of SAB 108 inconnection with the preparation of our annual financial statements for the yearended September 30, 2007. We are currently evaluating the impact that theadoption of SAB 108 will have on our consolidated results of operation and financialposition.

**FIN 48**

In July 2006, the FASB issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes (aninterpretation of FASB Statement No. 109)” (“FIN 48”). FIN 48 clarifiesthe accounting for uncertainty in tax positions and requires that companiesrecognize in their financial statements the impact of a tax position if it ismore likely than not that the position would be sustained on audit, based onthe technical merits of the position. The Company will be required to adopt theprovisions of FIN 48 beginning in fiscal 2008, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings as well as requiring additional disclosures. The Company iscurrently assessing the impact that adoption of FIN 48 may have on itsConsolidated Financial Statements.

**3.**                 BusinessCombinations

***Acquisition of Ubiquity***

On January 12, 2007, the Company announced that AvayaInternational Enterprises Limited (“AIEL”), a wholly-owned subsidiary of theCompany, commenced a conditional tender offer to acquire Ubiquity SoftwareCorporation plc (“Ubiquity”). Ubiquity develops and markets SIP-basedcommunications software. Ubiquity was publicly traded on the AlternativeInvestment Market of the 

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London Stock Exchange and is headquarteredin the United Kingdom. Terms of the offer provided for a purchase price of 37.3pence per Ubiquity share.

On February 15, 2007, the Company announced thatit received binding acceptances representing 96.7 percent of the outstandingshares of Ubiquity through its tender offer and declared the offer whollyunconditional. On February 28, 2007, the Company used $146 million of cashto acquire substantially all of the Ubiquity shares. During April 2007,the Company purchased the remaining outstanding shares for $1 million.

Based upon a preliminarypurchase price allocation, the Company recognized $41 million of intangibleassets related primarily to existing core technology with a weighted averageuseful life of approximately nine years, and recorded $122 million of goodwill.Management has made estimates and assumptions in the preliminary purchase priceallocation that could affect the reported amounts of assets, liabilities andexpenses resulting from this acquisition. Actual amounts could differ fromthese estimates. Management expects to finalize its purchase price allocationby the end of fiscal 2007. The purchase price for this acquisition is notconsidered to be material to the Consolidated Financial Statements and,therefore, pro forma financial information has not been presented. Thefinancial results of Ubiquity are included in the Company’s ConsolidatedFinancial Statements beginning on February 28, 2007.

***Acquisition of Traverse***

On November 9, 2006,the Company acquired Traverse Networks, Inc. (“Traverse”) for $15 millionin cash. Traverse is a U.S.-based developer of enterprise mobility solutionsfor unified communications. The Company acquired $3 million in intangibleassets with a weighted average useful life of 4.5 years, $4 million in otherassets and recorded $8 million of goodwill as part of the purchase priceallocation. Management has made estimates and assumptions that could affect thereported amounts of assets, liabilities and expenses resulting from this acquisition.Actual amounts could differ from these estimates. The purchase price for thisacquisition is not considered to be material to the Consolidated FinancialStatements and, therefore, pro forma financial information has not beenpresented. The financial results of Traverse are included in the Company’sConsolidated Financial Statements beginning on November 9, 2006.

**4.**                 Goodwilland Intangible Assets

Thechanges in the carrying value of goodwill for the nine months ended June 30,2007 by operating segment are as follows:

| ** **                                             | ** ** | **Global**         | ** ** | **Avaya**                         | ** ** | ** **   | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|-----------------------------------|------------|--------------|------------|
| ** **                                             | ** ** | **Communications** | ** ** | **Global**                        | ** ** | ** **   | ** ** |
| ** **                                             | ** ** | ** **         | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Total** | ** ** |
| ** **                                             | ** ** | ** **         | ** ** | **Dollars in millions** | ** ** |
| **Balance  as of September 30, 2006**             | ** ** |               | **$**      | **658**                           | ** ** |         |       | **$** | **283** | ** ** |   | **$** | **941** | ** ** |
| Acquisition of Traverse                                |       |               | 8          | ** **                        |       |         | —     | ** ** |   | 8 |   |
| Acquisition of Ubiquity                                |       |               | 122        | ** **                        |       |         | —     | ** ** |   | 122 |   |
| Impact of foreign currency exchange rate  fluctuations |       |               | 37         | ** **                        |       |         | 13         | ** ** |   | 50 |   |
| **Balance as of June 30,  2007**                  | ** ** |               | **$**      | **825**                           | ** ** |         |       | **$** | **296** | ** ** |   | **$** | **1,121** | ** ** |

 

9

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Thefollowing table presents the components of the Company’s acquired intangibleassets:

| ** **                                    | ** ** | **June 30, 2007** | ** ** | **September 30, 2006**  | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **Gross**                   | ** ** | ** **                        | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**                | ** ** | **Accumulated**                   | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | ** **                  | ** ** | **Amount**                        | ** ** | **Amortization** | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| ** **                                    | ** ** | ** **                  | ** ** | **Dollars in millions** | ** ** |
| Existing  technology                          |       |                        | $          | 161                               |       |   |   | $ | 74 |   |   | $ | 87 |   |   | $ | 103 |   |   |   | $ | 57 |   |   | $ | 46 |   |
| Customer  relationships and other intangibles |       |                        | 303        |                              |       |   | 134 |   |   | 169 |   |   | 292 |   |   |   | 94 |   |   | 198 |   |
| **Total  amortizable intangible assets**      | ** ** | ** **                  | **$**      | **464**                           |       | ** ** | ** ** | **$** | **208** |   | ** ** | **$** | **256** | ** ** | ** ** | **$** | **395** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **244** | ** ** |
| Minimum pension  adjustment                   |       |                        | 19         |                              |       |   | — |   |   | 19 |   |   | 19 |   |   |   | — |   |   | 19 |   |
| **Total intangible assets**                   | ** ** | ** **                  | **$**      | **483**                           |       | ** ** | ** ** | **$** | **208** |   | ** ** | **$** | **275** | ** ** | ** ** | **$** | **414** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **263** | ** ** |

 

During the nine months ended June 30, 2007, theacquisitions of Ubiquity and Traverse as well as the impact of foreigncurrency, partially offset by amortization, resulted in a net increase of $12million in the net intangible assets balance. The weighted average useful livesof the existing technology and customer relationships and other intangibles areapproximately six years and seven years, respectively.

Amortizationexpense for the Company’s acquired intangible assets was $17 million and $49million for the three and nine months ended June 30, 2007, respectively,and was $15 million and $48 million for the three and nine months ended June 30,2006, respectively. Estimated future amortization expense is shown in thefollowing table:

| ** **                      | ** ** | **Estimated future**         | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **amortization expense**     | ** ** |
| ** **                      | ** ** | **Dollars in millions** | ** ** |
| Remainder of fiscal 2007        |       |                              | $          | 19 |   |   |
| 2008                            |       |                              | 70         |   |   |
| 2009                            |       |                              | 68         |   |   |
| 2010                            |       |                              | 54         |   |   |
| 2011                            |       |                              | 14         |   |   |
| 2012 and thereafter             |       |                              | 31         |   |   |
| **Future amortization expense** | ** ** | ** **                        | **$**      | **256** |   |   |

 

The minimum pensionadjustment represents unrecognized prior service costs associated with therecording of a minimum pension liability in prior fiscal years. This intangibleasset may be eliminated or adjusted as necessary when the amount of minimum pensionliability is reassessed, which is conducted on an annual basis.

10

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**5.**                 SupplementaryFinancial Information

***Statements ofIncome Information***

| ** **                                                       | ** ** | **Three months ended**  | ** ** | **Nine months ended** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **June 30,**                 | ** ** | **June 30,**               | ** ** |
| ** **                                                       | ** ** | **2007**                          | ** ** | **2006**                        | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** |
| ** **                                                       | ** ** | **Dollars in millions** | ** ** |
| **OTHER INCOME, NET**                                            | ** ** |                              | ** ** | ** **                      |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Interest income                                                  |       |                              | $          | 13                              |       |   |   | $ | 9 |   |   |   | $ | 35 |   |   |   | $ | 24 |   |   |
| Loss on foreign currency transactions                            |       |                              | (1         | )                               |       |   | (1 | ) |   |   | (4 | ) |   |   | (3 | ) |   |
| Other, net                                                       |       |                              | (2         | )                               |       |   | (3 | ) |   |   | (8 | ) |   |   | (5 | ) |   |
| **Total  other income, net**                                     | ** ** |                              | **$**      | **10**                          | ** ** |   |   | **$** | **5** | ** ** |   |   | **$** | **23** | ** ** |   |   | **$** | **16** | ** ** |   |
| **COMPREHENSIVE  INCOME:**                                       | ** ** |                              | ** ** | ** **                      |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income                                                       |       |                              | $          | 55                              |       |   |   | $ | 44 |   |   |   | $ | 183 |   |   |   | $ | 153 |   |   |
| Other  comprehensive income:                                     |       |                              |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cumulative translation adjustment                                |       |                              | 22         |                            |       |   | 53 |   |   |   | 88 |   |   |   | 102 |   |   |
| Unrealized holding (loss) gain on available for sale  securities |       |                              | —     |                            |       |   | (1 | ) |   |   | 1 |   |   |   | (4 | ) |   |
| **Total comprehensive income**                                   | ** ** |                              | **$**      | **77**                          | ** ** |   |   | **$** | **96** | ** ** |   |   | **$** | **272** | ** ** |   |   | **$** | **251** | ** ** |   |

 

***Balance SheetInformation***

| ** **                                       | ** ** | **June 30,  2007**           | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY:**                                   | ** ** | ** **                        |       |                         | ** ** | ** ** |   |
| Finished goods                                   |       | $                                 | 300        |                         |       | $ | 281 |   |   |
| Raw materials                                    |       | 4                                 |       |                         | 4          |   |   |
| **Total  inventory**                             | ** ** | **$**                             | **304**    |                         |       | **$** | **285** | ** ** |   |
| **PROPERTY,  PLANT AND EQUIPMENT, NET:**         | ** ** | ** **                        |       |                         | ** ** | ** ** |   |
| Land and  improvements                           |       | $                                 | 47         |                         |       | $ | 56 |   |   |
| Buildings and  improvements                      |       | 473                               |       |                         | 460        |   |   |
| Machinery and  equipment                         |       | 697                               |       |                         | 654        |   |   |
| Rental equipment                                 |       | 251                               |       |                         | 230        |   |   |
| Assets under  construction                       |       | 9                                 |       |                         | 8          |   |   |
| Internal use  software                           |       | 234                               |       |                         | 226        |   |   |
| Total property,  plant and equipment             |       | 1,711                             |       |                         | 1,634      |   |   |
| Less: Accumulated  depreciation and amortization |       | (1,085                            | )          |                         | (966       | ) |   |
| **Property, plant and equipment,  net**          | ** ** | **$**                             | **626**    |                         |       | **$** | **668** | ** ** |   |

 

**6.**                 RestructuringPrograms

The net restructuring charge of $29 million recordedin the nine months ended June 30, 2007 is primarily comprised of employeeseparation charges related to our Europe, Middle East and Africa (“EMEA”)operations, in addition to operating lease obligations. These charges werepartially offset by a net benefit due to changes in estimates for priorrestructuring plans.

Restructuring charges,net, of $13 million for the third quarter of fiscal 2007 represent charges foremployee separation costs recorded with respect to the fiscal 2007restructuring plan.

11

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***Fiscal 2007 Restructuring Plan***

Thefollowing table summarizes the components of this reserve during the ninemonths ended June 30, 2007:

| ** **                             | ** ** | **Employee**                      | ** ** | ** **      | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                             | ** ** | **Separation**                    | ** ** | **Lease**       | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006 |       |                              | $          | —          |       |       |       | $ | — |   |   | $ | — |   |
| Charges                                |       |                              | 30         |            |       |       | 6          |   |   | 36 |   |
| Cash payments                          |       |                              | (10        | )               |       |       | (3         | ) |   | (13 | ) |
| **Balance as of June 30,  2007**  | ** ** | ** **                        | **$**      | **20**          |       | ** ** | ** ** | **$** | **3** |   | ** ** | **$** | **23** | ** ** |

 

The employee separationcosts are primarily related to workforce actions in the EMEA region as a resultof the Company’s continuing efforts to improve the region’s operationalperformance, in addition to other charges in the U.S. The operating leaseobligations relate to future rent payments, net of estimated sublease income,for unused space in connection with the closing or consolidation of officefacilities.

***Fiscal 2006 Restructuring Plan***

Thisreserve reflects the remaining balances associated with restructuring actionsinitiated during fiscal 2006. The following table summarizes the components ofthis reserve during the nine months ended June 30, 2007:

| ** **                              | ** ** | **Employee**                      | ** ** | ** **      | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                              | ** ** | **Separation**                    | ** ** | **Lease**       | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                              | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006  |       |                              | $          | 70              |       |       |       | $ | 17 |   |   | $ | 87 |   |
| Adjustments                             |       |                              | (2         | )               |       |       | (7         | ) |   | (9 | ) |
| Cash payments                           |       |                              | (43        | )               |       |       | (3         | ) |   | (46 | ) |
| Impact of foreign currency fluctuations |       |                              | 1          |            |       |       | 1          |   |   | 2 |   |
| **Balance as of June 30,  2007**   | ** ** | ** **                        | **$**      | **26**          |       | ** ** | ** ** | **$** | **8** |   | ** ** | **$** | **34** | ** ** |

 

The employee separationcosts are related to workforce actions in the EMEA region, as well as areduction in the number of service technicians in the U.S. The headcountreductions identified in this action have been completed and the cash paymentsare expected to be made through the end of fiscal 2008. The operating leaseobligations relate to future rent payments, net of estimated sublease income,for unused space in connection with the closing or consolidation ofinternational office facilities, primarily located in the United Kingdom.During the nine months ended June 30, 2007, the Company concluded leaserenegotiations, resulting in a change in the estimate and a $7 million reversalof the initial liability.

12

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***Restructuring Plans Prior to Fiscal 2006***

Thisreserve reflects the remaining balances associated with restructuring actionsinitiated prior to fiscal 2006. During the fourth quarter of fiscal 2005, theCompany recorded a restructuring charge to reorganize its North American salesand service organizations, consolidate facilities and reduce the workforce inorder to optimize the cost structure. The Company also previously recorded reservesin fiscal 2000 and 2002 for lease terminations. The following summarizes thecomponents of this restructuring reserve during the nine months ended June 30,2007:

| ** **                              | ** ** | **Employee**                      | ** ** | ** **      | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                              | ** ** | **Separation**                    | ** ** | **Lease**       | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                              | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006  |       |                              | $          | 1               |       |       |       | $ | 22 |   |   |   | $ | 23 |   |   |
| Adjustments                             |       |                              | 1          |            |       |       | 1          |   |   |   | 2 |   |   |
| Cash payments                           |       |                              | (2         | )               |       |       | (7         | ) |   |   | (9 | ) |   |
| Impact of foreign currency fluctuations |       |                              | —     |            |       |       | 1          |   |   |   | 1 |   |   |
| **Balance as of June 30,  2007**   | ** ** | ** **                        | **$**      | **—**      |       | ** ** | ** ** | **$** | **17** |   | ** ** | ** ** | **$** | **17** |   |   |

 

***EITF 95-3 Reserve***

Thisreserve reflects the remaining balance associated with employee separationcosts related to the acquisition of Tenovis Germany GmbH in November 2004(“Tenovis”). The following table summarizes the components of this reserveduring the nine months ended June 30, 2007:

| ** **                              | ** ** | **Employee**                      | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **Separation**                    | ** ** |
| ** **                              | ** ** | **Costs**                         | ** ** |
| ** **                              | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006  |       |                              | $          | 30 |   |   |
| Cash payments                           |       |                              | (15        | ) |   |
| Impact of foreign currency fluctuations |       |                              | 1          |   |   |
| **Balance as of June 30,  2007**   | ** ** | ** **                        | **$**      | **16** |   |   |

 

The headcount reductionsidentified in this action have been completed. The remaining balance includescosts related to some former employees who have elected to receive paymentsover an extended period of time.

**7.**                 FinancingArrangements

***Capital Lease Obligations***

TheCompany has entered into capital lease obligations for certain equipment andautomobiles, for which payment obligations extend through fiscal 2010. Theseobligations are classified as other currentliabilities and other liabilities within the Consolidated Balance Sheets andconsist of the following:

| ** **                               | ** ** | **June 30,  2007**           | ** ** | **September 30,  2006** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Dollars in millions** | ** ** |
| As reported in other current liabilities |       |                              | $          | 3                            |       |   |   | $ | 4 |   |   |
| As reported in other liabilities         |       |                              | 7          |                         |       |   | 9 |   |   |
| **Total capital lease obligations**      | ** ** | ** **                        | **$**      | **10**                       |       | ** ** | ** ** | **$** | **13** |   |   |

 

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***Credit Facility Amendments***

On February 23, 2005, the Company entered into aCredit Agreement among the Company, Avaya International Sales Limited, anindirect subsidiary of the Company, a syndicate of lenders and Citicorp USA, Inc.,as agent for the lenders (the “credit facility”). The commitments pursuant tothe Company’s previous Amended and Restated Five Year Revolving Credit FacilityAgreement, dated as of April 30, 2003 (as amended), among the Company, thelenders party thereto and Citibank, N.A., as agent for the lenders, wereterminated and the security interests securing obligations under that facilitywere fully released.

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can beoutstanding at any time is $400 million, of which $150 million may be in theform of letters of credit. The credit facility is a five-year revolvingfacility and is not secured by any of the Company’s assets. The credit facilitywas amended in May 2006 to extend the expiration date of the creditfacility to May 24, 2011 and to amend certain definitions resulting inreductions in interest and various fees payable to the lenders. The creditfacility contains affirmative and restrictive covenants, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio ofconsolidated debt to earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, a non-GAAPmeasure, of 2.00 to 1.00, (c) maintaining a minimum ratio of adjustedEBITDA, as defined, to interest expense of 4.00 to 1.00, (d) limitationson the incurrence of subsidiary indebtedness, (e) limitations on liens, (f) limitationson investments and (g) limitations on the creation or existence ofagreements that prohibit liens on our properties.

The credit facility also limits our ability to make dividend paymentsor distributions or to repurchase, redeem or otherwise acquire shares ofour common stock to an amount not to exceed 50% of consolidated net incomefor the fiscal year immediately preceding the fiscal year in which suchdividend, purchase, redemption, retirement or acquisition is paid or made. On September 8, 2006,the credit facility was amended to provide that the Company may use anadditional $500 million during the period from October 1, 2006 through September 30,2008 for such activities, over the amount provided for under the 50% of consolidatednet income test each year. Therefore,as of June 30, 2007, Avaya has remaining availability of $507 millionin fiscal 2007 for share repurchases under the credit facility.

Provided that the Company is in compliance with theterms of the credit facility, the Company may use up to $1 billion in cash(excluding transaction fees) and assumed debt for acquisitions completed after February 23,2005, and the Company has used $200 million as of June 30, 2007. Theacquisition amount will be permanently increased to $1.5 billion afterconsolidated adjusted EBITDA of the Company and its subsidiaries for any periodof twelve consecutive months equals or exceeds $750 million.

As of June 30, 2007, the Company was incompliance with all of the covenants included in the credit facility. There arecurrently $27 million of letters of credit issued under the creditfacility. There are no other outstanding borrowings under the facility and theremaining availability is $373 million as of June 30, 2007.

In addition, the Merger Agreement limits Avaya’sability without the Sponsors’ consent during the period from the date of theMerger Agreement until the closing of the Merger to, among other things, incurindebtedness and make acquisitions over certain thresholds. The MergerAgreement also prohibits Avaya without the Sponsors’ consent from repurchasingshares of its common stock or issuing shares of its common stock, in each casesubject to certain exceptions.

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**8.**                 EarningsPer Share of Common Stock

Basicearnings per common share is calculated by dividing net income by the weightedaverage number of common shares outstanding during the period. Diluted earningsper common share is calculated by adjusting net income and weighted averageoutstanding shares, assuming conversion of all potentially dilutive securitiesincluding stock options and restricted stock units (“RSUs”).

| ** **                                                                            | ** **   | **Three months ended**                                                | ** ** | **Nine months ended**                          | ** ** |
|---------------------------------------------------------------------------------------|--------------|---------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                            | ** **   | **June 30,**                                                               | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                            | ** **   | **    2007    **                        | ** ** | **    2006    ** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** |
| ** **                                                                            | *** *** | **Dollars in millions, except per share amounts** | ** ** |
| ***Earnings  Per Common Share—Basic:***                                          |         |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                            |         |                                                                            | $          | 55                                                       |       |   |   | $ | 44 |   |   |   | $ | 183 |   |   |   | $ | 153 |   |   |
| Earnings per share—basic                                                         |         |                                                                            | $          | 0.12                                                     |       |   |   | $ | 0.10 |   |   |   | $ | 0.40 |   |   |   | $ | 0.33 |   |   |
| Weighted average shares outstanding—basic                                        |         |                                                                            | 452        |                                                     |       |   | 459 |   |   |   | 453 |   |   |   | 465 |   |   |
| ***Earnings  Per Common Share—Diluted:***                                        |         |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                            |         |                                                                            | $          | 55                                                       |       |   |   | $ | 44 |   |   |   | $ | 183 |   |   |   | $ | 153 |   |   |
| Earnings per share—diluted                                                       |         |                                                                            | $          | 0.12                                                     |       |   |   | $ | 0.10 |   |   |   | $ | 0.40 |   |   |   | $ | 0.32 |   |   |
| ***Diluted  Weighted Average Shares Outstanding:***                                   |         |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding—basic                                       |         |                                                                            | 452        |                                                     |       |   | 459 |   |   |   | 453 |   |   |   | 465 |   |   |
| Dilutive Potential  Common Shares:                                                    |         |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock Options                                                                         |         |                                                                            | 5          |                                                     |       |   | 5 |   |   |   | 5 |   |   |   | 5 |   |   |
| Restricted Stock Units                                                                |         |                                                                            | 2          |                                                     |       |   | 1 |   |   |   | 1 |   |   |   | 1 |   |   |
| Warrants                                                                              |         |                                                                            | —     |                                                     |       |   | — |   |   |   | — |   |   |   | 1 |   |   |
| Weighted average  shares outstanding—diluted                                     |         |                                                                            | 459        |                                                     |       |   | 465 |   |   |   | 459 |   |   |   | 472 |   |   |
| ***Securities  excluded from the computation of diluted earnings per common share:*** |         |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock options(1)                                                                      |         |                                                                            | 20         |                                                     |       |   | 40 |   |   |   | 25 |   |   |   | 40 |   |   |

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(1)          Thesesecurities have been excluded from the diluted earnings per common sharecalculation because their inclusion would have been antidilutive as theirexercise prices were higher than the average market price during the period.

On April 19, 2005, the Board of Directorsauthorized a share repurchase plan (the “2005 plan”). Under the provisions ofthe 2005 plan, Avaya was authorized to use up to $500 million of cash torepurchase shares of its outstanding common stock through April 2007. DuringFebruary 2007, Avaya completed the 2005 plan.

On February 15, 2007, the Board ofDirectors authorized another share repurchase plan (the “2007 plan”), underwhich Avaya may use up to $500 million of cash for repurchases of itsoutstanding shares through February 2009. Avaya repurchased 7,304,779shares of its common stock during the nine months ended June 30, 2007. Thisrepresented 5,008,479 shares of common stock pursuant to the 2005 plan and2,296,300 shares of common stock pursuant to the 2007 plan. Approximately $471million is available through February 2009 for further share repurchasesunder the 2007 plan.

All repurchases are made at management’sdiscretion in the open market or in privately negotiated transactions incompliance with applicable securities laws and other legal requirements and aresubject to market conditions, share price, the terms of Avaya’s credit facilityand other factors.

The Merger Agreement prohibits Avayawithout the Sponsors’ consent from repurchasing shares of its common stockduring the period from the date of the Merger Agreement until the closing ofthe Merger, subject to certain exceptions.

15

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**9.**                 IncomeTaxes

Thefollowing table provides the provision for (benefit from) income taxes for thethree and nine months ended June 30, 2007 and 2006:

| ** **                                 | ** ** | **Three months ended**                         | ** ** | **Nine months ended**                          | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                 | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                 | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** |
| ** **                                 | ** ** | **Dollars in millions**                        | ** ** |
| Provision for  (benefit from) income taxes |       |                                                     | $          | 24                                                       |       |   |   | $ | (11 | ) |   |   | $ | 80 |   |   |   | $ | 48 |   |   |
|                                            |            |                                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provisionfor (benefit from) income taxes for the periods shown above are comprised ofU.S. Federal, state and non-U.S. taxes. The provision for the nine monthsended June 30, 2007 includes a $6 million benefit from theretroactive extension to January 1, 2006 of the research tax credit pursuantto the Tax Relief and Health Care Act of 2006, a $7 million tax benefit due toa reduction in estimated taxes payable for fiscal 2006 in Germany as a resultof additional restructuring charges reported for statutory purposes, and a $4million tax benefit attributable to tax return to provision adjustments due tothe filing of U.S. and non-U.S. income tax returns in the quarter.

**10.**          BenefitObligations

Thecomponents of net periodic benefit cost for the three and nine months ended June 30,2007 and 2006 are provided in the table below:

| ** **                                      | ** ** | **Pension Benefits—  U.S.**                    | ** ** | **Pension Benefits—  Non-U.S.**                | ** ** | **Postretirement  Benefits—U.S.**                   | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                      | ** ** | **Three months ended  June 30,**          | ** ** | **Three months ended  June 30,**          | ** ** | **Three months ended  June 30,**          | ** ** |
| ** **                                      | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** |
| ** **                                      | ** ** | **Dollars in millions**                        | ** ** |
| **Components of Net Periodic  Benefit Cost**    | ** ** |                                                     | ** ** | ** **                                               |       |                                                     | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                    |       |                                                     | $          | 3                                                        |       |                                                     |       | $ | 4 |   |   |   | $ | 3 | ** ** |   |   | $ | 4 |   |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                   |       |                                                     | 42         |                                                     |       |                                                     | 41         |   |   |   | 4 | ** ** |   |   | 4 |   |   |   | 11 |   |   |   | 8 |   |   |
| Expected return on plan assets                  |       |                                                     | (50        | )                                                        |       |                                                     | (51        | ) |   |   | — | ** ** |   |   | (1 | ) |   |   | (3 | ) |   |   | (2 | ) |   |
| Amortization of unrecognized prior service cost |       |                                                     | —     |                                                     |       |                                                     | 1          |   |   |   | — | ** ** |   |   | — |   |   |   | 8 |   |   |   | 4 |   |   |
| Recognized net actuarial loss                   |       |                                                     | 11         |                                                     |       |                                                     | 14         |   |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | 1 |   |   |
| **Net periodic benefit cost**                   | ** ** |                                                     | **$**      | **6**                                                    | ** ** |                                                     |       | **$** | **9** | ** ** |   |   | **$** | **7** | ** ** |   |   | **$** | **7** | ** ** |   |   | **$** | **17** | ** ** |   |   | **$** | **12** | ** ** |   |

 

| ** **                                            | ** ** | **Pension Benefits—  U.S.**          | ** ** | **Pension Benefits—  Non-U.S.**      | ** ** | **Postretirement  Benefits—U.S.**         | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                            | ** ** | **Nine months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
| ** **                                            | ** ** | **   2007   **   | ** ** | **   2006   **   | ** ** | **   2007   **   | ** ** | **   2006   ** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** |
| ** **                                            | ** ** | **Dollars in millions**              | ** ** |
| **Components of Net Periodic Benefit Cost**           | ** ** |                                           | ** ** | ** **                                     |       |                                           | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                          |       |                                           | $          | 10                                             |       |                                           |       | $ | 13 |   |   |   | $ | 8 |   |   |   | $ | 9 |   |   |   | $ | 3 |   |   |   | $ | 3 |   |   |
| Interest cost                                         |       |                                           | 125        |                                           |       |                                           | 124        |   |   |   | 14 |   |   |   | 12 |   |   |   | 31 |   |   |   | 25 |   |   |
| Expected return  on plan assets                       |       |                                           | (152       | )                                              |       |                                           | (154       | ) |   |   | (1 | ) |   |   | (1 | ) |   |   | (7 | ) |   |   | (6 | ) |   |
| Amortization of  unrecognized prior service cost |       |                                           | 2          |                                           |       |                                           | 4          |   |   |   | — |   |   |   | — |   |   |   | 24 |   |   |   | 12 |   |   |
| Recognized net  actuarial loss                        |       |                                           | 34         |                                           |       |                                           | 42         |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2 |   |   |
| **Net periodic benefit cost**                         | ** ** |                                           | **$**      | **19**                                         | ** ** |                                           |       | **$** | **29** | ** ** |   |   | **$** | **21** | ** ** |   |   | **$** | **20** | ** ** |   |   | **$** | **51** | ** ** |   |   | **$** | **36** | ** ** |   |

 

16

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The Company provides certain pension benefits for U.S.and non-U.S. employees, which are not pre-funded. The Company makes payments asthese benefits are disbursed. For the nine months ended June 30, 2007, theCompany made payments for these U.S. and non-U.S. pension benefits totaling $7 millionand $11 million, respectively. Estimated payments for these U.S. and non-U.S.pension benefits for the remainder of fiscal 2007 are $2 million and $2million, respectively.

In compliance with theterms of the Agreement dated May 28, 2006 between the Company and theCommunications Workers of America, the Company has contributed $24 million tothe represented employees’ post-retirement health trust for the nine monthsended June 30, 2007, and expects to make additional contributions totaling$11 million for the remainder of fiscal 2007. The Company also provides certainretiree medical benefits for U.S. employees, which are not pre-funded.Consequently, the Company makes payments as these benefits are disbursed. Forthe nine months ended June 30, 2007, the Company made payments totaling$22 million for these retiree medical benefits. Estimated payments for theseretiree medical benefits for the remainder of fiscal 2007 are $5 million.

**11.**          StockCompensation Plans

The Company has a stockcompensation plan that provides for the issuance to eligible employees ofnonqualified stock options and restricted stock units representing Avaya commonstock. In addition, the Company has a stock purchase plan under which eligibleemployees have the ability to purchase shares of Avaya common stock at 85% ofmarket value. As of June 30, 2007, there were 36 million shares authorizedfor future grants to purchase Avaya common stock under the Company’s stockcompensation plan. The Merger Agreement contains a covenant requiring Avaya tosuspend or terminate its employee stock purchase plan as soon as practicable.

**Stock Options**

Stock options are generally granted with an exerciseprice equal to the market value of a share of common stock on the date ofgrant, have a term of 10 years or less and vest within four years from thedate of grant. Most of the stock options granted in fiscal 2004 or later have aterm of seven years and vest over three years. For the nine months endedJune 30, 2007 and 2006, approximately $14 million and $9 million,respectively, of compensation expense related to stock options was recorded.

In connection with certain of the Company’sacquisitions, outstanding stock options held by employees of acquired companiesbecame exercisable for Avaya’s common stock, according to their terms,effective at the acquisition date. The fair value of these options was includedas part of the purchase price of the acquisition.

The Company considers several factors in calculatingthe fair value of share-based awards based on the lattice-binomial model. TheCompany calculates expected volatility based on implied and historicalvolatility of the Company’s common stock and other factors. The risk-freeinterest rate assumption is based upon observed interest rates appropriate forthe term of the Company’s employee stock options. The dividend yield assumptionis based on the Company’s intent not to issue a dividend under its dividendpolicy. The expected holding period assumption was estimated based on theCompany’s historical experience.

Share-based compensation expense recognized in theConsolidated Statements of Income for the nine months ended June 30, 2007and 2006 is based on awards ultimately expected to vest, reduced for estimatedforfeitures. SFAS 123(R) requires forfeitures to be estimated at the timeof grant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates. Forfeitures were estimated based on the Company’shistorical experience.

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Thefair value of each fiscal 2007 option grant was estimated on the grant-dateusing the lattice-binomial model with the following weighted averageassumptions:

| ** **                          | ** ** | **Nine months ended** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **June 30, 2007**     | ** ** |
| WEIGHTED AVERAGE  ASSUMPTIONS:      |       |                            |       |   |   |
| Dividend yield                      |       |                            | 0.00       | % |   |
| Expected volatility                 |       |                            | 56.59      | % |   |
| Risk-free interest rate             |       |                            | 4.65       | % |   |
| Annual forfeiture rate              |       |                            | 5.13       | % |   |
| Expected holding  period (in years) |       |                            | 3.57       |   |   |

 

Thefollowing table summarizes information concerning options granted under theCompany’s stock compensation plan for the year ended September 30, 2006and the nine months ended June 30, 2007, including information regardingexercises, forfeitures and expirations of stock options granted under theCompany’s stock compensation plan and predecessor plans:

| ** **                                    | ** ** | **Shares**       | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **(000’s)** | ** ** | **Exercise Price**   | ** ** |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2005 |       | 48,525           |       |                      | $          | 13.95 |   |   |
| Granted                                       |       | 6,503            |       |                      | 10.85      |   |   |
| Exercised                                     |       | (3,338           | )          |                      | 4.25       |   |   |
| Forfeited and Expired                         |       | (2,759           | )          |                      | 15.57      |   |   |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2006 |       | 48,931           |       |                      | 14.10      |   |   |
| Granted                                       |       | 5,681            |       |                      | 12.56      |   |   |
| Exercised                                     |       | (9,513           | )          |                      | 9.97       |   |   |
| Forfeited and Expired                         |       | (6,564           | )          |                      | 14.90      |   |   |
| OPTIONS OUTSTANDING AS  OF JUNE 30, 2007      |       | 38,535           |       |                      | $          | 14.76 |   |   |

 

Thefollowing table summarizes the status of the Company’s outstanding stockoptions as of June 30, 2007:

| ** **               | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |                  |
|--------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|-----------------------|
| ** **               | ** ** | ** **                              | ** ** | **Average**                             | ** ** | **Weighted**          | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** |   |
| ** **               | ** ** | ** **                              | ** ** | **Remaining**                           | ** ** | **Average**           | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |   |
| **Range of**        | ** ** | **Shares**                              | ** ** | **Contractual**                         | ** ** | **Exercise**          | ** ** | **Value** | ** ** | **Shares** | ** ** | **Exercise** | ** ** | **Value** | ** ** |   |
| **Exercise Prices** | ** ** | ** **                              | ** ** | **(000’s)**                        | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **(000’s)** | ** ** | **(000’s)** | ** ** | **Price** | ** ** | **(000’s)** | ** ** |   |
| $0.01 to $6.39           |       | 3,451                                   |       |                                    | 2.18       |                  |   |   | $ | 4.24 |   |   | $ | 43,678 |   | 3,451 |   |   | $ | 4.24 |   |   |   | $ | 43,678 |   |   |
| $6.40 to $11.18          |       | 5,564                                   |       |                                    | 5.15       |                  |   |   | 10.46 |   |   | 35,821 |   | 1,555 |   |   | 10.42 |   |   |   | 10,083 |   |   |
| $11.19 to $14.84         |       | 11,483                                  |       |                                    | 4.87       |                  |   |   | 12.82 |   |   | 46,843 |   | 5,841 |   |   | 13.19 |   |   |   | 21,697 |   |   |
| $14.85 to $17.44         |       | 11,409                                  |       |                                    | 3.61       |                  |   |   | 15.28 |   |   | 18,616 |   | 11,281 |   |   | 15.27 |   |   |   | 18,497 |   |   |
| $17.45 to $51.21         |       | 6,628                                   |       |                                    | 1.62       |                  |   |   | 26.34 |   |   | — |   | 6,628 |   |   | 26.34 |   |   |   | — |   |   |
| Total                    |       | 38,535                                  |       |                                    |       |                  |   |   | $ | 14.76 |   |   | $ | 144,958 |   | 28,756 |   |   | $ | 15.81 |   |   |   | $ | 93,955 |   |   |
|                          |            |                                         |            |                                         |            |                       |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the preceding table represents the total pretax intrinsic value, basedon the Company’s average stock price on June 30, 2007, which would havebeen received by the option holders had all option holders exercised theiroptions as of that date. The total number of in-the-money options exercisableon June 30, 2007 was approximately 22 million. The weighted averageremaining contractual life on June 30, 2007 for outstanding andexercisable options is 3.74 and 2.96 years, respectively.

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**Time-VestingRestricted Stock Units**

The Company’s stock compensation plan permits thegranting of RSUs to eligible employees and non-employee Directors at fairmarket value at the date of grant. RSUs typically become fully vested over afour-year period and are payable in shares of the Company’s common stock uponvesting.

Thefollowing table summarizes information concerning unvested RSUs granted underthe Company’s stock compensation plan as of September 30, 2006, andincludes information regarding grants under that plan and vesting andforfeitures of RSUs granted under that plan and predecessor plans that occurredduring the nine months ended June 30, 2007:

| ** **                                  | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                                  | ** ** | **Shares** | ** ** | **Grant-Date**       | ** ** |
| **Unvested Shares**                    | ** ** | ** ** | ** ** | **(000’s)**     | ** ** | **Fair Value** | ** ** |
| Unvested shares  at September 30, 2006 |       | 5,319      |       |                 | $          | 12.44 |   |   |
| Granted                                     |       | 2,800      |       |                 | 12.64      |   |   |
| Vested                                      |       | (390       | )          |                 | 10.99      |   |   |
| Forfeited                                   |       | (1,138     | )          |                 | 13.00      |   |   |
| Unvested shares at  June 30, 2007      |       | 6,591      |       |                 | $          | 12.51 |   |   |
|                                             |            |            |            |                      |            |  |  |  |  |  |

 

As of June 30, 2007,there was approximately $53 million of total unrecognized compensation costrelated to unvested share-based compensation arrangements granted under theCompany’s stock compensation plan and predecessor plans. That cost is expectedto be recognized over a weighted average period of four years. Compensationexpense related to RSUs was $4 million for each of the three month periodsended June 30, 2007 and 2006, and was $12 and $11 million for the ninemonth periods ended June 30, 2007 and 2006, respectively.

**Performance-Vestingand Market-Vesting Restricted Stock Units**

Performance-vesting and market-vesting RSUs vest uponthe achievement of certain targets and are payable in shares of the Company’scommon stock upon vesting, typically with a three-year performance period. Differenttargets may be established for different awards, some of which may contain “performance-vesting”conditions and some of which may contain “market-vesting” conditions.

“Performance-vesting” awards measure the Company’sperformance against pre-established targets. The fair value of RSUs containinga performance-vesting condition is based on the market price of the Company’sstock on the grant-date and assumes that the target payout level will beachieved. Compensation cost is adjusted for subsequent changes in the expectedoutcome of the performance-vesting condition until the vesting date.

“Market-vesting” awards measure the Company’s relativemarket performance against that of other companies. The fair value of RSUscontaining a market-vesting condition is based on the market price of theCompany’s stock on the grant date modified to reflect the impact of themarket-vesting condition including the estimated payout level based on thatcondition. Compensation cost is not adjusted for subsequent changes in theexpected outcome of the market-vesting condition.

EffectiveDecember 19, 2006, the Compensation Committee of the Board of Directorsapproved awards of 381,000 RSUs to executive officers of the Company pursuantto the terms of the Company’s stock compensation plan, each with amarket-vesting condition based on the Company’s total shareholder returnperformance as a percentile against a peer group.

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**Employee StockPurchase Plan**

Under the terms of the employee stock purchase plan,eligible employees may have up to 10% of eligible compensation deducted fromtheir pay to purchase Avaya common stock. The per share purchase price is 85%of the average high and low per share trading price of Avaya’s common stock onthe New York Stock Exchange on the last trading day of each month. Compensationexpense related to the employee stock purchase plan was $0.6 million for eachof the three month periods ended June 30, 2007 and 2006, and was $1.8 million for each of the ninemonth periods ended June 30, 2007 and 2006.

The Merger Agreementcontains a covenant requiring Avaya to suspend or terminate its employee stockpurchase plan as soon as practicable

**12.**          OperatingSegments

The Company reports its operations in two segments—GlobalCommunications Solutions (“GCS”) and Avaya Global Services (“AGS”). The GCSsegment develops, markets and sells communications systems including IPtelephony systems, multi-media contact center infrastructure and convergedapplications in support of customer relationship management, unifiedcommunications applications, appliances such as IP telephone sets andtraditional voice communications systems. The AGS segment develops, markets andsells comprehensive end-to-end global service offerings that enable customersto plan, design, implement, monitor and manage their converged communicationsnetworks worldwide.

The GCS segment includes the portion of the rental andmanaged services revenue attributed to the equipment used in connection withthe customer rental and managed services contracts. The portion of thesecontracts attributed to maintenance and other services is included in the AGSsegment.

The segments are managed as two individual businessesand, as a result, include certain allocated costs and expenses of sharedservices, such as information technology, human resources, legal and finance(collectively, “corporate overhead expenses”). At the beginning of each fiscal year, the amount of certain corporateoverhead expenses, including targeted annual incentive awards, to be charged tooperating segments is determined and fixed for the entire year. The annualincentive award accrual is adjusted quarterly based on actual year to dateresults and those estimated for the remainder of the year. Any adjustment ofthe annual incentive award accrual, as well as any other over/under absorptionof corporate overhead expenses against planned amounts, is recorded withinCorporate/Other Unallocated Amounts. Restructuring and impairment charges, aswell as Merger-related costs, are also recorded and reported withinCorporate/Other Unallocated Amounts.

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Summarizedfinancial information relating to the Company’s reportable segments is shown inthe following table:

| ** **                                 | ** **   | **Reportable Segments**      | ** ** | ** **   | ** ** | ** **          | ** ** |
|--------------------------------------------|--------------|-----------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                 | ** **   | **Global**                        | ** ** | **Avaya**    | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                                 | ** **   | **Communications**                | ** ** | **Global**   | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| ** **                                 | ** **   | **Solutions**                     | ** ** | **Services** | ** ** | **Amounts**         | ** ** | **Total** | ** ** |
| ** **                                 | *** *** | **Dollars in millions** | ** ** |
| **Three months ended  June 30, 2007** |         |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |         |                              | $          | 686          |       |                |       | $ | 590 |   |   |   | $ | — |   |   | $ | 1,276 |   |
| Operating income  (loss)                   |         |                              | 25         |         |       |                | 63         |   |   |   | (18 | ) |   | 70 |   |
| **Three  months ended June 30, 2006** |         |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |         |                              | $          | 704          |       |                |       | $ | 593 |   |   |   | $ | — |   |   | $ | 1,297 |   |
| Operating income  (loss)                   |         |                              | 36         |         |       |                | 34         |   |   |   | (42 | ) |   | 28 |   |
| **Nine  months ended June 30, 2007**  |         |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |         |                              | $          | 2,066        |       |                |       | $ | 1,784 |   |   |   | $ | — |   |   | $ | 3,850 |   |
| Operating income  (loss)                   |         |                              | 85         |         |       |                | 172        |   |   |   | (16 | ) |   | 241 |   |
| **Nine  months ended June 30, 2006**  |         |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |         |                              | $          | 2,026        |       |                |       | $ | 1,758 |   |   |   | $ | — |   |   | $ | 3,784 |   |
| Operating income (loss)                    |         |                              | 111        |         |       |                | 135        |   |   |   | (58 | ) |   | 188 |   |

 

Thefollowing table sets forth the Company’s long-lived assets by geographic area:

| ** **                                                   | ** ** | **June 30,  2007**           | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                                   | ** ** | **Dollars in millions** | ** ** |
| U.S.                                                         |       |                              | $          | 373                          |       |   |   | $ | 399 |   |   |
| Outside the U.S.:                                            |       |                              |       |                         |       |   |   |   |   |
| Germany                                                      |       |                              | 184        |                         |       |   | 200 |   |   |
| EMEA—Europe / Middle East / Africa (excluding  Germany) |       |                              | 42         |                         |       |   | 45 |   |   |
| APAC—Asia Pacific                                       |       |                              | 18         |                         |       |   | 18 |   |   |
| Americas, non-U.S.                                           |       |                              | 9          |                         |       |   | 6 |   |   |
| Total outside the U.S.                                       |       |                              | 253        |                         |       |   | 269 |   |   |
| Total                                                        |       |                              | $          | 626                          |       |   |   | $ | 668 |   |   |

 

**13.**          Commitmentsand Contingencies

**Legal Proceedings**

In the ordinary course of business, the Company isinvolved in litigation, claims, government inquiries, investigations, chargesand proceedings, including, but not limited to, those identified below,relating to intellectual property, commercial, securities, employment, employeebenefits, environmental and regulatory matters. Other than as described below,the Company believes there is no litigation pending against the Company thatcould have, individually or in the aggregate, a material adverse effect on theCompany’s financial position, results of operations or cash flows.

In accordance with SFAS No. 5,“Accounting for Contingencies,” the Company records an accrual for acontingency when it is both probable that a liability has been incurred and theamount of the loss can be reasonably estimated. If a range of liability isprobable and estimable and some amount within the range appears to be a betterestimate than any other amount within the range, the Company accrues thatamount. If a range of liability is probable and estimable and no amount withinthe range appears to be a better estimate than any other amount within therange, the Company accrues the minimum of such probable range. Often theseissues are subject to substantial uncertainties and, therefore, the probabilityof 

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loss andan estimation of damages are difficult to ascertain. These assessments caninvolve a series of complex judgments about future events and can rely heavilyon estimates and assumptions that have been deemed reasonable by management.Although the Company believes it has substantial defenses in these matters, itcould in the future incur judgments or enter into settlements of claims thatcould have a material adverse effect on its financial position, results ofoperations or cash flows in any particular period.

***Securities Litigation***

In April and May of 2005, purported classaction lawsuits were filed in the U.S. District Court for the District of NewJersey against us and certain of our officers alleging violations of thefederal securities laws. The actions purport to be filed on behalf ofpurchasers of our common stock during the period from October 5, 2004 (thedate of our signing of the agreement to acquire Tenovis) through April 19,2005.

The complaints, which aresubstantially similar to one another, allege, among other things, that theplaintiffs were injured by reason of certain allegedly false and misleadingstatements made by us relating to the cost of the Tenovis integration, thedisruption caused by changes in the delivery of our products to the market andreductions in the demand for our products in the U.S., and that based on theforegoing we had no basis to project our stated revenue goals for fiscal 2005.The Company has been served with a number of these complaints. No class hasbeen certified in the actions. The complaints seek compensatory damages plusinterest and attorneys’ fees. In August 2005, the court entered an orderidentifying a lead plaintiff and lead plaintiff’s counsel. A consolidatedamended complaint was filed in October 2005. Pursuant to a schedulingorder issued by the District Court, defendants filed their motion to dismissthe consolidated complaint in December 2005. In September 2006, theDistrict Court granted defendants’ motion to dismiss the case in its entiretyand with prejudice, which was appealed by the plaintiffs. The appeal iscurrently pending with the United States Court of Appeals for the ThirdCircuit, with the parties having completed their briefing submissions.

***Derivative Litigation***

In May and July of2005, three derivative complaints were filed against certain officers and themembers of the Board of Directors (“Board”) of the Company. Two complaints werefiled in the United States District Court for the District of New Jersey,and one was filed in the Superior Court of New Jersey—Somerset County. Theallegations in each of the complaints are substantially similar and include theCompany as a nominal defendant. The complaints allege, among other things, thatdefendants violated their fiduciary duties by failing to disclose materialinformation and/or by misleading the investing public about the Company’sbusiness, asserting claims substantially similar to those asserted in theactions described above under “Securities Litigation.” The complaints seekcontribution from the defendants to the Company for alleged violations of thesecurities laws, restitution to the Company and disgorgement of profits earnedby defendants, and fees and costs. The state court matter has been dismissedwithout prejudice to plaintiff’s possibly re-filing the complaint, pendingoutcome of the appeal in the “Securities Litigation” action described above.The matters pending in federal court have been administratively terminatedpossibly to be reinstated pending the outcome of the appeal in the “SecuritiesLitigation” action described above. Insofar as all of these actions areinactive, but subject to reinstatement, outcomes cannot be predicted and, as aresult, we cannot be assured that these cases will not have a material adverseeffect on our financial position, results of operations or cash flows.

***ERISA Class Action—Securities Litigation***

In July 2005, a purported class action lawsuitwas filed in the United States District Court for the District of New Jerseyagainst the Company and certain of its officers, employees and members of theBoard of Directors (the “Directors”), alleging violations of certain laws underthe Employee Retirement Income Security Act of 1974 (“ERISA”). On October 17,2005, an amended purported class action was 

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filed against us andcertain of our officers, employees and Directors. Like the initial complaint,the amended complaint purports to be filed on behalf of all participants andbeneficiaries of the Avaya Inc. Savings Plan, the Avaya Inc. Savings Plan forSalaried Employees and the Avaya Inc. Savings Plan for the Variable Workforce(collectively, the “Plans”), during the period from October 5, 2004through July 20, 2005. It contains factual allegations substantiallysimilar to those asserted in the matters under the heading of “SecuritiesLitigation.”

The complaint alleged,among other things, that the named defendants breached their fiduciary dutiesowed to participants and beneficiaries of the Plans and failed to act in theinterests of the Plans’ participants and beneficiaries in offering Avaya commonstock as an investment option, purchasing Avaya common stock for the Plans andcommunicating information to the Plans’ participants and beneficiaries. Thecomplaint sought a monetary payment to the plans to make them whole for thealleged breaches, costs and attorneys’ fees. The Defendants filed a motion todismiss the amended complaint in December 2005. In an order and opiniondated April 24, 2006, the District Court judge granted the Defendants’motion and dismissed the amended complaint in its entirety. In May 2006,the plaintiffs filed a Notice of Appeal with the United States Court of Appealsfor the Third Circuit. The parties have completed their respective briefingsubmissions and the court heard argument on the matter in April 2007.Although the defendants believe that the District Court correctly decided themotion to dismiss, given the uncertainties of the appeal, at this time theCompany cannot determine if this matter will have an effect on its business or,if it does, whether its outcome will have a material adverse effect on itsfinancial position, results of operations or cash flows. Due to the uncertaintysurrounding the issues involved in this matter and based on the facts andcircumstances known to date, the Company believes that an estimate or potentialrange of any loss that may be incurred cannot be made at this time.

***ERISA Class Action—Stock Funds***

In April 2006, apurported class action was filed in the United States District Court for theDistrict of New Jersey, alleging that the Company, certain employees and thePension and Employee Benefits Investment Committee violated the EmployeeRetirement Income Security Act of 1974 (“ERISA”), by including in the AvayaInc. Savings Plan for Salaried Employees, the Avaya Inc. Savings Plan and theAvaya Inc. Savings Plan for the Variable Workforce (“Plans”), investmentoptions for the Lucent Technologies Inc. Stock Fund (“Lucent Fund”) and theAvaya Inc. Stock Fund (“Avaya Fund”) for the period of October 2000 to April 2003(“Alleged Class Period”). The complaint asserts, among other things, thatduring the Alleged Class Period defendants breached their fiduciary dutiesunder ERISA by violating ERISA’s provisions against prohibited transactions;offering the Lucent Fund and Avaya Fund imprudently as investment options;failing properly to monitor the funds; and, failing properly to monitor theactions of other plan fiduciaries, thus causing the Plans to suffer damages.The complaint seeks monetary relief on behalf of the Plans and theirparticipants, and also seeks injunctive relief and costs, including attorneys’fees. Defendants have filed a motion to dismiss this case in its entirety andwith prejudice. In April 2007, the District Court issued an opiniondismissing all but one portion of one count of the complaint, reasoning thatthe circumstances surrounding the distribution of Avaya shares of common stockprior to the spin-off of Avaya from Lucent in October 2000 into thevarious Avaya Plans could not be addressed in the procedural posture of amotion to dismiss. In July 2007, the District Court dismissed theremaining count of the complaint with prejudice. The Plaintiff has appealedthis case to the United States Third Circuit Court of Appeals.

***Antitrust Lawsuit***

In July 2005, UnitedAsset Coverage, Inc. (“UAC”) filed a verified complaint against theCompany in the United States District Court, Northern District of Illinois,alleging, among other things, violations of federal and state antitrust laws,in the manner in which the Company seeks to protect its proprietary 

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information.The verified complaint sought a temporary restraining order against the Companyto enjoin immediately its practice of limiting the use of its proprietaryinformation in a manner which UAC believes is in violation of its contracts andlicensing agreements. The court denied UAC’s motion for temporary restraints inAugust 2005 as well as its motion for preliminary injunction in January 2006.The plaintiff, after pursuing this action for over a year after the preliminaryinjunction was denied, has dismissed this matter in its entirety and withprejudice.

***Shareholder Litigation Related to Proposed Merger***

In June and July 2007,seven purported class action complaints were filed against Avaya Inc., membersof the Board, certain officers of Avaya who are members of the Board, andSilver Lake Partners, L.L.P. and TPG Capital, L.P., in the Superior Court ofNew Jersey, Chancery and Law Divisions, Somerset County, related to the MergerAgreement. The complaints contain allegations substantially similar to oneanother and allege that the purchase price of $17.50 per share of outstandingAvaya common stock is inadequate and unfair consideration for the acquisitionof the Company. The complaints also allege that defendants, including theDirectors and/or officers of Avaya, breached their fiduciary duties toshareholders in entering into the Merger Agreement, including, but not limitedto, their duties of loyalty, good faith, and independence and engaged in self-dealingand in conflicts of interests with respect to the proposed Merger. Plaintiffsseek to have the court certify these cases as class actions, enjoin theproposed Merger and award plaintiffs costs and expenses, including attorneys’fees. Plaintiffs have also requested the court to consolidate the variousactions into one consolidated case, which defendants have not opposed. Themotion is pending. While the defendants believe these cases to be withoutmerit, because they are in their early stages, an outcome cannot be predictedat this time, and we cannot be assured that they will not prevent or delay theconsummation of the Merger and/or result in substantial costs. Due to theuncertainties surrounding the issues involved in these matters and based on thefacts and circumstances known to date, the Company believes that an estimate orpotential range of any loss that may be incurred or the scope of any injunctiverelief that may occur cannot be made at this time.

**Other Matters**

***Government Subpoenas***

On April 29, 2005, the Company received asubpoena to produce documents before a grand jury of the United States DistrictCourt, District of South Carolina, relating to the United States’ investigationof potential antitrust and other violations in connection with the federalE-Rate Program. The subpoena requests records from the period January 1,1997 to the present. The Company complied with the subpoena and has received noindication from the Department of Justice that it has any further obligationsor involvement in this matter. Nonetheless, at this time, we cannot determineif this matter will have an effect on our business or, if it does, whether itsoutcome will have a material adverse effect on our financial position, resultsof operations or cash flows.

On May 3, 2005, the Company received a subpoenafrom the Office of Inspector General, U.S. General ServicesAdministration, relating to a federal investigation of billing by the Companyfor telecommunications equipment and maintenance services. The subpoena requestsrecords from the period January 1, 1990 to the present. At this time, wecannot determine if this matter will have an effect on our business or, if itdoes, whether its outcome will have a material adverse effect on our financialposition, results of operations or cash flows.

The Company is cooperatingwith the relevant government entities with respect to these subpoenas. Based onthe facts and circumstances known to date, the Company believes that anestimate or potential range of any loss that may be incurred with respect tothese subpoenas cannot be made at this time.

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**Environmental,Health and Safety Matters**

The Company is subject to a wide range of governmentalrequirements relating to employee safety and health and to the handling andemission into the environment of various substances used in its operations. TheCompany is subject to certain provisions of environmental laws, particularly inthe United States and Germany, governing the cleanup of soil and groundwatercontamination. Such provisions impose liability for the costs of investigatingand remediating releases of hazardous materials at currently or formerly ownedor operated sites. In certain circumstances, this liability may also includethe cost of cleaning up historical contamination, whether or not caused by theCompany. The Company is currently conducting investigation and/or cleanup ofknown contamination at nine of its current or former facilities eithervoluntarily or pursuant to government directives. Based on currently availableinformation, none of the sites is reasonably likely to generate environmentalcosts that will be individually material, nor will environmental costs for allsites in the aggregate be material, to the Company’s financial position,results of operations or cash flows, in any fiscal year. There are no knownthird parties who may be responsible for investigation and/or cleanup at thesesites and therefore, for purposes of assessing the adequacy of accruals forthese liabilities, the Company has not assumed that it will recover amountsfrom any third party, including under any insurance coverage or indemnificationarrangement.

It is often difficult to estimate the future impact ofenvironmental matters, including potential liabilities. The Company hasestablished financial reserves to cover environmental liabilities where theyare probable and reasonably estimable. Reserves for estimated losses fromenvironmental matters are undiscounted and consist primarily of estimatedremediation and monitoring costs and are, depending on the site, basedprimarily upon internal or third party environmental studies and the extent ofcontamination and the type of required cleanup. The Company is not aware of,and has not included in reserves any provision for, unasserted environmentalclaims.

The reliability and precision of estimates of theCompany’s environmental costs may be affected by a variety of factors,including whether the remediation treatment will be effective, contaminationsources have been accurately identified and assumptions regarding the movementof contaminants are accurate. In addition, estimates of environmental costs maybe affected by changes in law and regulation, including the willingness ofregulatory authorities to conclude that remediation and/or monitoring performedby the Company is adequate.

The Company assesses the adequacy of environmentalreserves on a quarterly basis. The Company does not expect the outcome of thesematters to have a material impact on its financial position. Expenditures forenvironmental matters for the three and nine months ended June 30, 2007and 2006 were not material to the Company’s financial position, results ofoperations or cash flows. Payment for the environmental costs covered by thereserves may be made over a 30-year period. Although the Company does notseparately track recurring costs of managing hazardous substances andpollutants in ongoing operations, it does not believe them to be material.

We also may from time totime be subject to various state, federal and international laws andregulations governing the environment, including those restricting the presenceof certain substances in electronic products and making producers of thoseproducts financially responsible for the collection, treatment, recycling anddisposal of certain products. For example, the European Union (“EU”) has adoptedthe Restriction of the Use of Certain Hazardous Substances in Electrical andElectronic Equipment (“RoHS”) and Waste Electrical and Electronic Equipment (“WEEE”)directives. RoHS prohibits the use of certain substances, including mercury andlead, in certain products put on the market after July 1, 2006. The WEEEdirective obligates parties that place electrical and electronic equipment ontothe market in the EU to put a clearly identifiable mark on the equipment,register with and report to EU member countries regarding distribution of theequipment, and provide a mechanism to take back and properly dispose of theequipment. Each EU member country has enacted, or is expected soon to enact, 

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legislationclarifying what is and what is not covered by the WEEE directive in thatcountry. We believe that we have met the requirements of the RoHS and WEEEdirectives. Similar laws and regulations have been or may be enacted in otherregions which may require additional obligations to be undertaken by theCompany.

**Product Warranties**

TheCompany recognizes a liability for the estimated costs that may be incurred toremedy certain deficiencies of quality or performance of the Company’s products.These product warranties extend over a specified period of time generallyranging up to two years from the date of sale depending upon the productsubject to the warranty. The Company accrues a provision for estimated futurewarranty costs based upon the historical relationship of warranty claims tosales. The Company periodically reviews the adequacy of its product warrantiesand adjusts, if necessary, the warranty percentage and accrued warrantyreserve, which is included in other current liabilities in the ConsolidatedBalance Sheets, for actual experience.

| ** **                                           | ** ** | **Dollars in millions** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| Balance as of  September 30, 2006               |       |                              | $          | 29 |   |   |
| Reductions for  payments and costs to satisfy claims |       |                              | (37        | ) |   |
| Accruals for  warranties issued during the period    |       |                              | 39         |   |   |
| Balance as of  June 30, 2007                    |       |                              | $          | 31 |   |   |

 

**Guarantees ofIndebtedness and Other Off-Balance Sheet Arrangements**

***Letters of Credit***

In addition to its $400million committed credit facility, which is discussed in Note 7, “FinancingArrangements,” the Company has entered into uncommitted credit facilities thatvary in term totaling $133 million as of June 30, 2007. These uncommittedfacilities are for the purpose of securing third party financial guaranteessuch as letters of credit that ensure the Company’s performance or payment tothird parties. As of June 30, 2007, the Company has outstanding anaggregate of $102 million in irrevocable letters of credit under the committedand uncommitted credit facilities ($27 million under its committed creditfacility and $75 million under uncommitted facilities).

***Surety Bonds***

The Company arranges forthe issuance of various types of surety bonds, such as license, permit, bid andperformance bonds, which are agreements under which the surety companyguarantees that the Company will perform in accordance with contractual orlegal obligations. These bonds vary in duration although most are issued andoutstanding from six months to three years. These bonds are backed by $5million of our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$33 million as of June 30, 2007. Historically, no surety bonds havebeen drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchases components from a variety ofsuppliers and uses several contract manufacturers to provide manufacturingservices for its products. During the normal course of business, in order tomanage manufacturing lead times and to help assure adequate component supply,the Company enters into agreements with contract manufacturers and suppliersthat allow them to produce and procure inventory based upon forecastedrequirements provided by the Company. If the Company does not meet thesespecified purchase commitments, it could be required to purchase the inventory,or in the case of certain agreements, pay an early termination fee. As of June 30, 2007, the maximum potentialpayment 

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underthese commitments was approximately $120 million. Historically, the Company hasnot been required to pay a charge for not meeting its designated purchasecommitments with these suppliers.

All manufacturing of theCompany’s products is performed in accordance with detailed specifications andproduct designs furnished by the Company and is subject to rigorous qualitycontrol standards.

***Product Financing Arrangements***

The Company sells productsto various resellers that may obtain financing from certain unaffiliated thirdparty lending institutions. For the Company’sproduct financing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guaranteed repayment amount was approximately$7 million as of June 30, 2007. The Company reviews and sets the maximumcredit limit for each reseller participating in this financing arrangement.Historically, there have not been any guarantee repayments by the Company sinceit became publicly traded in 2000. The Company has estimated the fair value ofthis guarantee as of June 30, 2007, and has determined that it is notsignificant. There can be no assurance that the Company will not be obligatedto repurchase inventory under this arrangement in the future.

***Performance Guarantee***

In connection with thesales of certain businesses, the Company has assigned its rights andobligations under several real estate leases to the acquiring companies (the “assignees”).The remaining terms of these leases vary from one year to eight years. Whilethe Company is no longer the primary obligor under these leases, the lessor hasnot completely released the Company from its obligation, and holds itsecondarily liable in the event that the assignees default on these leases. Themaximum potential future payments the Company could be required to make, if allof the assignees were to default as of June 30, 2007, would beapproximately $13 million. The Company has assessed the probability of defaultby the assignees and has determined it to be remote.

***Credit Facility Indemnification***

In connection with itsobligations under the credit facility described in Note 7, “FinancingArrangements,” the Company has agreed to indemnify the third party lendinginstitutions for costs incurred by the institutions related to changes in taxlaw or other legal requirements. While there have been no amounts paid to thelenders pursuant to this indemnity in the past, there can be no assurance thatthe Company will not be obligated to indemnify the lenders under thisarrangement in the future.

***Transactions with Lucent Technologies Inc.***

Pursuant to the Contribution and DistributionAgreement, Lucent Technologies Inc., predecessor to Alcatel-Lucent (“Lucent”),contributed to the Company substantially all of the assets, liabilities andoperations associated with its enterprise networking businesses (“Company’sBusinesses”). The Contribution and Distribution Agreement, among other things,provides that, in general, the Company will indemnify Lucent for allliabilities including certain pre-distribution tax obligations of Lucentrelating to the Company’s Businesses and all contingent liabilities primarilyrelating to the Company’s Businesses or otherwise assigned to the Company. Inaddition, the Contribution and Distribution Agreement provides that certaincontingent liabilities not allocated to one of the parties will be shared byLucent and the Company in prescribed percentages. The Contribution andDistribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to 

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the business of the otherparty that exceed $50 million. The Company is unable to determine themaximum potential amount of other future payments, if any, that it could berequired to make under this agreement.

In addition, if the separation from Lucent fails toqualify as a tax-free distribution under Section 355 of the InternalRevenue Code because of an acquisition of the Company’s stock or assets, orsome other actions of the Company, then the Company will be solely liable forany resulting corporate taxes.

The Tax Sharing Agreement governs Lucent’s and theCompany’s respective rights, responsibilities and obligations after thedistribution with respect to taxes for the periods ending on or before thedistribution. Generally, pre-distribution taxes or benefits that are clearlyattributable to the business of one party will be borne solely by that party,and other pre-distribution taxes or benefits will be shared by the partiesbased on a formula set forth in the Tax Sharing Agreement. The Company may besubject to additional taxes or benefits pursuant to the Tax Sharing Agreementrelated to future settlements of audits by state and local and foreign taxingauthorities for the periods prior to the Company’s separation from Lucent.

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**Item 2.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.*

“Management’s Discussion and Analysis of FinancialCondition and Results of Operations” should be read in conjunction with theunaudited interim Consolidated Financial Statements and the notes includedelsewhere in this Quarterly Report on Form 10-Q.

Our accompanying unaudited interim ConsolidatedFinancial Statements as of June 30, 2007 and for the three and nine monthsended June 30, 2007 and 2006, have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial statements and the rules and regulations of the U.S.Securities and Exchange Commission, or the SEC, for interim financialstatements, and should be read in conjunction with our Consolidated FinancialStatements and other financial information for the fiscal year ended September 30,2006, which were included in our Annual Report on Form 10-K filedwith the SEC on December 8, 2006. In our opinion, the unaudited interimConsolidated Financial Statements reflect all adjustments, consisting of normaland recurring adjustments, necessary for a fair presentation of the financialcondition, results of operations and cash flows for the periods indicated.

Certain prior year amounts have beenreclassified to conform to the current year presentation.The consolidated results of operations forthe interim periods reported are not necessarily indicative of the results tobe experienced for the entire fiscal year.

***Merger Agreement with Silver Lake Partners and TPGPartners***

On June 4, 2007, Avaya entered into an Agreement and Plan of Merger(the “Merger Agreement”) with Sierra Holdings Corp., a Delaware corporation (“Parent”),and Sierra Merger Corp., a Delaware corporation and wholly owned subsidiary ofParent (“Merger Sub”). Under the terms of the Merger Agreement, Merger Sub willbe merged with and into the Company, with the Company continuing as thesurviving corporation and a wholly owned subsidiary of Parent (the “Merger”). Parentwas formed by two private equity funds, Silver Lake Partners III, L.P. and TPGPartners V, L.P. (collectively, the “Sponsors”), solely for the purpose ofentering into the Merger Agreement and consummating the Merger. The MergerAgreement provides for a purchase price of $17.50 per share of Avayacommon stock (the “Merger Consideration”), or approximately $8.21 billion inthe aggregate (excluding fees and expenses in connection with the Merger ofapproximately $0.28 billion).

The proposed transaction is expected to be completedin the fall of 2007, subject to receipt of shareholder approval and customaryregulatory approvals, as well as satisfaction of other customary closingconditions. There is no financing condition to the obligations of the Sponsorsto consummate the transaction, and equity and debt commitments sufficient tofund the Merger Consideration have been delivered to Parent. The Company filedits preliminary proxy statement with the SEC on July 18, 2007 and filed itsHart-Scott-Rodino notification with the Federal Trade Commission and theDepartment of Justice on June 15, 2007. TheDepartment of Justice and the Federal Trade Commission granted earlytermination of the Hart-Scott-Rodino waiting period effective June 28,2007. The date for the special meeting of shareholders to vote on adoption ofthe Merger Agreement is September 28, 2007, and the record date related tothis meeting is August 9, 2007.

During the three months ended June 30, 2007, theCompany incurred costs associated with the Merger of $8 million (approximately$4.6 million after tax, or $0.01 per diluted share) consisting primarily ofinvestment banking and legal fees directly related to the proposed Merger.

Pursuant to the terms ofthe stock compensation plans under which they were issued, outstanding stockoptions and time-vesting RSUs will vest and become exercisable on the later of:(i) the adoption by the Company’s stockholders of the Merger Agreement and(ii) the date on which all governmental consents required to complete theMerger, if any, are obtained (the “Vesting Conditions”). The proposed 

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Mergeris the contingent event which would result in cash settlement of the Company’soutstanding stock options and time-vesting RSUs. Due to the existence ofcertain unfulfilled conditions, including the approval of the proposed Mergerby the Company’s stockholders, that must be satisfied before the transaction iscompleted, no accelerated stock compensation expense was recorded during thethird quarter of fiscal 2007. If the Vesting Conditions are satisfied, theCompany expects to record an accelerated stock compensation charge ofapproximately $85 million related to time-vesting RSUs. If a Vesting Conditionoccurs or is to occur during a performance period, then the CompensationCommittee of the Board shall determine the extent to which performance-vestingRSUs and market-vesting RSUs shall vest or shall be adjusted.

**Forward-LookingStatements**

Our disclosure and analysis in this Quarterly Reporton Form 10-Q contains some forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. Forward-looking statements give our current expectations orforecasts of future events. You can identify these statements by the fact thatthey do not relate strictly to historical or current facts. They use words suchas “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe”and other words and terms of similar meaning in connection with any discussionof future operating or financial performance. From time to time, we also mayprovide oral or written forward-looking statements in other materials werelease to the public.

Any or all of our forward-lookingstatements in this report and in any other public statements we make may turn out to be wrong. They can beaffected by inaccurate assumptions we might make or by known or unknown risksand uncertainties. A detailed discussion of these and other risks anduncertainties that could cause actual results and events to differ materiallyfrom such forward-looking statements is included in the section below entitled “RiskFactors.” Consequently, no forward-looking statement can be guaranteedand you are cautioned not to place undue reliance on these forward-lookingstatements. Actual future results may vary materially. Except as may berequired under the federal securities laws, we undertake no obligation topublicly update forward-looking statements, whether as a result of newinformation, future events or otherwise. You are advised, however, to consultany further disclosures we make on related subjects in our reports to the SEC.

**Overview**

***Products, Applications and Services***

We are a leading provider of communications solutionsthat help enterprises transform their businesses by intelligently connectingcustomers, employees and business partners with enhanced business processes. Akey component of our enterprise communications strategy is to leverage oursubstantial experience and expertise in voice communications systems with aninnovative communications platform, advanced software development and expertservices to capitalize on the transition of traditional voice systems to ourmature IP telephony solutions. Our offers support advanced businesscommunications applications that can help our customers gain cost efficiencies,higher workforce productivity, new types of business automation and moreresponsive connections for all enterprise constituents.

Our enterprise communications solutions offerings arecomprised of a product portfolio that includes infrastructure hardware,application software, phone appliances and a comprehensive portfolio ofenterprises services focused on IT and communications solutions. Theseofferings are used by enterprises to deploy our platforms of IP telephonysystems and/or circuit-based voice telephony systems that can be converged withIP networks to enable IP telephony. Our communication solutions platforms arethe basis for us to provide enterprises with communications systems in thefollowing key areas: multi-media contact center communications in support ofcustomer relationship management, unified communications that 

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integrate unified desktop,conferencing, messaging and mobility solutions with third party enterpriseapplications and business communication applications that combine specializedservices with software connectors to facilitate communications-enabled businessprocesses. We support our broad customer base with comprehensive global serviceofferings that enable our customers to plan, design, implement, monitor andmanage their communications systems and/or converged networks.

Our global services organization is an importantconsideration for customers purchasing our products and applications and is asource of significant revenue for us, primarily from maintenance contracts, butwith a growing emphasis by us to provide our customers with communicationsfocused professional services. Our end-to-end portfolio of services offeringsprovides a single point of accountability that connects the skilledprofessionals of our services organization together with our network ofbusiness partners, development partners and our ability to diagnose customernetwork faults remotely, can provide 24-hours-a-day, seven-days-a-week serviceto our customers around the world. 

These offerings are partof what we collectively refer to as “Intelligent Communications,” which isabout embedding communications solutions into our customers’ business processesand business interactions to help them transform their businesses and innovatetheir business models. We believe our comprehensive suite of IntelligentCommunications offerings, as supported by our global services organization andextensive network of business and development partners, transforms theenterprise communications system into a strategic asset for businesses, byenabling them to communicate to “anyone, at any place, at any time and in anyway” they choose.

***Customers and Competitive Advantages***

Our customer base is diverse, ranging in size fromsmall businesses employing a few employees to large government agencies andmultinational companies with over 100,000 employees. Our customers includeenterprises operating in a broad range of industries around the world,including financial services, manufacturing, media and communications,professional services, health care, education and government.

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in nearly 100 other countries. In the first ninemonths of fiscal 2007, approximately 44% of our revenues were generated outsidethe U.S.

We enjoy severalstrengths that we believe provide us with a competitive advantage in theenterprise communications market:

·       businessfocus on IP telephony and converged network technologies;

·       extensivevoice experience and expertise, and a reputation for superior products andtechnology for voice processing and applications;

·       acomprehensive suite of industry-leading communications applications, includingremote/mobile offerings such as speech access, remote agents and softphones,which allow our customers to improve worker productivity and reduce network andreal estate costs by providing secure business communications to a dispersedworkforce;

·       investmentprotection for traditional telephony systems, allowing customers to upgrade andtake advantage of the benefits of IP communications while maintaining asignificant portion of their previous equipment investment (*i.e.* “IP-enable” their existing voice communicationssystems);

·       alarge installed global customer base;

·       world-classcontact center offerings that assist our customers in managing communicationswith their clients;

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·       aglobal services organization that offers end-to-end customer solutions,including remote maintenance and diagnostic services that sense and fix softwareoutages, often before customers even realize there may be a problem; and

·       strategic alliances withworld-class business partners, including our large network of softwaredevelopment partners who develop vertical and other software applications that workwith our telephony and contact center offerings to meet specific customerneeds.

***Financial Results Summary***

*Revenue—*Revenue was $3,850 million and $3,784 million for thefirst nine months of fiscal 2007 and 2006, respectively. Overall revenue grewby 1.7% as a result of increases in both of our operating segments outside theU.S. Revenues for the first nine months of fiscal 2007 included a favorablecurrency impact of $93 million that benefited both operating segments,primarily in Europe.

*GrossMargin—*Our gross margin for the first nine months of fiscal2007 increased by $39 million to $1,794 million compared with the first ninemonths of fiscal 2006 due to an increase in sales volume and a benefit fromforeign currency, and the gross margin rate for fiscal 2007 was slightly higherat 46.6% versus 46.4% for the first nine months of fiscal 2006. The increase inthe overall rate was the result of lower costs in our services segment. Thegross margin for the first nine months of fiscal 2006 includes an $11 millionbenefit, or a 0.3 percentage point impact, from a change in our vacation policyeliminating carryover vacation days for U.S. non-represented employees.

*Operating Expenses—*Our selling,general and administrative (SG&A) expenses decreased by $23 million to$1,184 million for the first nine months of fiscal 2007 compared to the firstnine months of fiscal 2006. This net decrease was primarily due to lowerheadcount and lower discretionary spending in connection with our costmanagement initiatives, as well as several benefits in the first nine months offiscal 2007, including a gain on the sale of real estate and an $8 millionbenefit from the favorable resolution of non-income tax audits in severaljurisdictions. These benefits were partially offset by expected increasedemployee benefit costs and unfavorable foreign currency. The increased employeebenefit costs were primarily due to the previously-disclosed increase inpost-retirement health benefits for union employees. The first nine months offiscal 2006 included a $22 million benefit from the favorable resolution ofnon-income tax audits in several jurisdictions and a $7 million benefit relatedto the change in our vacation policy, as well as $29 million of assetimpairment charges, primarily related to internal-use software assets.

During the first nine months of fiscal 2007, ourresearch and development (R&D) expenses increased by $14 million to $332million compared with the first nine months of fiscal 2006 due to an increasein gross investment and to a lesser extent, the acquisitions of Traverse andUbiquity. The first nine months of fiscal 2006 included a $3 million benefitrelated to the change in our vacation policy.

We also recorded $29 million in net charges forrestructuring actions during the first nine months of fiscal 2007. Theserepresent $36 million of charges for employee separation costs and leaseobligations, partially offset by a net benefit of $7 million for changes inestimates for prior restructuring plans primarily related to leased facilities.During the first nine months of fiscal 2006, we recorded net restructuringcharges of $42 million.

During the first nine months of fiscal 2007, weincurred costs associated with the Merger of $8 million consisting primarily ofinvestment banking and legal fees directly related to the proposed Merger.

*Profitability*—Weearned net income of $183 million and $153 million for the first nine months offiscal 2007 and 2006, respectively. Our operating income was $241 million, or6.3% of revenue, for the first nine months of fiscal 2007, compared to $188million, or 5.0% of revenue, for the first nine months of fiscal 2006. Operatingincome for the first nine months of fiscal 2007 includes an increase in grossmargin dollars 

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due tosales volume and favorable foreign currency, as well as several benefits incosts and operating expenses as described above, partially offset by increasedR&D investment and Merger-related costs. Operating income for the firstnine months of fiscal 2006 included a $21 million benefit from the change inour vacation policy and the $22 million benefit from the favorable resolutionof non-income tax audits in several jurisdictions, as well as the $29 millionasset impairment charge.

**Key Trends andUncertainties Affecting Our Results**

***Trends and Uncertainties Affecting Our Revenue***

The following arethe key factors we believe are currently affecting our revenue:

·       *Technologytransition*—Our growth strategy relies heavily on capturing a significantshare of the spending by enterprises on their transition of technology fromtraditional communications systems to IP communications. We believe that IPcommunications has gained widespread acceptance in the marketplace and overtime we expect demand to continue to increase as the industry goes through themainstream adoption phase in the product lifecycle. According to the latestavailable industry statistics, approximately half of all lines currently beingshipped are IP rather than traditional, or TDM. As a result of the technologytransition, spending by enterprises on traditional voice communication systemshas been declining. Increases in our product revenue attributable to sales ofIP telephony systems continue to be offset in part by declines in productrevenue attributable to traditional voice communication systems.

·       *Competitive environment*—We have historically operated, andcontinue to operate, in an extremely competitive environment. However, themigration of traditional technology to IP communications has resulted in anincreased number of competitors offering similar products and applications. Oneaspect of this environment is that we regularly face pricing pressures in themarkets in which we operate which may negatively impact our gross margins. Inaddition, we also face pricing pressure when long-term maintenance and managedservices contracts expire. They are typically renewed at lower prices due tocontinuing competitive pressure and expectations from the marketplace toacquire technology at lower costs. The impact of the price erosion affects bothour rental and managed services offers, as well as maintenance. We have beenable to partially mitigate the effects of pricing pressures on profitabilitythrough our cost reduction initiatives.

For other uncertaintiesrelated to the competitive environment in which we operate, see “Risk Factors—RisksRelated To Our Revenue and Business Strategy—We face intense competition from our current competitors and, as theenterprise communications and information technology markets evolve, may faceincreased competition from companies that do not currently compete directlyagainst us.”

·       *Pressures on services business*—Due to advances in technology, ourcustomers continue to expect traditional services to be at lower prices to them.In addition, our customers routinely look for opportunities to reduce theirinformation technology and related costs. A high correlation exists withrespect to customers in our direct channel who purchase products also electingto purchase maintenance contracts at the time of the product purchase. However,at the time of contract renewal, maintenance and managed services revenues havebeen affected by reductions in scope of contracted services (*i.e*. number of ports, number of sites, or hours and levelsof coverage), cancellations and increased competition, as well as the priceerosion noted above. These factors have resulted in challenges to our AvayaGlobal Services segment. We have been able to partially offset these impacts byfocusing on new types of services such as consulting and system integration. Thesenew types of services may have lower margins than our traditional services. Inaddition, we have also been able to reduce our costs to minimize the impact onour operating income.

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·       *Disruption in logistic**s*—As we continueto seek to optimize our end-to-end supply chain, we have been outsourcingvarious logistics functions over the course of the past few years. Aspreviously disclosed, in the fourth quarter of fiscal 2006 and the first halfof fiscal 2007, we moved certain warehousing and physical distributionoperations to a different third party provider at a new facility. Followingthis move we experienced disruption, resulting in delays in delivery ofproducts from this warehouse and warehousing operational inefficiencies. Wehave been working with this third party provider to resolve these issues. See “Manufacturingand Logistics” for more information.

·       *Foreign currency*—Our revenues outside of the U.S. were44% of our consolidated revenues in the first nine months of fiscal 2007compared to 42% in the first nine months of fiscal 2006. Revenues for the firstnine months of fiscal 2007 include a favorable currency impact of $93 millionas compared to the first nine months of fiscal 2006. Any strengthening of theU.S. dollar against other currencies, particularly the euro, will have anegative impact on our reported revenues. Conversely, any weakening of the U.S.dollar will have a positive impact.

·       *Economic conditions*—An important factor affecting our abilityto generate revenue is the effect of general economic conditions on ourcustomers’ willingness to spend on information technology and, particularly,enterprise communications technology. Variability in employment, corporateprofit growth, interest rates, energy prices and other factors in specificmarkets could impact corporate willingness to spend on communicationstechnology in the near term. Additionally, country-to-countryvariability in worldwide economic growth could also impact our business asgrowth rates of developed and more stable economies tend to be lower than thatof emerging economies, where there could be more variables affecting theeconomic growth.

***Manufacturing and Logistics***

The Company’s products are supplied through contractmanufacturers and original equipment manufacturers. Our manufacturers produce amajority of our products in facilities located in Mexico, Malaysia, the CzechRepublic, China, Israel, Poland, Ireland, France, Germany and the UnitedStates. The contract manufacturing of the Company’s products is performed inaccordance with detailed specifications and product designs furnished by theCompany and is subject to rigorous quality control standards.

As we continue to seek to optimize our end-to-endsupply chain, we have outsourced various logistics functions. We rely onthird-party logistics (3PL) service providers to provide certain services forour business, including warehousing, physical distribution, repairs and returnsprocessing. If a logistics service provider does not meet our service level andquality requirements, we may be unable to fulfill our customers’ orders or meetcertain customer support obligations in a timely and accurate manner, whichcould delay or decrease our revenue or otherwise have an adverse effect on ourrevenue and our costs. In the fourth quarter of fiscal 2006 and first quarterof fiscal 2007, we moved certain warehousing and physical distributionoperations to a different 3PL service provider at a new facility. That providerand facility provide our 3PL needs in North America and certain 3PL needsoutside of North America. There were disruptions and delays in delivery ofcertain products from this facility in the first quarter of fiscal 2007. Additionally,there was an adverse impact on our costs at this facility throughout the firsthalf of fiscal 2007. We and the 3PL service provider operating this facilitycontinue to work to promote stability in the 3PL operations there. We have beenmaking improvements as we progress through this transition. However, we cannotassure you that this issue will not continue to have an adverse effect on ourrevenue and our costs.

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We also face increasing complexity in our productdesign, logistics and procurement operations due to existing and upcomingrequirements relating to the materials composition of our products, such as theEuropean Union (“EU”) directives regarding Restriction of the Use of CertainHazardous Substances in Electrical and Electronic Equipment (“RoHS”) and theWaste Electrical and Electronic Equipment (“WEEE”) directive. We may berequired to reengineer products to utilize components compatible with thesechanging environmental requirements and the resulting reengineering andcomponent substitution may result in additional costs to us. Even if we are ableand willing to reengineer products or pay additional costs, we still may beadversely affected if the materials and components that we need are unavailableto us. In addition, if we were found to be in violation of these regulations,we could be subject to government fines, noncompliant products may be bannedfrom markets covered by the regulations and our customers could incurliability. Although we do not anticipate any material adverse effects based onthe nature of our operations and the effect of such regulations, there is noassurance that existing regulations or future regulations will not have anadverse effect on us.

We also purchase certain hardware components andlicense certain software components from third-party original equipmentmanufacturers and resell them under the Avaya brand. In some cases certaincomponents are only available from a single source or from a limited source ofsuppliers. Delays or shortages associated with these components could causesignificant disruption to our operations.

For more information onrisks associated with all of the above activities, see Item 1A. “Risk Factors—RisksRelated To Our Operations—We rely on outsourced product manufacturers,distributors and warehousing agents for our products and various issues withrespect to the delivery of our products could arise which could adverselyimpact both our revenue and our costs.”

**Results from Continuing Operations**

***Three Months Ended June 30, 2007 Compared withThree Months Ended June 30, 2006***

***Revenue***

The following table setsforth acomparison of revenue by type:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                    | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-------------------------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                    | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | *** ***                  | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                    | ** ** | **Dollars in millions**  | ** ** |
| $          | 636        |       | $          | 690        |       | $          | 619          |                          | $          | 639                                |       | Sales of products |   | $ | 626 |   | $ | 636 |   |   | 49 | % |   |   | 49 | % |   |   | $ | (10 | ) |   | -1.6 | % |
| 507        |       | 514        |       | 509        |       | 509        |         | Services                      |       | 507                                |       | 507 |   |   | 40 | % |   |   | 39 | % |   |   | — |   |   | 0.0 | % |
| 154        |       | 160        |       | 152        |       | 146        |         | Rental and managed   services |       | 143                                |       | 154 |   |   | 11 | % |   |   | 12 | % |   |   | (11 | ) |   | -7.1 | % |
| $          | 1,297      |       | $          | 1,364      |       | $          | 1,280        |                          | $          | 1,294                              |       | Total revenue |   | $ | 1,276 |   | $ | 1,297 |   |   | 100 | % |   |   | 100 | % |   |   | $ | (21 | ) |   | -1.6 | % |

 

The decrease in revenue for the third quarter offiscal 2007 compared to the same period last fiscal year was due to decline insales of products and rental and managed services, partially offset by a $30 millionbenefit from favorable foreign currency. 

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Thefollowing table sets forth a geographic comparison of revenue:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                                        | ** **   | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------------------------------------|--------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                                        | ** **   | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** **                                                        | ** **   | **2007**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                                        | *** *** | **Dollars in millions**  | ** ** |
| $          | 753        |       | $          | 788        |       | $          | 732        |                                                              | $            | 746                                |       | U.S. |   | $ | 694 |   | $ | 753 |   |   | 54 | % |   |   | 58 | % |   |   | $ | (59 | ) |   | -7.8 | % |
|       |       |       |       |       |       |       |       | Outside the U.S.:                                                 |         |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 182        |       | 183        |       | 186        |       | 178        |       | Germany                                                           |         | 172                                |       | 182 |   |   | 13 | % |   |   | 14 | % |   |   | (10 | ) |   | -5.5 | % |
| 205        |       | 208        |       | 203        |       | 190        |       | EMEA—Europe / Middle East / Africa (Excluding  Germany) |         | 216                                |       | 205 |   |   | 17 | % |   |   | 16 | % |   |   | 11 |   |   | 5.4 | % |
| 387        |       | 391        |       | 389        |       | 368        |       | Total EMEA                                                        |         | 388                                |       | 387 |   |   | 30 | % |   |   | 30 | % |   |   | 1 |   |   | 0.3 | % |
| 87         |       | 110        |       | 88         |       | 111        |       | APAC—Asia Pacific                                            |         | 116                                |       | 87 |   |   | 10 | % |   |   | 7 | % |   |   | 29 |   |   | 33.3 | % |
| 70         |       | 75         |       | 71         |       | 69         |       | Americas, non-U.S.                                                |         | 78                                 |       | 70 |   |   | 6 | % |   |   | 5 | % |   |   | 8 |   |   | 11.4 | % |
| 544        |       | 576        |       | 548        |       | 548        |       | Total outside the U.S.                                       |         | 582                                |       | 544 |   |   | 46 | % |   |   | 42 | % |   |   | 38 |   |   | 7.0 | % |
| $          | 1,297      |       | $          | 1,364      |       | $          | 1,280      |                                                              | $            | 1,294                              |       | Total revenue |   | $ | 1,276 |   | $ | 1,297 |   |   | 100 | % |   |   | 100 | % |   |   | $ | (21 | ) |   | -1.6 | % |

 

Revenues in the U.S. decreased by 7.8% compared withthe third quarter of fiscal 2006, primarily due to declines in sales ofproducts and related implementation services. Germany revenue declined due tolower sales of products, the decline in our rental base and lowerimplementation services, partially offset by the benefit from foreign currency.EMEA revenue, excluding Germany, grew by 5.4%, helped by strong demand inEastern Europe, as well as a benefit from foreign currency. Revenues in APACand Americas, non-U.S. increased by 33% and 11%, respectively. 

Thefollowing table sets forth a comparison of revenue from sales of products by channel:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|--------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** ** | ** **   | **2007**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | **Dollars in millions**  | ** ** |
| $          | 277        |       | $          | 302        |       | $          | 259        |       | $            | 277                                |       | Direct |   | $ | 258 |   | $ | 277 |   |   | 41 | % |   |   | 44 | % |   |   | $ | (19 | ) |   | -6.9 | % |
| 359        |       | 388        |       | 360        |       | 362        |       | Indirect   |         | 368                                |       | 359 |   |   | 59 | % |   |   | 56 | % |   |   | 9 |   |   | 2.5 | % |
| $          | 636        |       | $          | 690        |       | $          | 619        |       | $            | 639                                |       | Total sales of products |   | $ | 626 |   | $ | 636 |   |   | 100 | % |   |   | 100 | % |   |   | $ | (10 | ) |   | -1.6 | % |

 

The mix of sales ofproducts in the third quarter of fiscal 2007 shifted three percentage pointstoward indirect due to the decline in U.S. and Germany direct product salescompared to the same quarter last fiscal year. The revenue growth in APAC andin EMEA, primarily Eastern Europe, is primarily driven through the indirectchannel. 

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***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** ** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **    2007    ** | ** ** | **    2006    ** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dollars in millions**  | ** ** |
|       | 52.2       | %          |       |       | 54.8       | %          |       |       | 53.3       | %                                  |       |   | 52.9 | % |   | On sales of  products |   | $ | 324 |   | $ | 332 |   |   | 51.8 | % |   |   | 52.2 | % |   |   | $ | (8 | ) |   | -2.4 | % |
|       | 33.9       | %          |       |       | 32.1       | %          |       |       | 36.3       | %                                  |       |   | 36.3 | % |   | On services |   | 195 |   | 172 |   |   | 38.5 | % |   |   | 33.9 | % |   |   | 23 |   |   | 13.4 | % |
|       | 54.5       | %          |       |       | 57.5       | %          |       |       | 55.3       | %                                  |       |   | 51.4 | % |   | On rental and  managed services |   | 78 |   | 84 |   |   | 54.5 | % |   |   | 54.5 | % |   |   | (6 | ) |   | -7.1 | % |
|       | 45.3       | %          |       |       | 46.6       | %          |       |       | 46.8       | %                                  |       |   | 46.2 | % |   | Total gross  margin |   | $ | 597 |   | $ | 588 |   |   | 46.8 | % |   |   | 45.3 | % |   |   | $ | 9 |   |   | 1.5 | % |

 

The $9 million increase in gross margin for the third quarter of fiscal2007 reflects a benefit from foreign currency and reductions in cost ofproducts and services.

Sales of products gross margin and rate both decreased primarily due to thedecline in the volume of U.S. and Germany direct product sales, resulting in ahigher proportion of indirect channel non-U.S. sales, which generally carrylower margins.

Services gross margin increased by $23 million compared to third quarter offiscal 2006, and the gross margin rate increased by over four percentagepoints. The increase in gross margin was due to improved efficiencies andexpense controls.

Rental and managed services gross margindecreased due to reductions in scope of contracted services at the time ofcontract renewal particularly related to our rental base in Germany,cancellations of contracts with historically higher margins, and price erosionon new contracts. The gross margin rate was flat.

***Operating expenses***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                  | ** ** | **Third Fiscal Quarter** | ** **                           |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------|------------|------------------------------------|--------------------------------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                  | ** ** | ** **                         | ** **                           | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | ** **                  | ** ** | **2007**                           | ** **                           | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                | ** ** | **Dollars in millions**  | ** **                           |
| $423       |       | $          | 388        |       | $          | 389        |         | $                           | 393        |                               | Selling, general  and administrative |   | $ | 402 |   | $ | 423 |   |   | 31.5 | % |   |   | 32.6 | % |   |   | $ | (21 | ) |   | -5.0 | % |
| 115        |       | 110        |       | 114        |       | 114        |         | Research and  development   |       | 104                                |                                 | 115 |   |   | 8.2 | % |   |   | 8.9 | % |   |   | (11 | ) |   | -9.6 | % |
| 22         |       | 62         |       | 6          |       | 10         |         | Restructuring  charges, net |       | 13                                 |                                 | 22 |   |   | 1.0 | % |   |   | 1.7 | % |   |   | (9 | ) |   | -40.9 | % |
| —     |       | —     |       | —     |       | —     |         | Merger-related  costs       |       | 8                                  |                                 | — |   |   | 0.6 | % |   |   | 0.0 | % |   |   | 8 |   |   | 100.0 | % |
| $560       |       | $          | 560        |       | $          | 509        |         | $                           | 517        |                               | Total operating expenses             |   | $ | 527 |   | $ | 560 |   |   | 41.3 | % |   |   | 43.2 | % |   |   | $ | (33 | ) |   | -5.9 | % |
|            |            |            |            |            |            |            |              |                             |            |                                    |                                      |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $21 million decrease in SG&A expenses isprimarily due to the impact of lower headcount and lower discretionary spendingin connection with our cost management initiatives, partially offset byexpected higher employee benefit costs. The third quarter of fiscal 2006 alsoincluded $29 million of asset impairment charges primarily related tointernal-use software assets, partially offset by a $22 million benefit for thefavorable resolution of non-income tax audits.

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R&D expenses decreased by $11 million compared tothe same quarter last fiscal year due to a higher proportion of costs fordevelopment of software products, resulting in increased capitalization ofR&D spending. This decrease is partially offset by spending in connectionwith Traverse and  a full quarter ofUbiquity expenses, two companies which we have acquired during the fiscal year.

Restructuring charges, net for the third quarter offiscal 2007 represent $13 million of net charges for employee separation costs.

Merger-related costsconsist primarily of investment banking and legal costs associated with theproposed Merger with an entity controlled by the Sponsors.

***Other Income, Net***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** *** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|--------------|------------|------------------------------------|------------|
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | *** *** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** *** | ** ** | **Dollars in millions**  | ** ** |
|       | $          | 5          |       |       |       | $          | 8            |         |       |                               | $          | 6 |   |   |   | $ | 7 |   |   | Other income, net |   |   | $ | 10 |   |   |   | $ | 5 |   |   | $ | 5 |   | 100 | % |
|            |            |            |            |            |            |            |              |              |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net for thethird quarters of fiscal 2007 and 2006 primarily represents interest incomeearned on cash and cash equivalents.

***Interest Expense***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **   | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|--------------|------------|------------------------------------|------------|
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | *** *** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** *** | ** ** | **Dollars in millions**  | ** ** |
|       | $          | —     |       |       |       | $          | —       |         |       |                               | $          | — |   |   |   | $ | — |   |   | Interest expense |   |   | $ | 1 |   |   |   | $ | — |   |   | $ | 1 |   | 100 | % |
|            |            |            |            |            |            |            |              |              |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Capital lease obligationsof $10 million represent our only financing arrangement as of June 30,2007, and therefore, we have incurred insignificant interest expense.

***Provision for(Benefit from) Income Taxes***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------|------------|
| 3Q06       | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** ** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dollars in millions**  | ** ** |
| $          | (11)       |       |       | $          | 35         |       |       |       | $          | 25                                 |       |   |   | $ | 31 |   |   | Provision for  (benefit from) income taxes |   |   | $ | 24 |   |   | $ | (11 | ) | $ | 35 |   | -318 | % |
|            |            |            |            |            |            |            |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes in the third quarter of fiscal 2007 iscomprised of U.S. Federal, state and non-U.S. taxes including a $4 million taxbenefit attributable to tax return to provision adjustments due to the filing,in the quarter, of U.S. and non-U.S. income tax returns resulting in aneffective tax rate of 31.3%.

The benefit from income taxes in the thirdquarter of fiscal 2006 was primarily due to an $18 million tax benefitassociated with transfer pricing adjustments and a $3 million tax benefitresulting from a non-U.S. audit settlement. These benefits were partiallyoffset by provisions for U.S. Federal, state and non-U.S. taxes, resulting inan effective tax benefit rate of 33.1%.

**Segment Results**

***Global Communications Solutions (“GCS”)***

The GCS segment is focused on the sale ofcommunications systems, equipment and applications to our enterprise customers.Our primary offerings in this segment include IP communications and traditional

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voice communicationssolutions, multi-media contact center infrastructure and applications insupport of customer relationship management, unified communications applicationsand appliances.

Largecommunications systems are IP and traditional communications systems marketedto large enterprises. These systems include:

·        mediaservers which provide call processing on the customer’s local area network;

·        mediagateways which support traffic routing between traditional voice and IPcommunications solutions;

·        associatedappliances, such as telephone handsets and related software applications;

·        AvayaIntegrated Management, a Web-based comprehensive set of tools that manages complexvoice and data network infrastructures;

·        AvayaCommunications Manager, a voice application software that manages callprocessing, facilitates secure customer interactions across a variety of mediaand supports a range of Avaya and third-party applications; and

·        AvayaExtension to Cellular, which transparently bridges any cellular phone to anyAvaya communications server.

Smallcommunications systems are IP and traditional telephony systems marketed tosmaller enterprises. These systems include:

·        AvayaIP Office, an IP telephony solution for small and medium-sizedenterprises;

·        traditionalkey systems, Partner®, Merlin Magix®, Merlin LegendTM and I5 brands;

·        associatedappliances, such as telephone handsets; and

·        mediaservers for voice applications used by smaller businesses.

Converged voiceapplications consist of applications for multi-media contact centers andunified communications. These include:

·        applicationsin support of customer relationship management;

·        messagingfor IP and traditional systems;

·        applicationenablement services; and

·        unifiedcommunication client applications.

Thefollowing table sets forth revenue by similar class of products within the GCSsegment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                     | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|--------------------------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                     | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | ** **                     | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                   | ** ** | **Dollars in millions**  | ** ** |
| $          | 455        |       | $          | 483        |       | $          | 435          |                           | $          | 440                                |       | Large  Communications Systems |   | $ | 437 |   | $ | 455 |   |   | 64 | % |   |   | 65 | % |   | $ | (18 | ) | -4.0 | % |
| 92         |       | 96         |       | 85         |       | 84         |         | Small  Communications Systems  |       | 74                                 |       | 92 |   |   | 11 | % |   |   | 13 | % |   | (18 | ) | -19.6 | % |
| 144        |       | 169        |       | 151        |       | 162        |         | Converged Voice   Applications |       | 153                                |       | 144 |   |   | 22 | % |   |   | 20 | % |   | 9 |   | 6.3 | % |
| 13         |       | 12         |       | 11         |       | 12         |         | Other                          |       | 22                                 |       | 13 |   |   | 3 | % |   |   | 2 | % |   | 9 |   | 69.2 | % |
| $          | 704        |       | $          | 760        |       | $          | 682          |                           | $          | 698                                |       | Total GCS revenue |   | $ | 686 |   | $ | 704 |   |   | 100 | % |   |   | 100 | % |   | $ | (18 | ) | -2.6 | % |

 

39

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Overall GCS revenue declined by $18 million, or 2.6%due to product revenue decreases in the U.S. and a decline in our rental basein Germany. These declines were partially offset by a benefit from foreigncurrency and increased sales volume in EMEA, excluding Germany, and APAC. The$18 million decrease in large communications systems revenue was primarily theresult of decreased sales of enterprise gateways and other equipment,particularly in our U.S. direct market, partially offset by growth in AsiaPacific and Latin America. Small communications systems revenues decreased by$18 million due to continued declines of our sales of traditional products inthe U.S. and in our Germany rental base. Converged voice applications revenuesincreased by $9 million due to increased demand for applications outside of theU.S., especially IP messaging and certain contact center applications, offsetby declines in demand for traditional messaging products.

Thefollowing table sets forth operating income of the GCS segment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| 3Q06       | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** ** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dollars in millions**  | ** ** |
|            |            |            |            |            |            |            |            |            |            |                                    |            |  |  |  |  |  |  |  |  |

|   | $ | 36 |   |   |   | $ | 86 |   |   |   | $ | 22 |   |   |   | $ | 38 |   |   | Operating income |   |   | $ | 25 |   |   |   | $ | 36 |   |   |   | 3.6 | % |   |   | 5.1 | % |   | $ | (11 | ) | -30.6 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|-----|---|-------|---|

 

The $11 million decreasein operating income was primarily due to lower gross margin as a result ofdecreased sales volumes in the U.S. and Germany and unfavorable channel mix, aswell as expenses associated with Ubiquity and Traverse. These unfavorable itemswere partially offset by decreases in netR&D expense due to a higher proportion of costs for development of softwareproducts resulting in increased capitalization of R&D spending andbenefits from our cost savings initiatives.

***Avaya Global Services (“AGS”)***

The AGS segment is focused on supporting our broadcustomer base with comprehensive end-to-end global service offerings thatenable our customers to plan, design, implement, monitor and manage theirconverged communications networks and contact center systems worldwide. AGSprovides its services through the following offerings:

Product Support Services—AGS monitors and optimizescustomers’ network performance ensuring availability and keeps communicationnetworks current with the latest software releases. In the event of an outage,our services team helps customers restore their networks. This division waspreviously referred to as “Maintenance.”

Consulting and Systems Integration—Through operation,implementation and integration specialists and consultants worldwide, AGS helpscustomers leverage and optimize their multi-technology, multi-vendorenvironments through the use of contact centers, unified communication networksand IP communications. This division was previously referred to as “Implementationand Integration Services.”

Global Managed Services—AGS supplements our customers’in-house staff and manages complex multi-vendor, multi-technology networks,optimizes network performance and configurations, backs up systems, detects andresolves faults, performs moves, adds and changes, and manages our customers’communication environment and related assets. This category includes customerswho have chosen a bundled solution with enhanced services not provided in abasic maintenance contract, and service of solutions sold under a rentalpayment basis. The managed services business generally involves largercontracts with customers who outsource responsibility for their voiceapplications domain to us. We face challenges in this area, including ensuringthat we deliver consistent levels of service globally to these large, and oftenmulti-national, customers while controlling costs and expanding the requiredskill set of our AGS organization.

40

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The profitability of our AGS segment is also affected bythe fixed costs associated with our represented workforces in the U.S. and EMEAand includes the impact of increases in employee benefit costs. In addition,our profitability is impacted by the complexities associated with maintenanceof global, multi-vendor IP networks as compared with local, closed, proprietaryTDM networks, such as the need to assure a sufficient level of servicetechnicians with IP skills.

Thefollowing table sets forth revenue by similar class of services within the AGSsegment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                          | ** ** | **Third Fiscal Quarter** | ** **                |
|------------|------------|------------|------------|------------|------------|------------|--------------|-------------------------------------|------------|------------------------------------|---------------------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                          | ** ** | ** **                         | ** **                | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | *** *** | ** **                          | ** ** | **2007**                           | ** **                | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                        | ** ** | **Dollars in millions**  | ** **                |
| $402       |       | $          | 404        |       | $          | 411        |         | $                                   | 412        |                               | Product Support  Services |   | $ | 408 |   | $ | 402 |   |   | 69 | % |   |   | 68 | % |   |   | $ | 6 |   |   | 1.5 | % |
| 106        |       | 111        |       | 98         |       | 97         |         | Consulting and  Systems Integration |       | 99                                 |                      | 106 |   |   | 17 | % |   |   | 18 | % |   |   | (7 | ) |   | -6.6 | % |
| 84         |       | 89         |       | 89         |       | 87         |         | Global Managed  Services            |       | 83                                 |                      | 84 |   |   | 14 | % |   |   | 14 | % |   |   | (1 | ) |   | -1.2 | % |
| 1          |       | —     |       | —     |       | —     |         | Other                               |       | —                             |                      | 1 |   |   | 0 | % |   |   | 0 | % |   |   | (1 | ) |   | -100.0 | % |
| $593       |       | $          | 604        |       | $          | 598        |         | $                                   | 596        |                               | Total AGS revenue         |   | $ | 590 |   | $ | 593 |   |   | 100 | % |   |   | 100 | % |   |   | $ | (3 | ) |   | -0.5 | % |
|            |            |            |            |            |            |            |              |                                     |            |                                    |                           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Overall AGS revenue for the third quarter of fiscal 2007 was roughly flatcompared to the same quarter last fiscal year. Product support servicesrevenues increased by $6 million, due to growth in contract maintenancerevenues outside the U.S. Consulting and systems integration revenues declinedby $7 million due to lower direct product sales, resulting in lowerimplementation revenues, particularly in the U.S and Germany. Global managed services revenues wererelatively flat due to reductions in scope related to our Germany rental base,cancellations of contracted services, and price erosion on new contracts,substantially offset by a benefit from foreign currency.

Thefollowing table sets forth operating income of the Avaya Global Servicessegment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** ** | ** ** | **2007**                           | ** ** | **2006** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dollars in millions**  | ** ** |
|            |            |            |            |            |            |            |            |            |            |                                    |            |  |  |  |  |  |  |  |  |

|   | $ | 34 |   |   |   | $ | 36 |   |   |   | $ | 53 |   |   |   | $ | 56 |   |   | Operating income |   |   | $ | 63 |   |   |   | $ | 34 |   |   |   | 10.7 | % |   |   | 5.7 | % |   | $ | 29 |   | 85.3 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|------|---|--------|--------|-----|---|--------|---|----|--------|------|---|

 

The $29 million increasein operating income is primarily due to higher gross margin as a result ofimproved efficiencies and expense controls, partially offset by expectedincreased employee benefit costs.

**Corporate/Other Unallocated Amounts**

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|--------------|------------|------------------------------------|------------|
| **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **2Q07**   | ** ** | ** **   | ** ** | **2007**                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** ** | **Dollars in millions**  | ** ** |
| $          | (42)       |       | $          | (47        | )          |       | $          | 15           |       |                               | $          | (13 | ) | Operating (loss)  income |   | $ | (18 | ) | $ | (42 | ) | $ | 24 |   | 57 | % |
|            |            |            |            |            |            |            |            |              |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Corporate/Other Unallocated amounts include a $13million net restructuring charge and $8 million of Merger-related costs in thethird quarter of fiscal 2007. At the beginning of each fiscal year, the amountof corporate overhead and certain other expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year. Any adjustment of the annual incentive accrual, as well asany other over/under absorption of corporate overhead expenses against plannedamounts, is recorded within Corporate/Other Unallocated Amounts. In addition,certain discrete items, such as charges relating to restructuring actions, aswell as Merger-related costs, are not allocated to the operating segments andremain in Corporate/Other Unallocated Amounts.

41

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The operating loss for thethird quarter of fiscal 2006 was primarily related to restructuring charges of$22 million and asset impairment charges of $29 million primarily related tocertain internal-use software assets. These items were partially offset by $22million related to the favorable resolution on non-income tax audits in severaljurisdictions.

***Nine Months Ended June 30, 2007 Compared withNine Months Ended June 30, 2006***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **                   | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Sales of products            |       | $                                                  | 1,884      |   | $ | 1,820 |   |   | 49 | % |   |   | 48 | % |   | $ | 64 |   | 3.5 | % |
| Services                     |       | 1,525                                              |       | 1,503 |   |   | 40 | % |   |   | 40 | % |   | 22 |   | 1.5 | % |
| Rental and  managed services |       | 441                                                |       | 461 |   |   | 11 | % |   |   | 12 | % |   | (20 | ) | -4.3 | % |
| Total revenue                |       | $                                                  | 3,850      |   | $ | 3,784 |   |   | 100 | % |   |   | 100 | % |   | $ | 66 |   | 1.7 | % |

 

The increase in revenue for the nine months ended June 30,2007 compared to the same period last fiscal year was due to increases in salesof products and services, partially offset by a decline in rental and managedservices. Revenue for the nine months of fiscal 2007 include a benefit of $93million from favorable foreign currency.

Thefollowing table sets forth a geographic comparison of revenue:

| ** **                                                   | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                                                   | ** ** | **Dollars in millions**                  | ** ** |
| U.S.                                                         |       | $                                                  | 2,172      |   | $ | 2,206 |   |   | 56 | % |   |   | 58 | % |   | $ | (34 | ) | -1.5 | % |
| Outside the U.S.:                                            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                      |       | 536                                                |       | 550 |   |   | 14 | % |   |   | 14 | % |   | (14 | ) | -2.5 | % |
| EMEA—Europe / Middle East / Africa (Excluding  Germany) |       | 609                                                |       | 557 |   |   | 16 | % |   |   | 15 | % |   | 52 |   | 9.3 | % |
| Total EMEA                                                   |       | 1,145                                              |       | 1,107 |   |   | 30 | % |   |   | 29 | % |   | 38 |   | 3.4 | % |
| APAC—Asia Pacific                                       |       | 315                                                |       | 273 |   |   | 8 | % |   |   | 8 | % |   | 42 |   | 15.4 | % |
| Americas, non-U.S.                                           |       | 218                                                |       | 198 |   |   | 6 | % |   |   | 5 | % |   | 20 |   | 10.1 | % |
| Total outside the U.S.                                       |       | 1,678                                              |       | 1,578 |   |   | 44 | % |   |   | 42 | % |   | 100 |   | 6.3 | % |
| Total revenue                                                |       | $                                                  | 3,850      |   | $ | 3,784 |   |   | 100 | % |   |   | 100 | % |   | $ | 66 |   | 1.7 | % |

 

Revenues in the U.S. decreased 1.5% compared with thefirst nine months of fiscal 2006, primarily due to decreases in sales of largeand small communications systems and product support services. Germany’srevenue decreased 2.5% due to the decline in our rental base, partially offsetby a benefit from foreign currency. EMEA revenue, excluding Germany, grew by9.3% due to a benefit from foreign currency and strong demand in Eastern Europe.The increases in APAC and Americas, non-U.S. revenue were primarily due to theincreased demand for IP products through the direct channel.

42

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Thefollowing table sets forth a comparison of revenue from sales of products by channel:

| ** **              | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**                  | ** ** |
| Direct                  |       | $                                                  | 794        |   | $ | 795 |   |   | 42 | % |   |   | 44 | % |   | $ | (1 | ) | -0.1 | % |
| Indirect                |       | 1,090                                              |       | 1,025 |   |   | 58 | % |   |   | 56 | % |   | 65 |   | 6.3 | % |
| Total sales of products |       | $                                                  | 1,884      |   | $ | 1,820 |   |   | 100 | % |   |   | 100 | % |   | $ | 64 |   | 3.5 | % |

 

The mix of sales ofproducts in the first nine months of fiscal 2007 shifted two percentage pointstoward indirect due to the decline in the U.S. and Germany direct product salescompared to the same period last fiscal year.

***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:

| ** **                      | ** ** | **Nine Months Ended June 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**                  | ** ** |
| On sales of  products           |       | $                                                  | 992        |   | $ | 964 |   |   | 52.7 | % |   |   | 53.0 | % |   | $ | 28 |   | 2.9 | % |
| On services                     |       | 565                                                |       | 527 |   |   | 37.0 | % |   |   | 35.1 | % |   | 38 |   | 7.2 | % |
| On rental and  managed services |       | 237                                                |       | 264 |   |   | 53.7 | % |   |   | 57.3 | % |   | (27 | ) | -10.2 | % |
| Total gross margin              |       | $                                                  | 1,794      |   | $ | 1,755 |   |   | 46.6 | % |   |   | 46.4 | % |   | $ | 39 |   | 2.2 | % |

 

The $39 million increase in gross margin for the first nine months offiscal 2007 reflects an increase in the volume of sales of products, the impactof improved efficiencies and a benefit from foreign currency. The overall grossmargin rate was flat compared to the first nine months of fiscal 2006. Thefirst nine months of fiscal 2006 gross margin includes an $11 million benefit,or a 0.3 percentage point impact, from the change in our vacation policy.

Gross margin on sales of products increased by $28 million primarily due tohigher sales volume. Factors affecting the slight decline in the gross marginrate included higher costs associated with our warehousing issues and thehigher proportion of indirect sales which generally carry lower margins,partially offset by benefits from cost reductions from employee restructuringactions.

Services gross margin increased by $38 million and the rate increased byalmost two percentage points when compared to first nine months of fiscal 2006.Cost reductions from employee restructuring actions in prior periods and fromimproved efficiencies and expense controls were partially offset by expectedincreases in employee benefit costs.

Rental and managed services gross marginand rate both decreased due to reductions in scope of contracted services atthe time of contract renewal particularly related to our rental base inGermany, cancellation of contracts with historically higher margins and priceerosion on new contracts.

43

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***Operating expenses***

| ** **                           | ** ** | **Nine Months Ended June 30,** | ** ** |       |
|--------------------------------------|------------|----------------------------------------------------|------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| ** **                           | ** ** | **2007**                                           | ** ** | **2006**   | ** ** | **  2007  ** | ** ** | **  2006  ** | ** ** | **Change** | ** ** |   |
| ** **                           | ** ** | **Dollars in millions**                  | ** ** |       |
| Selling, general  and administrative |       | $                                                  | 1,184      |       | $ | 1,207 |   |   | 30.7 | % |   |   | 31.9 | % |   | $ | (23 | ) | -1.9 | % |
| Research and  development            |       | 332                                                |       | 318        |   |   | 8.6 | % |   |   | 8.4 | % |   | 14 |   | 4.4 | % |
| Restructuring  charges, net          |       | 29                                                 |       | 42         |   |   | 0.8 | % |   |   | 1.1 | % |   | (13 | ) | -31.0 | % |
| Merger-related  costs                |       | 8                                                  |       | —     |   |   | 0.2 | % |   |   | 0.0 | % |   | 8 |   | 100.0 | % |
| Total operating expenses             |       | $                                                  | 1,553      |       | $ | 1,567 |   |   | 40.3 | % |   |   | 41.4 | % |   | $ | (14 | ) | -0.9 | % |

 

The $23 million decrease in SG&A expenses isprimarily due to lower headcount, lower discretionary spending, an $8 millionbenefit resulting from the favorable resolution of non-income tax audits and again on the sale of real estate in fiscal 2007, partially offset by expectedincreases in employee benefit costs. The first nine months of fiscal 2006included a $7 million benefit related to the change in our vacation policy, aswell as a $29 million asset impairment charge primarily related to internal-usesoftware assets.

R&D expenses increased by $14 million compared tothe first nine months of the last fiscal year due to increased gross investmentand to a lesser extent, the acquisitions of Traverse and Ubiquity. The firstnine months of fiscal 2006 included a $3 million benefit related to the changein our vacation policy.

Restructuring charges, net for the first nine monthsof fiscal 2007 represent $36 million of charges for employee separation costsand lease obligations, partially offset by a net benefit of $7 million forchanges in estimates for prior restructuring plans primarily related tofacilities.

Merger-related costs forthe first nine months of fiscal 2007 consist primarily of investment bankingand legal costs associated with the proposed Merger.

***Other Income, Net***

| ** **        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------|------------|----------------------------------------------------|------------|
| ** **        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **        | ** ** | **Dollars in millions**                  | ** ** |
| Other income, net |       |                                               | $          | 23 |   |   |   | $ | 16 |   |   | $ | 7 |   | 44 | % |
|                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net for thefirst nine months of fiscal 2007 and 2006 primarily represents interest incomeearned on cash and cash equivalents.

***Interest Expense***

| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Interest expense |       |                                               | $          | 1 |   |   |   | $ | 3 |   |   | $ | (2 | ) | -67 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Capital lease obligationsof $10 million represent our only financing arrangement as of June 30,2007, and therefore, we have incurred insignificant interest expense.

***Provision forIncome Taxes***

| ** **                  | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Dollars in millions**                  | ** ** |
| Provision for  income taxes |       |                                               | $          | 80 |   |   |   | $ | 48 |   |   | $ | 32 |   | 67 | % |
|                             |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

44

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The provision for income taxes for the nine month periods shown above iscomprised of U.S. Federal, state and non-U.S. taxes. The provision for the ninemonths ended June 30, 2007 includes a $6 million benefit from theretroactive extension to January 1, 2006 of the research tax creditpursuant to the Tax Relief and Health Care Act of 2006, a $7 million taxbenefit due to a reduction in estimated tax payable for fiscal 2006 in Germanyas a result of additional restructuring charges reported for statutory purposes,and a $4 million tax benefit attributable to tax return to provisionadjustments due to the filing, in the quarter, of U.S. and non-U.S. income taxreturns. The provision for the first nine months of fiscal 2007 resulted in aneffective tax rate of 30.5%, which we believe is not indicative of theestimated tax rate for the full fiscal year. 

The provision for income taxes for thenine months ended June 30, 2006 was impacted by an $18 million taxbenefit associated with transfer pricing adjustments. The provision for incometaxes for the nine months ended June 30, 2006 resulted in an effectiverate of 23.9%.

**Segment Results**

***Global Communications Solutions***

Thefollowing table sets forth revenue by similar class of products within the GCSsegment:

| ** **                    | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**                  | ** ** |
| Large  Communications Systems |       | $                                                  | 1,312      |   | $ | 1,282 |   |   | 64 | % |   |   | 62 | % |   | $ | 30 |   | 2.3 | % |
| Small  Communications Systems |       | 243                                                |       | 274 |   |   | 12 | % |   |   | 14 | % |   | (31 | ) | -11.3 | % |
| Converged Voice  Applications |       | 466                                                |       | 436 |   |   | 22 | % |   |   | 22 | % |   | 30 |   | 6.9 | % |
| Other                         |       | 45                                                 |       | 34 |   |   | 2 | % |   |   | 2 | % |   | 11 |   | 32.4 | % |
| Total GCS revenue             |       | $                                                  | 2,066      |   | $ | 2,026 |   |   | 100 | % |   |   | 100 | % |   | $ | 40 |   | 2.0 | % |

 

Overall GCS revenue grew by $40 million, or 2.0%. Productrevenue increases, particularly related to converged voice applications and abenefit from foreign currency, were offset by the expected reduced sales oftraditional products and a decline in our rental base in Germany. The $30million increase in large communication systems revenue was the result ofincreased demand for enterprise gateways and other equipment. Smallcommunications systems revenues decreased by $31 million due to continueddeclines of our sales of traditional products and our rental base. Convergedvoice applications revenues increased by $30 million due to increased demandfor applications, especially IP messaging and contact center applications,offset by declines in demand for traditional messaging products.

Thefollowing table sets forth operating income of the GCS segment:

| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       |                                               | $          | 85 |   |   | $ | 111 |   |   | 4.1 | % |   |   | 5.5 | % |   | $ | (26 | ) | -23.4 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $26 million decline inoperating income was primarily due to highercosts associated with our warehousing issues, increases in R&Dinvestment and the benefit of $11 million from a change in the Company’svacation policy for the first nine months of fiscal 2006, partially offset bythe impact of increases in sales volume. 

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***Avaya Global Services***

Thefollowing table sets forth revenue by similar class of services within the AGSsegment:

| ** **                          | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                          | ** ** | **Dollars in millions**                  | ** ** |
| Product Support  Services           |       | $                                                  | 1,231      |   | $ | 1,215 |   |   | 69 | % |   |   | 69 | % |   | $ | 16 |   | 1.3 | % |
| Consulting and  Systems Integration |       | 294                                                |       | 290 |   |   | 16 | % |   |   | 17 | % |   | 4 |   | 1.4 | % |
| Global Managed  Services            |       | 259                                                |       | 251 |   |   | 15 | % |   |   | 14 | % |   | 8 |   | 3.2 | % |
| Other                               |       | —                                             |       | 2 |   |   | 0 | % |   |   | 0 | % |   | (2 | ) | -100.0 | % |
| Total AGS revenue                   |       | $                                                  | 1,784      |   | $ | 1,758 |   |   | 100 | % |   |   | 100 | % |   | $ | 26 |   | 1.5 | % |

 

Overall AGS revenue increased by $26 million, or 1.5%,due to increases in product support services, as well as a benefit from foreigncurrency. 

Product support services revenues increased by $16 million compared to thethird quarter of fiscal 2006, particularly in the international regions. Consultingand systems integration revenues increased by $4 million due to anincrease in professional services in the U.S. Global managed services revenuesincreased by $8 million due to higher customer termination fees and favorableforeign currency, which were partially offset by reductions in scope related toour Germany rental base, cancellations of contracted services and price erosionon new contracts.

Thefollowing table sets forth operating income of the Avaya Global Servicessegment:

| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       | $                                                  | 172        |   | $ | 135 |   |   | 9.6 | % |   |   | 7.7 | % |   | $ | 37 |   | 27.4 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $37 million increasein operating income is primarily due to the shift in mix of contractmaintenance and implementation revenues, lower inventory-related costs, reducedcosts resulting from prior restructuring actions and improved efficiencies andexpense controls. These items were partially offset by expected increases inemployee benefit costs. Operating income for the first nine months of fiscal2006 included a benefit of $10 million from the change in our vacation policy.

**Corporate/Other Unallocated Amounts**

| ** **     | ** ** | **Nine Months Ended June 30,** | ** ** |
|----------------|------------|----------------------------------------------------|------------|
| ** **     | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **     | ** ** | **Dollars in millions**                  | ** ** |
| Operating loss |       | $                                                  | (16        | ) | $ | (58 | ) | $ | 42 |   | 72 | % |
|                |            |                                                    |            |  |  |  |  |  |  |  |  |  |

 

For the first nine monthsof fiscal 2007, the operating loss in Corporate/Other Unallocated Amounts isprimarily attributable to $29 million of net restructuring charges and $8million of Merger-related costs, partially offset by $8 million in gains on thesale of real estate and the $8 million benefit from non-income tax auditsettlements in several jurisdictions. The operating loss for the nine months offiscal 2006 was primarily related to a $29 million impairment charge primarilyassociated with certain internal-use software assets, $42 million of netrestructuring charges, and certain real estate expenses. These costs werepartially offset by lower accruals for employee incentive awards and a $22million benefit from the favorable resolution of non-income tax audits inseveral jurisdictions.

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**Liquidity andCapital Resources**

During the first nine months of fiscal2007, we generated positive cash flow from operations of $424 million. Wealso received $110 million in connection with the issuance of common stockunder our employee stock purchase plan and stock compensation plans. Thissource of cash was partially offset by $94 million of cash used during thefirst nine months of fiscal 2007 to repurchase shares in connection with our2005 and 2007 share repurchase plans. In addition, we used $15 million and $147million of cash to acquire Traverse and Ubiquity, respectively, and used $150million of cash for capital expenditures and software development costs. Cashand cash equivalents increased by $158 million to $1,057 million as of June 30,2007 from $899 million as of September 30, 2006. 

***Sources and Uses of Cash for the Nine Months Ended June 30,2007***

Acondensed statement of cash flows for the first nine months of fiscal 2007 and2006 follows:

| ** **                                                    | ** ** | **Nine months ended June 30,**                                           | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **       2007       ** | ** ** | **       2006       ** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**                                                            | ** ** |
| Net cash provided by  (used for):                             |       |                                                                                         |       |   |   |   |   |   |   |
| Operating activities                                          |       |                                                                                         | $          | 424 |   |   |   | $ | 456 |   |   |
| Investing activities                                          |       |                                                                                         | (304       | ) |   |   | (139 | ) |   |
| Financing activities                                          |       |                                                                                         | 13         |   |   |   | (250 | ) |   |
| Effect of  exchange rate changes on cash and cash equivalents |       |                                                                                         | 25         |   |   |   | 5 |   |   |
| Net increase in  cash and cash equivalents                    |       |                                                                                         | 158        |   |   |   | 72 |   |   |
| Cash and cash equivalents at beginning of year                |       |                                                                                         | 899        |   |   |   | 750 |   |   |
| Cash and cash  equivalents at end of period                   |       |                                                                                         | $          | 1,057 |   |   |   | $ | 822 |   |   |

 

***Operating Activities***

Our net cash provided by operating activities was $424million for the first nine months of fiscal 2007, compared to $456 million inthe first nine months of fiscal 2006. The lower amount of cash provided byoperating activities compared to the prior year was primarily driven by higheremployee incentive payments. The first nine months of fiscal 2007 includedpayment of employee incentives based on fiscal 2006 performance. The first ninemonths of fiscal 2006 included payments of lower discretionary awards based onfiscal 2005 performance. This change in the level of incentive paymentsresulted in an approximately $70 million increase in cash usage in the firstnine months of fiscal 2007 compared with the same period of fiscal 2006. 

*Accounts Receivable, Net*—The followingsummarizes our accounts receivable, net and related metrics:

| ** **                                                                       | ** ** | **June 30,**                 | ** ** | **September 30,** | ** ** | ** ** | ** **   |
|----------------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|--------------|
| ** **                                                                       | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** **   |
| ** **                                                                       | ** ** | **Dollars in millions** | ** ** |
| Accounts  receivable, gross                                                      |       |                              | $          | 928                    |       |       |         | $ | 928 |   |   | $ | — |   |
| Allowance for  doubtful accounts                                                 |       |                              | (59        | )                      |       |       | (57          | ) |   | (2 | ) |
| Accounts  receivable, net                                                        |       |                              | $          | 869                    |       |       |         | $ | 871 |   |   | $ | (2 | ) |
| Allowance for doubtful accounts as a percent of accounts receivable,  gross |       |                              | 6.4        | %                      |       |       |  

6.1  | % |   | +0.3 pts |   |
| Past due  receivables as a percent of accounts receivable, gross                 |       |                              | 18.5       | %                      |       |       |  

17.8 | % |   | +0.7 pts |   |

 

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| ** **                    | ** ** | **For the three months ended** | ** ** | ** **                         | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|------------------------------------|------------|
| ** **                    | ** ** | ** June 30, **                      | ** ** | ** September 30, ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2007**                                           | ** ** | **2006**                           | ** ** | **Change** | ** ** |
| Days sales  outstanding (DSO) |       |                                               | 61 days    |                               |       |   | 57 days |   |   | +4 days |   |
|                               |            |                                                    |            |                                    |            |  |  |  |  |  |  |

 

**The accounts receivable balance asof June 30, 2007 was substantially flat when compared to September 30, 2006.The increase in DSO was the result of current quarter sales occurring later inthe quarter when compared to the three months ended September 30, 2006 as wellas the increase in the deferred revenue balance as of June 30, 2007.**

*Inventory—*The following summarizes ourinventory and inventory turnover:

| ** **          | ** ** | **June 30,**                 | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|---------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **          | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** ** |
| ** **          | ** ** | **Dollars in millions** | ** ** |
| Finished goods      |       | $                                 | 300        |                   |       | $          | 281        |   |   | $ | 19 |   |
| Raw materials       |       | 4                                 |       |                   | 4          |       |       | — |   |
| Total inventory     |       | $                                 | 304        |                   |       | $          | 285        |   |   | $ | 19 |   |
| Inventory  turnover |       | 8.9 times                         |       |                   | 10.2 times |       |       | -1.3  times |   |

 

Inventory increased by $19 million since the beginningof the fiscal year and inventory turnover declined due to changes in the mix ofproduct demand as well as in anticipation of seasonally strong demand for ourproducts in the fourth fiscal quarter. 

*Accounts Payable*—The following summarizesour accounts payable:

| ** **               | ** ** | **June 30,**                 | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|--------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **               | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions** | ** ** |
| Accounts payable         |       |                              | $          | 395                    |       |       |       | $ | 418 |   |   | $ | (23 | ) |
| Days payable outstanding |       |                              | 52         |                   |       |       | 51         |   |   | +1 day |   |
|                          |            |                                   |            |                        |            |            |            |  |  |  |  |  |  |  |

 

Accounts payable decreasedin the first nine months of fiscal 2007 due to lower spending levels and thetiming of payments during the quarter.

***Investing Activities***

Net cash used for investing activities was $304million in the first nine months of fiscal 2007, compared with $139 million inthe same period last year. Activities in the current period include $162million for the acquisitions of Ubiquity and Traverse, $79 million for capitalexpenditures and $71 million for capitalized software development costs.

Cash used in the sameperiod of fiscal 2006 included $83 million for capital expenditures and $53 millionfor capitalized software development costs.

***Financing Activities***

Net cash provided by financing activities was $13million in the first nine months of fiscal 2007, compared with cash used of$250 million in the same period last year. Activities in the current periodprimarily include $110 million of cash received in connection with the issuanceof common stock under our employee stock purchase plan and stock compensationplans, partially offset by $94 million of cash used to repurchase our commonstock pursuant to our share repurchase plans.

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Cash used in the sameperiod of fiscal 2006 consisted primarily of $256 million to repurchase ourcommon stock and $14 million to repay our senior notes partially offset by $20million of cash received in connection with the issuance of common stock under employeestock purchase plan and the exercise of options under our stock compensationplans.

***Future Cash Requirements and Sources of Liquidity***

***Impact of Proposed Merger***

We expect the proposed Merger to be completed in thefall of 2007, subject to receipt of shareholder approval and customaryregulatory approvals, as well as satisfaction of other customary closingconditions.

We will incur indebtednessand utilize cash in order to complete the proposed Merger. As a result, ourfuture cash requirements, sources of liquidity and uncertainties regarding ourliquidity may change after the completion of the Merger. Because the proposedMerger is not complete, the discussion in this section does not consider theimpact of proposed costs which will only be incurred upon consummation of theproposed Merger, nor does it consider the incurrence of the relatedindebtedness contemplated by the Merger.

***Future Cash Requirements***

Our primary future cash requirements will be to fundcapital expenditures, restructuring payments, employee benefit obligations andMerger-related costs.

Specifically, weexpect our primary cash requirements for the remainder of fiscal 2007 to be asfollows:

·       *Capital expenditures*—We expect to spendapproximately $75 million for capital expenditures and capitalized softwaredevelopment costs during the fourth quarter of fiscal 2007.

·       *Restructuring payments—*We expect to makepayments of approximately $20 million during the remainder of fiscal 2007 foremployee separation costs and lease termination obligations associated withrestructuring actions we have taken to date. If we take any further actions toreduce costs and expenses, we would expect to make additional paymentsthroughout the remainder of fiscal 2007.

·       *Employee benefit obligations*—We estimate that we will pay $2million each for U.S. and non-U.S. pension benefits for the remainder of fiscal2007. We also estimate that we will makepayments of $5 million for retiree medical benefits that are not pre-fundedduring the remainder of fiscal 2007.

·       *Merger-related costs—*We have incurred $8 million forMerger-related costs during the third quarter of fiscal 2007, and we expect toincur an additional $15 million during the remainder of fiscal 2007. Payment ofthese costs is not dependent on the successful completion of the Merger. Substantiallyall accrued Merger-related costs are expected to be paid after closing of theMerger, which we expect to complete in the fall of 2007.

***Future Sources of Liquidity***

We expect our primary source of cash during theremainder of fiscal 2007 to be positive net cash provided by operatingactivities. We expect that growth in profitable revenues and continued focus onaccounts receivable, inventory management and cost containment will enable usto continue to generate positive net cash from operations.

We and a syndicate of lenders are currently party to a$400 million revolving credit facility, which expires in May 2011. TheMerger Agreement limits Avaya’s ability without the Sponsors’ consent duringthe period from the date of the Merger Agreement until the closing of theMerger to, among other things, 

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incur indebtedness overcertain thresholds. For more information regarding the credit facility, seeNote 7 “Financing Arrangements” to our Consolidated Financial Statements.

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $1,057 million and our net cash provided by operating activitieswill be sufficient to meet our future cash requirements described above. Our abilityto meet these requirements will depend on our ability to generate cash in thefuture, which is subject to general economic, financial, competitive,legislative, regulatory and other factors that are beyond our control.

***Uncertainties Regarding Our Liquidity***

If we do not generate sufficient cash from operations,face unanticipated cash needs such as the need to fund significant strategicacquisitions or do not otherwise have sufficient cash and cash equivalents, wemay need to incur debt or issue equity. In order to meet our cash needs we may,from time to time, borrow under our credit facility or issue other long- orshort-term debt or equity, if the market and the terms of our existing debtinstruments permit us to do so.

We believe thefollowing uncertainties exist regarding our liquidity:

·       *Ability to Increase Revenue*—Our ability to generate net cashfrom operating activities has been a primary source of our liquidity. If ourrevenues were to decline, our ability to generate net cash from operating activitiesin a sufficient amount to meet our cash needs could be adversely affected.

·       *Acquisitions—*Wemay from time to time in the future make acquisitions. Such acquisitions mayrequire significant amounts of cash or may result in increased debt service requirementsto the extent we assume or incur debt in connection with such acquisitions.

***Fair Value of Financial Instruments***

The carrying amounts of cash and cash equivalents,accounts receivable, accounts payable and accrued liabilities approximate fairvalue because of their short-term maturity and variable rates of interest.

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We aretherefore subject to the risk associated with foreign currency exchange ratesand interest rates that could affect our results of operations, financialposition and cash flows. We manage our exposure to these market risks throughour regular operating and financing activities and, when deemed appropriate,through the use of derivative financial instruments. We use derivativefinancial instruments to reduce earnings and cash flow volatility associatedwith foreign exchange rate changes. Derivative financial instruments are usedas risk management tools and not for speculative or trading purposes. As of June 30,2007 and September 30, 2006, the estimated fair values of our foreigncurrency forward contracts were a gain of $3 million and a loss of$2 million, respectively. The gain was included in other current assets,while the loss was included in other current liabilities. The estimated fairvalues of these forward contracts were based on market quotes obtained throughindependent pricing sources.

***Debt Ratings***

Our ability to obtainexternal financing and the related cost of borrowing is affected by our debtratings, which are periodically reviewed by the major credit rating agencies. Asof June 30, 2007, we had a long-term corporate family rating of Ba3 withratings under review for possible downgrades from Moody’s and a corporatecredit rating of B+ with ratings on the credit watch with negative implicationsfrom Standard & Poor’s. These ratings are not recommendations to buy,sell or hold securities. The ratings are subject to change or withdrawal at anytime by the respective credit rating agencies. Each credit rating should beevaluated independently of any other ratings.

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***Credit Facility***

Our credit facility contains affirmative andrestrictive covenants that we must comply with, as described in Note 7, “FinancingArrangements” to our Consolidated Financial Statements. As of June 30, 2007, wewere in compliance with all of the covenants included in the credit facility.

There are currently $27million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility and the remainingavailability is $373 million as of June 30, 2007. We believe the creditfacility provides us with an important source of backup liquidity.

**Critical AccountingPolicies and Estimates**

The preparation ofthe Consolidated Financial Statements and related disclosures in conformitywith accounting principles generally accepted in the United States requires usto establish accounting policies that contain estimates and assumptions thataffect the amounts reported in the Consolidated Financial Statements andaccompanying notes. These policies include:

·       Revenuerecognition;

·       Collectibilityof accounts receivable;

·       Inventories;

·       Deferredtax assets and tax liabilities;

·       Themeasurement of long-lived assets, including goodwill, the impairment of whichwould impact operating expenses;

·       Restructuringprograms;

·       Pensionand post-retirement benefits costs;

·       Commitmentsand contingencies; and

·       Accountingfor stock options.

We have other important accounting policies and practices;however, once adopted, these other policies either generally do not require usto make significant estimates or assumptions or otherwise only requireimplementation of the adopted policy and not a judgment as to the policy itself.We base our estimates on our historical experience and also on assumptions thatwe believe are standard and reasonable. Despite our intention to establishaccurate estimates and assumptions, actual results could differ from thoseestimates for various reasons including those described in “Forward LookingStatements.”

During the nine monthsended June 30, 2007, management believes there have been no significantchanges to the items that we disclosed as our critical accounting polices andestimates in Management’s Discussion and Analysis of Financial Condition andResults of Operations in our Annual Report on Form 10-K for the fiscalyear ended September 30, 2006.

**Item 3.**                        *Quantitative and Qualitative Disclosures About Market Risk.*

See Avaya’s Annual Reporton Form 10-K filed with the SEC on December 8, 2006. As of June 30,2007, there has been no material change in this information.

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**Item 4.**                        *Controls and Procedures.*

a)                *Evaluation of Disclosure Controls and Procedures.*

As of the end ofthe period covered by this report, our management, under the supervision andwith the participation of the principal executive officer and principalfinancial officer, evaluated the effectiveness of the design and operation ofour disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)). Based on this evaluation, our principal executive officer and principalfinancial officer have concluded (1) that the disclosure controls andprocedures were effective to provide reasonable assurance that informationrequired to be disclosed in reports that we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in SEC rules and forms and (2) that the disclosure controlsand procedures were effective to ensure that information required to bedisclosed in the reports that we file or submit under the Exchange Act isaccumulated and communicated to our management, including the principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

b)               *Changes in Internal Control Over Financial Reporting.*

There were no changes in our internal control overfinancial reporting during the third quarter of fiscal 2007 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PARTII**                 OTHER INFORMATION

**Item 1.**                        *Legal Proceedings.*

See Note 13, “Commitmentsand Contingencies” to the Consolidated Financial Statements.

**Item 1A.**                *Risk Factors.*

(CautionaryStatements Under the Private Securities Litigation Reform Act of 1995)

We provide the following cautionary discussion ofrisks, uncertainties and possibly inaccurate assumptions relevant to ourbusinesses. We note these factors forinvestors as permitted by the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933 and Section 21E ofthe Securities Exchange Act of 1934. Theseare factors that we think could cause our actual results to differ materiallyfrom expected and historical results. However,it is not possible to predict or identify all such factors. Consequently, youshould not consider the following to be a complete discussion of all potentialrisks or uncertainties.

It should also be noted that we may not be able to complete the proposedMerger on the terms summarized elsewhere in this Form 10-Q or onother acceptable terms, or at all, due to a number of factors, including thefailure to satisfy customary closing conditions. The risks and uncertaintiesdescribed below do not contemplate or give effect to potential risks associatedwith the proposed Merger, including any potential adverse reaction of ourcustomers, suppliers, distributors and other business partners to the proposedMerger.

The risks and uncertainties discussed in more detail belowinclude, but are not limited to:

·       priceand product competition, including from competitors who may offer products andapplications similar to those we offer as part of another offering, and fromcurrent leaders in information technology which benefit from the convergence ofenterprise voice and data networks;

·       rapidor disruptive technological development, including the effects of thetechnology shift from traditional TDM to IP telephony;

·       dependenceon new product development;

·       customerdemand for our products and services, including risks specifically associatedwith the services business and, in particular, the maintenance and rental andmanaged services lines of business, primarily due to renegotiations of customercontracts and changes in scope, pricing erosion and cancellations;

·       supplyissues related to our outsourced manufacturing operations, logistics,distribution or components;

·       risksrelated to inventory, including warranty costs, obsolescence charges, excesscapacity, material and labor costs, and our distributors’ decisions regarding theirown inventory levels;

·       generalindustry and market conditions and growth rates and general domestic andinternational economic conditions including interest rate and currency exchangerate fluctuations;

·       theeconomic, political and other risks associated with international sales andoperations, including increased exposure to currency fluctuations and toEuropean economies as a result of a large percentage of our business beingconducted in Europe;

·       theability to successfully integrate acquired companies, which may requiresignificant management time and attention;

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·       theability to attract and retain qualified employees;

·       controlof costs and expenses, including difficulties in completing restructuringactions in a timely and efficient manner due to labor laws and requiredapprovals;

·       U.S.and non-U.S. government regulation; and

·       theability to form and implement alliances.

Below is a detaileddiscussion of certain risks affecting our business. The categorization of risksset forth below is meant to help you better understand the risks facing ourbusiness and is not intended to limit your consideration of the possibleeffects of these risks to the listed categories. Any adverse effects related tothe risks discussed below may, and likely will, adversely affect many aspectsof our business.

***Risks Related To Our Revenue and Business Strategy***

**A key component of our strategy is our focus on thedevelopment and sale of advanced communications products and applications andrelated services, including IP communications solutions, and this strategy maynot be successful.**

A key component of our strategy is our focus on thedevelopment and sale of IP communications solutions and other advancedcommunications products and applications and related services.  Our product offerings include IPcommunications and traditional voice communications systems, multi-mediacontact center infrastructure and applications in support of customerrelationship management, unified communications applications and appliances,such as IP telephone sets.  Theseofferings are part of what we refer to as “Intelligent Communications,” whichis about embedding communications solutions into our customers’ businessprocesses to help them transform their businesses and innovate their businessmodels.

In order to executeour strategy successfully, we must continue to:

·       expandour current customer base by selling our advanced communications products,applications and services to enterprises that have not previously purchased ourproducts and applications;

·       makesales to our existing customers that incorporate our advanced communicationsproducts, applications and services;

·       trainour sales staff and distribution partners to sell new types of products,applications and services and improve our marketing of such products,applications and services;

·       researchand develop IP communications solutions and other advanced communicationsproducts and applications;

·       increasethe performance and reliability of new products and ensure that the performanceand reliability of these products meet our customers’ expectations;

·       acquirekey technologies through licensing, development contracts, alliances andacquisitions;

·       trainour services employees and channel partners to service new products andapplications, and take other measures to ensure we can deliver consistentlevels of service globally to our multinational customers;

·       enhance our servicesorganization’s ability to service more complex, multi-vendor IP networks,versus traditional closed, proprietary TDM networks, and in general ensure thatthere is a sufficient level of service technicians with IP skills;

·       develop relationships withnew types of channel partners who are capable of both selling more advancedproducts and extending our reach into new and existing markets; and

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·       establishpresence in key geographic markets.

Our investments aretargeted around achieving our strategic vision of Intelligent Communications. Ourvision may fail to predict our customers’ business needs or changes in technologicaltrends, which may adversely affect our operating results. If we do notsuccessfully execute our strategy, our operating results may be adverselyaffected.

**The market opportunity for advanced communicationsproducts, applications and services, including IP communications solutions, maynot develop in the ways that we anticipate.**

The demand for ourproducts can change quickly and in ways that we may not anticipate because themarket is characterized by rapid, and sometimes disruptive, technological developments,evolving industry standards, frequent new product introductions andenhancements, changes in customer requirements and a limited ability toaccurately forecast future customer orders. Our operating results may beadversely affected if the market opportunity for advanced communicationsproducts, applications and services, including IP telephony solutions, does notdevelop in the ways that we anticipate. The ratio of revenue attributable to IPtelephony solutions versus traditional voice communication systems is expectedto increase as more and more companies convert to IP telephony solutions. However,IP lines currently constitute a small percentage of global installed enterpriselines and if IP does not gain widespread acceptance in the marketplace as analternative replacement option for enterprise communications systems ouroverall revenue and operating results may be adversely affected. Even if we aresuccessful in increasing our revenue from sales of IP communications solutions,if revenue from traditional enterprise voice communications systems andservices declines faster than revenue from IP communications solutionsincreases, our overall revenue and operating results may be adversely affected.We cannot predict whether:

·       thedemand for advanced communications products, applications, and services,including IP solutions, will grow as quickly as we anticipate;

·       currentor future competitors or new technologies will cause the market to evolve in amanner different than we expect;

·       othertechnologies will become more accepted or standard in our industry; or

·       we will be able to maintaina leadership or profitable position as this opportunity develops.

**We face intense competition from our currentcompetitors and, as the enterprise communications and information technologymarkets evolve, may face increased competition from companies that do notcurrently compete directly against us.**

Historically, our GCS segment has competed againstother providers of enterprise voice communications solutions such as NortelNetworks Corporation, Siemens AG, Alcatel-Lucent and NEC Corporation. As wefocus on the development and marketing of advanced communications solutions,such as IP solutions, we face intense competition from these providers of voicecommunications solutions as well as from data networking companies such asCisco Systems, Inc. and 3Com Corp. The GCS segment also facescompetition in the small and medium business market from many competitors,including Cisco, Nortel, Alcatel-Lucent, NEC, Matsushita Electric Corporationof America, Inter-Tel, Incorporated, 3Com, and Mitel Networks Corp., althoughthe market for these products is fragmented. Our AGS segment competes withcompanies like those above offering services with respect to their own productofferings, as well as many consulting and systems integration firms and networkservice providers.

In addition, because themarket for our products is subject to rapid technological change, as the marketevolves we may face competition in the future from companies that do notcurrently compete in the enterprise communications market, including companiesthat currently compete in other sectors of the information technology,communications and software industries or communications companies that serve 

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residentialrather than enterprise customers. In particular, as the convergence ofenterprise voice and data networks becomes more widely deployed by enterprises,the business, information technology and communication applications deployed onconverged networks become more integrated. We may face increased competitionfrom current leaders in information technology infrastructure, informationtechnology, personal and business applications and the software that connectsthe network infrastructure to those applications, such as the alliance enteredinto between Microsoft Corp. and Nortel. We may also face competition fromcompanies that seek to sell remotely hosted services or software as a servicedirectly to the end customer. Competition from these potential market entrantsmay take many forms, including offering products and applications similar tothose we offer as part of another offering. In addition, these technologiescontinue to move from a proprietary environment to an open standards-basedenvironment.

Several of these existingcompetitors have, and many of our future competitors may have, greaterfinancial, personnel, research and other resources, more well-establishedbrands or reputations and broader customer bases than we and, as a result,these competitors may be in a stronger position to respond quickly to potentialacquisitions and other market opportunities, new or emerging technologies andchanges in customer requirements. Some of these competitors may have customerbases that are more geographically balanced than ours and, therefore, may beless affected by an economic downturn in a particular region. Competitors withgreater resources also may be able to offer lower prices, additional productsor services or other incentives that we cannot match or do not offer. Industryconsolidations such as the merger between Alcatel and Lucent Technologies Inc.may also create competitors with broader and more geographic coverage, with theability to reach enterprises through service provider customers.

In addition, existingcustomers of data networking companies that compete against us may be inclinedto purchase enterprise communications solutions from their current datanetworking vendor rather than from us. Also, as communications and datanetworks converge, we may face competition from systems integrators thattraditionally have been focused on data network integration. We cannot predictwith precision which competitors may enter our markets in the future, what formsuch competition may take or whether we will be able to respond effectively tothe entry of new competitors into our markets or the rapid evolution intechnology and product development that has characterized our markets. Inaddition, in order to effectively compete with any new market entrant, we mayneed to make additional investments in our business or use more capitalresources than our business currently requires or reduce prices, which mayadversely affect our profitability.

**Ourrevenues are dependent on general economic conditions and the willingness ofenterprises to make capital investments.**

One factor thatsignificantly affects our operating results is the impact of economicconditions on the willingness of enterprises to make capital investments,particularly in enterprise communications technology and related services.Although general economic conditions have improved in recent years, we believethat enterprises continue to be concerned about sustained economic growth and theyhave tried to maintain or improve profitability through cost control andconstrained capital spending. Because it is not certain whether enterpriseswill increase spending on enterprise communications technology significantly inthe near term, we could experience continued pressure on our ability toincrease our revenue. Our ability to grow revenue is also affected by otherfactors, such as competitive pricing pressures and price erosion, see Item 2. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—KeyTrends and Uncertainties Affecting Our Results—Trends and UncertaintiesAffecting Our Revenue—Technology transition,” “—Competitive environment’’ and “—Pressureson services business.”

If these or otherconditions limit our ability to grow revenue or cause our revenue to declineand we cannot reduce costs on a timely basis or at all, our operating resultswill be adversely affected.

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***Risks Related To Our Operations***

**We rely on outsourced product manufacturers,distributors and warehousing agents for our products andvarious issues with respect to the delivery of our products could arise whichcould adversely impact both our revenue and our costs.**

We have outsourced substantially all of ourmanufacturing operations and we may experience significant disruption to ouroperations by outsourcing too much of our manufacturing. Our ability to realizethe intended benefits of our manufacturing outsourcing initiative depends onthe willingness and ability of our contract manufacturers to produce ourproducts. If a contract manufacturer terminates its relationship with us or isunable to fill our orders on a timely basis or in accordance with our qualityrequirements, we may be unable to deliver the affected products to meet ourcustomers’ orders, which could delay or decrease our revenue or otherwise havean adverse effect on our operations. In fiscal 2006 we experienced these typesof disruptions and delays and they impacted our ability to meet timelines forcertain of our customer requirements. In addition, we periodically review ourproduct manufacturing operations and consider appropriate changes as necessary.Although we endeavor to appropriately manage any disruption in transitioningfrom one contract manufacturer to another contract manufacturer, we mayexperience significant disruption to our operations during any contractmanufacturer transition, and did experience such a disruption recently whilemaking this type of transition.

As we continue to seek to optimize our end-to-endsupply chain, we have outsourced various logistics functions. We rely onthird-party logistics (3PL) service providers to provide certain services forour business, including warehousing, physical distribution, repairs and returnsprocessing. If a logistics service provider does not meet our service level andquality requirements, we may be unable to fulfill our customers’ orders or meetcertain customer support obligations in a timely and accurate manner, whichcould delay or decrease our revenue or otherwise have an adverse effect on ourrevenue and our costs. In the fourth quarter of fiscal 2006 and first quarterof fiscal 2007, we moved certain warehousing and physical distributionoperations to a different 3PL service provider at a new facility. That providerand facility provide our 3PL needs in North America and certain 3PL needsoutside of North America. There were disruptions and delays in delivery ofcertain products from this facility in the first quarter of fiscal 2007. Additionally,there was an adverse impact on our costs at this facility throughout the firsthalf of fiscal 2007. We and the 3PL service provider operating this facilitycontinue to work to promote stability in the 3PL operations there. We have beenmaking improvements as we progress through this transition. However, we cannotassure you that this issue will not continue to have an adverse effect on ourrevenue and increase our costs.

We also rely on outside sources for the supply of thecomponents of our products and for the finished products that we purchase fromthird parties. In some cases certain components are only available from asingle source or from a limited number of suppliers. Delays or shortagesassociated with these components could cause significant disruption to ouroperations. We have in the past experienced component shortages that haveaffected our operations and we may in the future experience these shortages. Shortagescould be a result of manufacturing or capacity issues at our outsourcedmanufacturers or suppliers or strong demand for certain products for which wehave not made adequate forecasts. Our operating results could be adverselyaffected if shortages or delays persist or if the price of the necessarycomponents increases or the components become unavailable at reasonable pricesor at all.

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For more informationconcerning the risks associated with our contract manufacturers operatinginternationally, please see “—Risks Related To Our Operations—As ourinternational business has grown significantly in the last fiscal year, changesin economic or political conditions in a specific country or region couldnegatively affect our revenue, costs, expenses and financial condition.”

**If we are unable to integrate acquired businesses intoours effectively, our operating results may be adversely affected. Even if weare successful, the integration of these businesses has required, and willlikely continue to require, significant resources and management attention.**

We may not be able tosuccessfully integrate acquired businesses into ours, and therefore we may notbe able to realize the intended benefits from an acquisition. If we fail tosuccessfully integrate these acquisitions or if they fail to perform as weanticipated, our existing businesses and our revenue and operating resultscould be adversely affected. If the due diligence of the operations of theseacquired businesses performed by us and by third parties on our behalf wereinadequate or flawed, or if we later discover unforeseen financial or businessliabilities, the acquired businesses may not perform as expected. Additionally,acquisitions could result in difficulties assimilating acquired operations andproducts and the diversion of capital and management’s attention away fromother business issues and opportunities. To the extent that the Company expandsinternationally through acquisitions and fails to identify and respond tocross-cultural employee issues appropriately, it may fail to retain employeesacquired through those acquisitions, which may negatively impact itsintegration efforts. Acquisitions could also have a negative impact on ourresults of operations if it is subsequently determined that goodwill or otheracquired intangible assets are impaired, thus resulting in an impairment chargein a future period. Finally, acquisitions often necessitate restructurings inorder to optimize the operational performance of the combined entity and tocontrol costs and expenses. These restructurings are more difficult due tolabor laws and required approvals when the acquired business is a companyoperating in multiple and/or non-U.S. jurisdictions, which may hindercompletion of restructuring actions in a timely and efficient manner and delayanticipated cost savings.

**We are dependent on our intellectual property. If weare not able to protect our proprietary rights or if those rights areinvalidated or circumvented, our business may be adversely affected.**

We believe that developingnew products and technology is critical to our success. As a leader intechnology and innovation in the telecommunications services, applications andservices industries, we are dependent on the maintenance of our currentintellectual property rights and the establishment of new intellectual propertyrights. We generally protect our intellectual property through patents,trademarks, trade secrets, copyrights, confidentiality and nondisclosureagreements and other measures. We cannot assure you that patents will be issuedfrom pending applications that we have filed or that our patents will besufficient to protect our key technology. Although we have been granted manypatents, have obtained other intellectual property rights and continue to filenew patent applications and seek additional proprietary rights, there can be noassurances made that any of our patents, patent applications or our otherproprietary rights will not be challenged, invalidated, or circumvented. Inaddition, our business is global and the level of protection of our proprietarytechnology will vary by country, particularly in countries that do not havewell-developed judicial systems or laws that adequately protect intellectualproperty rights and any actions taken in these countries may have results thatare different than if such actions were taken under the laws of the UnitedStates. Patent litigation and other challenges to our patents and other proprietaryrights are costly and unpredictable and may result in preventing us frommarketing and selling a product in a particular geographic area. Patentfilings by third parties, whether made before or after the date of our filings,could render our intellectual property less valuable. Competitors and othersmay also misappropriate our intellectual property, disputes as to ownership ofintellectual property may arise and our intellectual property may otherwisefall into the public domain. If 

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we areunable to protect our proprietary rights, we may be at a disadvantage to otherswho did not incur the substantial time and expense required to create theproducts that we have created.

**The failure to maintain adequate security over ourinformation systems could adversely affect our operating results.**

We rely on the security ofour information systems, among other things, to protect our proprietaryinformation and information of our customers. Information technology systemfailures, including a breach of our data security, could disrupt our ability tofunction in the normal course of business by potentially causing, among otherthings, delays in the fulfillment or cancellation of customer orders,disruptions in the manufacture or shipment of products, or an unintentionaldisclosure of customer or our information. Additionally, if we do not maintainadequate security procedures over our information systems, we may be subject toconsequences such as computer hacking, cyber-terrorism or other unauthorizedattempts by third parties to access our or our customers’ proprietaryinformation. Even if we are able to maintain procedures that are adequate toaddress current security risks, unauthorized users may be able to develop newtechniques that will enable them to successfully circumvent our currentsecurity procedures. The failure to protect our proprietary information couldseriously harm our business and future prospects or expose us to claims by ourcustomers, employees or others that we did not take the appropriate measures toadequately protect their proprietary information. We have taken steps toaddress these concerns for our information systems by implementing networksecurity and internal control measures. However, an information system failureor data security breach of ours or a third-party vendor could have a materialadverse effect on our operating results.

**As our international business has grown significantlyin the last two fiscal years, changes in economic or political conditions in aspecific country or region could negatively affect our revenue, costs, expensesand financial condition.**

We conduct significantsales and customer support operations in countries outside of the United Statesand also depend on non-U.S. operations of our contract manufacturers and ourdistribution partners. For the first nine months of fiscal 2007 and 2006, wederived 44% and 42% of our revenue, respectively, from sales outside the UnitedStates. Our future international operating results, including our ability toimport our products to, export our products from, or sell our products invarious countries, could be materially adversely affected by a variety ofuncontrollable and changing factors. These factors include political conditions,economic conditions, legal and regulatory constraints, currency regulations,health or similar issues, natural disasters and other matters in any of thecountries or regions in which we currently operate or intend to operate in thefuture. Currently, we have concerns about weakness and uncertainty in Europeaneconomies, including high unemployment levels and low economic growthforecasts, particularly in Germany where we have a high concentration of ourbusiness.

Other factors which may impact our internationaloperations include foreign trade, environmental, monetary and fiscal policies,laws, regulations and other activities of foreign governments, agencies andsimilar organizations, and risks associated with having facilities located incountries which have historically been less stable than the United States. Forexample, the EU has enacted the RoHS and WEEE directives, which are discussedin Item 2. “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Key Trends and Uncertainties Affecting Our Results—Manufacturingand Logistics.” 

Additional risks inherentin our international operations generally include, among others, the costs anddifficulties of managing international operations, adverse tax consequences,including imposition of withholding or other taxes on payments by subsidiaries,and greater difficulty in enforcing intellectual property rights. Our effectivetax rates in the future could be adversely affected if the geographicaldistribution of our earnings and losses is unfavorable, by changes in thevaluation of our deferred tax assets 

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orliabilities, or by changes in tax laws, regulations, accounting principles, orinterpretations thereof. The various risks inherent in doing business in theUnited States generally also exist when doing business outside of the UnitedStates, and may be exaggerated by the difficulty of doing business in numeroussovereign jurisdictions due to differences in culture, laws and regulations.

**Fluctuations in foreign currency exchange rates couldnegatively impact our operating results.**

Since a significantportion of our business is conducted outside the United States, we faceexposure to movements in currency exchange rates. Foreign currency exchangerates and fluctuations may have an impact on our revenue, costs or cash flowsfrom our international operations, which could adversely affect our financialperformance. Our primary currency exposures are to the euro, British pound,Indian rupee and Canadian dollar. These exposures may change over time asbusiness practices evolve and as the geographic mix of our business changes. Forexample, as our business grows in emerging markets, we may see an increase inour exposure to emerging market currencies, which can have high volatility. Anincrease in the value of the U.S. dollar could increase the real cost to ourcustomers of our products in those markets outside the United States, and aweakened U.S. dollar could increase the cost of local operating expenses andprocurement of raw materials. We may from time to time enter into foreignexchange forward contracts to reduce the short-term impact of foreign currencyfluctuations, however, any attempts to hedge against foreign currencyfluctuation risks may be unsuccessful and result in an adverse impact to ouroperating results.

***Risks Related to Contingent Liabilities***

**We may incur liabilities as a result of our obligationto indemnify, and to share certain liabilities with, Lucent in connection withour spin-off from Lucent in September 2000.**

Pursuant to the Contribution and DistributionAgreement, Lucent contributed to us substantially all of the assets,liabilities and operations associated with its enterprise networking businessesand distributed all of the outstanding shares of our common stock to itsstockholders. The Contribution and Distribution Agreement, among other things,provides that, in general, we will indemnify Lucent for all liabilitiesincluding certain pre-distribution tax obligations of Lucent relating to ourbusinesses and all contingent liabilities primarily relating to our businessesor otherwise assigned to us. In addition, the Contribution and DistributionAgreement provides that certain contingent liabilities not directlyidentifiable with one of the parties will be shared in the proportion of 90% byLucent and 10% by us. The Contribution and Distribution Agreement also providesthat contingent liabilities in excess of $50 million that are primarily relatedto Lucent’s businesses shall be borne 90% by Lucent and 10% by us andcontingent liabilities in excess of $50 million that are primarily related toour businesses shall be borne equally by the parties.

Please see Note 13, “Commitments andContingencies,” to our Consolidated Financial Statements for adescription of certain matters involving Lucent for which we have assumedresponsibility under the Contribution and Distribution Agreement.

We cannot assure you thatLucent will not submit a claim for indemnification or cost sharing to us inconnection with any future matter. In addition, our ability to assess theimpact of matters for which we may have to indemnify or share the cost withLucent is made more difficult by the fact that we do not control the defense ofthese matters.

**We may be subject to litigation and infringementclaims, which could cause us to incur significant expenses or prevent us fromselling our products or services.**

From time to time, we receive notices from thirdparties asserting that our proprietary or licensed products, systems andsoftware infringe their intellectual property rights. We cannot assure you thatthe number of these notices will not increase in the future and that otherswill not claim that our proprietary or 

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licensed products, systemsand software are infringing their intellectual property rights or that we donot in fact infringe those intellectual property rights. We may be unaware ofintellectual property rights of others that may cover some of our technology.Irrespective of the merits of these claims, if someone claimed that our proprietaryor licensed systems and software infringed their intellectual property rights,any resulting litigation could be costly and time consuming and would divertthe attention of management and key personnel from other business issues. Thecomplexity of the technology involved and the uncertainty of intellectualproperty litigation increase these risks. These matters may result in anynumber of outcomes for us, including entering into licensing agreements,redesigning our products to avoid infringement, being enjoined from sellingproducts that are found to infringe, paying damages if products are found toinfringe, and indemnifying customers from claims as part of our contractualobligations. Royalty or license agreements may be very costly or we may beunable to obtain royalty or license agreements on terms acceptable to us or atall. We also may be subject to significant damages or an injunction against usor our proprietary or licensed systems. A successful claim of patent or otherintellectual property infringement against us could materially adversely affectour operating results. We have made and will likely continue to makeinvestments to license and/or acquire the use of third party intellectualproperty rights and technology as part of our strategy to manage this risk, butwe cannot assure you that we will be successful. We may also be subject toadditional notice and other requirements to the extent we incorporate opensource software into our applications.

In addition, third partieshave claimed, and may in the future claim, that a customer’s use of ourproducts, systems or software infringes the third party’s intellectual propertyrights. Under certain circumstances, we may be required to indemnify ourcustomers for some of the costs and damages related to such an infringementclaim. Any indemnification requirement could have a material adverse effect onour business and our operating results.

**If the distribution does not qualify for tax-freetreatment, we could be required to pay Lucent or the Internal Revenue Service asubstantial amount of money.**

Lucent has received a private letter ruling from theInternal Revenue Service stating, based on certain assumptions andrepresentations, that the distribution would not be taxable to Lucent.Nevertheless, Lucent could incur a significant tax liability if thedistribution did not qualify for tax-free treatment because any of thoseassumptions or representations were not correct.

We could be liable for all or a portion of any taxesowed for the following reasons. First, as part of the distribution, we andLucent entered into the Tax Sharing Agreement, which generally allocatesbetween Lucent and us the taxes and liabilities relating to the failure of thedistribution to be tax-free. Under the Tax Sharing Agreement, if thedistribution fails to qualify as a tax-free distribution because of an issuanceor an acquisition of our stock or an acquisition of our assets, or some otheractions of ours, then we will be solely liable for any resulting taxes to Lucent.

Second, aside from the TaxSharing Agreement, under U.S. Federal income tax laws, we and Lucent arejointly and severally liable for Lucent’s U.S. Federal income taxes resultingfrom the distribution being taxable. This means that even if we do not have toindemnify Lucent under the Tax Sharing Agreement, we may still be liable forall or part of these taxes if Lucent fails to pay them. These liabilities ofLucent could arise from actions taken by Lucent over which we have no control,including an issuance or acquisition of stock (or acquisition of assets) ofLucent.

**Item2.**                        *Unregistered Sales of Equity Securities and Use of Proceeds.*

None.

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**Item3.**                        *Defaults Upon Senior Securities.*

None. 

**Item5.**                        *Other Information.*

We make available free of charge, through our investorrelations’ website, http://investors.Avaya.com, our Form 10-K, Form 10-Qand Form 8-K reports and all amendments to those reports as soon asreasonably practicable after such material is electronically filed with orfurnished to the Securities and Exchange Commission. 

As disclosed in theCompany’s Annual Proxy Statement on Schedule 14A filed with the SEC on December 22,2006, Mark Leslie, one of the Company’s directors, had previously advised theBoard of Directors that he received a “Wells Notice” that the SEC may commencea civil enforcement action against him in connection with his previous serviceswhile an employee of Veritas Software Corporation (now Symantec Corporation) in2000 and 2001. The relevant transactions predated Mr. Leslie’s tenure as aDirector of the Company, and the SEC’s inquiry is not directed at, and does notconcern, the Company or any other member of the Board of management. On July 2,2007, the SEC announced that is has filed civil fraud charges in the UnitedStates District Court for the Northern District of California against fiveformer executives at Veritas, including Mr. Leslie. The SEC’s complaintalleges that Mr. Leslie, among others, artificially inflated and/ormanipulated Veritas’ reported financial results and misled Veritas’ independentauditors in connection with two transactions with AOL in September 2000.

**Item6.**                        *Exhibits.*
| Exhibit Number | ** ** | ** **                                                                                                                                                    | ** ** | ** ** |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| 2.1            |       | Agreement and Plan of  Merger, dated as of June 4, 2007, by and among Avaya Inc., Sierra  Holdings Corp. and Sierra Merger Corp.(1)                      |
| 3.1            |       | Restated  Certificate of Incorporation of Avaya Inc.(2)                                                                                                       |
| 3.2            |       | Amended and  Restated By-laws of Avaya Inc., as amended on July 18, 2002.(3)                                                                             |
| 10.1           |       | Form of  Severance Agreement for Senior Officers.*                                                                                                       |
| 10.2           |       | Form of  Amendment to Severance Agreement for Senior Officers.*                                                                                          |
| 10.3           |       | Avaya Inc.  Deferred Compensation Plan, as amended.*                                                                                                          |
| 31.1           |       | Certification of  Principal Executive Officer Pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.* |
| 31.2           |       | Certification of  Principal Financial Officer Pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.* |
| 32.1           |       | Certification of  Principal Executive Officer pursuant to18 U.S.C. Section 1350.*                                                                        |
| 32.2           |       | Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350.*                                                                       |

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*                    Filedherewith.

(1)          Incorporated byreference from Exhibit 2.1 to Avaya’s Current Report on Form 8-Kfiled with the SEC on June 5, 2007.

(2)          Incorporated by referencefrom Exhibit 3.1 to Amendment No. 1 to Avaya’s Registration Statementon Form 10 (Reg. No. 1-15951) filed with the SEC on August 9,2000.

(3)          Incorporated byreference from Exhibit 3.1 to Avaya’s Quarterly Report on Form 10-Qfor the quarter ended June 30, 2002, filed with the SEC on August 14,2002.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                     | AVAYA INC. |
|---------------------|------------|
|                | By:        | /s/  AMARNATH K. PAI |
|                | * *   | Amarnath K. Pai*Vice President Finance Operations and   Corporate Controller   (Principal Accounting Officer)* |
| August 6, 2007 |       |   |

 

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