**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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FORM 10-Q
| x | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|--------------------------------------------------------------------------------------------------------|

 

**ForThe Quarterly Period Ended March 31, 2005**

**OR**
| o | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|---------------------------------------------------------------------------------------------------------|

 

**CommissionFile Number 001-15951**

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AVAYA INC.

| **A DELAWARE  CORPORATION** | ** ** | **I.R.S.  EMPLOYER  NO. 22-3713430** |
|-----------------------------|------------|--------------------------------------|

 

**211Mount Airy Road, Basking Ridge, New Jersey 07920Telephone Number 908-953-6000**

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Indicate by check mark whetherthe 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 an accelerated filer (as defined by 12(b)-2 ofthe Securities and Exchange Act of 1934). Yes  x   No  o

As of April 30, 2005, 477,043,010 common shareswere outstanding.

 

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**TABLE OF CONTENTS**
| Item                                   | ** **   | **Description**                                                                             | ** ** | **Page** |
|----------------------------------------|--------------|---------------------------------------------------------------------------------------------|------------|----------|
| **PART I  FINANCIAL INFORMATION** |         |                                                                                        |       |     |
| 1.                                     |         | Financial  Statements                                                                       |       |     | 3 |   |
| 2.                                     |         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       |     | 29 |   |
| 3.                                     |         | Quantitative  and Qualitative Disclosures About Market Risk                                 |       |     | 59 |   |
| 4.                                     |         | Controls  and Procedures                                                                    |       |     | 59 |   |
| **PART II OTHER  INFORMATION**    |         |                                                                                        |       |     |
| 1.                                     |         | Legal  Proceedings                                                                          |       |     | 61 |   |
| 2.                                     | *** *** | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities           |       |     | 61 |   |
| 3.                                     |         | Defaults  Upon Senior Securities                                                            |       |     | 61 |   |
| 4.                                     |         | Submission  of Matters to a Vote of Security Holders                                        |       |     | 61 |   |
| 5.                                     |         | Other  Information                                                                          |       |     | 61 |   |
| 6.                                     |         | Exhibits                                                                                    |       |     | 61 |   |
|                                   |         | Signatures                                                                                  |       |     | 62 |   |

 

This Quarterly Report on Form 10-Q containstrademarks, service marks and registered marks of Avaya and its subsidiariesand other companies, as indicated. Unless otherwise provided in this QuarterlyReport on Form 10-Q, trademarks identified by ® and TM are registeredtrademarks or trademarks, respectively, of Avaya Inc. or its subsidiaries. Allother trademarks are the properties of their respective owners. Liquid YieldOptionTM Notes is a trademark of Merrill, Lynch & Co., Inc.

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**Item 1.**                        *Financial Statements*

**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFINCOME**
| ** **                                                                                       | ** ** | **Three months ended** | ** ** | **Six months ended**                           | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **March 31,**               | ** ** | **March 31,**                                       | ** ** |
| **Dollars in millions, except per share amounts (unaudited)** | ** ** | ** **                       | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUE                                                                                          |       |                             |       |                                                     |       |   |   |   |   |
| Sales of products                                                                                |       | $                                | 543        |                                                     | $          | 495 |   | $ | 1,097 |   | $ | 977 |   |
| Services                                                                                         |       | 498                              |       | 445                                                      |       | 975 |   | 861 |   |
| Rental and managed  services                                                                     |       | 181                              |       | 66                                                       |       | 298 |   | 139 |   |
|                                                                                             |       | 1,222                            |       | 1,006                                                    |       | 2,370 |   | 1,977 |   |
| COSTS                                                                                            |       |                             |       |                                                     |       |   |   |   |   |
| Sales of products                                                                                |       | 245                              |       | 236                                                      |       | 490 |   | 458 |   |
| Services                                                                                         |       | 339                              |       | 264                                                      |       | 647 |   | 530 |   |
| Rental and managed  services                                                                     |       | 75                               |       | 35                                                       |       | 127 |   | 70 |   |
|                                                                                             |       | 659                              |       | 535                                                      |       | 1,264 |   | 1,058 |   |
| GROSS MARGIN                                                                                     |       | 563                              |       | 471                                                      |       | 1,106 |   | 919 |   |
| OPERATING EXPENSES                                                                               |       |                             |       |                                                     |       |   |   |   |   |
| Selling, general and  administrative                                                             |       | 406                              |       | 328                                                      |       | 763 |   | 641 |   |
| Research and development                                                                         |       | 105                              |       | 83                                                       |       | 203 |   | 166 |   |
| TOTAL OPERATING EXPENSES                                                                         |       | 511                              |       | 411                                                      |       | 966 |   | 807 |   |
| OPERATING INCOME                                                                                 |       | 52                               |       | 60                                                       |       | 140 |   | 112 |   |
| Other income (expense),  net                                                                     |       | —                           |       | (19                                                      | )          | (38 | ) | (13 | ) |
| Interest expense                                                                                 |       | (5                               | )          | (19                                                      | )          | (15 | ) | (40 | ) |
| INCOME FROM CONTINUING  OPERATIONS BEFORE INCOME TAXES                                      |       | 47                               |       | 22                                                       |       | 87 |   | 59 |   |
| Provision for (benefit  from) income taxes                                                       |       | 11                               |       | (81                                                      | )          | 18 |   | (74 | ) |
| INCOME FROM CONTINUING  OPERATIONS                                                               |       | 36                               |       | 103                                                      |       | 69 |   | 133 |   |
| DISCONTINUED OPERATIONS                                                                          |       |                             |       |                                                     |       |   |   |   |   |
| Income (loss) from  discontinued operations                                                      |       | —                           |       | 21                                                       |       | (2 | ) | 3 |   |
| (Benefit from) provision  for income taxes                                                       |       | —                           |       | (1                                                       | )          | — |   | 1 |   |
| INCOME (LOSS) FROM  DISCONTINUED  OPERATIONS                                                     |       | —                           |       | 22                                                       |       | (2 | ) | 2 |   |
| **NET  INCOME**                                                                                  | ** ** | **$**                            | **36**     | ** **                                               | **$**      | **125** | ** ** | **$** | **67** |   | **$** | **135** |   |
| **Earnings Per Common Share—Basic:**                                                        |       |                             |       |                                                     |       |   |   |   |   |
| Earnings per share from  continuing operations                                                   |       | $                                | 0.08       |                                                     | $          | 0.24 |   | $ | 0.15 |   | $ | 0.31 |   |
| Earnings (loss) per  share from discontinued operations                                          |       | —                           |       | 0.05                                                     |       | (0.01 | ) | — |   |
| Earnings per share                                                                               |       | $                                | 0.08       |                                                     | $          | 0.29 |   | $ | 0.14 |   | $ | 0.31 |   |
| **Earnings Per Common Share—Diluted:**                                                      |       |                             |       |                                                     |       |   |   |   |   |
| Earnings per share from  continuing operations                                                   |       | $                                | 0.07       |                                                     | $          | 0.22 |   | $ | 0.15 |   | $ | 0.30 |   |
| Earnings (loss) per  share from discontinued operations                                          |       | —                           |       | 0.05                                                     |       | (0.01 | ) | — |   |
| Earnings per share                                                                               |       | $                                | 0.07       |                                                     | $          | 0.27 |   | $ | 0.14 |   | $ | 0.30 |   |
|                                                                                                  |            |                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |

 

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**
| **Dollars in millions,  except per share amounts (unaudited)**                                                                                                                                     | ** ** | ** ** | ** ** | **March 31,  2005** | ** ** | **September 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|--------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                  |       |       |       |                     |       |                         |       | ** ** |   |
| Current assets:                                                                                                                                                                                                             |       |       |       |                     |       |                         |       | ** ** |   |
| Cash and cash equivalents                                                                                                                                                                                                   |       |       | $          | 855                      |       |                         |       | $ | 1,617 | ** ** |   |
| Receivables, less allowances of $44 million and $48  million as of March 31, 2005 and September 30, 2004, respectively                                                                                            |       |       | 793        |                     |       |                         | 696        | ** ** |   |
| Inventory                                                                                                                                                                                                                   |       |       | 364        |                     |       |                         | 239        | ** ** |   |
| Deferred income taxes, net                                                                                                                                                                                                  |       |       | 69         |                     |       |                         | 27         | ** ** |   |
| Other current assets                                                                                                                                                                                                        |       |       | 139        |                     |       |                         | 145        | ** ** |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                                       |       |       | 2,220      |                     |       |                         | 2,724      | ** ** |   |
| Property, plant and equipment, net                                                                                                                                                                                          |       |       | 747        |                     |       |                         | 509        | ** ** |   |
| Deferred income taxes, net                                                                                                                                                                                                  |       |       | 360        |                     |       |                         | 400        | ** ** |   |
| Goodwill                                                                                                                                                                                                                    |       |       | 939        |                     |       |                         | 257        | ** ** |   |
| Other intangible assets, net                                                                                                                                                                                                |       |       | 390        |                     |       |                         | 75         | ** ** |   |
| Other assets                                                                                                                                                                                                                |       |       | 187        |                     |       |                         | 194        | ** ** |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                           | ** ** | ** ** | **$**      | **4,843**                |       |                         |       | **$** | **4,159** | ** ** |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                              |       |       |       |                     |       |                         |       | ** ** |   |
| Current liabilities:                                                                                                                                                                                                        |       |       |       |                     |       |                         |       | ** ** |   |
| Accounts payable                                                                                                                                                                                                            |       |       | $          | 403                      |       |                         |       | $ | 345 | ** ** |   |
| Debt maturing within one year                                                                                                                                                                                               |       |       | 74         |                     |       |                         | 299        | ** ** |   |
| Payroll and benefit obligations                                                                                                                                                                                             |       |       | 289        |                     |       |                         | 328        | ** ** |   |
| Deferred revenue                                                                                                                                                                                                            |       |       | 234        |                     |       |                         | 178        | ** ** |   |
| Other current liabilities                                                                                                                                                                                                   |       |       | 365        |                     |       |                         | 273        | ** ** |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                  |       |       | 1,365      |                     |       |                         | 1,423      | ** ** |   |
| Long-term debt                                                                                                                                                                                                              |       |       | 114        |                     |       |                         | 294        | ** ** |   |
| Benefit obligations                                                                                                                                                                                                         |       |       | 1,595      |                     |       |                         | 1,263      | ** ** |   |
| Deferred income taxes                                                                                                                                                                                                       |       |       | 119        |                     |       |                         | —     | ** ** |   |
| Other liabilities                                                                                                                                                                                                           |       |       | 411        |                     |       |                         | 385        | ** ** |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                              |       |       | 2,239      |                     |       |                         | 1,942      | ** ** |   |
| 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, 480,984,308 and 455,827,524 issued (including 109,873 and  0 treasury shares) as of March 31, 2005 and September 30, 2004,  respectively |       |       | 5          |                     |       |                         | 5          | ** ** |   |
| Additional paid-in-capital                                                                                                                                                                                                  |       |       | 2,936      |                     |       |                         | 2,592      | ** ** |   |
| Accumulated deficit                                                                                                                                                                                                         |       |       | (907       | )                        |       |                         | (974       | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                                        |       |       | (793       | )                        |       |                         | (829       | ) |   |
| Less: Treasury stock at cost                                                                                                                                                                                                |       |       | (2         | )                        |       |                         | —     | ** ** |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                            |       |       | 1,239      |                     |       |                         | 794        | ** ** |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                        | ** ** | ** ** | **$**      | **4,843**                |       | ** **                   | ** ** | **$** | **4,159** | ** ** |   |

 

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                                 | ** ** | **Six months ended** | ** **            |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------|-----------------------|
| ** **                                                                                                 | ** ** | **March 31,**             | ** **            |
| **Dollars in millions  (unaudited)**                                                             | ** ** | ** **                     | ** **            | **     2005     ** | ** ** | **     2004     ** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                  |       |                           |                  |   |   |   |   |   |   |
| Net income                                                                                                 |       |                           | $   67 |   |   |   | $ 135 |   |   |
| Less: (Loss)  income from discontinued operations, net                                                     |       |                           | (2                    | ) |   |   | 2 |   |   |
| Income from  continuing operations                                                                         |       |                           | 69                    |   |   |   | 133 |   |   |
| Adjustments to reconcile  income from continuing operations to net cash provided by operating  activities: |       |                           |                  |   |   |   |   |   |   |
| Depreciation and  amortization                                                                             |       |                           | 130                   |   |   |   | 79 |   |   |
| Loss on  extinguishment of debt, net                                                                       |       |                           | 43                    |   |   |   | 21 |   |   |
| Purchased  in-process research and development                                                             |       |                           | 4                     |   |   |   | — |   |   |
| Deferred taxes                                                                                             |       |                           | 6                     |   |   |   | 5 |   |   |
| Reversal of  liabilities related to tax settlement                                                         |       |                           | —                |   |   |   | (47 | ) |   |
| Provision for  uncollectible receivables                                                                   |       |                           | 7                     |   |   |   | 7 |   |   |
| Amortization of  restricted stock units                                                                    |       |                           | 5                     |   |   |   | 10 |   |   |
| Unrealized losses  on foreign currency exchange                                                            |       |                           | 19                    |   |   |   | 34 |   |   |
| Adjustments for  other non-cash items, net                                                                 |       |                           | (13                   | ) |   |   | 3 |   |   |
| Changes in operating  assets and liabilities, net of effects of acquired businesses:                       |       |                           |                  |   |   |   |   |   |   |
| Receivables                                                                                                |       |                           | 16                    |   |   |   | 61 |   |   |
| Inventory                                                                                                  |       |                           | (30                   | ) |   |   | 19 |   |   |
| Restricted cash                                                                                            |       |                           | 9                     |   |   |   | (42 | ) |   |
| Accounts payable                                                                                           |       |                           | (21                   | ) |   |   | (37 | ) |   |
| Payroll and  benefits                                                                                      |       |                           | (133                  | ) |   |   | 13 |   |   |
| Accrued interest  payable on long-term debt                                                                |       |                           | (24                   | ) |   |   | (48 | ) |   |
| Deferred revenue                                                                                           |       |                           | (13                   | ) |   |   | (10 | ) |   |
| Other assets and  liabilities                                                                              |       |                           | (14                   | ) |   |   | (61 | ) |   |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                                                  |       |                           |                  |   |   |   |   |   |   |
| FROM CONTINUING  OPERATIONS                                                                                |       |                           | 60                    |   |   |   | 140 |   |   |
| **INVESTING ACTIVITIES:**                                                                                  |       |                           |                  |   |   |   |   |   |   |
| Capital  expenditures                                                                                      |       |                           | (56                   | ) |   |   | (32 | ) |   |
| Capitalized  software development costs                                                                    |       |                           | (27                   | ) |   |   | (19 | ) |   |
| Acquisitions of  businesses, net of cash acquired                                                          |       |                           | (383                  | ) |   |   | (103 | ) |   |
| (Payments)  proceeds from sales of discontinued operations                                                 |       |                           | (2                    | ) |   |   | 252 |   |   |
| Proceeds from sale  of CommScope common stock                                                              |       |                           | —                |   |   |   | 28 |   |   |
| Other investing  activities, net                                                                           |       |                           | 18                    |   |   |   | 5 |   |   |
| NET CASH (USED FOR) PROVIDED BY INVESTING ACTIVITIES                                                       |       |                           |                  |   |   |   |   |   |   |
| FROM CONTINUING  OPERATIONS                                                                                |       |                           | (450                  | ) |   |   | 131 |   |   |
| **FINANCING ACTIVITIES:**                                                                                  |       |                           |                  |   |   |   |   |   |   |
| Issuance of common  stock                                                                                  |       |                           | 40                    |   |   |   | 319 |   |   |
| Repayment of  long-term debt                                                                               |       |                           | (417                  | ) |   |   | (249 | ) |   |
| Other financing  activities, net                                                                           |       |                           | (3                    | ) |   |   | (2 | ) |   |
| NET CASH (USED FOR) PROVIDED BY FINANCING ACTIVITIES                                                       |       |                           |                  |   |   |   |   |   |   |
| FROM CONTINUING  OPERATIONS                                                                                |       |                           | (380                  | ) |   |   | 68 |   |   |
| Effect of exchange  rate changes on cash and cash equivalents                                              |       |                           | 8                     |   |   |   | 9 |   |   |
| Net (decrease)  increase in cash and cash equivalents from continuing operations                           |       |                           | (762                  | ) |   |   | 348 |   |   |
| Net decrease in  cash and cash equivalents from discontinued operations                                    |       |                           | —                |   |   |   | (24 | ) |   |
| Cash and cash  equivalents at beginning of fiscal year                                                     |       |                           | 1,617                 |   |   |   | 1,192 |   |   |
| Cash and cash  equivalents at end of period                                                                |       |                           | $ 855            |   |   |   | $ 1,516 |   |   |
|                                                                                                            |            |                                |                       |  |  |  |  |  |  |  |  |

 

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESNOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**1.**   Backgroundand Basis of Presentation

***Background***

Avaya Inc. (the “Company” or “Avaya”) providescommunication systems, applications and services for enterprises, includingbusinesses, government agencies and other organizations. The Company’s productofferings include Internet Protocol (“IP”) telephony systems and traditionalvoice communications systems, multi-media contact center infrastructure andapplications in support of customer relationship management, unifiedcommunications applications and appliances, such as IP telephone sets. TheCompany supports its broad customer base with comprehensive global serviceofferings that enable our customers to plan, design, implement, monitor andmanage their communications networks.

We were incorporated under the laws of theState of Delaware under the name “Lucent EN Corp.” on February 16, 2000,as a wholly owned subsidiary of Lucent Technologies Inc. (“Lucent”). As of June 27,2000, our name was changed to “Avaya Inc.” On September 30, 2000, Lucentcontributed its enterprise networking business to us and distributed all of theoutstanding shares of our capital stock to its shareowners. We refer to thesetransactions in this Quarterly Report on Form 10-Q as the “distribution.”Prior to the distribution, we had no material assets or activities as aseparate corporate entity. Following the distribution, we became an independentpublic company, and Lucent has no continuing stock ownership interest in us.

***Basis of Presentation***

The accompanying unaudited consolidated financialstatements as of March 31, 2005 and for the three and six months ended March 31,2005 and 2004, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the Securities and Exchange Commission for interim financial statements, andshould be read in conjunction with the Company’s consolidated financialstatements and other financial information for the fiscal year ended September 30,2004, which were included in its Annual Report on Form 10-K filedwith the Securities and Exchange Commission on December 13, 2004. In theCompany’s opinion, the unaudited interim consolidated financial statementsreflect all adjustments, consisting of normal and recurring adjustments,necessary for a fair presentation of the financial condition, results ofoperations and cash flows for the periods indicated. Certain prior year amountshave been reclassified to conform to the current interim period presentation. Theconsolidated results of operations for the interim periods reported are notnecessarily indicative of the results to be experienced for the entire fiscalyear.

In order to better reflectthe way the Company manages the business, beginning in October 2004, theCompany began reporting its results in two operating segments—GlobalCommunications Solutions (“GCS”) and Avaya Global Services (“AGS”).

**2.   Summary ofSignificant Accounting Policies**

***Stock Compensation***

The Company’s employees participate in stock optionplans and stock purchase plans. The Company applies the recognition andmeasurement principles of Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”) and related interpretations inaccounting for such stock compensation. Accordingly, no stock-basedemployee compensation cost related to stock options is reflected in the Company’sConsolidated Statements of Income, as all options granted under the 

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plan had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant. The Company records compensation expense for the amortization ofrestricted stock units issued to employees based on the fair market value ofthe restricted stock units at the date of grant over the vesting period, whichis typically three years.

Thefollowing table illustrates the effect on net income and earnings per share asif the Company had applied the fair value recognition provisions of Statementof Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-BasedCompensation” as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure.”
| ** **                                                                                                                | ** ** | **Three months ended** | ** ** | **Six months ended**               | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **March 31,**               | ** ** | **March 31,**                           | ** ** |
| **Dollars in millions, except per share amounts**                                           | ** ** | ** **                       | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| Net income, as  reported                                                                                                  |       |                             | $          | 36                                           |       |   |   | $ | 125 |   |   |   | $ | 67 |   |   |   | $ | 135 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects              |       |                             | 2          |                                         |       |   | 2 |   |   |   | 3 |   |   |   | 6 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based  method, net of related tax effects |       |                             | (11        | )                                            |       |   | (7 | ) |   |   | (19 | ) |   |   | (16 | ) |   |
| Net income, pro  forma                                                                                                    |       |                             | $          | 27                                           |       |   |   | $ | 120 |   |   |   | $ | 51 |   |   |   | $ | 125 |   |   |
| Earnings per  Common Share—Basic:                                                                                    |       |                             |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                             | $          | 0.08                                         |       |   |   | $ | 0.29 |   |   |   | $ | 0.14 |   |   |   | $ | 0.31 |   |   |
| Pro forma                                                                                                                 |       |                             | $          | 0.06                                         |       |   |   | $ | 0.27 |   |   |   | $ | 0.11 |   |   |   | $ | 0.29 |   |   |
| Earnings per  Common Share—Diluted:                                                                                  |       |                             |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                             | $          | 0.07                                         |       |   |   | $ | 0.27 |   |   |   | $ | 0.14 |   |   |   | $ | 0.30 |   |   |
| Pro forma                                                                                                                 |       |                             | $          | 0.06                                         |       |   |   | $ | 0.26 |   |   |   | $ | 0.11 |   |   |   | $ | 0.28 |   |   |
|                                                                                                                           |            |                                  |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**3.   RecentAccounting Pronouncement**

***SFAS 123(R)***

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004), “Share-Based Payment,” (“SFAS 123(R)”). SFAS 123(R) requires theCompany to recognize compensation expense for stock options and discounts underemployee stock purchase plans granted to employees based on the estimated fairvalue of the equity instrument at the time of grant. Currently, the Companydiscloses the pro forma net income and earnings per share as if the Companyapplied the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure.” Because of the deferral ofthe effective date of SFAS 123(R), which was announced by the SEC in April 2005,the requirements of SFAS 123(R) are effective for the Company beginning inthe first quarter of fiscal 2006. The Company is currently evaluating itsalternatives to determine how it will apply the provisions of SFAS 123(R).

**4.   BusinessCombinations and Other Transactions**

***Acquisition of Tenovis***

On November 18, 2004, the Company completed itsacquisition of Tenovis. Tenovis is the parent company of Avaya-Tenovis GmbH &Co. KG (formerly Tenovis GmbH & Co. KG), a major European provider ofenterprise communications systems and services. The acquisition of Tenovissignificantly expands the Company’s European operations and increases theCompany’s access to European customers, particularly in Germany. In connectionwith the share purchase agreement, Avaya paid $381 million in cash (whichincludes $10 million of transaction fees that were not paid to the sellers) andassumed $278 

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million in debt. Additionally,the Company acquired cash and cash equivalents of $116 million, resulting in anet cash outlay related to the acquisition of $265 million. Results ofoperations for Tenovis are included in Avaya’s consolidated results as of November 18,2004.

At the date of acquisition, the Company recordedTenovis’s accounts receivable, inventory, fixed assets, liabilities andidentified intangibles at estimated fair value. The remainder of the purchaseprice in excess of the net assets acquired was recorded as goodwill. TheCompany allocated $298 million to intangible assets (including contractualcustomer relationships, existing technology and trademarks) based on valuationstudies performed by third party valuation consultants. These intangible assetsare being amortized over their estimated useful lives. In addition, the Companyallocated $1 million to in-process research and development, which was writtenoff to research and development expense in the Consolidated Statement of Incomeduring the first quarter of fiscal 2005.

During the secondquarter of fiscal 2005, the preliminary purchase price allocation was adjustedupon completion of our review of additional information and final third partyvaluation reports. The following adjustments increased goodwill arising fromthe acquisition of Tenovis by $163 million to $611 million as of March 31,2005.

·       TheCompany adjusted its valuation of the acquired intangible assets and long-livedtangible assets. These valuations were based, in part, on valuation reports whichwere completed by third-party valuation consultants during the second quarterof fiscal 2005. As a result, the Company recorded a purchase price allocationadjustment to reduce acquired intangible assets by $103 million. Thisrepresents decreases of $50 million for existing technology, $31 million forcustomer contracts and relationships and $22 million for trademarks. Long-livedtangible assets were also reduced by $138 million, including the $88 milliondecrease discussed below related to a property subject to a sale-leasebackarrangement.

·       TheCompany increased the restructuring liability from $73 million to $87 millionto reflect the revised estimate of restructuring-related costs in accordancewith EITF 95-3. This liability is for costs to be incurred to terminateTenovis employees as part of the integration of Tenovis operations. During thesecond quarter, the Company finalized its plan for involuntary employeeterminations related to the acquisition. The amount to be ultimately paid issubject to regulatory approval. This increase was recorded as an adjustment tothe purchase price allocation. The final plan provides for the termination ofcertain employees across various Tenovis functional groups, including sales,operations, finance, human resources, etc. The terminations are planned to becompleted by the end of the third quarter of fiscal 2006. Since the acquisitiondate, termination payments aggregating $10 million have been paid and chargedagainst the liability. The accrual as of March 31, 2005 is $77 million.

·       InFebruary 2004, Tenovis entered into an arrangement to sell one of itsproperties to a third party and lease it back. As a result of certain terms,Tenovis was considered to have continuing involvement in the property, whichprecluded accounting for the arrangement as a sale under SFAS No. 98 regardingsale-leaseback transactions. The arrangement was initially recorded as asecured borrowing in the purchase price allocation. Subsequently the Companydetermined that the arrangement should be accounted for as an operating lease. Asa result, the preliminary purchase price allocation was adjusted, resulting inan $88 million reduction of fixed assets, $68 million reduction in debt and a$20 million reduction in goodwill.

·       Otheradjustments reflecting various changes to working capital accounts were basedupon additional information received during the second quarter of fiscal 2005.

·       Asa result of the above changes to the initial purchase price allocation, thedeferred tax liability included in the purchase price allocation was reduced by$41 million.

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These adjustments to the initial purchase priceallocation resulted from a comprehensive review by management of the draft thirdparty valuation reports and analysis of information received subsequent torecording the initial purchase price allocation to ensure that the fair valuesassigned to the acquired assets and liabilities are appropriately estimated. Asof March 31, 2005, the purchase price allocation is still subject to finaladjustment for amounts relating to the restructuring liability and to certainworking capital accounts, including accounts receivable and inventory. TheCompany expects to finalize the allocation of the purchase price for the assetsacquired and the liabilities assumed by the end of fiscal 2005.

Thefollowing table summarizes the estimated fair values of the assumed assets andliabilities as of the acquisition date, adjusted for items during the secondquarter of fiscal 2005:
| ** **                                                   | ** ** | **Preliminary**         | ** ** | **Adjusted**            | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                   | ** ** | **Purchase Price** | ** ** | **Purchase Price** | ** ** |
| **Dollars in millions**                            | ** ** | ** **              | ** ** | **Allocation**          | ** ** | **Allocation** | ** ** |
| Cash                                                         |       |                    | $          | 116                     |       |   |   | $ | 116 |   |   |
| Rental equipment                                             |       |                    | 132        |                    |       |   | 132 |   |   |
| Fixed assets                                                 |       |                    | 272        |                    |       |   | 134 |   |   |
| Intangible assets  and in-process research & development |       |                    | 402        |                    |       |   | 299 |   |   |
| Long-term debt                                               |       |                    | (347       | )                       |       |   | (278 | ) |   |
| Deferred tax  liability                                      |       |                    | (160       | )                       |       |   | (119 | ) |   |
| Restructuring                                                |       |                    | (73        | )                       |       |   | (87 | ) |   |
| Pension liability                                            |       |                    | (313       | )                       |       |   | (313 | ) |   |
| Working capital  and other assets and liabilities            |       |                    | (96        | )                       |       |   | (114 | ) |   |
| **Net assets acquired**                                      |       |                    | (67        | )                       |       |   | (230 | ) |   |
| Goodwill                                                     |       |                    | 448        |                    |       |   | 611 |   |   |
| **Purchase  price**                                          | ** ** | ** **              | **$**      | **381**                 |       | ** ** | ** ** | **$** | **381** |   |   |
|                                                              |            |                         |            |                         |            |  |  |  |  |  |  |  |  |

 

Thefollowing unaudited pro forma financial information presents the Company’sresults as if the Tenovis acquisition had occurred at the beginning of therespective periods:
| ** **                                                                      | ** ** | **  Three months  ** | ** ** | **Six months** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------|------------|
| ** **                                                                      | ** ** | **Ended**                                     | ** ** | **Ended**           | ** ** |
| ** **                                                                      | ** ** | **March 31,**                            | ** ** | **March 31,**  | ** ** |
| **Dollars in millions, except per share amounts** | ** ** | ** **                                    | ** ** | **2004**            | ** ** | **       2005       ** | ** ** | **      2004      ** | ** ** |
| Revenue                                                                         |       |                                          | $          | 1,235               |       |   |   | $ | 2,473 |   |   |   | $ | 2,500 |   |   |
| Net income                                                                      |       |                                          | $          | 97                  |       |   |   | $ | 41 |   |   |   | $ | 74 |   |   |
| Earnings per  share—basic                                                  |       |                                          | $          | 0.22                |       |   |   | $ | 0.09 |   |   |   | $ | 0.17 |   |   |
| Earnings per share—diluted                                                 |       |                                          | $          | 0.21                |       |   |   | $ | 0.08 |   |   |   | $ | 0.16 |   |   |
|                                                                                 |            |                                               |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

These pro forma results have been prepared forcomparative purposes only and include certain adjustments such as additionalestimated amortization expense as a result of identifiable intangible assetsarising from the acquisition. The pro forma results are not necessarilyindicative of the results of operations that actually would have resulted hadthe acquisition been in effect at the beginning of the respective periods or offuture results.

In connection with the acquisition, the Companyperformed an evaluation to identify the existence of any variable interestentities (“VIEs”) related to Tenovis. As a result of this evaluation, theCompany identified three VIEs and further determined the Company, through itsownership of Tenovis, was the primary beneficiary of all three VIEs. However,in accordance with FIN 46(R), “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51” (“FIN 46(R)”), the Company is not requiredto apply the provisions of FIN 46(R) to two of the VIEs because it isunable to obtain the information necessary to perform the accounting requiredto consolidate these VIEs. Although the Company has made an effort to gatherthe required information, management of these two VIEs has declined in writingto transfer any of 

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the necessary financialdata to the Company. For information concerning the Company’s one consolidatedVIE, see Note 8 to the consolidated financial statements. Informationconcerning the Company’s two non-consolidated VIEs follows below.

The first non-consolidated VIE is a non-U.S.telecommunications hardware manufacturer and service provider. Prior to itsacquisition by the Company, Tenovis agreed to purchase from the VIE certainamounts of products and services, and the VIE contracted with Tenovis toprovide certain IT services and purchasing services with respect to rawmaterials. During the six months ended March 31, 2005, Tenovis purchased productsand services aggregating $18 million. These contracts expire in August 2007.Additionally, Tenovis is required to pay monthly rental subsidies on the VIE’spremises, and in the event the VIE is unable to pay its portion of the rentalpayments, Tenovis is liable for the VIE’s portion as well. During the sixmonths ended March 31, 2005, Tenovis paid approximately $300,000 inconnection with rental subsidies. The maximum exposure to loss as of March 31,2005 for the remainder of the agreement is the minimum purchase ordercommitments and the minimum service levels for service contracts of $14million, and the guarantee for rents to be paid by the VIE of $2 million.

The secondnon-consolidated VIE provides development, testing and quality control servicesto Tenovis and other companies in the telecommunications industry. Prior to theacquisition, Tenovis guaranteed the VIE minimum revenue over a period of threeyears through guaranteed annual purchase orders. This service contract expiredon March 31, 2005 and consequently the entity is no longer considered tobe a VIE of the Company. During the six months ended March 31, 2005,Tenovis purchased services aggregating $4 million from this VIE.

***Other Acquisitions***

On October 4, 2004, the Company completed thepurchase of Spectel plc (“Spectel”), a world leader in audio and webconferencing solutions, for $110 million in cash (including $6 million oftransaction fees that were not paid to the sellers), net of $3 million of cashacquired. The acquisition enables the Company to continue to expand itscapabilities in conferencing, which is a core business communicationstechnology. In connection with the acquisition, the Company allocated $3million to in-process research and development, which was written off to researchand development expense in the Consolidated Statement of Income during thefirst quarter of fiscal 2005.

On October 15, 2004, the Company acquired a 23%share of Agile Software NZ Limited (“Agile Software”), a software subsidiary ofAgile (NZ) Limited, which primarily produces contact center software, as wellas other software products. Under terms of the subscription and shareholdingagreement, the Company has the option to acquire the remaining equity in AgileSoftware; this option vests in October 2005 and has no expiration date. Thefair value of this purchase option is not material to the Company’sconsolidated results of operations, financial position or cash flows. TheCompany accounts for its investment in Agile Software using the equity method.

On December 15, 2004, the Company acquiredsubstantially all of the assets of RouteScience Technologies, Inc. (“RouteScience”),a software company based in California focused on products that monitor, assessand optimize network applications.

The respective purchase prices for the above threeacquisitions were not material, either individually or in the aggregate, to theconsolidated financial statements of the Company. Therefore, disclosures of proforma financial information have not been presented.

Through a series of transactions during fiscal 2004,the Company increased its ownership of the issued share capital of Tata TelecomLtd. (“Tata”), a leading voice communications solutions provider in India, from25.1% to 59.1% for a total of $24 million. After the closing, Tata’s name waschanged to Avaya GlobalConnect Ltd. (“AGC”), and the Company beganconsolidating its results on August 4, 2004. This 

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acquisition was notmaterial to the consolidated financial statements of the Company. Therefore,disclosures of pro forma financial information have not been presented.

The Company acquiredsubstantially all of the assets and certain liabilities of Expanets Inc. on November 25,2003. If the acquisition had occurred at the beginning of fiscal 2004, Avaya’srevenues for the first six months of fiscal 2004 would have been $2,025 millionand net income would have been $119 million, or earnings of $0.28 per basicshare and $0.26 per diluted share. Avaya’s actual results for the first sixmonths of fiscal 2004 were revenues of $1,977 million, net income of $135million, and earnings of $0.31 per basic share and $0.30 per diluted share.

***Discontinued Operations***

Thefollowing table displays revenue and income (loss) before income taxes fromdiscontinued operations for the three and six months ended March 31, 2005and 2004:
| ** **                                                            | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,**           | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Dollars in millions**                                     | ** ** | ** **                                       | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Revenue from  discontinued operations:                                |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Connectivity Solutions                                                |       |                                             | $          | —                                                   |       |   |   | $ | 29 |   |   |   | $ | — |   |   |   | $ | 167 |   |   |
| Expanets                                                              |       |                                             | —     |                                                     |       |   | 1 |   |   |   | — |   |   |   | 8 |   |   |
| Total revenue from discontinued operations                            |       |                                             | $          | —                                                   |       |   |   | $ | 30 |   |   |   | $ | — |   |   |   | $ | 175 |   |   |
| Income (loss)  before income taxes from  discontinued operations:     |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Connectivity  Solutions:                                              |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Results of operations                                                 |       |                                             | $          | —                                                   |       |   |   | $ | (59 | ) |   |   | $ | — |   |   |   | $ | (72 | ) |   |
| Gain (loss) on sale                                                   |       |                                             | —     |                                                     |       |   | 81 |   |   |   | (2 | ) |   |   | 81 |   |   |
| Total income (loss) before income taxes for  Connectivity Solutions   |       |                                             | —     |                                                     |       |   | 22 |   |   |   | (2 | ) |   |   | 9 |   |   |
| Expanets—results  of operations                                  |       |                                             | —     |                                                     |       |   | (1 | ) |   |   | — |   |   |   | (6 | ) |   |
| Total income  (loss) before income taxes from discontinued operations |       |                                             | $          | —                                                   |       |   |   | $ | 21 |   |   |   | $ | (2 | ) |   |   | $ | 3 |   |   |
|                                                                       |            |                                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the six months ended March 31,2005, the $2 million loss associated with the sale of the Company’sConnectivity Solutions business was primarily the result of the finalization ofthe working capital adjustment in accordance with the asset purchase agreement.

**5.   Goodwilland Intangible Assets**

Thechanges in the carrying value of goodwill for the six months ended March 31,2005 by operating segment are as follows:
| ** **                                             | ** ** | **Global**         | ** ** | **Avaya**     | ** ** | ** **   | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|---------------|------------|--------------|------------|
| ** **                                             | ** ** | **Communications** | ** ** | **Global**    | ** ** | ** **   | ** ** |
| **Dollars in millions**                      | ** ** | ** **         | ** ** | **Solutions** | ** ** | **Services** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2004                      |       |               | $          | 187           |       |         |       | $ | 70 |   |   | $ | 257 |   |
| Goodwill acquired:                                     |       |               |       |          |       |         |       |   |   |   |   |
| Tenovis                                                |       |               | 349        |          |       |         | 262        |   |   | 611 |   |
| Other acquisitions                                     |       |               | 58         |          |       |         | 12         |   |   | 70 |   |
| Impact of foreign currency exchange rate  fluctuations |       |               | 1          |          |       |         | —     |   |   | 1 |   |
| **Balance as of March 31, 2005**                       | ** ** | ** **         | **$**      | **595**       |       | ** **   | ** ** | **$** | **344** |   | ** ** | **$** | **939** | ** ** |
|                                                        |            |                    |            |               |            |              |            |  |  |  |  |  |  |  |  |  |

 

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The segment allocation of goodwill arising from otheracquisitions was adjusted during the second quarter of fiscal 2005 to reflectthe updated purchase price allocation for Spectel.

The followingtable presents the components of the Company’s acquired intangible assets withfinite lives.
| ** **                                          | ** ** | **March 31, 2005** | ** ** | **September 30, 2004** | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **Gross**                    | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | **Carrying**                 | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| **Dollars in millions**                   | ** ** | ** **                   | ** ** | **Amount**                       | ** ** | **Amortization** | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| Existing  technology                                |       |                         | $          | 95                               |       |   |   | $ | 34 |   |   | $ | 61 |   |   | $ | 28 |   |   |   | $ | 26 |   |   | $ | 2 |   |
| Customer  relationships and other intangibles  |       |                         | 308        |                             |       |   | 22 |   |   | 286 |   |   | 32 |   |   |   | 2 |   |   | 30 |   |
| Total amortizable  intangible assets                |       |                         | $          | 403                              |       |   |   | $ | 56 |   |   | $ | 347 |   |   | $ | 60 |   |   |   | $ | 28 |   |   | $ | 32 |   |
|                                                     |            |                              |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the first quarter of fiscal 2005, the Companyacquired $298 million of intangible assets in connection with the acquisitionof Tenovis consisting of existing technology of $36 million, customerrelationships of $254 million and trademarks of $8 million. Other acquisitionsduring the first quarter of fiscal 2005 resulted in additional existingtechnology and customer relationships of $31 million and $14 million,respectively. These acquisitions, as well as the impact of foreign currencyfluctuations, resulted in an increase in the gross balance of intangible assetsof $343 million compared to the balance as of September 30, 2004. Theweighted average useful life of the existing technology, customerrelationships, and trademarks are 5 years, 6 years, and 1.5 years, respectively.For further information concerning these intangible assets, see Note 4 “BusinessCombinations and Other Transactions.”

Amortization expense for the Company’s acquiredintangible assets with finite lives was $15 million and $26 million for thethree and six months ended March 31, 2005, respectively. Estimated futureamortization expense is (i) $33 million in the remainder of fiscal 2005; (ii) $65million in fiscal 2006; (iii) $61 million in fiscal 2007; (iv) $60million in fiscal 2008; (v) $59 million in fiscal 2009; and (vi) $69million thereafter. The majority of the future estimated amortization expenseis associated with intangible assets acquired with Tenovis. As these assets arerecorded in euros, the future estimated amortization expense is subject tofluctuation in connection with foreign currency translation.

In addition, included inother intangible assets in the Consolidated Balance Sheets as of March 31,2005 and September 30, 2004 is an intangible asset of $43 millionrepresenting unrecognized prior service costs associated with the recording ofa minimum pension liability in fiscal 2004, 2003 and 2002. This intangibleasset may be eliminated or adjusted as necessary when the amount of minimumpension liability is reassessed, which is conducted at least annually.

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**6.   ComprehensiveIncome**

Othercomprehensive income is recorded directly to a separate component ofstockholders’ equity in accumulated other comprehensive loss and includesunrealized gains and losses excluded from the Consolidated Statements of Income.These unrealized gains and losses for the three and six months ended March 31,2005 and 2004 consisted primarily of adjustments to the minimum pensionliability, net of income taxes and valuation allowance, foreign currencytranslation, which is not adjusted for income taxes since it primarily relatesto indefinite investments in non-U.S. subsidiaries, and unrealized holdinggains and losses on securities classified as available for sale.
| ** **                                                                                                                                                                                                                     | ** ** | **Three months ended** | ** ** | **Six months ended**                           | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                     | ** ** | **March 31,**               | ** ** | **March 31,**                                       | ** ** |
| **Dollars in millions**                                                                                                                                                                                              | ** ** | ** **                       | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Net income                                                                                                                                                                                                                     |       |                             | $          | 36                                                       |       |   |   | $ | 125 |   |   |   | $ | 67 |   |   |   | $ | 135 |   |   |
| Other comprehensive  income:                                                                                                                                                                                                   |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustments                                                                                                                                                                                       |       |                             | (33        | )                                                        |       |   | 4 |   |   |   | 34 |   |   |   | 53 |   |   |
| Unrealized holding (loss) gain on available-for-sale  securities                                                                                                                                                               |       |                             | (1         | )                                                        |       |   | — |   |   |   | 2 |   |   |   | — |   |   |
| Minimum pension liability adjustment, net of a  reversal of deferred income taxes of $14 million offset by a reversal of the  corresponding $14 million valuation allowance for the three and six months  ended March 31, 2004 |       |                             | —     |                                                     |       |   | 36 |   |   |   | — |   |   |   | 36 |   |   |
| Total comprehensive  income                                                                                                                                                                                                    |       |                             | $          | 2                                                        |       |   |   | $ | 165 |   |   |   | $ | 103 |   |   |   | $ | 224 |   |   |
|                                                                                                                                                                                                                                |            |                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**7.   SupplementaryFinancial Information**

***Statements ofIncome Information***
| ** **                                                                                                  | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| **Dollars in millions**                                                                           | ** ** | ** **                                       | ** ** | **   2005   **   | ** ** | **   2004    ** | ** ** | **  2005  ** | ** ** | **   2004   ** | ** ** |
| **OTHER  INCOME (EXPENSE), NET**                                                                            |       |                                             |       |                                           |       |   |   | ** ** |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Loss on long-term debt extinguishment, net                                                                  |       |                                             | $          | (2                                             | )          |   |   | $ | (21 | ) |   |   | $ | (43 | ) |   |   | $ | (21 | ) |   |
| Gain (loss) on foreign currency transactions                                                                |       |                                             | 1          |                                           |       |   | — |   |   |   | (2 | ) |   |   | 3 | ** ** |   |
| Interest income                                                                                             |       |                                             | 6          |                                           |       |   | 4 |   |   |   | 12 |   |   |   | 7 | ** ** |   |
| Loss on sale of CommScope common stock received in connection  with the sale of Connectivity Solutions |       |                                             | —     |                                           |       |   | (5 | ) |   |   | — |   |   |   | (5 | ) |   |
| Other, net                                                                                                  |       |                                             | (5         | )                                              |       |   | 3 |   |   |   | (5 | ) |   |   | 3 | ** ** |   |
| **Total other income (expense),  net**                                                                      | ** ** | ** **                                       | **$**      | **—**                                     |       | ** ** | ** ** | **$** | **(19** | **)** | ** ** | ** ** | **$** | **(38** | **)** | ** ** |   | **$** | **(13** | **)** |   |
|                                                                                                             |            |                                                  |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Balance SheetInformation***
| **Dollars in millions**                    | ** ** | ** ** | ** ** | **March 31, 2005** | ** ** | **September 30, 2004** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------------------------|------------|----------------------------------|------------|
| **INVENTORY**                                        |       |       |       |                         |       |                             |       |   |   |
| Finished goods                                       |       |       | $          | 353                          |       |                             |       | $ | 221 |   |   |
| Work in process and raw  materials                   |       |       | 11         |                         |       |                             | 18         |   |   |
| **Total inventory**                                  | ** ** | ** ** | **$**      | **364**                      |       | ** **                       | ** ** | **$** | **239** |   |   |
| **PROPERTY,  PLANT AND EQUIPMENT, NET**              |       |       |       |                         |       |                             |       |   |   |
| Land and improvements                                |       |       | $          | 51                           |       |                             |       | $ | 27 |   |   |
| Buildings and  improvements                          |       |       | 437        |                         |       |                             | 394        |   |   |
| Machinery and equipment,  including rental equipment |       |       | 797        |                         |       |                             | 581        |   |   |
| Assets under  construction                           |       |       | 7          |                         |       |                             | 1          |   |   |
| Internal use software                                |       |       | 205        |                         |       |                             | 175        |   |   |
| Total property, plant  and equipment                 |       |       | 1,497      |                         |       |                             | 1,178      |   |   |
| Less: Accumulated  depreciation and amortization     |       |       | (750       | )                            |       |                             | (669       | ) |   |
| **Property, plant and equipment, net**               | ** ** | ** ** | **$**      | **747**                      |       | ** **                       | ** ** | **$** | **509** |   |   |

 

***Cash FlowInformation***
| ** **                               | ** ** | **Six months ended March 31,** | ** ** |
|------------------------------------------|------------|----------------------------------------------------|------------|
| **Dollars in millions**        | ** ** | ** **                                         | ** ** | **       2005       ** | ** ** | **       2004       ** | ** ** |
| **CASH USED FOR ACQUISITIONS**           |       |                                               |       |   |   |   |   |   |   |
| Working capital, other  than cash        |       |                                               | $          | 172 |   |   |   | $ | 28 |   |   |
| Property, plant and  equipment           |       |                                               | 272        |   |   |   | 4 |   |   |
| Goodwill                                 |       |                                               | 683        |   |   |   | 84 |   |   |
| Intangibles and other  assets            |       |                                               | 349        |   |   |   | 40 |   |   |
| Long-term debt                           |       |                                               | (278       | ) |   |   | — |   |   |
| Other liabilities                        |       |                                               | (815       | ) |   |   | (63 | ) |   |
| Net assets from  discontinued operations |       |                                               | —     |   |   |   | 10 |   |   |
| **Net cash used to acquire businesses**  | ** ** | ** **                                         | **$**      | **383** |   | ** ** | ** ** | **$** | **103** |   |   |
|                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |

 

**8. Long-Term Debt**

Debtoutstanding consists of the following:
| **Dollars in millions**                                                                | ** ** | ** ** | ** ** | **March 31, 2005** | ** ** | **September 30, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------|------------|------------------------------|------------|----------------------------------|------------|
| Debt maturing within one  year:                                                                  |       |       |       |                         |       |                             |       |   |   |
| Secured floating rate  notes                                                                     |       |       | $          | 72                           | (1)        |                             |       | $ | — |   |   |
| LYONs convertible debt,  net of discount                                                         |       |       | —     |                         |       |                             | 297        | (3) |   |
| Other current debt                                                                               |       |       | 2          | (2)                          |       |                             | 2          |   |   |
| Total current portion of  long-term debt                                                         |       |       | $          | 74                           |       |                             |       | $ | 299 |   |   |
| Long-term debt:                                                                                  |       |       |       |                         |       |                             |       |   |   |
| Secured floating rate  notes, net of discount                                                    |       |       | 94         | (1)                          |       |                             | —     |   |   |
| 111¤8%  Senior Notes, net of discount, premium and net deferred gain on interest rate  swap |       |       | 14         |                         |       |                             | 294        | (4) |   |
| Other long-term debt                                                                             |       |       | 6          | (2)                          |       |                             | —     |   |   |
| Total long-term debt                                                                             |       |       | $          | 114                          |       |                             |       | $ | 294 |   |   |
| **Total debt**                                                                                   | ** ** | ** ** | **$**      | **188**                      |       | ** **                       | ** ** | **$** | **593** |   | ** ** |

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(1)          These notes, which weassumed in the acquisition of Tenovis, have been fixed at a rate of 6.22%through the entry into of an interest rate swap, the fair value of which isalso included in the balance. The balance also includes foreign currencyimpacts.

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(2)          Primarily represents thecurrent and long-term portions of two capital lease obligations associated withTenovis.

(3)          The carrying value ofthe Liquid Yield OptionTMNotes, or LYONs, represented the value of549,022 notes outstanding. These notes were redeemed for cash or converted intoshares of Avaya common stock during the first quarter of fiscal 2005.

(4)          The carrying value ofthe 111¤8%Senior Notes due April 2009 (“Senior Notes”) as of September 30,2004 of $294 million is comprised of the aggregate principal amount outstandingof $284 million increased for $5 million of unamortized premium, net ofdiscount and the net unamortized deferred gain of $5 million related to thetermination of interest rate swap agreements. All of these notes except forapproximately $13 million aggregate principal amount were repurchased for cashthrough a public tender offer during the first quarter of fiscal 2005. Thesenotes are no longer secured.

Thefollowing table summarizes the Company’s long-term debt obligations by periodas of March 31, 2005:
| ** **                        | ** ** | **Payments due by period** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| **Dollars in millions** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years(a)** | ** ** | **3-5 years(b)** | ** ** | **More than  5 years** | ** ** |
| Total long-term  debt obligations |       | $                                         | 188        |   |   | $ | 74 |   |   |   | $ | 98 |   |   |   | $ | 16 |   |   |   | $ | 0 |   |   |
|                                   |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Includes securedfloating rate notes and capital lease obligations.

(b)          Includes senior notesand capital lease obligations.

See below for a detaileddiscussion of actions the Company has taken during the first six months offiscal 2005 related to its long-term debt.

***Secured Floating Rate Notes***

In November 2001, Tenovis entered into an assetsecuritization transaction whereby Tenovis Finance Limited, a variable interestentity for which Tenovis is the primary beneficiary, issued Secured FloatingRate Notes due 2013 (“secured floating rate notes”) that were secured by a poolof Tenovis’s current and future receivables associated with rental contracts. Inaccordance with FIN 46(R), the Company consolidated Tenovis Finance Limitedupon the acquisition of Tenovis. Tenovis Finance Limited is a special purposecompany established to issue the secured floating rate notes and enter into allrelated financial arrangements.

The secured floating rate notes are denominated ineuros and were originally issued in an aggregate principal amount of Euro 300million, representing 3,000 notes each having a principal amount of Euro100,000. As of the acquisition date, each note translated to principal of$130,300, or $268 million in total for the 2,060 notes outstanding. During thesix months ended March 31, 2005, the Company repaid principal of $103million. As a result of the repayment, the Company recognized a pre-tax loss of$2 million, which is included in other income (expense), net for the secondquarter of fiscal 2005. This loss primarily consists of a $2 million reductionin the net unamortized discount recorded at the time of the original debtissuance.

The balance as of March 31, 2005 of $166 millionincludes the outstanding principal amount of $164 million and the fair value ofthe related interest rate swaps of $5 million, described below, partiallyoffset by the unamortized discount of $3 million. Interest and principal arepayable quarterly on February 14, May 14, August 14 and November 14of each year in accordance with the amortization schedule,  resulting in the notes being scheduled forfull repayment in November 2007. Principal payments of $33 million arerequired for the remainder of fiscal 2005. The notes are collateralized by $738million of Tenovis’s current and future receivables associated with rentalcontracts.

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In November 2001,Tenovis Finance Limited entered into two interest rate swap agreements, eachwith an original notional amount of Euro 150 million, which matched thenotional amount of the secured floating rate notes outstanding. Mirroring thesecured floating rate notes, the interest rate swaps have a final maturity dateof November 2007. These interest rate swap agreements were executed inorder to convert the secured notes floating rate debt into fixed rate debt. Underthese agreements, Tenovis receives a floating interest rate based on thethree-month EURIBOR and pays a fixed interest rate of 4.72%. Because there is a1.50% spread on the underlying floating rate notes, the total fixed rateinterest payment on the notes is 6.22% per annum. The swaps are marked tomarket at each reporting date.

As a result of the partial repayment on the secured floatingrate notes during the six months ended March 31, 2005, the interest rateswaps were each partially reduced by $41 million, for a total reduction of $82million. In connection with this partial unwinding, the Company paid $7 millionin interest and related costs, which reduced the fair market value of the swapsincluded in the secured floating rate notes balance to $5 million as of March 31,2005.

On May 4, 2005, theCompany gave notice to the holders of the secured floating rate notes of its intentionto repay the remaining principal of $164 million secured floating rate notes onMay 17, 2005. In conjunction with the repayment, the Company willterminate the remaining portion of the associated interest rate swapagreements.

***Senior Notes***

On November 1, 2004, the Company commenced a cashtender offer for any and all of its Senior Notes and a consent solicitation toamend the related indenture as described below. The offer included an earlyconsent date of November 15, 2004, and expired on December 1, 2004. Theconsideration for each $1,000 principal amount of Senior Notes validly tenderedby the early consent date and not validly withdrawn and accepted for paymentwas $1,158.95, which included a consent payment of $30 per $1,000 principalamount.

As of the early consent date, holders tendered $271million aggregate principal amount of Senior Notes, and were paid $314 millionin cash. An additional $100,000 aggregate principal amount was tendered priorto December 1, 2004, and cash of $113,000 was paid. Upon repurchase of thenotes, the Company paid interest of $4 million, which had accrued from October 1,2004 through November 15, 2004. Following these transactions, there were$13 million aggregate principal amount of the Senior Notes outstanding.

As a result of the cash tender offer, the Companyrecognized a pre-tax loss of $41 million, which is included in other income(expense), net for the first quarter of fiscal 2005. This loss consists of (i) $43million of premiums on the repurchase, (ii) the write-off of $5 million ofdeferred financing costs and (iii) $1 million of fees, partially offset bythe recognition of (iv) $4 million of unamortized net premium recorded atthe time of the original debt issuances, and (v) $4 million of deferredgain related to the interest rate swaps.

During the first quarterof fiscal 2005, the Company received the requisite consents with respect to theconsent solicitation for the adoption of certain proposed amendments to theindenture relating to the Senior Notes. On November 16, 2004, the Companyand the trustee for the Senior Notes executed a supplemental indenture, whicheliminated substantially all of the restrictive covenants, the reportingrequirements and certain events of default from the indenture. Additionally,the supplemental indenture eliminated the requirement under the indenture toprovide security for the Senior Notes and accordingly, the Company’sobligations under the Senior Notes that remain outstanding are unsecured.

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***LYONs Convertible Debt***

On October 31, 2004,$238,000 principal amount of LYONs were put to the Company pursuant to theterms of the indenture governing the LYONs for an aggregate redemption price of$129,000. On November 18, 2004, the Company announced that it would redeemfor cash all of the outstanding LYONs on December 20, 2004. As providedpursuant to the indenture governing the LYONs, the redemption price was $545.67per $1,000 principal amount at maturity of LYONs. Prior to December 20,2004, holders of $549 million principal amount at maturity of LYONs convertedtheir outstanding LYONs into 20,546,199 shares of Avaya common stock pursuantto the terms of the indenture. Pursuant to the indenture, each $1,000 principalamount was exchangeable for 37.4437 shares of Avaya common stock. On December 20,2004, $61,000 aggregate principal amount at maturity of LYONs, whichrepresented all remaining outstanding LYONs, were redeemed for cash at anaggregate redemption price of $33,000.

***Fair Value of Long-Term Debt***

Thefollowing table summarizes the components of the Company’s long-term debt,their aggregate carrying values and related fair market values as of March 31,2005 and September 30, 2004:
| ** **                        | ** ** | **March 31, 2005** | ** ** | **September 30, 2004**       | ** ** |
|-----------------------------------|------------|------------------------------|------------|----------------------------------------|------------|
| **Dollars in millions** | ** ** | ** **                   | ** ** | **Number  of Notes  Outstanding** | ** ** | **Carrying  Value** | ** ** | **Fair  Value** | ** ** | **Number  of Notes  Outstanding** | ** ** | **Carrying  Value** | ** ** | **Fair  Value** | ** ** |
| Secured Floating  Rate Notes      |       |                         | 1,260      |                                   |       |   | $ | 166 |   |   | $ | 166 |   |   | — |   |   |   | $ | — |   |   | $ | — |   |
| LYONs                             |       |                         | —     |                                   |       |   | $ | — |   |   | $ | — |   |   | 549,022 |   |   |   | $ | 297 |   |   | $ | 307 |   |
| Senior Notes                      |       |                         | 13,205     |                                   |       |   | $ | 14 |   |   | $ | 15 |   |   | 284,395 |   |   |   | $ | 289 |   |   | $ | 330 |   |
|                                   |            |                              |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In addition to the items in the table above, long-termdebt as of March 31, 2005 includes $8 million of other debt, of which $6million represents capital lease obligations associated with Tenovis. Long-termdebt as of September 30, 2004 includes $5 million of net unamortizeddeferred gain related to the termination of the interest rate swap agreementsrelated to the Senior Notes and $2 million other debt, primarily related toAvaya GlobalConnect commercial paper, the Company’s majority owned subsidiaryin India.

The carrying value of the debt instruments listedabove reflects the aggregate principal amount outstanding adjusted for theunamortized discount and premium related to each debt instrument, as well asthe related interest rate swap values.

The fair market values ofthe debt instruments listed above are based upon quoted market prices andyields obtained through independent pricing sources for the same or similartypes of borrowing arrangements taking into consideration the underlying termsof the debt.

**Credit Facility**

On February 23, 2005, the Company entered into aCredit Agreement (the “credit facility”), among the Company, AvayaInternational Sales Limited, an indirect subsidiary of the company (“AISL”),with lenders party thereto and with Citicorp USA, Inc., as agent for thelenders. The commitments pursuant to the Company’s previous Amended andRestated Five Year Revolving Credit Facility Agreement, dated as of April 30,2003 (as amended), among the Company, the lenders party thereto and Citibank,N.A., as agent for the lenders, were terminated and the security interestssecuring obligations under that facility were fully released.

Under the credit facility, borrowings are available inU.S. dollars or Euros to the Company and AISL, and the maximum amount ofborrowings that can be outstanding is $400 million, of which $150 million maybe in the form of letters of credit. The credit facility is a five-yearrevolving facility (with an expiration date 

17

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of February 23, 2010)and is not secured by any assets. The credit facility contains affirmative andrestrictive covenants that the Company must comply with, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio of (i) consolidateddebt to (ii) earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, of 2.00 to 1.00,(c) maintaining a minimum ratio of adjusted EBITDA to interest expense of4.00 to 1.00, (d) limitations on the incurrence of subsidiaryindebtedness, (e) limitations on liens, (f) limitations oninvestments and (g) limitations on the creation or existence of agreementsthat prohibit liens on our properties. The credit facility also limits theCompany’s ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock to an amount notto exceed 50% of consolidated net income of the Company for the fiscal yearimmediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. For fiscal 2005, stockrepurchases are currently limited under the credit facility to$148 million. The Company will seek to obtain an amendment from thelenders under the credit facility in the event that it determines to repurchaseshares of common stock in excess of the foregoing limitations pursuant to itsstock repurchase plan. As of March 31, 2005, the Company was in compliancewith all of the covenants included in the credit facility.

The credit facility provides that the Company may useup to $1 billion in cash (excluding transaction fees) and assumed debt foracquisitions completed after the date of the agreement, provided that it is incompliance with the terms of the agreement. The acquisition amount will bepermanently increased to $1.5 billion after consolidated EBITDA of the Companyand its subsidiaries for any period of twelve consecutive months equals orexceeds $750 million.

There are currently $53 million of letters of creditissued under the credit facility. There are no other outstanding borrowingsunder the facility, and the remaining availability is $347 million. The Companybelieves the credit facility provides it with an important source of backupliquidity.

From time to time, certain of the lenders providecustomary commercial and investment banking services to the Company.

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**9.   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, restricted stock units, warrants, and convertibledebt.
| ** **                                                                                           | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,**           | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Dollars and shares in millions, except per share amounts** | ** ** | ** **                                       | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Earnings Per Common  Share—Basic:**                                                           |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                                                                   |       |                                             | $          | 36                                                       |       |   |   | $ | 103 |   |   | $ | 69 |   | $ | 133 |   |
| Income (loss)  from discontinued operations                                                          |       |                                             | —     |                                                     |       |   | 22 |   |   | (2 | ) | 2 |   |
| Net income                                                                                           |       |                                             | $          | 36                                                       |       |   |   | $ | 125 |   |   | $ | 67 |   | $ | 135 |   |
| Weighted average shares—basic                                                                   |       |                                             | 480        |                                                     |       |   | 435 |   |   | 470 |   | 428 |   |
| Earnings per share from continuing operations                                                        |       |                                             | $          | 0.08                                                     |       |   |   | $ | 0.24 |   |   | $ | 0.15 |   | $ | 0.31 |   |
| Earnings (loss)  per share from discontinued operations                                              |       |                                             | —     |                                                     |       |   | 0.05 |   |   | (0.01 | ) | — |   |
| Earnings per  share—basic                                                                       |       |                                             | $          | 0.08                                                     |       |   |   | $ | 0.29 |   |   | $ | 0.14 |   | $ | 0.31 |   |
| **Earnings  Per Common Share—Diluted:**                                                         |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                                                                   |       |                                             | $          | 36                                                       |       |   |   | $ | 103 |   |   | $ | 69 |   | $ | 133 |   |
| Interest charges  associated with convertible debt                                                   |       |                                             | —     |                                                     |       |   | 1 |   |   | 2 |   | 4 |   |
| Income from  continuing operations used for diluted EPS                                              |       |                                             | 36         |                                                     |       |   | 104 |   |   | 71 |   | 137 |   |
| Income (loss)  from discontinued operations                                                          |       |                                             | —     |                                                     |       |   | 22 |   |   | (2 | ) | 2 |   |
| Net income used  for diluted EPS                                                                     |       |                                             | $          | 36                                                       |       |   |   | $ | 126 |   |   | $ | 69 |   | $ | 139 |   |
| Weighted average shares—basic                                                                   |       |                                             | 480        |                                                     |       |   | 435 |   |   | 470 |   | 428 |   |
| Potential dilutive  securities:                                                                      |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |
| Assumed exercise of stock options                                                                    |       |                                             | 7          |                                                     |       |   | 10 |   |   | 7 |   | 9 |   |
| Assumed vesting of restricted stock units                                                            |       |                                             | 1          |                                                     |       |   | 1 |   |   | 1 |   | 2 |   |
| Assumed exercise of warrants                                                                         |       |                                             | 5          |                                                     |       |   | 6 |   |   | 6 |   | 6 |   |
| Assumed conversion of LYONs                                                                          |       |                                             | —     |                                                     |       |   | 21 |   |   | 9 |   | 21 |   |
| Weighted average  shares—diluted                                                                |       |                                             | 493        |                                                     |       |   | 473 |   |   | 493 |   | 466 |   |
| Earnings per share from continuing operations                                                        |       |                                             | $          | 0.07                                                     |       |   |   | $ | 0.22 |   |   | $ | 0.15 |   | $ | 0.30 |   |
| Earnings (loss)  per share from discontinued operations                                              |       |                                             | —     |                                                     |       |   | 0.05 |   |   | (0.01 | ) | — |   |
| Earnings per  share—diluted                                                                     |       |                                             | $          | 0.07                                                     |       |   |   | $ | 0.27 |   |   | $ | 0.14 |   | $ | 0.30 |   |
| **Securities  excluded from the computation of diluted earnings per common share**                   |       |                                             |       |                                                     |       |   |   |   |   |   |   |   |   |
| Options(1)                                                                                           |       |                                             | 29         |                                                     |       |   | 9 |   |   | 27 |   | 25 |   |
| Warrants(1)                                                                                          |       |                                             | 5          |                                                     |       |   | 7 |   |   | 5 |   | 7 |   |
| Total                                                                                                |       |                                             | 34         |                                                     |       |   | 16 |   |   | 32 |   | 32 |   |
|                                                                                                      |            |                                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          These securities havebeen excluded from the diluted earnings per common share calculation becausetheir inclusion would have been antidilutive as their exercise prices werehigher than the average market price during the period.

On April 19, 2005,the Board of Directors authorized a share repurchase plan. Under the provisionsof this plan, Avaya is authorized to repurchase up to $500 million of itsoutstanding common stock over the next two years. These repurchases will bemade at management’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legal 

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requirementsand are subject to market conditions, share price, the terms of Avaya’s creditfacility and other factors. See Note 8, “Long-Term Debt,” for furtherinformation concerning the limitations under the credit facility.

**10.   BenefitObligations**

Thecomponents of net periodic benefit cost (credit) for U.S. plans for the threemonths and six months ended March 31, 2005 and 2004 are provided in thetable below:
| ** **                                            | ** ** | **Pension Benefits-  U.S.**                 | ** ** | **Pension Benefits-  Non-U.S.**                     | ** ** | **Postretirement  Benefits**                             | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                            | ** ** | **Three months ended  March 31,** | ** ** | **Three months ended  March 31,**         | ** ** | **Three months ended  March 31,**         | ** ** |
| **Dollars in millions**                     | ** ** | ** **                                       | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| **Components of Net Periodic  Benefit Cost (Credit)** |       |                                             |       |                                                     |       |                                                     |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                          |       |                                             | $          | 4                                                        |       |                                                     |       | $ | 4 | ** ** |   |   | $ | 3 |   |   |   | $ | 1 |   |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                         |       |                                             | 42         |                                                     |       |                                                     | 42         | ** ** |   |   | 4 |   |   |   | — |   |   |   | 10 |   |   |   | 10 |   |   |
| Expected return on plan assets                        |       |                                             | (54        | )                                                        |       |                                                     | (54        | ) |   |   | — |   |   |   | — |   |   |   | (3 | ) |   |   | (4 | ) |   |
| Amortization of unrecognized prior service cost       |       |                                             | 2          |                                                     |       |                                                     | 2          |   |   |   | — |   |   |   | — |   |   |   | 2 |   |   |   | 3 |   |   |
| Recognized net actuarial loss                         |       |                                             | 9          |                                                     |       |                                                     | 4          |   |   |   | — |   |   |   | — |   |   |   | 1 |   |   |   | 1 |   |   |
| **Net periodic benefit cost  (credit)**               | ** ** | ** **                                       | **$**      | **3**                                                    |       | ** **                                               | ** ** | **$** | **(2** | ) | ** ** | ** ** | **$** | **7** |   | ** ** | ** ** | **$** | **1** |   | ** ** | ** ** | **$** | **11** |   | ** ** | ** ** | **$** | **11** |   |   |
|                                                       |            |                                                  |            |                                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                            | ** ** | **Pension Benefits-  U.S.**               | ** ** | **Pension Benefits-  Non-U.S.**                     | ** ** | **Postretirement  Benefits**                             | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                            | ** ** | **Six months ended  March 31,** | ** ** | **Six months ended  March 31,**           | ** ** | **Six months ended  March 31,**           | ** ** |
| **Dollars in millions**                     | ** ** | ** **                                     | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| **Components of Net Periodic  Benefit Cost (Credit)** |       |                                           |       |                                                     |       |                                                     |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                          |       |                                           | $          | 8                                                        |       |                                                     |       | $ | 8 | ** ** |   |   | $ | 5 |   |   |   | $ | 2 |   |   |   | $ | 2 |   |   |   | $ | 2 |   |   |
| Interest cost                                         |       |                                           | 84         |                                                     |       |                                                     | 84         | ** ** |   |   | 6 |   |   |   | 1 |   |   |   | 20 |   |   |   | 20 |   |   |
| Expected return on plan assets                        |       |                                           | (108       | )                                                        |       |                                                     | (106       | ) |   |   | — |   |   |   | (1 | ) |   |   | (5 | ) |   |   | (8 | ) |   |
| Amortization of unrecognized prior service cost       |       |                                           | 3          |                                                     |       |                                                     | 4          | ** ** |   |   | — |   |   |   | — |   |   |   | 5 |   |   |   | 5 |   |   |
| Recognized net actuarial loss                         |       |                                           | 18         |                                                     |       |                                                     | 7          | ** ** |   |   | — |   |   |   | — |   |   |   | 3 |   |   |   | 3 |   |   |
| **Net periodic benefit cost  (credit)**               | ** ** | ** **                                     | **$**      | **5**                                                    |       | ** **                                               | ** ** | **$** | **(3** | ) | ** ** | ** ** | **$** | **11** |   | ** ** | ** ** | **$** | **2** |   | ** ** | ** ** | **$** | **25** |   | ** ** | ** ** | **$** | **22** |   |   |
|                                                       |            |                                                |            |                                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The results of the non-U.S. pension plans for fiscal2005 include the unfunded pension plans assumed with the acquisition ofTenovis.

The Company provides certain pension benefits for U.S.and non-U.S. employees, which are not pre-funded. Consequently, theCompany makes payments as these benefits are disbursed. For the six monthsended March 31, 2005, the Company made payments for these U.S. andnon-U.S. pension benefits totaling $3 million and $5 million, respectively.Estimated payments for these U.S. and non-U.S. pension benefits for theremainder of fiscal 2005 are $4 million and $4 million, respectively.

The Company also providescertain retiree medical benefits for U.S. employees, which are not pre-funded.Consequently, the Company makes payments as these benefits are disbursed. Forthe six months ended March 31, 2005, the Company made payments totaling$10 million for these retiree medical benefits. Estimated payments for theseretiree medical benefits for the remainder of fiscal 2005 are $15 million.

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**11.   StockCompensation Plans**

The Company has a stock compensation plan whichprovides for the issuance to eligible employees of nonqualified stock optionsand restricted stock units representing Avaya common stock. In addition, theCompany has a stock purchase plan under which eligible employees have theability to purchase shares of Avaya common stock at 85% of market value.

On December 16, 2004, the Compensation Committeeof the Board of Directors approved awards of 0.4 million performance vestingrestricted stock units to executive officers of the Company pursuant to theterms of the Avaya Inc. 2004 Long Term Incentive Plan. The performance vestingrestricted stock units vest upon the achievement of certain targets.

Additionally, during thesix months ended March 31, 2005, the Company granted to eligible employeesapproximately six million stock options at a weighted average exercise price of$15.71 per option and approximately two million restricted stock units at aweighted average market value of $15.78 per unit.

**12.   OperatingSegments**

The Company reports its operations in two segments—GlobalCommunications Solutions and Avaya Global Services. This structure represents achange from the Company’s three-segment structure utilized in fiscal 2004, andbetter reflects how the businesses are being managed consistent with theCompany’s operating structure and go-to-market strategies. Accordingly, priorperiod amounts have been restated to reflect this change. The GlobalCommunications Solutions segment, which includes our prior reportable segmentsof Enterprise Communications Group (“ECG”) and Small and Medium BusinessSolutions (“SMBS”), develops, markets and sells communications systemsincluding IP telephony systems, multi-media contact center infrastructureand converged applications in support of customer relationship management,unified communications applications, appliances such as IP telephone sets andtraditional voice communications systems.TheAvaya Global Services segment develops, markets and sells comprehensiveend-to-end global service offerings that enable customers to plan, design,implement, monitor and manage their converged communications networksworldwide.

The Global Communications Solutions segment includesthe portion of the Tenovis rental and managed services revenue attributable tothe equipment used in connection with the customer contracts. The portion ofthe customer contracts attributable to maintenance and other services isincluded in the Avaya Global Services segment.

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. At the beginning of each fiscal year, theamount of certain corporate overhead expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year in the annual plan. The annual incentive award accrual isadjusted quarterly based on actual year to date results and those estimated forthe remainder of the year. This adjustment of the annual incentive awardaccrual, as well as any other over/under absorption of corporate overheadsagainst plan is recorded and reported within the Corporate/Unallocated caption.

The Company has outsourced the majority of itsmanufacturing operations related to its Global Communications Solutions segmentto a number of contract manufacturers. All manufacturing of the Company’sproducts is performed in accordance with detailed specifications and productdesign furnished by the Company and is subject to quality control standards.

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Summarizedfinancial information relating to the Company’s reportable segments is shown inthe following table:
| ** **                                  | ** ** | **Reportable Segments** | ** ** | ** **                            | ** ** | ** **                  | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|
| **Dollars in millions**           | ** ** | ** **                   | ** ** | **Global  Communications  Solutions** | ** ** | **Avaya  Global  Services** | ** ** | **Corporate/Other  Unallocated  Amounts** | ** ** | **Total** | ** ** |
| **Three months ended  March 31, 2005** |       |                         |       |                                  |       |                        |       |   |   |   |   |   |   |
| Revenue                                     |       |                         | $          | 625                                   |       |                        | $          | 597 |   |   | $ | — |   |   | $ | 1,222 |   |
| Operating (loss)  income                    |       |                         | (12        | )                                     |       | 27                          |       |   | 37 |   |   | 52 |   |
| **Three  months ended March 31, 2004** |       |                         |       |                                  |       |                        |       |   |   |   |   |   |   |
| Revenue                                     |       |                         | $          | 493                                   |       |                        | $          | 511 |   |   | $ | 2 |   |   | $ | 1,006 |   |
| Operating (loss)  income                    |       |                         | (3         | )                                     |       | 63                          |       |   | — |   |   | 60 |   |
| **Six  months ended March 31, 2005**   |       |                         |       |                                  |       |                        |       |   |   |   |   |   |   |
| Revenue                                     |       |                         | $          | 1,217                                 |       |                        | $          | 1,153 |   |   | $ | — |   |   | $ | 2,370 |   |
| Operating income                            |       |                         | 13         |                                  |       | 83                          |       |   | 44 |   |   | 140 |   |
| **Six  months ended March 31, 2004**   |       |                         |       |                                  |       |                        |       |   |   |   |   |   |   |
| Revenue                                     |       |                         | $          | 973                                   |       |                        | $          | 1,000 |   |   | $ | 4 |   |   | $ | 1,977 |   |
| Operating (loss) income                     |       |                         | (1         | )                                     |       | 116                         |       |   | (3 | ) |   | 112 |   |
|                                             |            |                              |            |                                       |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table sets forth the Company’s long-lived assets by geographic area:
| **Dollars in millions**       | ** ** | ** ** | ** ** | **March 31, 2005** | ** ** | **September 30, 2004** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------|------------|----------------------------------|------------|
| U.S.                                    |       |       | $          | 443                          |       |                             |       | $ | 460 |   |   |
| International:                          |       |       |       |                         |       |                             |       |   |   |
| EMEA—Europe / Middle East / Africa |       |       | 285        |                         |       |                             | 31         |   |   |
| APAC—Asia Pacific                  |       |       | 14         |                         |       |                             | 13         |   |   |
| Americas, non-U.S.                      |       |       | 5          |                         |       |                             | 5          |   |   |
| Total international                     |       |       | 304        |                         |       |                             | 49         |   |   |
| Total                                   |       |       | $          | 747                          |       |                             |       | $ | 509 |   |   |

 

Long-lived assetsrepresent property, plant and equipment, net of accumulated depreciation. Theincrease in international long-lived assets was due to the acquisition ofTenovis.

**13.   Commitmentsand Contingencies**

**Legal Proceedings**

From time to time, the Companyis involved in legal proceedings arising in the ordinary course of business.Other than as described below, the Company believes there is no litigationpending against the Company that could have, individually or in the aggregate,a material adverse effect on the Company’s financial position, results ofoperations or cash flows.

***Year 2000 Actions***

On September 30, 2000, Lucent contributed its enterprise networking businessto us and distributed all of the outstanding shares of our capital stock to itsshareowners. We refer to these transactions in this Quarterly Report on Form 10-Qas the “distribution.”

Three separate purported class action lawsuits arepending against Lucent, Avaya’s former parent, one in state court in WestVirginia, one in federal court in the Southern District of New York and anotherin federal court in the Southern District of California. The case in New Yorkwas filed in January 1999 and, 

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after being dismissed, wasrefiled in September 2000. The case in West Virginia was filed in April 1999and the case in California was filed in June 1999, and amended in 2000 toinclude Avaya as a defendant. The Company has assumed Lucent’s obligations forall of these cases under the Contribution and Distribution Agreement between us and Lucent, which sets forth theagreements between us and Lucent with respect to the principal corporatetransactions required to effect the distribution (the “Contribution and DistributionAgreement”). All three actions are based upon claims that Lucent soldproducts that were not Year 2000 compliant, meaning that the products weredesigned and developed without considering the possible impact of the change inthe calendar from December 31, 1999 to January 1, 2000. Thecomplaints allege that the sale of these products violated statutory consumerprotection laws and constituted breaches of implied warranties.

A class was certified in the West Virginia state courtmatter. The certified class in the West Virginia matter includes those personsor entities that purchased, leased or financed the products in question. Inaddition, the court also certified as a subclass all class members who hadservice protection plans or other service or extended warranty contracts withLucent in effect as of April 1, 1998, as to which Lucent failed to offer afree Year 2000-compliant solution. The federal court in the New Yorkaction has issued a decision and order denying class certification, dismissingall but certain fraud claims by one representative plaintiff. No class claimsremain in this case at this time. The federal court in the California actionalso issued an opinion and order granting class certification. The classincludes any entities that purchased or leased certain products on or after January 1,1990, excluding those entities who did not have a New Jersey choice of lawprovision in their contracts and those who did not purchase equipment directlyfrom defendants. The federal court in the California action issued an orderstaying the action pending the outcome of the West Virginia matter.

In May 2004, the Company entered into asettlement agreement with the plaintiffs in all of the above-describedactions. Under the general terms of the agreement, eligible class members whoacquired certain products between 1990 and 1999 may receive credits up to $110 millionor a cash alternative. The credits are valid for a three-year period and can beapplied toward a 45 percent discount on purchases of new Avaya productsand/or a 30 percent discount on Avaya maintenance services. Alternatively,eligible class members may receive a one-time cash payment equal to 25 percentof the credits to which they may be entitled. The state court in West Virginiaapproved the settlement in July 2004 and issued an order of final approvalof the settlement. The claims process commenced in August 2004 and thetime period for filing claims expired in October 2004. The Company is nowin the process of analyzing the claims to determine the credits and/or paymentsfor which class members may be eligible.

Pursuant to the terms ofthe Contribution and Distribution Agreement, Lucent is responsible for 50% ofthe costs related to these matters in excess of $50 million, including attorneys’fees. The Company has notified Lucent that costs incurred in these matters,including costs expended since these matters commenced in 1999, have exceededthe $50 million threshold. Accordingly, Lucent will be responsible for aportion of the cost of the settlement. Based on existing reserves for thesematters, the Company does not believe the settlement will have a materialadverse effect on its financial position, results of operations or cash flows.

***Commissions Arbitration Demand***

In July 2002, CommunicationsDevelopment Corporation, or CDC, a British Virgin Islands corporation, madeformal demand for arbitration for alleged unpaid commissions in an amount inexcess of $10 million, stemming from the sale of products from Avaya’sbusinesses that were formerly owned by Lucent involving the Ministry of RussianRailways. In April 2003, CDC initiated the arbitration before the AmericanArbitration Association. The plaintiff alleges that as a result of agreementsentered into between the plaintiff and Avaya, it is owed commissions on salesby Avaya to the Ministry of Russian Railways on a continuing basis. The Companybelieves that the agreements relating to the plaintiff’s claim have expired 

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or donot apply to the products in question. As the sales of products continue, CDCmay likely increase its commission demand. The parties have selectedarbitrators in this matter. A hearing date has not yet been set.

***Variable Workforce Grievances***

The Communications Workersof America and the International Brotherhood of Electrical Workers, unionsrepresenting the Company’s technicians, have filed grievances regarding aninterpretation of the variable workforce agreements (“Agreements”) entered intobetween the Company and the unions in June 2003. The unions allege thatAvaya has violated the Agreements by activating some, but not all, variableworkforce employees (approximately 850 in total) for duty from August 2003,and not paying such employees for the minimum amount of weeks to which theyclaim entitlement under their interpretation of the Agreements. Aftercommencement of the arbitration proceeding the parties reached an agreement in January 2005to resolve this dispute as well as others relating to interpretation of theAgreements on terms which are not material to Avaya’s financial position,results of operations or cash flows. The Agreements expired by their terms in December 1,2004 and the Company no longer has a variable workforce.

***Securities Litigation***

In April and May of 2005, purported classaction lawsuits were filed in the Federal District Court for the District ofNew Jersey 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 are substantially similar to oneanother, allege, among other things, that the plaintiffs were injured by reasonof certain allegedly false and misleading statements made by us relating to thecost of the Tenovis integration, the disruption caused by changes in thedelivery of our products to the market and reductions in the demand for ourproducts in the U.S., and that based on the foregoing we had no basis toproject our stated revenue goals for fiscal 2005. The Company has been servedwith one of these complaints. Noclass has been certified in the actions. Thecomplaints seek compensatory damages plus interest and attorneys’ fees.

These matters are still inthe early stages of litigation and an outcome 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.

***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. At this time, we cannot determine if this matter will havean effect on our business or, if it does, whether its outcome will have amaterial adverse effect on our financial position, results of operations orcash flows.

On May 3, 2005, theCompany received a subpoena from the Office of Inspector General, U.S. GeneralServices Administration, relating to a federal investigation of billing by theCompany for telecommunications equipment and maintenance services. The subpoenarequests records from the period January 1, 1990 to the present. At thistime, we cannot determine if this matter will have an effect on our businessor, if it does, whether its outcome will have a material adverse effect on ourfinancial position, results of operations or cash flows.

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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, 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 seven of its current or former facilities eithervoluntarily or pursuant to government directives. None of the sites isreasonably likely to generate environmental costs that will be individuallymaterial nor will environmental costs for all sites in the aggregate bematerial. There are no known third parties who may be responsible forinvestigation and/or cleanup at these sites and therefore, for purposes ofassessing the adequacy of financial reserves for these liabilities, the Companyhas not assumed that it will recover amounts from any third party, including underany insurance coverage or indemnification arrangement. Although the Companydoes not separately track recurring costs of managing hazardous substances andpollutants in ongoing operations, it does not believe them to be material.

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 from environmentalmatters are undiscounted and consist primarily of estimated remediation andmonitoring costs and are, depending on the site, based primarily upon internalor third-party environmental studies and the extent of contamination andthe type of required cleanup. The Company is not aware of, and has not includedin reserves any provision for, any unasserted environmental claims.

The reliability and precision of estimates of theCompany’s environmental costs may be affected by a variety of factors, includingwhether the remediation treatment will be effective, contamination sources havebeen accurately identified and assumptions regarding the movement ofcontaminants are accurate. In addition, estimates of environmental costs may beaffected 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 theadequacy of environmental reserves on a quarterly basis. The Company does notexpect the outcome of these matters to have a material impact on its financialposition. Expenditures for environmental matters for the first quarter offiscal 2005 and fiscal 2004 were not material to the Company’s financialposition, results of operations or cash flows. Payment for the environmentalcosts covered by the reserves may be made over a 30-year period.

**Product Warranties**

The Company recognizes a liability for the estimatedcosts that may be incurred to remedy certain deficiencies of quality orperformance of the Company’s products. These product warranties extend over aspecified period of time generally ranging up to one year from the date of saledepending upon the product subject to the warranty. The Company accrues forwarranty costs as part of its cost of sales based on associated material costs,technical support and help desk labor costs, and associated overhead. TheCompany accrues this provision for estimated future warranty costs based uponthe historical relationship of warranty claims to sales. The Companyperiodically reviews the adequacy of its product warranties and adjusts, ifnecessary, the warranty percentage and accrued warranty reserve, which isincluded in other current liabilities in the Consolidated Balance Sheets, foractual experience.

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Thefollowing table summarizes the activity related to the product warrantyliability during the six months ended March 31, 2005:
| **Dollars in millions**                      | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|
| Balance as of  September 30, 2004                 |       | $          | 23         |       |
| Reductions for  payments and costs to satisfy claims   |       | (22        | )          |
| Accruals for  warranties issued during the period*     |       | 28         |       |
| Changes to  accrual relating to preexisting warranties |       | 1          |       |
| Balance as of  March 31, 2005                     |       | $          | 30         |       |

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*                    Includes theopening balances of accruals related to acquisitions that occurred in the firstquarter of fiscal 2005.

The increase in theproduct warranty liability for the six months ended March 31, 2005 is dueto the additional accruals for product warranty associated with acquisitionsmade subsequent to September 30, 2004.

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

***Letters of Credit***

As of March 31, 2005, the Company hadentered into uncommitted credit facilities that vary in term totaling $133million for the purpose of securing third party financial guarantees such asletters of credit which ensure the Company’s performance or payment to thirdparties. Additionally, the Company had $545 million of committed creditfacilities, including the $400 million credit facility which is discussed inNote 8, “Long-Term Debt.” The Company had outstanding an aggregate of $129million in irrevocable letters of credit under the committed and uncommittedcredit facilities (including an aggregate of $53 million under its $400 millioncommitted credit facility) and $1 million of restricted cash.

***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 company guaranteesthat the Company will perform in accordance with contractual or legalobligations. These bonds vary in duration although most are issued andoutstanding from one to three years. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$20 million as of March 31, 2005. Historically, no surety bonds havebeen drawn upon and there is no future expectation that any surety bonds willbe drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchasescomponents from a variety of suppliers and uses several contract manufacturersto provide manufacturing services for its products. During the normal course ofbusiness, in order to manage manufacturing lead times and to help assureadequate component supply, the Company enters into purchase agreements withcontract manufacturers and suppliers that allow them to produce and procureinventory based upon forecasted requirements provided by the Company. If theCompany does not meet these specified purchase commitments, it could berequired to purchase the inventory, or in the case of certain agreements, payan early termination fee. As of March 31,2005, the maximum potential payment under these commitments was approximately$132 million. Historically, the Company has not been required to pay a chargefor not meeting its designated purchase commitments with these suppliers.

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***Product Financing Arrangements***

The Company sells products to various resellers thatmay obtain financing from certain unaffiliated third party lendinginstitutions.

The Company has a product financing arrangement withone U.S. reseller. Avaya is obligated under certain circumstances to repurchaseinventory previously sold to this reseller, in the event the lendinginstitution, which financed the transaction, repossesses the reseller’sinventory of the Company’s products. The Company’s obligation to repurchaseinventory from the lending institution terminates 180 days from the dateof invoicing by the Company to the reseller. The repurchase amount is equal tothe price originally paid to the Company by the lending institution for theinventory. This reseller has financed $49 million of inventory purchases underthis arrangement as of March 31, 2005, which is the maximum exposure tothe Company under this arrangement. There have not been any repurchases made byAvaya since the Company entered into this agreement in March 2001. TheCompany has estimated the fair value of this guarantee as of March 31,2005, and has determined that it is not significant. There can be no assurancethat the Company will not be obligated to repurchase inventory under thisarrangement in the future.

For the Company’s productfinancing 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 guarantee repayment amount reported tothe Company from the lending institution was approximately $6 million as of March 31,2005. The Company reviews and sets the maximum credit limit for each resellerparticipating in this financing arrangement. There have not been any guaranteerepayments by Avaya since the Company entered in this arrangement in October 2000.The Company has estimated the fair value of this guarantee as of March 31,2005, and has determined that it is not significant. There can be no assurancethat the Company will not be obligated to repurchase inventory under thisarrangement in the future.

***Performance Guarantees***

In connection with thesale of Connectivity Solutions and the sale of a portion of the Expanetsbusiness, the Company has assigned its rights and obligations under severalreal estate leases to the acquiring companies (the “assignees”). The remainingterms of these leases vary from less than one year to nine years. While theCompany is no longer the primary obligor under these leases, the lessor has notcompletely released the Company from its obligation, and holds it secondarilyliable in the event that the assignees default on these leases. The maximumpotential future payments the Company could be required to make, if all of the assigneeswere to default as of March 31, 2005, would be approximately $22 million. TheCompany has assessed the probability of default by the assignees and hasdetermined it to be remote.

***Credit Facility Indemnification***

In connection with itsobligations under the credit facility described in Note 8, “Long-TermDebt,” the Company has agreed to indemnify the third party lending institutionsfor costs incurred by the institutions related to changes in tax law or otherlegal requirements. While there have been no amounts paid to the lenderspursuant to this indemnity in the past, there can be no assurance that theCompany will not be obligated to indemnify the lenders under this arrangementin the future.

***Transactions with Lucent***

In connection with the Company’s spin-off from Lucentin September 2000, the Company and Lucent executed and delivered theContribution and Distribution Agreement and certain related agreements.

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Pursuant to the Contribution and DistributionAgreement, Lucent contributed to the Company substantially all of the assets,liabilities and operations associated with its enterprise networking businesses(“the Company’s Businesses”). The Contribution and Distribution Agreement,among other things, provides that, in general, the Company will indemnifyLucent for all liabilities including certain pre-distribution tax obligationsof Lucent relating to the Company’s Businesses and all contingent liabilitiesprimarily relating to the Company’s Businesses or otherwise assigned to theCompany. In addition, the Contribution and Distribution Agreement provides thatcertain contingent liabilities not allocated to one of the parties will beshared by Lucent and the Company in prescribed percentages. The Contributionand Distribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to thebusiness of the other party that exceed $50 million. The Company is unableto determine the maximum potential amount of other future payments, if any,that it could be required 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.

In April 2005, Lucent announced that its resultsincluded adjustments related to certain income tax matters from previous years.In connection with the distribution, the Company and Lucent entered into a TaxSharing Agreement which governs Lucent’s and the Company’s respective rights,responsibilities and obligations after the distribution with respect to taxesfor the periods ending on or before the distribution. Generally,pre-distribution taxes or benefits that are clearly attributable to thebusiness of one party will be borne solely by that party, and otherpre-distribution taxes or benefits will be shared by the parties based on aformula set forth in the Tax Sharing Agreement. The Company will determine theimpact, if any, pursuant to the Tax Sharing Agreement upon the final resolutionof these income tax matters.

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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 theconsolidated financial statements and the notes included elsewhere in thisquarterly report. The matters discussed in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contain certainforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. See “Forward Looking Statements” at the end ofthis discussion.

Our accompanying unauditedconsolidated financial statements as of March 31, 2005 and for the threeand six months ended March 31, 2005 and 2004, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the 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 30,2004, which were included in our Annual Report on Form 10-K filed with theSEC on December 13, 2004. 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. Certainprior year amounts have been reclassified to conform to the current interimperiod presentation. The consolidated results of operations for the interimperiods reported are not necessarily indicative of the results to beexperienced for the entire fiscal year.

**Overview**

***Products, Applications and Services***

We are a leading provider of communications systems,applications and services that help enterprises transform their businesses byredefining the way they work and interact with their customers, employees,business partners, suppliers and others. Our goal is to help our customersoptimize their enterprise communications networks in order to serve theircustomers better, enabling them to reduce costs and grow revenue whilepreserving the security and reliability of their networks. A key component ofour strategy is to leverage our substantial experience and expertise intraditional voice communications systems to capitalize on the transition ofthese traditional voice systems to Internet Protocol (“IP”) and the adoption ofIP telephony systems. We believe our comprehensive suite of IP telephonysystems, communications applications and appliances, as supported by our globalservices organization and extensive network of business 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.

Our product offerings include:

·       IPtelephony systems;

·       multi-mediacontact center infrastructure and applications in support of customerrelationship management;

·       unifiedcommunications applications, which include voice and multi-media messaging;

·       appliances,such as telephone sets; and

·       traditionalvoice communication systems.

We support ourbroad customer base with comprehensive global service offerings that enable ourcustomers to plan, design, implement, maintain and manage their communicationsnetworks. We believe our global service organization is an importantconsideration for customers purchasing our products and applications and is asource of significant revenue for us, primarily from maintenance contracts. Theskilled professionals of our services organization, together with our networksof business partners and our ability 

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todiagnose customer network faults remotely, can provide 24 hour a day, seven daya week service to our customers around the world. Our end-to-end portfolio ofservice offerings provides a single point of accountability and includes:

·       value-addedmaintenance services;

·       professionalservices, consulting, design and network integration;

·       productimplementation; and

·       rentaland managed services.

***Customers and Competitive Advantages***

Our broad customer base is diverse, ranging in sizefrom small businesses employing ten 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, manufacturing, media and communications, professionalservices, health care, education and governmental. As a result of ouracquisition of Tenovis in November 2004, we have significantly increasedour presence in Europe, particularly in Germany.

We are focused on the migration of our customers’traditional voice communications to a converged network that provides for theintegration of voice, data, video and other application traffic on a singlenetwork. We offer customers the flexibility to implement a new IP telephonysystem or “IP-enable” their existing voice communications system, therebypreserving their existing communication technology investments and allowingthem to implement IP telephony at their own pace. The appliances that operateon converged networks, including IP phones, computer workstations, wirelessphones and other devices, are replacing traditional telephones. The flexibilityof converged networks offers increased functionality and provides ourenterprise customers with the ability to reach the right person at the enterprise,at the right time, in the right place and in the right way, thereby optimizingbusiness interactions and enhancing our customers’ ability to grow revenue andreduce costs. Our products, applications and services are driving theintegration of communications and business processes, making communications animportant component of our customers’ business strategies.

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

·       clearfocus on the enterprise;

·       extensivevoice experience and expertise;

·       abilityto “IP-enable” existing voice communication systems;

·       alarge installed global customer base;

·       acomprehensive suite of industry-leading communications applications;

·       aglobal services organization that offers end-to-end customer solutions; and

·       strategicalliances with world-class business partners.

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**KeyTrends and Uncertainties Affecting Our Results**

***Trends andUncertainties Affecting Our Revenue***

Thefollowing are the key factors currently affecting our revenue:

·       *Acquisition of Tenovis—*Our acquisition of Tenovis resultedin a significant increase in our revenues. The large installed base of Europeancustomers which we acquired has enabled us to increase our presence in Europe. Theintegration of the Tenovis business into ours was and remains a substantialeffort requiring significant managerial resources and attention. Other factorsincluding strong competition in the European market, as well as weakness inEuropean economies and the high concentration of our business in Germany, couldaffect our business in Europe.

·       *Technology transition*—There are severalfactors that indicate that enterprises may be poised to transition theirtraditional communications systems to next-generation communications technology.First, IP telephony lines constitute a very small percentage of globalinstalled enterprise telephony lines. In addition, the average age of theseenterprise telephony systems is approximately ten years. Although these systemscontinue to operate reliably after ten years, enterprises typically willconsider a new investment in enterprise communications technology at this pointin the telephony system’s lifecycle. Accordingly, we believe that enterprisesmay consider new investments in enterprise communications and if they decide tomake such investments, may consider IP telephony. In addition, we have notedover the past year that sales of our IP telephony gateways, which enableenterprises to connect remote locations to their headquarters, continue to be agrowing part of our IP telephony portfolio.

We believe these factorsindicate that enterprises are deploying larger IP telephony systems and thatearly adopters of IP telephony are now deploying this technology on a widerscale within their businesses. Because our IP telephony gateways supporttraffic between traditional voice communications systems and IP telephonysystems, we offer our customers the flexibility to deploy a new IP telephonyinfrastructure or use our IP telephony gateways to “IP-enable” theirtraditional voice communications systems, thereby preserving their existingcommunications technology investments.

Finally, we believe thatenterprises are recognizing that IP telephony can help optimize resources byfacilitating activities of an enterprise’s personnel regardless of theirphysical location. Using our IP telephony systems and our contact centerapplications, an enterprise’s employees can serve customers globally from anylocation, thereby helping to maximize efficiency and productivity in thedeployment of the enterprise’s assets. Other factors enterprises may consideras they decide whether to deploy IP telephony include whether IP telephony willprovide the level of security and reliability provided by traditional telephonysystems.

As a result of thetechnology transition, however, spending by enterprises on traditional voicecommunication systems has been declining. Increases in our revenue attributableto sales of IP telephony systems continue to be offset in part by declines inrevenue attributable to traditional voice communications systems.

·       *Pricing and competitive environment*—We have historicallyoperated, and continue to operate, in an extremely competitive environment. Accordingly,we regularly face pricing pressures in the markets in which we operate. We havebeen able to mitigate the effects of pricing pressures on profitability throughour actions to improve gross margins, as described below. For otheruncertainties related to the competitive environment in which we operate, see “ForwardLooking Statements—**We face intensecompetition from our current competitors and, as the enterprise communicationsand information technology markets evolve, may face increased competition fromcompanies that do not currently complete directly against us.”**

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·       *Pressures on services business*—We expect to continue to facechallenges in our Avaya Global Services (“AGS”) segment. Although theproportion of customers who elect to purchase maintenance contracts at the timeequipment is purchased has remained at relatively constant levels, the AGSbusiness has been negatively affected by contract renegotiations at the time ofrenewal, changes in scope (i.e. number of ports, number of sites, or hours andlevels of coverage) and pricing pressures. Our managed services businessgenerally involves larger contracts with customers who outsource responsibilityfor their telephony systems to us. We expect to face challenges in this arearelating to timing and closure of the new business opportunities, as well aspricing pressures and scope changes as discussed above.

·       *Foreign currency—*With our acquisition of Tenovis, ourinternational revenues exceeded 40% of our total consolidated revenues for thesecond quarter of fiscal 2005. Any weakening of the U.S. dollar against othercurrencies, particularly the euro, will have a positive impact on our reportedrevenues and profitability. Conversely, any strengthening of the U.S. dollarwill have a negative impact.

·       *Economic conditions—*An important factoraffecting our ability to generate revenue is the effect of general economicconditions on our customers’ willingness to spend on information technology andparticularly, enterprise communications technology. As economic conditions havegradually improved in most of our markets over the past few years, we have seenindications that enterprises may be more willing to spend on enterprisecommunications technology than in the past several years. Third-party estimatesindicate that economic growth in most economies, including the United States,was very strong in 2004 and that economic growth will continue at a slower pacein 2005. While the world economy is expected to grow, variability inemployment, corporate profit growth, interest rates, energy prices and otherfactors in specific markets could impact corporate willingness to spend oncommunications technology in the near term.

***Continued Focus onCost Structure***

During fiscal 2005, we arecontinuing to focus on controlling our costs, particularly in relation to ourrevenue. As a result of the growth of our revenue discussed above and ourcontinued focus on controlling costs, we returned to profitability in the thirdquarter of fiscal 2003 and have been profitable in each of the seven subsequentquarters.

As discussed in moredetail below, our gross margin decreased from 46.8% for the three months ended March 31,2004 to 46.1% for the three months ended March 31, 2005. The gross marginrate increased slightly from 46.5% to 46.7% for the six month period. Thedecrease for the quarter is primarily due to the acquisition of Tenovis, whohistorically has achieved lower margins than Avaya. The slight increase for thesix months is attributable to higher volumes, an improved mix of hardware andsoftware products, and the results of our cost reduction initiatives. Thebenefits from these positive results were partially offset by the acquisitionof Tenovis.

As a percentage ofrevenue, selling, general and administrative (SG&A) expenses increased from32.6% to 33.2% for the three months ended March 31, 2005, and decreasedfrom 32.4% to 32.2% for six months ended March 31, 2005. The increase inabsolute dollar terms for both periods was due to the inclusion of TenovisSG&A expenses following the acquisition, as well as our other recentacquisitions. However, as a result of the operational efficiencies we have beenable to achieve, as a percent of revenue, the negative impacts from ouracquisitions have been partially offset in the second quarter of fiscal 2005,and were more than offset for the six months ended March 31, 2005.

***Strategic Use ofCash and Cash Equivalents***

As further discussed in “Liquidityand Capital Resources,” we have been focused on using cash for strategicacquisitions and debt reduction, as well as generating cash from our operatingactivities. We used 

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cash andcash equivalents of $762 million during the six months ended March 31,2005, substantially all of which was used for acquisitions and debt reduction. Weused net cash of $265 million and $110 million to acquire Tenovis and Spectel,respectively. In addition, we used $314 million to reduce substantially theamount of senior notes outstanding and $103million to repay a portion of our outstanding principal of secured floatingrate notes.

As of September 30,2004, our cash and cash equivalents exceeded our debt by $1,024 million and asof March 31, 2005, our cash and cash equivalents exceeded our debt by $667million. We expect to have positive operating cash flow for the remainder offiscal 2005.

On April 19, 2005,the Board of Directors authorized a share repurchase plan. Under the provisionsof this plan, Avaya is authorized to repurchase up to $500 million of itsoutstanding common stock over the next two years. These repurchases will bemade at management’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms ofAvaya’s credit facility and other factors. OnApril 20, the Company commenced purchasing shares under this plan. SeeNote 8, “Long-Term Debt,” to our consolidated financial statements forfurther information concerning the limitations under the credit facility.

On May 4, 2005, wegave notice to the holders of the secured floating rate notes of our intentionto repay the remaining principal of $164 million secured floating rate notes onMay 17, 2005.

***Current and FutureProfitability and its Effect on Deferred Tax Assets***

As of March 31, 2005,we had $429 million in net deferred tax assets resulting from tax creditcarryforwards, net operating losses and other deductible temporary differences,which are available to reduce taxable income predominantly in the U.S. infuture periods. This amount is net of a valuation allowance, which wascalculated in accordance with the provisions of Statement of FinancialAccounting Standards No. 109, “Accounting for Income Taxes.”

We continue to analyze ourprofitability and the probability of the realization of our deferred tax assetsin future periods as a result of profitable operations. We have determined thata partial valuation allowance is required until sufficient positive evidenceexists to support its reversal.

**Operating Segments**

Beginning in the firstquarter of fiscal 2005, we are managing our business based on two operatingsegments—Global Communications Solutions, which includes our prior reportablesegments of Enterprise Communications Group (ECG) and Small and Medium BusinessSolutions (SMBS), and Avaya Global Services. This realignment of operatingsegments enables management to assess results of operations in a mannerconsistent with our operating structure and go-to-market strategies. Ourcomparative results for the quarters presented have been reclassified toreflect our new segment structure.

Thefollowing table sets forth the allocation of our revenue among our operatingsegments and expressed as a percentage of total revenue:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 493        |       | $          | 506        |       | $          | 565        |                              | $          | 592                                 |       | Global Communications  Solutions |   | $ | 625 |   | $ | 493 |   | 51 | % | 49 | % | $ | 132 |   | 26.8 | % |
| 511        |       | 510        |       | 511        |       | 556        |       | Avaya Global Services             |       | 597                                 |       | 511 |   | 49 | % | 51 | % | 86 |   | 16.8 | % |
| 1,004      |       | 1,016      |       | 1,076      |       | 1,148      |       | Total operating  segments         |       | 1,222                               |       | 1,004 |   | 100 | % | 100 | % | 218 |   | 21.7 | % |
| 2          |       | —     |       | —     |       | —     |       | Corporate / Unallocated           |       | —                              |       | 2 |   | 0 | % | 0 | % | (2 | ) | -100.0 | % |
| $          | 1,006      |       | $          | 1,016      |       | $          | 1,076      |                              | $          | 1,148                               |       | Total |   | $ | 1,222 |   | $ | 1,006 |   | 100 | % | 100 | % | $ | 216 |   | 21.5 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The increase in revenuescontributed by the Global Communications Solutions segment and the Avaya GlobalServices segment for the second quarter of fiscal 2005 compared to the secondquarter of fiscal 2004 is primarily due to acquisitions and increased salesfrom all international regions. These positive effects were partially offset byweaker sales in the U.S.

**Acquisitions and Divestitures**

***Acquisition of Tenovis***

On November 18, 2004, we acquired all of theissued share capital of Tenovis Germany GmbH, or Tenovis. Tenovis is a majorEuropean provider of enterprise communications systems and services. Under theterms of the share purchase agreement we paid $381 million in cash (whichincludes $10 million of transaction fees that were not paid to the sellers) andassumed $278 million in debt. Additionally, we acquired cash and cashequivalents of $116 million, resulting in a net cash outlay related to theacquisition of $265 million. We also recorded $313 million of pensionliabilities in connection with this acquisition. Tenovis results are includedin our consolidated financial statements as of November 18, 2004.

In the followingdiscussion, we present certain financial information related to Tenovis and itsimpact on Avaya’s overall financial results. The planned integration of Tenovisin the coming months will result in significant cross-deployment of resourcesand the integration of various legal entities and operations. As a result, wewill not be able to provide a meaningful level of visibility into the resultsof “stand alone” Tenovis, as we have done herein and previously. Therefore, wedo not intend to provide separate Tenovis financial information in the future.

***Other Acquisitions***

On October 4, 2004, we acquired all of the issuedshare capital of Spectel plc, or Spectel, pursuant to the terms of a SharePurchase Agreement dated August 2, 2004, for $110 million in cash (whichincludes $6 million of transaction fees that were not paid to the sellers), netof cash acquired of $3 million. Spectel is a company incorporated in Irelandand a leading provider of audio conferencing solutions. Results from Spectelare included in our consolidated financial statements beginning on October 4,2004.

On October 15, 2004, we acquired a 23% share ofAgile Software NZ Limited, a software subsidiary of Agile NZ Limited, whichprimarily produces contact center software, as well as other software products.We account for this investment using the equity method.

On December 15, 2004, we acquired substantiallyall of the assets of RouteScience Technologies, Inc., a software companybased in California focused on products that monitor, assess and optimizenetwork applications.

Through a series of transactions during fiscal 2004,we increased our ownership of the issued share capital of Tata Telecom Ltd., orTata, a leading voice communications solutions provider in India, from 25.1% to59.1% for a total of $24 million. After the closing, Tata’s name was changed toAvaya GlobalConnect, or AGC, and we began consolidating its results on August 4,2004.

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**Results from Continuing Operations**

***Three Months Ended March 31, 2005 Compared withThree Months Ended March 31, 2004***

***Revenue***

The primary driver of the increase in ourrevenues for the second quarter of fiscal 2005 compared to the second quarterof fiscal 2004 was our acquisition of Tenovis, which added revenues of $237million. This impact was partially offset by declines in U.S. sales of bothproducts and services. The decline in U.S. revenues was primarily attributableto the following:

·       Wepreviously announced changes in our go-to-market strategy to realign our salesand marketing efforts by expanding direct sales coverage of key accounts; byenlarging the number of strategic accounts; by identifying a second tier ofnamed accounts served by a combination of our direct sales team and our channelpartners; and by servicing our medium and small business customers primarilythrough our channel partners. This had the result, among other things, ofreassigning accounts among different channels and sales teams. Although weexpect this realignment to provide benefits as we focus our direct salesefforts on our larger enterprise customers, the benefits have taken longer thanexpected to materialize, resulting in a temporary disruption to oursales efforts. This disruption primarily affected our U.S. business.

·       The secondquarter saw decreased purchases of products by our indirect channel businesspartners which primarily affected our sales of small and medium businessproducts, which are sold almost entirely through indirect channels in the U.S.

·       We continueto see declines in revenues from our U.S. services business, particularly inthe maintenance and rental and managed services lines of business, primarilydue to renegotiations by customers of their contracts to change the scope ofexisting maintenance and managed services contracts, pricing pressures andcancellations.

·       We havedevoted significant management attention and resources to the Tenovisintegration. These integration efforts have diverted management’s time andattention away from other business issues.

Revenues were also positively impacted by theacquisition of a majority interest in AGC in the fourth quarter of fiscal 2004.Additionally, foreign currency translation positively impacted revenues by $8million due to of the weakening of the U.S. dollar, particularly against theeuro.

A detailed analysis of the impact of these factors is included in thediscussion below.

Thefollowing table sets forth a comparison of revenue by type:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                   | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in  millions**     | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 495        |       | $          | 506        |       | $          | 565        |                         | $          | 554                                 |       | Sales of products |   | $ | 543 |   | $ | 495 |   | 44 | % | 49 | % | $ | 48 |   | 9.7 | % |
| 445        |       | 446        |       | 454        |       | 477        |       | Services                     |       | 498                                 |       | 445 |   | 41 | % | 44 | % | 53 |   | 11.9 | % |
| 66         |       | 64         |       | 57         |       | 117        |       | Rental and  managed services |       | 181                                 |       | 66 |   | 15 | % | 7 | % | 115 |   | 174.2 | % |
| $          | 1,006      |       | $          | 1,016      |       | $          | 1,076      |                         | $          | 1,148                               |       | Total revenue |   | $ | 1,222 |   | $ | 1,006 |   | 100 | % | 100 | % | $ | 216 |   | 21.5 | % |
|            |            |            |            |            |            |            |            |                              |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Higher revenues in all categories were primarily dueto the acquisition of Tenovis, and to a lesser extent, AGC. The increase inrevenues from sales of products related to acquisitions was partially offset bylower volumes, particularly through the indirect channel, as a result of thesales force realignment and the distraction caused by the Tenovis integration. Theincrease in revenues from services and rental and managed services waspartially offset by lower volumes due primarily to renegotiations affecting thescope of existing maintenance and managed service contracts, as well as pricingpressures and cancellations.

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Thefollowing table sets forth a geographic comparison of revenue:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions**   | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 760        |       | $          | 769        |       | $          | 822        |                                | $          | 734                                 |       | U.S.  International: |   | $ | 689 |   | $ | 760 |   | 56 | % | 76 | % | $ | (71 | ) | -9.3 | % |
| 133        |       | 135        |       | 142        |       | 278        |       | EMEA—Europe/Middle East/Africa |       | 387                                 |       | 133 |   | 32 | % | 13 | % | 254 |   | 191.0 | % |
| 59         |       | 58         |       | 59         |       | 74         |       | APAC—Asia Pacific              |       | 89                                  |       | 59 |   | 7 | % | 6 | % | 30 |   | 50.8 | % |
| 54         |       | 54         |       | 53         |       | 62         |       | Americas, non-U.S.                  |       | 57                                  |       | 54 |   | 5 | % | 5 | % | 3 |   | 5.6 | % |
| 246        |       | 247        |       | 254        |       | 414        |       | Total international                 |       | 533                                 |       | 246 |   | 44 | % | 24 | % | 287 |   | 116.7 | % |
| $          | 1,006      |       | $          | 1,016      |       | $          | 1,076      |                                | $          | 1,148                               |       | Total revenue |   | $ | 1,222 |   | $ | 1,006 |   | 100 | % | 100 | % | $ | 216 |   | 21.5 | % |
|            |            |            |            |            |            |            |            |                                     |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

U.S. revenues were down considerably against thecomparable prior year quarter due to the realignment of our sales and marketingstructure, the integration efforts associated with Tenovis and lower levels ofpurchases from our indirect channel partners, as well as decreases in the scopeof existing maintenance contracts and pricing pressures, as described above.

Higher revenues in EMEA were primarily attributable tothe acquisition of Tenovis. Revenues in EMEA also benefited from the increasedacceptance of IP telephony, which increased customers’ willingness to spend onconverged communications technology. Excluding Tenovis, revenues in EMEAincreased by $17 million, primarily related to sales of large communicationssystems. In addition, currency translation had a positive impact as the eurostrengthened against the U.S. dollar. Revenues in APAC benefited from the acquisitionof a majority ownership interest in AGC in the fourth quarter of fiscal 2004, whichadded approximately $19 million in incremental revenues, as well as highervolumes in China and Japan, particularly in connection with sales to ourcustomers in the financial services industry. Revenues in the Americas,non-U.S. region benefited from higher volumes associated with the call centerbusiness due to the expansion and upgrade of the installed base in LatinAmerica.

Thefollowing table sets forth a comparison of revenue from sales of products by channel:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 211        |       | $          | 219        |       | $          | 280        |                              | $          | 261                                 |       | Direct |   | $ | 265 |   | $ | 211 |   | 49 | % | 43 | % | $ | 54 |   | 25.6 | % |
| 284        |       | 287        |       | 285        |       | 293        |       | Indirect                          |       | 278                                 |       | 284 |   | 51 | % | 57 | % | (6 | ) | -2.1 | % |
| $          | 495   |       | $          | 506        |       | $          | 565   |                              | $          | 554                                 |       | Total sales of products |   | $ | 543  |   | $ | 495 |   | 100 | % | 100 | % | $ | 48 |   | 9.7 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue from the sales ofproducts through the direct channel increased due to the acquisition ofTenovis, which sells primarily through the direct channel. The effects of theTenovis acquisition were partially offset by our sales force realignment whichresulted in redirection of the focus of our channel composition to concentratedirect channel efforts on larger customers and transactions. The responsibilityfor handling many smaller customers and transactions has been transferred toour indirect channel partners.

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***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 259        |       | $          | 273        |       | $          | 328        |                              | $          | 309                                 |       | On sales of  products |   | $ | 298 |   | $ | 259 |   | 54.9 | % | 52.3 | % | $ | 39 |   | 15.1 | % |
| 181        |       | 183        |       | 183        |       | 169        |       | On services                       |       | 159                                 |       | 181 |   | 31.9 | % | 40.7 | % | (22 | ) | -12.2 | % |
| 31         |       | 32         |       | 27         |       | 65         |       | On rental and  managed services   |       | 106                                 |       | 31 |   | 58.6 | % | 47.0 | % | 75 |   | 241.9 | % |
| $          | 471        |       | $          | 488        |       | $          | 538        |                              | $          | 543                                 |       | Total gross margin |   | $ | 563 |   | $ | 471 |   | 46.1 | % | 46.8 | % | $ | 92 |   | 19.5 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Gross margin on the salesof products increased $39 million compared to the second quarter of fiscal 2004due primarily to additional sales volumes gained from the acquisition ofTenovis, the increased proportion of software to hardware in our product mixand the benefits associated with our ongoing cost reduction initiatives. However,while the acquisition of Tenovis added additional gross margin in dollars, as apercent of revenue, our overall gross margin gains were partially offset by thelower margins achieved by Tenovis.

Gross margin on servicesdecreased $22 million due mainly to decreased U.S. volumes, and gross margin asa percent of revenue declined due to the impact of the relatively lower marginTenovis services business. In addition, gross margins were negatively impactedby changes in revenue mix, primarily due to a higher proportion of governmentcontracts and wire installations, which generate lower margins.

Gross margin on rental andmanaged services increased $75 million due entirely to the acquisition ofTenovis. This increase was partially offset by lower revenues associated withU.S. managed services.

***Operating expenses***

Thefollowing table sets forth a comparison of operating expenses:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 328        |       | $          | 307        |       | $          | 326        |                              | $          | 357                                 |       | Selling, general  and administrative |   | $ | 406 |   | $ | 328 |   | 33.2 | % | 32.6 | % | $ | 78 |   | 23.8 | % |
| 83         |       | 89         |       | 93         |       | 98         |       | Research and  development         |       | 105                                 |       | 83 |   | 8.6 | % | 8.3 | % | 22 |   | 26.5 | % |
| $          | 411        |       | $          | 396        |       | $          | 419        |                              | $          | 455                                 |       | Total operating expenses |   | $ | 511 |   | $ | 411 |   | 41.8 | % | 40.9 | % | $ | 100 |   | 24.3 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in SG&Aexpenses is primarily due to the acquisition of Tenovis, and to a lesserextent, our other acquisitions. The increase in SG&A expenses as a percentof revenue due to acquisitions was partially offset due to improved operationalefficiencies.

Research and development(R&D) expenses increased due to the acquisition of Tenovis.

***Other Income(Expense), Net***

Thefollowing table sets forth a comparison of other income (expense), net:
|          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|----------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q04** | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **Change** | ** ** |
| $        | (19        | )          | $          | (11        | )          |       | $          | 9                                 |       |                                | $          | (38 | ) | Other income (expense),  net |   | $ | — |   | $ | (19 | ) | $ | 19 |   | -100 | % |
|          |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income (expense),net for the second fiscal quarter of 2005 is primarily related to the $2million loss on the repayment of $103 million principal amount of securedfloating rate notes, as well as other miscellaneous expenses that were offsetby $6 million of interest income. Other income (expense), net for 

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the sameperiod last year was primarily related to the $21 million loss on theextinguishment of $224 million aggregate principal amount of senior notes.

***Interest Expense***

Thefollowing table sets forth a comparison of interest expense:
| ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** 2Q04 ** | ** ** | ** 3Q04 ** | ** ** | ** 4Q04 ** | ** ** | ** 1Q05 ** | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | ** 2004 ** | ** ** | **Change** | ** ** |
|                 | $          | 19                   |       |                 |       | $                    | 14         |                              |       |                                | $          | 12 |   |   |   | $ | 10 |   |   | Interest expense |   |   | $ | 5 |   |   |   | $ | 19 |   |   | $ | (14 | ) | -74 | % |
|                      |            |                      |            |                      |            |                      |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in interestexpense is due to lower year over year debt levels. Overall debt decreasedprimarily due to the repurchases of our senior notes in fiscal 2004 and thefirst quarter of fiscal 2005, as well as the redemption for cash and conversioninto common stock of our LYONs in the first quarter of fiscal 2005. Thisdecrease was partially offset by interest expense associated with the debtassumed in the Tenovis acquisition. A portion of this assumed debt was repaidduring the three months ended March 31, 2005.

***Provision for Income Taxes***

Thefollowing table sets forth a comparison of the provision for (benefit from)income taxes:
|          | ** ** | ** ** | ** ** | ** **           | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** **           |
|----------|------------|------------|------------|----------------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|----------------------|
| **2Q04** | ** ** | **3Q04**   | ** ** | ** 4Q04 ** | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** 2005 ** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $        | (81        | )          |       | $                    | 9          |       |       |                              | $          | 16                                  |                 |   |   | $ | 7 |   |   | Provision for (benefit  from) income taxes |   |   | $ | 11 |   |   | $ | (81 | ) | $ | 92 |   | -114 | % |
|          |            |            |            |                      |            |            |            |                                   |            |                                     |                      |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for incometaxes in the second quarter of fiscal 2005 was composed of state and foreignincome taxes. The benefit from income taxes for the same period last fiscalyear was primarily due to an $89 million benefit from the favorable settlementof certain tax matters for the periods prior to the distribution in accordancewith the Tax Sharing Agreement between us and Lucent, partially offset by a $6million provision for state and foreign income taxes and a $2 million provisionfor other adjustments.

**Segment Results**

As discussed above, wechanged our operating segment structure effective October 2004. Theresults for the quarters presented have been reclassified to reflect our newsegment structure.

***Global Communications Solutions***

The Global Communications Solutions segment sellscommunications systems and converged voice applications designed for both largeand small enterprises. Our offerings in this segment include IP telephonysystems, multi-media contact center infrastructure and applications in supportof customer relationship management, unified communications applications andappliances, and traditional voice communications systems.

LargeCommunications Systems are IP and traditional telephony systems marketed tolarge 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 IPtelephony systems;

·       associatedappliances, such as telephone handsets and soft clients;

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·       AvayaIntegrated ManagementTM, a Web-based comprehensive set of tools that managescomplex voice and data network infrastructures;

·       AvayaCommunications ManagerTM, 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 CellularTM offering, which transparently bridges any cell phone toany Avaya communications server.

SmallCommunications Systems are IP and traditional telephony systems marketed tosmall enterprises. These systems include:

·       AvayaIP OfficeTM, an IP telephony system for small and medium-sizedenterprises;

·       TraditionalKey Systems, PartnerTM, MagixTM and LegendTM 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:

·       applicationsthat facilitate and enhance interaction in an enterprise with customers,partners, suppliers and employees; and

·       messagingfor IP and traditional systems.

Thefollowing table sets forth revenue by similar class of products within theGlobal Communications Solutions segment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 295        |       | $          | 299        |       | $          | 336        |                              | $          | 354                                 |       | Large  Communications Systems |   | $ | 393 |   | $ | 295 |   | 63 | % | 60 | % | $ | 98 |   | 33.2 | % |
| 58         |       | 57         |       | 59         |       | 69         |       | Small  Communications Systems     |       | 78                                  |       | 58 |   | 13 | % | 12 | % | 20 |   | 34.5 | % |
| 131        |       | 133        |       | 159        |       | 150        |       | Converged Voice  Applications     |       | 145                                 |       | 131 |   | 23 | % | 26 | % | 14 |   | 10.7 | % |
| 9          |       | 17         |       | 11         |       | 19         |       | Other                             |       | 9                                   |       | 9 |   | 1 | % | 2 | % | — |   | 0.0 | % |
| $          | 493        |       | $          | 506        |       | $          | 565        |                              | $          | 592                                 |       | Total revenue |   | $ | 625 |   | $ | 493 |   | 100 | % | 100 | % | $ | 132 |   | 26.8 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue for all GCS product classeswas primarily attributable to the acquisition of Tenovis, as well as a slightincrease due to foreign currency translation. Large Communications Systems alsobenefited from the acquisition of a majority interest in AGC, as well as highervolumes associated with gateways, servers and terminals sold in connection withIP systems. The increase in Small Communications Systems revenues attributableto Tenovis was partially offset by lower sales volumes, mainly in the indirectchannel, due to decreased purchases by our U.S. indirect channel partners. Revenuefrom Converged Voice Applications also increased due to higher volumes.

Thefollowing table sets forth operating income (loss) of the Global CommunicationsSolutions segment:
|                                  | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|----------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **  2Q04  ** | ** ** | ** 3Q04 ** | ** ** | ** 4Q04 ** | ** ** | ** 1Q05 ** | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | ** 2004 ** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
|                                  | $          | (3                   | )          |                 |       | $                    | 17         |                              |       |                                | $          | 55 |   |   |   | $ | 25 |   |   | Operating income (loss) |   | $ | (12 | ) |   | $ | (3 | ) |   | -1.9 | % | -0.6 | % | $ | (9 | ) | 300.0 | % |
|                                  |            |                      |            |                      |            |                      |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

39

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The increase in theoperating loss for the second quarter of fiscal 2005 was due entirely toTenovis.

***Avaya Global Services***

The Avaya GlobalServices segment is focused on supporting our broad customer base withcomprehensive end-to-end global service offerings that enable our customers toplan, design, implement, monitor and manage their converged communicationsnetworks worldwide. AGS provides its services through the following offerings:

Maintenance—AGSmonitors and optimizes customers’ network performance ensuring availability andkeeps communication networks current with the latest software releases. In theevent of an outage, our customers receive the on-site support they need torecover quickly.

Implementation andintegration services—Through operation, implementation and integrationspecialists worldwide, AGS helps customers leverage and optimize theirmulti-technology, multi-vendor environments through the use of contact centers,unified communication networks, and IP telephony.

Rental and managedservices—AGS supplements our customers’ in-house staff and manages complexmulti-vendor, multi-technology networks, optimizes network performance andconfigurations, backs up systems, detects and resolves faults, performs moves,adds, and changes and manages our customers’ trouble tickets and inventory.

Thefollowing table sets forth revenue by similar class of services within theAvaya Global Services segment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                               | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                               | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q04**   | ** ** | **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **Dollars in millions**        | ** ** | ** **                          | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 362        |       | $          | 359        |       | $          | 358        |                                     | $          | 371                                 |       | Maintenance |   | $ | 372 |   | $ | 362 |   | 62 | % | 71 | % | $ | 10 |   | 2.8 | % |
| 83         |       | 87         |       | 95         |       | 103        |       | Implementation  and integration services |       | 122                                 |       | 83 |   | 21 | % | 16 | % | 39 |   | 47.0 | % |
| 66         |       | 64         |       | 57         |       | 79         |       | Rental and  managed services             |       | 96                                  |       | 66 |   | 16 | % | 13 | % | 30 |   | 45.5 | % |
| —     |       | —     |       | 1          |       | 3          |       | Other                                    |       | 7                                   |       | — |   | 1 | % | 0 | % | 7 |   | n/a |   |
| $          | 511        |       | $          | 510        |       | $          | 511        |                                     | $          | 556                                 |       | Total revenue |   | $ | 597 |   | $ | 511 |   | 100 | % | 100 | % | $ | 86 |   | 16.8 | % |
|            |            |            |            |            |            |            |            |                                          |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue for AGS was primarilyattributable to the acquisition of Tenovis, as well as a slight increase due toforeign currency impacts, partially offset by lower volumes in the maintenanceand rental and managed services businesses.

The acquisition of Tenovis favorably impacted revenuefor each of the service lines. However, these sales increases were partiallyoffset by lower volumes, especially in the U.S. Our maintenance business ishighly correlated to product sales, and because our products typically carry a12-month warranty, the opportunity to realize maintenance revenues occurssubsequent to the expiration of the warranty. In addition, our maintenance revenueswere unfavorably impacted by renegotiations by customers of their contracts tochange the scope of existing maintenance and managed services contracts, pricingpressures and cancellations. Implementation and integration services revenueswere favorably impacted by expanded sales volume of government contracts, wireinstallations and the trending of product sales in the recent quarters. Rentaland managed services revenues in the U.S. were unfavorably affected by customerchanges in scope, pricing pressures and cancellations.

40

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Thefollowing table sets forth operating income of the Avaya Global Servicessegment:
|                      | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** 2Q04 ** | ** ** | ** 3Q04 ** | ** ** | ** 4Q04 ** | ** ** | ** 1Q05 ** | ** ** | **Dollars in millions** | ** ** | ** **                          | **2005**   | ** ** | ** 2004 ** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
|                 | $          | 63                   |       |                 |       | $                    | 68         |                              |       |                                | $          | 65 |   |   |   | $ | 56 |   |   | Operating income |   | $ | 27 |   |   | $ | 63 |   |   | 4.5 | % | 12.3 | % | $ | (36 | ) | -57.1 | % |
|                      |            |                      |            |                      |            |                      |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Tenovis servicesbusiness contributed an operating loss as a result of the relatively lowergross margin rates on rental and managed services, as well as additionalSG&A expenses. The decrease in operating income was also attributable tothe mix in revenues. There was lower sales volume of traditional Avaya servicessuch as maintenance versus expanded volume of lower margin services such asimplementation and integration. In addition, because the vast majority of ourcosts of services in the U.S. relates to our relatively fixed AGS workforce, asvolumes decrease our gross margin and operating income are adversely affected.These fixed costs, coupled with the low margins achieved by Tenovis and thechange in sales mix, resulted in AGS gross margins decreasing from 41% to 33%,directly impacting our operating income. These impacts were partially mitigatedby operational efficiencies including activities related to AGS workforcereductions which took effect during the second quarter.

**Corporate/Unallocated**

Revenues that are notassociated with one of our operating segments are presented underCorporate/Unallocated. Revenue of $2 million in the second quarter of fiscal2004 represents sales associated with the acquisition of Expanets. These saleswere not allocated to one of our operating segments because the sales were ofnon-Avaya products that were ordered prior to the acquisition, and wereconsummated subsequent to the closing of the acquisition.

Operating income of $37million in the second quarter of fiscal 2005 is primarily due to lowercorporate overhead expenses mainly driven by a reduction of the estimatedannual incentive award expenses, as well as lower than expected informationtechnology and other corporate expenses. At the beginning of each fiscal year,the amount of certain corporate overhead expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year in the annual plan. The annual incentive award accrual isadjusted quarterly based on actual year to date results and those estimated forthe remainder of the year. This adjustment of the annual incentive awardaccrual, as well as any other over/under absorption of corporate overheadsagainst plan is recorded and reported within the Corporate/Unallocated caption.

***Six Months Ended March 31, 2005 Compared with SixMonths Ended March 31, 2004***

***Revenue***

The increase in revenuecompared to the first six months of fiscal 2004 was driven primarily by theacquisition of Tenovis, which added revenues of $361 million. Revenues werealso positively impacted by the acquisition of a majority interest in AGC inthe fourth quarter of fiscal 2004. Additionally, revenues increasedapproximately $20 million due to foreign currency translation due to of theweakening of the U.S. dollar, particularly against the euro.

Thefollowing table sets forth a comparison of revenue by type:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Sales of products                 |       | $                                                  | 1,097      |   | $ | 977 |   | 46 | % | 49 | % | $ | 120 |   | 12.3 | % |
| Services                          |       | 975                                                |       | 861 |   | 41 | % | 44 | % | 114 |   | 13.2 | % |
| Rental and managed  services      |       | 298                                                |       | 139 |   | 13 | % | 7 | % | 159 |   | 114.4 | % |
| Total revenue                     |       | $                                                  | 2,370      |   | $ | 1,977 |   | 100 | % | 100 | % | $ | 393 |   | 19.9 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

41

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Higher revenues in all categories were primarily dueto the acquisition of Tenovis. Revenues from sales of products also benefitedfrom the acquisition of a majority interest in AGC in the fourth quarter offiscal 2004. The increases in revenues from direct sales of product werepartially offset by lower volumes in the indirect channel as a result of thesales force realignment and the distraction caused by the Tenovis integration. Theincrease in revenues from services and rental and managed services, primarilyattributable to Tenovis, was partially offset by lower volumes due mainly torenegotiations affecting the scope of existing managed services contracts, aswell as pricing pressures and cancellations.

Thefollowing table sets forth a geographic comparison of revenue:
| ** **                          | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**   | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| U.S.                                |       | $                                                  | 1,423      |   | $ | 1,498 |   | 60 | % | 76 | % | $ | (75 | ) | -5.0 | % |
| International:                      |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| EMEA—Europe/Middle East/Africa |       | 665                                                |       | 261 |   | 28 | % | 13 | % | 404 |   | 154.8 | % |
| APAC—Asia Pacific              |       | 163                                                |       | 109 |   | 7 | % | 6 | % | 54 |   | 49.5 | % |
| Americas, non-U.S.                  |       | 119                                                |       | 109 |   | 5 | % | 5 | % | 10 |   | 9.2 | % |
| Total international                 |       | 947                                                |       | 479 |   | 40 | % | 24 | % | 468 |   | 97.7 | % |
| Total revenue                       |       | $                                                  | 2,370      |   | $ | 1,977 |   | 100 | % | 100 | % | $ | 393 |   | 19.9 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

U.S. revenues were down against the comparable prior six-monthperiod due to the realignment of our sales and marketing structure, theintegration efforts associated with Tenovis, and lower levels of purchases fromour indirect channel partners, as well as decreases in the scope of existingmaintenance contracts and pricing pressures in our Services business asdescribed above.

Higher revenues in EMEA were primarily attributable tothe acquisition of Tenovis. Revenues in EMEA continue to benefit from theincreased acceptance of IP telephony, which increased customers’ willingness tospend on converged communications technology. Excluding Tenovis, revenues inEMEA increased by $42 million, primarily related to sales of largecommunications systems. In addition, currency translation had a positive impactas the euro strengthened against the U.S. dollar. Revenues in APAC benefitedfrom the acquisition of a majority ownership interest in AGC as well as highervolumes in China and Japan, particularly in connection with sales to ourcustomers in the financial services industry. Revenues in the Americas,non-U.S. region benefited from higher volumes associated with the call centerbusiness due to the expansion and upgrade of the installed base in LatinAmerica.

The following table setsforth acomparison of revenue from sales of products by channel:
| ** **                        | ** ** | **Six Months Ended March31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------|------------|
| ** **                        | ** ** | ** **                                   | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Direct                            |       | $                                            | 526        |   | $ | 424 |   | 48 | % | 43 | % | $ | 102 |   | 24.1 | % |
| Indirect                          |       | 571                                          |       | 553 |   | 52 | % | 57 | % | 18 |   | 3.3 | % |
| Total sales of products           |       | $                                            | 1,097      |   | $ | 977 |   | 100 | % | 100 | % | $ | 120 |   | 12.3 | % |
|                                   |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue from the sales ofproducts through the direct channel increased due to the acquisition ofTenovis, which sells primarily through the direct channel. The effects of theTenovis acquisition were partially offset by our efforts to redirect the focusof our channel composition to concentrate direct channel efforts on largercustomers and transactions. The responsibility of handling many smallercustomers and transactions has been transferred to our indirect channelpartners.

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***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| On sales of  products             |       | $                                                  | 607        |   | $ | 519 |   |   | 55.3 | % |   |   | 53.1 | % |   | $ | 88 |   | 17.0 | % |
| On services                       |       | 328                                                |       | 331 |   |   | 33.6 | % |   |   | 38.4 | % |   | (3 | ) | -0.9 | % |
| On rental and  managed services   |       | 171                                                |       | 69 |   |   | 57.4 | % |   |   | 49.6 | % |   | 102 |   | 147.8 | % |
| Total gross  margin               |       | $                                                  | 1,106      |   | $ | 919 |   |   | 46.7 | % |   |   | 46.5 | % |   | $ | 187 |   | 20.3 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Gross margin on the sales of products increased dueprimarily to additional sales volumes gained from the acquisition of Tenovis,the increased proportion of software to hardware in our product mix and thebenefits associated with our ongoing cost reduction initiatives. However, whilethe acquisition of Tenovis added additional gross margin in dollars, as apercent of revenue, our overall gross margin gains were partially offset by thelower margins achieved by Tenovis.

Gross margin on services decreased due mainly to theimpact of lower volumes and higher costs in the U.S., as well as the impact ofthe relatively lower margin Tenovis services business. In addition, grossmargins were negatively impacted by changes in revenue mix primarily due to ahigher proportion of government contracts and wire installations, whichgenerate lower margins.

Gross margin on rental andmanaged services increased due primarily to the acquisition of Tenovis, whichwas partially offset by lower revenues associated with U.S. managed services.

***Operating expenses***

Thefollowing table sets forth a comparison of operating expenses:
| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**    | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| Selling, general  and administrative |       | $                                                  | 763        |   | $ | 641 |   |   | 32.2 | % |   |   | 32.4 | % |   | $ | 122 |   | 19.0 | % |
| Research and  development            |       | 203                                                |       | 166 |   |   | 8.6 | % |   |   | 8.4 | % |   | 37 |   | 22.3 | % |
| Total operating expenses             |       | 966                                                |       | 807 |   |   | 40.8 | % |   |   | 40.8 | % |   | $ | 159 |   | 19.7 | % |
|                                      |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in SG&A expenses is primarily due tothe acquisition of Tenovis, and to a lesser extent, our other acquisitions. Theincrease in SG&A expenses as a percent of revenue due to acquisitions wasmore than offset by improved operational efficiencies.

Research and developmentexpenses increased due to the acquisition of Tenovis.

***Other Income (Expense), Net***

Thefollowing table sets forth a comparison of other income (expense), net:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| **Dollars in millions** | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Other income  (expense), net      |       | $                                                  | (38        | ) | $ | (13 | ) | $ | (25 | ) | 192 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Other income (expense),net for the six months ended March 31, 2005 is due primarily due to a $41million loss on the repurchase of $271 million aggregate principal amount ofsenior notes and a $2 million loss on the repayment of $103 million principalamount of secured floating fate notes. Other income (expense), net for the sameperiod last fiscal year was mainly due to the $21 million loss on the 

43

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extinguishmentof a portion of our senior notes and a $5 million loss on the sale of Commscopecommon stock (which we acquired with the disposal of our Connectivity Solutionsbusiness), partially offset by $7 million of interest income.

***Interest Expense***

Thefollowing table sets forth a comparison of interest expense:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| **Dollars in millions** | ** ** | ** **                                         | ** ** | ** 2005 ** | ** ** | ** 2004 ** | ** ** | **Change** | ** ** |
| Interest expense                  |       |                                               | $          | 15 |   |   |   | $ | 40 |   |   | $ | (25 | ) | -63 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in interestexpense is due to lower year over year debt levels. Overall debt decreasedprimarily due to the repurchases of our senior notes in fiscal 2004 and thefirst quarter of fiscal 2005, as well as the redemption for cash and conversioninto common stock of our LYONs in the first quarter of fiscal 2005. Thisdecrease was partially offset by interest expense associated with the debtassumed in the Tenovis acquisition. A portion of this assumed debt was repaidduring the second quarter of fiscal 2005.

***Provision for Income Taxes***

The following table sets forth a comparison of theprovision for (benefit from) income taxes:
| ** **                                 | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|
| **Dollars in millions**          | ** ** | ** **                                         | ** ** | ** 2005 ** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Provision for  (benefit from) income taxes |       |                                               | $          | 18 |   |   | $ | (74 | ) | $ | 92 |   | -124 | % |
|                                            |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for incometaxes for the first half of fiscal 2005 was composed of state and foreignincome taxes. The benefit from income taxes for the same period last fiscalyear primarily related to the $89 million benefit for favorable settlement ofcertain tax matters for periods prior to the distribution in accordance withthe Tax Sharing Agreement between us and Lucent, partially offset by an $11million provision for state and foreign income taxes and $4 million provisionfor other adjustments.

**Segment Results**

As discussed above, wechanged our operating segment structure effective October 2004. Theresults for the periods presented have been reclassified to reflect our newsegment structure.

***Global Communications Solutions***

The following table setsforth revenue by similar class of products within the Global CommunicationsSolutions segment:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Large  Communications Systems     |       | $                                                  | 747        |   | $ | 575 |   | 62 | % | 59 | % |   | $ | 172 |   |   | 29.9 | % |
| Small  Communications Systems     |       | 147                                                |       | 112 |   | 12 | % | 11 | % |   | 35 |   |   | 31.3 | % |
| Converged Voice  Applications     |       | 295                                                |       | 260 |   | 24 | % | 27 | % |   | 35 |   |   | 13.5 | % |
| Other                             |       | 28                                                 |       | 26 |   | 2 | % | 3 | % |   | 2 |   |   | 7.7 | % |
| Total revenue                     |       | $                                                  | 1,217      |   | $ | 973 |   | 100 | % | 100 | % |   | $ | 244 |   |   | 25.1 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in total revenue for GCS was primarilyattributable to the acquisition of Tenovis, as well as the benefits fromcurrency translation. Large Communications Systems also had increased revenuesfrom stronger sales volumes and a more favorable product mix with respect tosoftware and gateways, as 

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well as the acquisition ofa majority interest in AGC. The increase in Small Communications Systemsrevenues attributable to Tenovis was partially offset by lower U.S. salesvolumes, mainly in the indirect channel due to lower purchases by our U.S.indirect channel partners. Revenuefrom Converged Voice Applications also increased due to higher volumes andproduct mix associated with contact centers, as well as the acquisition of AGC.

Thefollowing table sets forth operating income (loss) of the Global CommunicationsSolutions segment:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                         | ** ** | ** 2005 ** | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| Operating income  (loss)          |       |                                               | $          | 13 |   |   | $ | (1 | ) |   | 1.1 | % |   |   | -0.1 | % |   |    $ 14    |   | -1400.0 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome was primarily related to greater sales volumes coupled with a morefavorable product mix with respect to software and applications which createdimproved product margins. In addition, the cost reduction initiatives wereeffectively executed to drive profitability. The increase in operating incomewas partially offset by the operating results of Tenovis, which had a negativeimpact on operating income.

***Avaya Global Services***

Thefollowing table sets forth revenue by similar class of services within theAvaya Global Services segment:
| ** **                               | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions**        | ** ** | ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| Maintenance                              |       | $                                                  | 743        |   | $ | 705 |   | 64 | % | 70 | % | $ | 38 |   | 5.4 | % |
| Implementation  and integration services |       | 225                                                |       | 156 |   | 20 | % | 16 | % | 69 |   | 44.2 | % |
| Rental and  managed services             |       | 175                                                |       | 139 |   | 15 | % | 14 | % | 36 |   | 25.9 | % |
| Other                                    |       | 10                                                 |       | — |   | 1 | % | 0 | % | 10 |   | n/a |   |
| Total revenue                            |       | $                                                  | 1,153      |   | $ | 1,000 |   | 100 | % | 100 | % | $ | 153 |   | 15.3 | % |
|                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue for AGS was primarilyattributable to the acquisition of Tenovis, sales of new services and favorableforeign currency impact, partially offset by lower volumes and pricingpressures in maintenance and rental and managed services revenues in the U.S.

The acquisition of Tenovis generated revenue for eachof the service lines. In addition, increases in maintenance revenues were dueto sales of new services and off-warranty sales, partially offset by lowervolumes in existing contract-related maintenance sales. These lower volumeswere primarily due to changes in contract scope for U.S. customers and pricingpressures. Implementation and integration services revenues benefited from thetrending of product sales in recent quarters and increases in ourinfrastructure implementation business. Rental and managed services revenueswere unfavorably impacted by customer changes in scope, pricing pressures andcancellations.

Thefollowing table sets forth operating income of the Avaya Global Servicessegment:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Dollars in millions** | ** ** | ** **                                         | ** ** | ** 2005 ** | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| Operating income                  |       |                                               | $          | 83 |   |   | $ | 116 |   |   | 7.2 | % |   |   | 11.6 | % |   | $ | (33 | ) | -28.4 | % |
|                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The Tenovis servicesbusiness contributed an operating loss. The decrease in operating income wasalso attributable to the mix in revenues. There was lower sales volume oftraditional Avaya services such as maintenance versus expanded volume of lowermargin services such as implementation and integration. In addition, becausethe vast majority of our costs of services in the U.S. relates to ourrelatively fixed AGS workforce, as volumes decrease our gross margin andoperating income are adversely affected. These fixed costs coupled with the lowmargins achieved by Tenovis and the change in sales mix, resulted in lowergross margins, which directly impacted our operating income. These impacts werepartially mitigated by operational efficiencies including activities related tothe AGS workforce reductions.

**Corporate/Unallocated**

Revenues that are not associated with one of ouroperating segments are presented under Corporate/Unallocated. Revenue of $4million in the six months ended March 31, 2004 represents sales associatedwith the acquisition of Expanets. These sales were not allocated to one of ouroperating segments because the sales were of non-Avaya products that wereordered prior to the acquisition, and were consummated subsequent to theclosing of the acquisition.

Operating income of $44million in the six months ended March 31, 2005 is primarily due to lowercorporate overhead expenses mainly driven by a reduction of the estimatedannual incentive award expenses, as well as lower than expected informationtechnology and other corporate expenses. At the beginning of each fiscal year,the amount of certain corporate overhead expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixed forthe entire year in the annual plan. The annual incentive award accrual isadjusted quarterly based on actual year to date results and those estimated forthe remainder of the year. This adjustment of the annual incentive awardaccrual, as well as any other over/under absorption of corporate overheadsagainst plan is recorded and reported within the Corporate/Unallocated caption.

**Results of Discontinued Operations**

The $2 million loss fromdiscontinued operations is primarily related to the result of the finalizationof the working capital adjustment related to the sale of our ConnectivitySolutions business, in accordance with the asset purchase agreement.

**Liquidity and Capital Resources**

During the first six months of fiscal 2005, we focusedon reducing the amount of our debt, while balancing our cash needs forstrategic acquisitions. Our cash and cash equivalents decreased to $855 millionas of March 31, 2005 from $1,617 million as of September 30,2004.

As part of ourde-leveraging strategy, we called and repurchased all of our remainingoutstanding LYONs (after substantially all the holders of LYONs converted theirLYONs into Avaya common stock shortly before the repurchase date) andrepurchased substantially all of our outstanding senior notes during the firstquarter of fiscal 2005. These reductions in debt were partially offset by theclosing of the Tenovis acquisition and the assumption of certain related debt,of which we repaid a significant portion subsequent to the acquisition. Theimpact of these transactions is described in the “Investing Activities” and “FinancingActivities” discussions below. Primarily as a result of these actions, wereduced our debt balance from $593 million as of September 30, 2004 to$188 million as of March 31, 2005.

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***Sources and Uses of Cash for the Six Months Ended March 31,2005***

Acondensed statement of cash flows for the six months ended March 31, 2005and 2004 follows:
| ** **                                                                       | ** ** | **Six months ended March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| **Dollars in millions**                                                | ** ** | ** **                                         | ** ** | **       2005       ** | ** ** | **       2004       ** | ** ** |
| Net cash provided  by (used for):                                                |       |                                               |       |   |   |   |   |   |   |
| Operating activities from continuing operations                                  |       |                                               | $          | 60 |   |   |   | $ | 140 |   |   |
| Investing activities from continuing operations                                  |       |                                               | (450       | ) |   |   | 131 |   |   |
| Financing activities from continuing operations                                  |       |                                               | (380       | ) |   |   | 68 |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                    |       |                                               | 8          |   |   |   | 9 |   |   |
| Net (decrease)  increase in cash and cash equivalents from continuing operations |       |                                               | (762       | ) |   |   | 348 |   |   |
| Net decrease in cash and cash equivalents from  discontinued operations          |       |                                               | —     |   |   |   | (24 | ) |   |
| Cash and cash equivalents at beginning of year                                   |       |                                               | 1,617      |   |   |   | 1,192 |   |   |
| Cash and cash  equivalents at end of period                                      |       |                                               | $          | 855 |   |   |   | $ | 1,516 |   |   |
|                                                                                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |

 

***Operating Activities***

Our net cash provided by operating activities fromcontinuing operations was $60 million for the six months of fiscal 2005,compared to $140 million for the six months of fiscal 2004. The decrease incash provided by operating activities was primarily driven by higher incentivepayments, interest payments, and lower profitability.

*Higher incentives*—The firstsix months of fiscal 2005 included payments of management incentives based onthe full fiscal year 2004 performance, whereas the payments paid during thefirst six months of fiscal 2004 were based on only the second half of fiscal2003. The higher payments are also attributable to our significantly increasedprofitability in fiscal 2004 compared to fiscal 2003.

*Interest payments*—Inconnection with the debt repurchases and repayments, we made cash payments of$24 million for interest.

*Decrease in Net Income*—We generated net income of $67 million forthe first six months of fiscal 2005 compared to $135 million in the same periodlast year, a $68 million year-over-year decline.

Changes in our working capital accounts are addressedbelow.

*AccountsReceivable, Net*—The following summarizes our accountsreceivable and related metrics:
| ** **                                                                 | ** ** | **March 31,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|------------|------------|
| **Dollars in millions**                                          | ** ** | ** **         | ** ** | **2005**               | ** ** | **2004**   | ** ** | **Change** | ** ** |
| Accounts  receivable, gross                                                |       | $                  | 837        |                   |       | $          | 744        |   |   | $ | 93 |   |
| Allowance for  doubtful accounts                                           |       | (44                | )          |                   | (48        | )          |       | 4 |   |
| Accounts receivable,  net                                                  |       | $                  | 793        |                   |       | $          | 696        |   |   | $ | 97 |   |
| Allowance for doubtful accounts as a percent of  gross accounts receivable |       | 5.3                | %          |                   | 6.5        | %          |       | -1.2  pts |   |
| Days sales outstanding (DSO)                                               |       | 58 days            |       |                   | 58 days    |       |       | no change |   |
| Past due  receivables as a percent of gross receivables                    |       | 24.7               | %          |                   | 13.3       | %          |       | +11.4 pts |   |
|                                                                            |            |                    |            |                        |            |            |            |  |  |  |  |  |  |  |

 

The accounts receivable balance has increased by $97million since September 30, 2004 due primarily to the acquisition ofTenovis. The allowance for doubtful accounts as a percent of gross accountsreceivable decreased by 1.2 percentage points. The allowance for doubtfulaccounts as of March 31, 2005 

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includes Tenovis’spost-acquisition allowance for doubtful accounts, while the allowance atacquisition date was netted against Tenovis’s gross accounts receivable. TheDSO, including Tenovis, has remained constant at 58 days. This metric is mainlydriven by the higher revenue levels towards the end of each quarter. The pastdue receivables percentage has increased by 11.4 percentage points since yearend, driven by Tenovis receivables, as the majority of rental customers withinTenovis have net, 10 days payment terms. Historically, Tenovis’s customers donot meet these terms, thus creating a significant percentage falling overdue onthe eleventh day. Typically, Avaya’s payment terms are approximately 30 days.

*Inventory*—Thefollowing summarizes our inventory and inventory turnover:
| ** **                         | ** ** | **March 31,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------|------------|------------|------------|
| **Dollars in millions**  | ** ** | ** **         | ** ** | **2005**               | ** ** | **2004**   | ** ** | **Change** | ** ** |
| Finished goods                     |       | $                  | 353        |                   |       | $          | 221        |   |   | $ | 132 |   |
| Work in process  and raw materials |       | 11                 |       |                   | 18         |       |       | (7 | ) |
| Total inventory                    |       | $                  | 364        |                   |       | $          | 239        |   |   | $ | 125 |   |
| Inventory  turnover                |       | 7.2 times          |       |                   | 9.0 times  |       |       | -1.8  times |   |
|                                    |            |                    |            |                        |            |            |            |  |  |  |  |  |  |  |

 

Tenovis accounted for the majority of the increase ininventory of $125 million since September 30, 2004. In addition, due tothe lower levels of purchases made by our indirect channel partners andincreased lead times for inventories purchased from our contract manufacturersin the second quarter of fiscal 2005, there was an increase in our inventoryholdings. These two factors had an adverse affect on the inventory turns as of March 31,2005. Additionally, the acquisition of Tenovis, whose inventory turnover was6.1, also had a negative impact on our inventory turnover.

*Accounts Payable*—Thefollowing summarizes our accounts payable:
| ** **                        | ** ** | **March 31,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|--------------------|------------|------------------------|------------|------------|------------|
| **Dollars in millions** | ** ** | ** **         | ** ** | **2005**               | ** ** | **2004**   | ** ** | **Change** | ** ** |
| Accounts payable                  |       |               | $          | 403                    |       |       |       | $ | 345 |   |   |   | $ | 58 |   |   |
|                                   |            |                    |            |                        |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

Our accounts payableincreased primarily as a result of trade payables recorded related to ouracquisitions.

***Investing Activities***

Net cash used forinvesting activities was $450 million for the first six months of fiscal 2005,compared with net cash provided by financing activities from continuingoperations of $131 million for the same period last year. Activities in thecurrent period include $383 million, net, used for acquisitions, including $265million for Tenovis and $110 million for Spectel. We also used $56 million forcapital expenditures and $27 million for capitalized software development costs.

***Financing Activities***

Net cash used forfinancing activities was $380 million for the first six months of fiscal 2005,compared with net cash provided by financing activities from continuingoperations of $68 million for the same period last year. Cash used in thecurrent period consisted primarily of $314 million to repurchase substantiallyall of our senior notes in a public tender offer, and $103 million to repay aportion of our outstanding principal of secured floating rate notes. These usesof cash were partially offset by $40 million of cash received in connectionwith the issuance of common stock under our employee stock purchase plan and stockoption plans.

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***Cash Flows of Discontinued Operations***

Discontinued operationsdid not use or provide cash for the first six months of fiscal 2005. Net cashused in discontinued operations for the same period last year was $18 millionfor Connectivity Solutions and $6 million for Expanets.

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

***Future CashRequirements***

Our primary future cash requirements will be to fundworking capital requirements and capital expenditures, to service the debt weassumed in connection with the Tenovis acquisition, and for benefit payments inconnection with the restructuring of Tenovis.

Specifically, we expect our primary cash requirementsfor the remainder of fiscal 2005 to be as follows:

·       *Debt repayments—*We acquired debt of $278million, including secured floating rate notes and capital lease obligations,in connection with the Tenovis acquisition, of which $103 million in principalof secured floating rate notes was repaid during the first six months of fiscal2005. Additionally, on May 4, 2005, we gave notice to the holders of thesecured floating rate notes of our intention to repay the remaining principalof $164 million secured floating rate notes on May 17, 2005. Consequently,we will terminate the remaining portion of the associated interest rate swapagreements.

·       *Capital expenditures*—We expect to spendapproximately $64 million for capital expenditures and approximately $13million for capitalized software development costs.

·       *Restructuring payments*—We have made $10 millionin payments related to Tenovis employee terminations and expect to makeadditional payments of approximately $9 million during the remainder of fiscal2005 and $68 million during fiscal 2006.

·       *Share Repurchase Plan*—In accordance withthe share repurchase plan authorized by the Board of Directors on April 19,2005, we may use up to $500 million of cash to repurchase shares of ouroutstanding common stock over the next two years. These repurchases will bemade at management’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms ofAvaya’s credit facility and other factors. SeeNote 8, “Long-Term Debt,” to our consolidated financial statements forfurther information concerning the limitations under the credit facility.

In addition, we may usecash in the future to make strategic acquisitions.

***Future Sources of Liquidity***

We expect our primary source of cash during theremainder of fiscal 2005 to be positive net cash provided by operatingactivities. We expect that growth in our revenues and continued focus onaccounts receivable and inventory management and cost containment will enableus to continue to generate positive net cash from operating activities.

Based on past performance and current expectations, webelieve that our existing cash and cash equivalents of $855 million and our netcash provided by operating activities will be sufficient to meet our futurecash requirements described above. We also believe we have sufficient cash andcash equivalents for future acquisitions. Our ability to meet theserequirements will depend on our ability to generate cash in the future, whichis subject to general economic, financial, competitive, legislative, regulatoryand other factors that are beyond our control.

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We and a syndicate of lenders are currently party to acredit facility of $400 million (see Note 8 “Long-Term Debt” to ourconsolidated financial statements), which expires in February 2010. Ourexisting cash and cash equivalents and net cash provided by operatingactivities may be insufficient if we face unanticipated cash needs such as thefunding of a future acquisition or other capital investment. Furthermore, if weacquire a business in the future that has existing debt, our debt servicerequirements may increase, thereby increasing our cash needs.

If we do not generatesufficient cash from operations, face unanticipated cash needs such as the needto fund significant strategic acquisitions or do not otherwise have sufficientcash and cash equivalents, we may need to incur additional debt or issue equity.In order to meet our cash needs we may, from time to time, borrow under ourcredit facility or issue other long- or short-term debt or equity, if themarket and the terms of our existing debt instruments permit.

***Uncertainties Regarding Our Liquidity***

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 ourrevenue were to stagnate or decline, our ability to generate net cash fromoperating activities in a sufficient amount to meet our cash needs could beadversely affected.

·       *Impact of Tenovis Acquisition*—Our recent acquisition ofTenovis could affect our liquidity as the integration of Tenovis’s business andoperations into ours will require significant cash resources.

·       *Debt Ratings*—Our ability to obtain external financing andthe related cost of borrowing are affected by our debt ratings. See “DebtRatings.”

·       *Future Acquisitions*—We may from time to time in the futuremake additional acquisitions. Such acquisitions may require significant amountsof cash or may result in increased debt service requirements to the extent weassume or incur debt in connection with such acquisition or acquisitions.

***Fair Value of Financial Instruments***

The fair value of our secured floating rate notes(including the related interest rate swaps) was $166 million as of March 31,2005, which decreased from $281 million during the second quarter of fiscal2005 due to the repayment of $103 million principal amount, correspondingreductions in interest rate swaps and net discount and change in foreigncurrency rates. The estimated aggregate fair market value of the senior notesdecreased from September 30, 2004 by $315 million to $15 million asof March 31, 2005 due to the repurchase of $271 million principal amountof these notes, and the corresponding decreases in the net premium andtermination of the interest rate swaps. The LYONs estimated aggregate fairvalue as of September 30, 2004 was $307 million, and was completelyeliminated following the redemption of all remaining LYONs on December 20,2004. The fair market values are based upon quoted market prices and yieldsobtained through independent pricing sources for the same or similar types ofborrowing arrangements taking into consideration the underlying terms of thedebt.

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 assumed two interest rate swaps in connection withour acquisition of Tenovis. These interest rate swaps, which were entered intoin order to effectively convert our secured floating rate notes into fixed ratenotes, have a fair value of $5 million as of March 31, 2005. See Note 8, “Long-TermDebt,” to our consolidated financial statements for more information.

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We conduct our business on a multi-nationalbasis in a wide variety of foreign currencies. We are therefore subject to therisk associated with foreign currency exchange rates and interest rates thatcould affect our results of operations, financial position and cash flows. Wemanage our exposure to these market risks through our regular operating andfinancing activities and, when deemed appropriate, through the use ofderivative financial instruments. We use derivative financial instruments toreduce earnings and cash flow volatility associated with foreign exchange ratechanges. Derivative financial instruments are used as risk management tools andnot for speculative or trading purposes. As of March 31, 2005 and September 30,2004, the estimated fair values of our foreign currency forward contracts werea loss of $1 million and a gain of $8 million, respectively, and wereincluded in other current assets. The estimated fair values of these forwardcontracts were based on market quotes obtained through independent pricingsources.

***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.Debt ratings and outlooks as of March 31, 2005 and September 30, 2004are as follows: 
| ** **                        | ** ** | **March 31, 2005** | ** **          | **September 30, 2004** | ** ** |
|-----------------------------------|------------|------------------------------|---------------------|----------------------------------|------------|
| ** **                        | ** ** | **Debt Ratings**        | ** **          | **Outlook**                      | ** ** | **Debt Ratings** | ** ** | **Outlook** | ** ** |
| Moody’s:                     |       |                         |                |                             |       |   |   |   |   |   |   |   |   |
| Issuer rating                     |       |                         | B1                  |                             |       | Positive |   |   | B2 |   |   | Positive |   |
| Senior notes                      |       |                         | withdrawn during Q2 |                             |       | B1 |   |   | Positive |   |
| Senior implied rating             |       |                         | Ba3                 |                             |       | Positive |   |   | B1 |   |   | Positive |   |
| Standard &  Poor’s: |       |                         |                |                             |       |   |   |   |   |   |   |   |   |
| Long-term senior unsecured debt   |       |                         | withdrawn during Q2 |                             |       | B |   |   | Positive |   |
| Senior notes                      |       |                         | withdrawn during Q1 |                             |       | B | + |   | Positive |   |
| Corporate credit                  |       |                         | BB                  |                             |       | Stable |   |   | B | + |   | Positive |   |

 

On April 21, 2005,Standard & Poor’s reaffirmed the above rating and outlook.

These security ratings arenot recommendations to buy, sell or hold securities. The ratings are subject tochange or withdrawal at any time by the respective credit rating agencies. Eachcredit rating should be evaluated independently of any other ratings.

***Credit Facility***

Our credit facilitycontains affirmative and restrictive covenants that we must comply with,including: (a) periodic financial reporting requirements, (b) maintaininga maximum ratio of (i) consolidated debt to (ii) earnings beforeinterest, taxes, depreciation and amortization, adjusted for certain businessrestructuring charges and related expenses and non-cash charges, referred to asadjusted EBITDA, of 2.00 to 1.00, (c) maintaining a minimum ratio ofadjusted EBITDA to interest expense of 4.00 to 1.00, (d) limitations onthe 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 creditfacility also limits the Company’s ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares ofits common stock to an amount not to exceed 50% of consolidated net incomeof the Company for the fiscal year immediately preceding the fiscal year inwhich such dividend, purchase, redemption, retirement or acquisition is paid ormade. For fiscal 2005, stock repurchases are currently limited under the creditfacility to $148 million. We expect to seek an amendment from the lendersunder the credit facility in the event that we determine to repurchase shares 

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of common stock in excessof the foregoing limitations pursuant to our stock repurchase plan. As of March 31,2005, we were in compliance with all of the covenants included in the creditfacility.

The credit facilityprovides that we may use up to $1 billion in cash (excluding transaction fees)and assumed debt for acquisitions completed after February 23, 2005,provided that we are in compliance with the terms of the agreement. Theacquisition amount will be permanently increased to $1.5 billion afterconsolidated EBITDA of us and our subsidiaries for any period of twelveconsecutive months equals or exceeds $750 million.

There are currently $53 million of letters ofcredit issued under the credit facility. There are no other outstandingborrowings under the facility and the remaining availability is $347 million.We believe the credit facility provides us with an important source of backupliquidity. See Note 8, Long-Term Debt, to our consolidated financialstatements, for a more detailed discussion of our credit facility.

**ForwardLooking Statements**

(Cautionary StatementsUnder the Private Securities Litigation Reform Act of 1995)

Our disclosure andanalysis in this report contains some forward-looking statements. Forward-lookingstatements give our current expectations or forecasts of future events. You canidentify these statements by the fact that they do not relate strictly tohistorical or current facts. They use words such as “anticipate,” “estimate,” “expect,”“project,” “intend,” “plan,” “believe,” and other words and terms of similarmeaning in connection with any discussion of future operating or financialperformance. From time to time, we also may provide oral or written forward-lookingstatements in other materials we release to the public.

Any or all of our forward-lookingstatements in this report, in the 2004 Annual Report to Shareholders and in anyother public statements we make *may turn outto be wrong*. They can be affected by inaccurate assumptions we mightmake or by known or unknown risks and uncertainties. Many factors mentioned inthe discussion below will be important in determining future results.

Consequently, no forward-lookingstatement can be guaranteed and you are cautioned not to place undue relianceon these forward-looking statements. Actual future results may vary materially.

Except as may be requiredunder the federal securities laws, we undertake no obligation to publiclyupdate 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.Also note that we provide the following cautionary discussion of risks,uncertainties and possibly inaccurate assumptions relevant to our businesses.These are factors that we think could cause our actual results to differmaterially from expected and historical results. Other factors besides thoselisted here could also adversely affect us. This discussion is provided aspermitted by the Private Securities Litigation Reform Act of 1995.

Therisks and uncertainties referred to above include, but are not limited to:

·       priceand product competition,

·       rapidor disruptive technological development,

·       dependenceon new product development,

·       themix of our products and services,

·       customerdemand for our products and services,

·       risksrelated to inventory, including warranty costs, obsolescence charges, excesscapacity and material and labor costs,

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·       theability to successfully integrate acquired companies,

·       theability to attract and retain qualified employees,

·       controlof costs and expenses,

·       theability to form and implement alliances,

·       theeconomic, political and other risks associated with international sales andoperations, including increased exposure to currency fluctuations as a resultof our acquisition of Tenovis,

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

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

Set forth below is a detailed discussion of certain ofthese risks and other 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 BusinessStrategy***

**Although our revenue has continued to increase since2003, we experienced significant revenue declines during 2001, 2002 and 2003.In addition, our U.S. revenues for the quarter ended March 31, 2005declined compared to the quarter ended March 31, 2004. If business capitalspending, particularly for enterprise communications products, applications andservices, does not improve or deteriorates, our revenue may not grow or maydecline, and our operating results may be adversely affected.**

Our revenue for the fiscalyears ended September 30, 2001, 2002 and 2003 was $5,473 million,$4,387 million and $3,796 million, respectively. The decline in revenueover this period is attributable to, among other things, declines in the marketfor our traditional business, enterprise voice communications systems, and theeffect of general economic conditions on our customers’ willingness to spend onenterprise communications technology during the last several years. The declinein revenue contributed to our net losses for the fiscal years ended September 30,2001, 2002 and 2003 of $352 million, $666 million and$88 million, respectively, and our accumulated deficit in the amount of$974 million as of September 30, 2004.

Our revenue increased from$3,796 million in fiscal 2003 to $4,069 in fiscal 2004 and from $1,977 millionin the first six months of fiscal 2004 to $2,370 million in the first sixmonths of fiscal 2005. Our operating results for the first six months of fiscal2005 include the operating results of Tenovis from November 18, 2004, aswell as other acquisitions. Excluding these acquisitions, our revenuesdecreased slightly compared to the six months ended March 31, 2004.

Our operating results aresignificantly affected by the impact of economic conditions on the willingnessof enterprises to make capital investments, particularly in enterprisecommunications technology and related services. Although general economicconditions have improved in recent years, we believe that enterprises continueto be concerned about their ability to increase revenues and thereby increasetheir profitability. Accordingly, they have tried to maintain or improveprofitability through cost control and constrained capital spending. Because itis not certain whether enterprises will increase spending on enterprisecommunications technology significantly in the near term, we could experiencecontinued pressure on our ability to increase our revenue.

If these or other conditions limit our ability to growrevenue or cause our revenue to decline and we cannot reduce costs on a timelybasis or at all, our operating results will be adversely affected.

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**Revenue generated by our traditional business,enterprise voice communications systems, has been declining for the last severalyears and if we do not successfully execute our strategy to expand our sales inmarket segments with higher growth rates, our revenue and operating results maycontinue to be adversely affected.**

We have been experiencingdeclines in revenue from our traditional business, enterprise voicecommunications systems. We expect, based on various industry reports, themarket segments for these traditional systems to continue to decline. We areexecuting a strategy to capitalize on products, advanced communications andappliances that provide higher growth opportunities in our market, including IPtelephony systems. Many of the products and applications, including IPtelephony systems, have not yet been widely adopted by enterprises.

Although revenue fromsales of IP telephony systems have exceeded the decline in revenue from salesof traditional enterprise voice communications systems, even if we continue tobe successful in increasing our revenue from sales of IP telephony systems, ifrevenue from sales of traditional enterprise voice communications systemsdeclines faster than revenue from sales of IP telephony systems increases, ouroverall revenue and operating results may be adversely affected.

Our traditional enterprise voice communicationssystems and the advanced communications products and applications describedabove are a part of our Global Communications Solutions segment. If we areunsuccessful in executing our strategy, the contribution to our results fromthis segment may fail to grow or may decline, reducing our overall operatingresults. Our Avaya Global Services segment may also be adversely affected tothe extent that services revenues are related to sales of these products andapplications.

**A key component of our strategy is our focus on thedevelopment and marketing of advanced communications products and applicationsand related services, including IP telephony systems, and this strategy may notbe successful or may adversely affect our business.**

We arefocused on the development and sales of IP telephony systems and other advancedcommunications products and applications and related services. In order toexecute this strategy successfully, we must continue to:

·       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 more IP telephony systems and other products and applications thatuse modes of communications other than voice, which has historically been ourcore area of expertise;

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

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

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

·       enhanceour services organization’s ability to identify whether Avaya or non-Avayasources are causing network faults as converged networks move from closed,proprietary networks to standards-based networks;

·       developrelationships with new types of channel partners;

·       makesales to our existing customers that incorporate our advanced communicationsproducts, applications and services with and without retaining their existingnetwork infrastructure;

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

·       expandour geographic scope.

If wedo not successfully execute this strategy, our operating results may beadversely affected. Moreover, even if we successfully address these challenges,our operating results may still be adversely affected if the market opportunityfor advanced communications products, applications and services, including IPtelephony systems, does not develop in the ways that we anticipate. Becausethis market opportunity is in its early stages, we cannot predict whether:

·       thedemand for advanced communications products, applications, and services,including IP telephony systems, will grow as fast 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

·       wewill be able to maintain a leadership or profitable position as thisopportunity 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 complete directly against us.**

Historically, our GCSbusinesses have competed against other providers of enterprise voicecommunications systems such as Nortel Networks Corporation, SiemensAktiengesellschaft, Alcatel S.A. and NEC Corporation. As we focus on thedevelopment and marketing of advanced communications systems, such as IPtelephony systems, we face intense competition from these providers of voicecommunications systems as well as from data networking companies such as CiscoSystems, Inc. and 3Com Corp. We face competition in the small and mediumbusiness market from many competitors, including Cisco, Nortel, Alcatel, NEC,Matsushita Electric Corporation of America, Inter-Tel,  3Com Corp., and Mitel Networks Corp., althoughthe market for these products is fragmented. Our AGS segment competes primarilywith NextiraOne, LLC, Norstan, Inc, Siemens and Verizon Communications Inc. aswell as many consulting firms. In addition, because the market for our productsis subject to rapid technological change, as the market evolves we may facecompetition in the future from companies that do not currently compete in theenterprise communications market, including companies that currently compete inother sectors of the information technology, communications and softwareindustries or communications companies that serve residential rather thanenterprise customers. In particular, as the convergence of enterprise voice anddata networks becomes more widely deployed by enterprises, the business,information technology and communication applications deployed on convergednetworks become more integrated, and these technologies continue to move from aproprietary environment to an open standards-based environment, we may faceincreased competition from current leaders in information technologyinfrastructure, information technology, personal and business applications andthe software that connects the network infrastructure to those applications.Competition from these potential market entrants may take many forms, includingoffering products and applications similar to those we offer as part of alarger, bundled offering.

Several of these existing competitors have, and manyof our future competitors may have, greater financial, personnel, research andother resources, more well-established brands or reputations and broadercustomer bases than we and as a result, these competitors may be in a strongerposition to respond quickly to potential acquisitions and other marketopportunities, new or emerging technologies and changes in customerrequirements. Some of these competitors may have customer bases that are moregeographically balanced than ours and therefore, may be less affected by aneconomic downturn in a 

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particularregion. Competitors with greater resources also may be able to offer lowerprices, additional products or services or other incentives that we cannotmatch or do not offer. In addition, existing customers of data networkingcompanies that compete against us may be inclined to purchase enterprisecommunications systems from their current data networking vendor than from us.We cannot predict with precision which competitors may enter our markets in thefuture, what form such competition may take or whether we will be able to respondeffectively to the entry of new competitors into our markets or the rapidevolution in technology and product development that has characterized ourmarkets. In addition, in order to effectively compete with any new marketentrant, we may need to make additional investments in our business or use morecapital resources than our business currently requires or reduce prices, whichmay adversely affect our profitability.

***Risks Related To Our Operations***

**If we are unable to effectively integrate the Tenovisbusiness into ours, 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,including the effort required to implement disclosure controls and proceduresand to extend our internal control over financial reporting to Tenovis.**

We may not be able tosuccessfully integrate acquired businesses into ours, and therefore we may notbe able to realize the intended benefits from the 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 and audit of the operationsof these acquired businesses performed by us and by third parties on our behalfwas inadequate or flawed, we could later discover unforeseen financial orbusiness liabilities, or the acquired businesses may not perform as expected.Additionally, acquisitions could result in difficulties assimilating acquiredoperations and products, and the diversion of capital and management’sattention away from other business issues and opportunities. Acquisitions couldalso have a negative impact on our results of operations if it is subsequentlydetermined that goodwill or other acquired intangible assets are impaired, thusresulting in an impairment charge in a future period.

In November 2004, weacquired all of the issued share capital of Tenovis, a company incorporated andheadquartered in Germany, with offices in Austria, Belgium, France, Germany,Italy, Spain, Switzerland and the Netherlands. From an operational standpoint,the Tenovis integration effort was and remains substantial, and requires moresignificant managerial resources and attention than anticipated. The Tenovisacquisition may be made more complicated by the fact that it is the largestacquisition we have made to date and we have relatively little experienceintegrating acquisitions outside the United States. Integration of acquiredcompanies in general may result in problems related to integration oftechnology, management, personnel or products, and we have experienced certainof these problems with Tenovis.

In addition, we are continuingto implement disclosure controls and procedures and to extend our internalcontrol over financial reporting to Tenovis. At the same time, we are preparingfor our assessment and our external auditor’s review of our internal controlover financial reporting in fiscal 2005. This overall assessment is a costlyand complex task that is subject to evolving standards, and requires largeamounts of internal personnel resources as well as consultants, significantmanagement time and attention, and material amounts of training. Implementingdisclosure controls and procedures, extending internal control over financialreporting and performing the required assessment at the acquired businesseswill likely require additional significant resources and management attention,make our overall assessment and integration of these acquisitions more complexand may otherwise disrupt our operations.

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Our ability to implement disclosure controls andprocedures and to extend our internal control over financial reporting to Tenovisis made more difficult by several factors that are set forth in “Controls andProcedures.”

**We depend on contract manufacturers to produce themajority of our products and if these manufacturers are unable to fill ourorders on a timely and reliable basis, we will likely be unable to deliver ourproducts to meet customer orders or satisfy their requirements.**

Wehave outsourced the majority of our manufacturing operations. Our ability torealize the intended benefits of our manufacturing outsourcing initiativedepends on the willingness and ability of our contract manufacturers to produceour products. We may experience significant disruption to our operations byoutsourcing too much of our manufacturing. If a contract manufacturerterminates its relationship with us or is unable to fill our orders on a timelybasis, we may be unable to deliver the affected products to meet our customers’orders, which could delay or decrease our revenue or otherwise have an adverseeffect on our operations. Additionally, our outsourcing agreement with our mostsignificant contract manufacturer, Celestica, expires in May 2006. Theagreement will automatically renew for successive one-year terms unlesseither party elects to terminate the agreement by giving notice to the otherparty six months prior to the expiration of the renewal term. We rely onoutside sources for the supply of the components of our products and for thefinished products that we purchase from third parties. Delays or shortagesassociated with these components could cause significant disruption to ouroperations.

**If weare unable to protect our proprietary rights, our business and future prospectsmay be harmed.**

Although we attempt to protect our intellectualproperty through patents, trademarks, trade secrets, copyrights,confidentiality and nondisclosure agreements and other measures, intellectualproperty is difficult to protect and these measures may not provide adequateprotection for our proprietary rights, particularly in countries that do nothave well-developed judicial systems or laws protecting intellectual propertyrights. Patent filings by third parties, whether made before or after the dateof our filings, could render our intellectual property less valuable.Competitors may misappropriate our intellectual property, disputes as toownership of intellectual property may arise and our intellectual property mayotherwise become known or independently developed by competitors. The failureto protect our intellectual property could seriously harm our business andfuture prospects because we believe that developing new products and technologythat are unique to us is critical to our success. If we do not obtainsufficient international protection for our intellectual property, ourcompetitiveness in international markets could be significantly impaired, whichwould limit our growth and future revenue.

Inaddition, we rely on the security of our information systems, among otherthings, to protect our proprietary information and information of our customers.If we do not maintain adequate security procedures over our informationsystems, we may be susceptible to computer hacking, cyberterrorism or otherunauthorized attempts by third parties to access our proprietary information orthat of our customers. Even if we are able to maintain procedures that areadequate to address current security risks, hackers, cyberterrorists or otherunauthorized users may develop new techniques that will enable them tosuccessfully circumvent our current security procedures. The failure to protectour proprietary information or to comply adequately with data privacy lawscould seriously harm our business and future prospects or expose us to claimsby our customers, employees or others that we did not adequately protect theirproprietary information.

***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 theContribution and Distribution Agreement, Lucent contributed to us substantiallyall of the assets, liabilities and operations associated with its enterprisenetworking businesses and distributed 

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all of the outstandingshares of our common stock to its stockholders. The Contribution andDistribution Agreement, among other things, provides that, in general, we willindemnify Lucent for all liabilities including certain pre-distribution taxobligations of Lucent relating to our businesses and all contingent liabilitiesprimarily relating to our businesses or otherwise assigned to us. In addition,the Contribution and Distribution Agreement provides that certain contingentliabilities not directly identifiable with one of the parties will be shared inthe proportion of 90% by Lucent and 10% by us. The Contribution andDistribution Agreement also provides that contingent liabilities in excess of$50 million that are primarily related to Lucent’s businesses shall beborne 90% by Lucent and 10% by us and contingent liabilities in excess of$50 million that are primarily related to our businesses shall be borneequally by the parties.

Please see Note 13, Commitments andContingencies—Legal Proceedings, to our Consolidated FinancialStatements for a description of certain matters involving Lucent for which wehave assumed responsibility under the Contribution and Distribution Agreement.

We cannot assure you that Lucent will not submit aclaim for indemnification or cost sharing to us in connection with any futurematter. In addition, our ability to assess the impact of matters for which wemay have to indemnify or share the cost with Lucent is made more difficult bythe fact that we do not control the defense of these 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.**

We cannot assure you thatothers will not claim that our proprietary or licensed products, systems andsoftware are infringing their intellectual property rights or that we do not infact infringe those intellectual property rights. We may be unaware ofintellectual property rights of others that may cover some of our technology.If someone claimed that our proprietary or licensed systems and softwareinfringed their intellectual property rights, any resulting litigation could becostly and time consuming and would divert the attention of management and keypersonnel from other business issues. The complexity of the technology involvedand the uncertainty of intellectual property litigation increase these risks.Claims of intellectual property infringement also might require us to enterinto costly royalty or license agreements. However, we may be unable to obtainroyalty or license agreements on terms acceptable to us or at all. We also maybe subject to significant damages or an injunction against us or ourproprietary or licensed systems. A successful claim of patent or otherintellectual property infringement against us could materially adversely affectour operating results. We may also be subject to additional notice and otherrequirements to the extent we incorporate open source software into ourapplications.

In addition, third parties have in the past, and mayin the future, claim that a customer’s use of our products, systems or softwareinfringes the third party’s intellectual property rights. Under certaincircumstances, we may be required to indemnify our customers for some of thecosts and damages related to such an infringement claim. Any indemnificationrequirement could have a material adverse effect on our business and ouroperating 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 aprivate letter ruling from the Internal Revenue Service stating, based oncertain assumptions and representations, that the distribution would not betaxable to Lucent. Nevertheless, Lucent could incur a significant tax liabilityif the distribution did not qualify for tax-free treatment because any of thoseassumptions or representations were not correct.

We could be liable for allor a portion of any taxes owed for the following reasons. First, as part of thedistribution, we and Lucent entered into a tax sharing agreement that generallyallocates between Lucent and us the taxes and liabilities relating to thefailure of the distribution to be tax-free. Under the tax 

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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 toLucent.

Second, aside from the tax sharing agreement, underU.S. federal income tax laws, we and Lucent are jointly and severally liablefor Lucent’s U.S. federal income taxes resulting from the distribution beingtaxable. This means that even if we do not have to indemnify Lucent under thetax sharing agreement, we may still be liable for all or part of these taxes ifLucent fails to pay them. These liabilities of Lucent could arise from actionstaken by Lucent over which we have no control, including an issuance oracquisition of stock (or acquisition of assets) of Lucent.

**Item3.**                        *Quantitative and Qualitative Disclosures About Market Risk.*

See Avaya’s Annual Report on Form 10-K forthe fiscal year ended September 30, 2004 filed with the SEC on December 13,2004. As of March 31, 2005, there has been no material change in thisinformation.

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

a)     *Evaluation of disclosure controls andprocedures*.   Wehave established disclosure controls and procedures to ensure that materialinformation relating to us, including our consolidated subsidiaries, is madeknown to the officers who certify our reports and to other members of seniormanagement and the Board of Directors.

Based on their evaluationas of the end of the period covered by this Quarterly Report on Form 10-Q,and subject to the limitations noted below as to control systems and the issuesdescribed below as to our operations of Tenovis, our principal executiveofficer and principal financial officer have concluded that our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) are effective to ensure that theinformation required to be disclosed by us in reports that we file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time periods specified in SEC rules and forms.

The Company’s disclosure controls are designed toprovide a reasonable level of assurance that the stated objectives are met. TheCompany’s management, including the principal executive officer and principalfinancial officer, does not expect that the Company’s disclosure controls orinternal controls will prevent all errors and all fraud. A control system, nomatter how well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. The design of acontrol system must also reflect the fact that there are resource constraints,with the benefits of controls considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been prevented or detected. Because of theinherent limitations in a control system, misstatements due to error or fraudmay occur and not be prevented or detected.

b)     *Changes in internal controls*.

*Tenovis*

We disclosed in our Form 10-Qfor the first fiscal quarter of 2005 various issues related to the integrationof Tenovis and the implementation of disclosure controls and procedures andinternal control over financial reporting to Tenovis. We continue to face theseissues with respect to Tenovis and we expect that it will take several moremonths to complete the implementation of these controls and procedures andstrengthen those controls and procedures so that they are comparable to thoseused in our U.S. operations. To date, we have successfully implemented controlsand procedures over some of these processes in some 

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of the geographic regionsin which Tenovis operates, however, significant portions of our implementationplan are still in process.

Other than as describedabove there were no significant changes in our internal control over financialreporting during our first fiscal quarter that have materially affected, or arereasonably likely to materially affect our ability to record, process,summarize and report financial information.

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**PART II**

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

See Note 13, “Commitmentsand Contingencies” to the consolidated financial statements.

**Item 2.   *Changes in Securities, Useof Proceeds and Issuer Purchases of Equity Securities*.**

On April 19, 2005,the Board of Directors authorized a share repurchase plan. Under the provisionsof this plan, Avaya is authorized to repurchase up to $500 million of itsoutstanding common stock over the next two years. These repurchases will bemade at management’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms ofAvaya’s credit facility and other factors. As of April 30, 2005, we have purchased4,075,000 shares of our common stock at an average share price of $8.21. See Note 8, “Long-Term Debt,” to ourconsolidated financial statements for further information concerning thelimitations under the credit facility.

**Item 3.   *Defaults Upon SeniorSecurities*.**

None.

**Item 4.   *Submission of Matters to aVote of Security Holders*.**

Avayaheld its Annual Meeting of Stockholders on February 15, 2005. At thatmeeting, shareholders elected Philip A. Odeen, Hellene S. Runtagh, Paula Sternand Richard F. Wallman as Class 1 Directors of the Company for a term toexpire at the Annual Meeting to be held in year 2008.  The results of the voting are as follows:
| ** **          | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------|------------|--------------------|------------|-------------------------|------------|
| Philip A. Odeen     |       | 410,314,105        |       |                    | 18,976,385 |   |   |
| Hellene S.  Runtagh |       | 422,987,542        |       |                    | 6,302,947  |   |   |
| Paula Stern         |       | 418,845,103        |       |                    | 10,445,387 |   |   |
| Richard F. Wallman  |       | 405,408,322        |       |                    | 23,882,168 |   |   |

 

The following directorsalso have terms in office that continue after the Annual Meeting: Donald K.Peterson, Bruce R. Bond, Joseph P. Landy, Mark Leslie, Daniel C. Stanzione,Anthony P. Terracciano and Ronald L. Zarrella.

**Item 5.   *Other Information*.**

We make available free ofcharge, through our investor relations’ website, *http://investors.Avaya.com*,our Form 10-K, Form 10-Q and Form 8-K reportsand all amendments to those reports as soon as reasonably practicable aftersuch material is electronically filed with or furnished to the Securities andExchange Commission.

**Item 6.   *Exhibits***
| 31.1 | Certification of Donald K. Peterson pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.  |
|------|-------------------------------------------------------------------------------------------------------|
| 31.2 | Certification  of Garry K. McGuire pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.   |
| 32.1 | Certification  of Donald K. Peterson pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |
| 32.2 | Certification  of Garry K. McGuire pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.   |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized. 
|              | AVAYA INC. |
|-------------------|------------|
|              | By:        | /s/  AMARNATH K. PAI |
|              |       | Amarnath  K. Pai |
|              |       | *Vice-President  Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| May 10, 2005 |       |   |

 

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