**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2006**

**or**

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

**Forthe transition period from                    to                    **

**CommissionFile Number 001-15951**

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**AVAYA INC.**

(Exact name of registrantas specified in its charter)

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

 

**(908) 953-6000**

(Registrant’s telephonenumber, including area code)

**None**

(Formername, former address and former fiscal year, if changed since last report)

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

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

Large accelerated filer x  Acceleratedfiler o  Non-accelerated filer o

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

Asof April 30, 2006, 461,822,623 shares of Common Stock, $.01 par value ofthe registrant were outstanding.

 

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**TABLEOF 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 |            |       | 30       |   |
| 3.         |         | Quantitative and  Qualitative Disclosures About Market Risk                                 |            |       | 61       |   |
| 4.         |         | Controls and Procedures                                                                     |            |       | 61       |   |
| ** ** |         | **PART II  OTHER INFORMATION**                                                         |            |       |     |   |
| 1.         |         | Legal Proceedings                                                                           |            |       | 63       |   |
| 1A.        | *** *** | Risk factors                                                                                |            |       | 63       |   |
| 2.         |         | Unregistered Sales  of Equity Securities and Use of Proceeds                                |            |       | 63       |   |
| 3.         |         | Defaults Upon Senior  Securities                                                            |            |       | 63       |   |
| 4.         |         | Submission of  Matters to a Vote of Security Holders                                        |            |       | 63       |   |
| 5.         |         | Other Information                                                                           |            |       | 64       |   |
| 6.         |         | Exhibits                                                                                    |            |       | 64       |   |
|       |         | Signatures                                                                                  |            |       | 65       |   |

 

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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**Part I—FinancialInformation**

**Item 1.   *Financial Statements.***

**AVAYA INC.CONSOLIDATED STATEMENTS OF INCOME**

| ** **                                                  | ** ** | **Three months ended**                                                                 | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **March 31,**                                                                               | ** ** | **March 31,**             | ** ** |
| ** **                                                  | ** ** | **2006**                                                                                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                  | ** ** | **Dollars in millions, except per share amounts (unaudited)** | ** ** |
| REVENUE                                                     |       |                                                                                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales of products                                           |       |                                                                                             | $          | 593                            |       |   |   | $ | 543 |   |   |   | $ | 1,184 |   |   |   | $ | 1,097 |   |   |
| Services                                                    |       |                                                                                             | 487        |                           |       |   | 498 |   |   |   | 988 |   |   |   | 975 |   |   |
| Rental and managed services                                 |       |                                                                                             | 158        |                           |       |   | 181 |   |   |   | 315 |   |   |   | 298 |   |   |
|                                                        |       |                                                                                             | 1,238      |                           |       |   | 1,222 |   |   |   | 2,487 |   |   |   | 2,370 |   |   |
| COSTS                                                       |       |                                                                                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales of products                                           |       |                                                                                             | 275        |                           |       |   | 245 |   |   |   | 552 |   |   |   | 490 |   |   |
| Services                                                    |       |                                                                                             | 317        |                           |       |   | 339 |   |   |   | 638 |   |   |   | 647 |   |   |
| Rental and managed services                                 |       |                                                                                             | 68         |                           |       |   | 75 |   |   |   | 130 |   |   |   | 127 |   |   |
|                                                        |       |                                                                                             | 660        |                           |       |   | 659 |   |   |   | 1,320 |   |   |   | 1,264 |   |   |
| GROSS MARGIN                                                |       |                                                                                             | 578        |                           |       |   | 563 |   |   |   | 1,167 |   |   |   | 1,106 |   |   |
| OPERATING  EXPENSES                                         |       |                                                                                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                         |       |                                                                                             | 399        |                           |       |   | 406 |   |   |   | 784 |   |   |   | 763 |   |   |
| Research and development                                    |       |                                                                                             | 106        |                           |       |   | 105 |   |   |   | 203 |   |   |   | 203 |   |   |
| Restructuring charges                                       |       |                                                                                             | 20         |                           |       |   | — |   |   |   | 20 |   |   |   | — |   |   |
| TOTAL OPERATING EXPENSES                                    |       |                                                                                             | 525        |                           |       |   | 511 |   |   |   | 1,007 |   |   |   | 966 |   |   |
| OPERATING INCOME                                            |       |                                                                                             | 53         |                           |       |   | 52 |   |   |   | 160 |   |   |   | 140 |   |   |
| Other income (expense), net                                 |       |                                                                                             | 6          |                           |       |   | — |   |   |   | 11 |   |   |   | (38 | ) |   |
| Interest expense                                            |       |                                                                                             | (2         | )                              |       |   | (5 | ) |   |   | (3 | ) |   |   | (15 | ) |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE INCOME  TAXES |       |                                                                                             | 57         |                           |       |   | 47 |   |   |   | 168 |   |   |   | 87 |   |   |
| Provision for income taxes                                  |       |                                                                                             | 19         |                           |       |   | 11 |   |   |   | 59 |   |   |   | 18 |   |   |
| INCOME FROM CONTINUING  OPERATIONS                          |       |                                                                                             | 38         |                           |       |   | 36 |   |   |   | 109 |   |   |   | 69 |   |   |
| (LOSS) FROM DISCONTINUED  OPERATIONS                        |       |                                                                                             | —     |                           |       |   | — |   |   |   | — |   |   |   | (2 | ) |   |
| **NET INCOME**                                              | ** ** | ** **                                                                                       | **$**      | **38**                         |       | ** ** | ** ** | **$** | **36** |   | ** ** | ** ** | **$** | **109** |   | ** ** | ** ** | **$** | **67** |   |   |
| **Earnings  Per Common Share—Basic:**                  |       |                                                                                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from continuing operations               |       |                                                                                             | $          | 0.08                           |       |   |   | $ | 0.08 |   |   |   | $ | 0.23 |   |   |   | $ | 0.15 |   |   |
| (Loss) per share from discontinued operations               |       |                                                                                             | —     |                           |       |   | — |   |   |   | — |   |   |   | (0.01 | ) |   |
| Earnings per share                                          |       |                                                                                             | $          | 0.08                           |       |   |   | $ | 0.08 |   |   |   | $ | 0.23 |   |   |   | $ | 0.14 |   |   |
| **Earnings  Per Common Share—Diluted:**                |       |                                                                                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from continuing operations               |       |                                                                                             | $          | 0.08                           |       |   |   | $ | 0.07 |   |   |   | $ | 0.23 |   |   |   | $ | 0.15 |   |   |
| (Loss) per share from discontinued operations               |       |                                                                                             | —     |                           |       |   | — |   |   |   | — |   |   |   | (0.01 | ) |   |
| Earnings per  share                                         |       |                                                                                             | $          | 0.08                           |       |   |   | $ | 0.07 |   |   |   | $ | 0.23 |   |   |   | $ | 0.14 |   |   |

 

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

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**AVAYA INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                         | ** ** | **March 31,  2006**                                                                 | ** ** | **September 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                         | ** ** | **Dollars in millions,  except per share amounts  (unaudited)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                         |       |                                                                                     |       |                         |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                    |       |                                                                                     |       |                         |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                         |       |                                                                                     | $          | 745                          |       |   |   | $ | 750 |   |   |
| Accounts receivable,  less allowances of $51 million and $58 million as of March 31, 2006 and  September 30, 2005, respectively                                                                                          |       |                                                                                     | 799        |                         |       |   | 862 |   |   |
| Inventory                                                                                                                                                                                                                          |       |                                                                                     | 292        |                         |       |   | 288 |   |   |
| Deferred tax asset, net                                                                                                                                                                                                            |       |                                                                                     | 133        |                         |       |   | 143 |   |   |
| Other current assets                                                                                                                                                                                                               |       |                                                                                     | 181        |                         |       |   | 128 |   |   |
| TOTAL CURRENT ASSETS                                                                                                                                                                                                               |       |                                                                                     | 2,150      |                         |       |   | 2,171 |   |   |
| Property, plant and  equipment, net                                                                                                                                                                                                |       |                                                                                     | 708        |                         |       |   | 738 |   |   |
| Deferred tax asset, net                                                                                                                                                                                                            |       |                                                                                     | 866        |                         |       |   | 911 |   |   |
| Intangible assets                                                                                                                                                                                                                  |       |                                                                                     | 307        |                         |       |   | 337 |   |   |
| Goodwill                                                                                                                                                                                                                           |       |                                                                                     | 916        |                         |       |   | 914 |   |   |
| Other assets                                                                                                                                                                                                                       |       |                                                                                     | 168        |                         |       |   | 148 |   |   |
| **TOTAL ASSETS**                                                                                                                                                                                                                   | ** ** | ** **                                                                               | **$**      | **5,115**                    |       | ** ** | ** ** | **$** | **5,219** |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                      |       |                                                                                     |       |                         |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                               |       |                                                                                     |       |                         |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                   |       |                                                                                     | $          | 383                          |       |   |   | $ | 402 |   |   |
| Debt maturing within one  year                                                                                                                                                                                                     |       |                                                                                     | 5          |                         |       |   | 5 |   |   |
| Payroll and benefit  obligations                                                                                                                                                                                                   |       |                                                                                     | 262        |                         |       |   | 300 |   |   |
| Deferred revenue                                                                                                                                                                                                                   |       |                                                                                     | 271        |                         |       |   | 244 |   |   |
| Other current  liabilities                                                                                                                                                                                                         |       |                                                                                     | 316        |                         |       |   | 368 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                         |       |                                                                                     | 1,237      |                         |       |   | 1,319 |   |   |
| Long-term debt                                                                                                                                                                                                                     |       |                                                                                     | 24         |                         |       |   | 25 |   |   |
| Benefit obligations                                                                                                                                                                                                                |       |                                                                                     | 1,588      |                         |       |   | 1,561 |   |   |
| Deferred tax liability,  net                                                                                                                                                                                                       |       |                                                                                     | 83         |                         |       |   | 96 |   |   |
| Other liabilities                                                                                                                                                                                                                  |       |                                                                                     | 273        |                         |       |   | 257 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                                     |       |                                                                                     | 1,968      |                         |       |   | 1,939 |   |   |
| Commitments and contingencies (Note)                                                                                                                                                                                               |       |                                                                                     |       |                         |       |   |   |   |   |
| **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, 461,815,717 and 471,328,963  issued (including 360,150 and 207,053 treasury shares) as of March 31,  2006 and September 30, 2005,  respectively |       |                                                                                     | 5          |                         |       |   | 5 |   |   |
| Additional  paid-in-capital                                                                                                                                                                                                        |       |                                                                                     | 2,735      |                         |       |   | 2,895 |   |   |
| Retained earnings (accumulated  deficit)                                                                                                                                                                                           |       |                                                                                     | 56         |                         |       |   | (53 | ) |   |
| Accumulated other  comprehensive loss                                                                                                                                                                                              |       |                                                                                     | (882       | )                            |       |   | (883 | ) |   |
| Less: Treasury stock at  cost                                                                                                                                                                                                      |       |                                                                                     | (4         | )                            |       |   | (3 | ) |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                                                                                                                                                                   |       |                                                                                     | 1,910      |                         |       |   | 1,961 |   |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                | ** ** | ** **                                                                               | **$**      | **5,115**                    |       | ** ** | ** ** | **$** | **5,219** |   |   |

 

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

4

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**AVAYA INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                 | ** ** | **Six months ended**                 | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **March 31,**                             | ** ** |
| ** **                                                                                                 | ** ** | **   2006   **   | ** ** | **   2005   ** | ** ** |
| ** **                                                                                                 | ** ** | **Dollars in millions  (unaudited)** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                  | ** ** |                                           | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income                                                                                                 |       |                                           | $          | 109 |   |   |   | $ | 67 |   |   |
| Less: Loss from discontinued operations, net                                                               |       |                                           | —     |   |   |   | (2 | ) |   |
| Income from continuing operations                                                                          |       |                                           | 109        |   |   |   | 69 |   |   |
| Adjustments to  reconcile income from continuing operations to net cash provided by operating  activities: |       |                                           |       |   |   |   |   |   |   |
| Depreciation and amortization                                                                              |       |                                           | 134        |   |   |   | 130 |   |   |
| Amortization of restricted stock units                                                                     |       |                                           | 8          |   |   |   | 5 |   |   |
| Share-based compensation                                                                                   |       |                                           | 8          |   |   |   | — |   |   |
| Restructuring charges                                                                                      |       |                                           | 20         |   |   |   | — |   |   |
| Deferred income taxes                                                                                      |       |                                           | 47         |   |   |   | 6 |   |   |
| Provision for uncollectible receivables                                                                    |       |                                           | 6          |   |   |   | 7 |   |   |
| Loss on extinguishment of debt, net                                                                        |       |                                           | —     |   |   |   | 43 |   |   |
| Purchased in-process research and development                                                              |       |                                           | —     |   |   |   | 4 |   |   |
| Unrealized losses on foreign currency exchange                                                             |       |                                           | (7         | ) |   |   | 19 |   |   |
| Adjustments for other non-cash items, net                                                                  |       |                                           | —     |   |   |   | (13 | ) |   |
| Changes in  operating assets and liabilities, net of effects of acquired businesses:                       |       |                                           |       |   |   |   |   |   |   |
| Receivables                                                                                                |       |                                           | 55         |   |   |   | 16 |   |   |
| Inventory                                                                                                  |       |                                           | (4         | ) |   |   | (30 | ) |   |
| Restricted cash                                                                                            |       |                                           | 1          |   |   |   | 9 |   |   |
| Accounts payable                                                                                           |       |                                           | (20        | ) |   |   | (21 | ) |   |
| Payroll and benefits                                                                                       |       |                                           | (12        | ) |   |   | (133 | ) |   |
| Restructuring reserve                                                                                      |       |                                           | (40        | ) |   |   | (17 | ) |   |
| Accrued interest payable on long-term debt                                                                 |       |                                           | —     |   |   |   | (24 | ) |   |
| Deferred revenue                                                                                           |       |                                           | 36         |   |   |   | (13 | ) |   |
| Other assets and liabilities                                                                               |       |                                           | (66        | ) |   |   | 3 |   |   |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                                                  |       |                                           | 275        |   |   |   | 60 |   |   |
| **INVESTING ACTIVITIES:**                                                                                  | ** ** |                                           | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Capital expenditures                                                                                       |       |                                           | (54        | ) |   |   | (56 | ) |   |
| Capitalized software development costs                                                                     |       |                                           | (37        | ) |   |   | (27 | ) |   |
| Acquisitions of businesses, net of cash acquired                                                           |       |                                           | —     |   |   |   | (383 | ) |   |
| (Payments for) sales of discontinued operations                                                            |       |                                           | —     |   |   |   | (2 | ) |   |
| Other investing activities, net                                                                            |       |                                           | (8         | ) |   |   | 18 |   |   |
| NET CASH (USED FOR) INVESTING ACTIVITIES                                                                   |       |                                           | (99        | ) |   |   | (450 | ) |   |
| **FINANCING ACTIVITIES:**                                                                                  | ** ** |                                           | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Issuance of common stock                                                                                   |       |                                           | 14         |   |   |   | 40 |   |   |
| Repurchase of common stock                                                                                 |       |                                           | (193       | ) |   |   | — |   |   |
| Repayment of long-term debt                                                                                |       |                                           | —     |   |   |   | (417 | ) |   |
| Other financing activities, net                                                                            |       |                                           | —     |   |   |   | (3 | ) |   |
| NET CASH (USED FOR) FINANCING ACTIVITIES                                                                   |       |                                           | (179       | ) |   |   | (380 | ) |   |
| Effect of exchange rate changes on cash and cash  equivalents                                              |       |                                           | (2         | ) |   |   | 8 |   |   |
| Net (decrease) in cash and cash equivalents                                                                |       |                                           | (5         | ) |   |   | (762 | ) |   |
| Cash and cash equivalents at beginning of fiscal year                                                      |       |                                           | 750        |   |   |   | 1,617 |   |   |
| Cash and cash  equivalents at end of period                                                                |       |                                           | $          | 745 |   |   |   | $ | 855 |   |   |

 

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

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**AVAYAINC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

**1.**Background and Basis of Presentation

***Background***

Avaya Inc. (the “Company,”“Avaya,” “we,” or “us”) provides communication systems, applications andservices for enterprises, including businesses, government agencies and otherorganizations. The Company’s product offerings include Internet Protocol (“IP”)telephony systems and traditional voice communications systems, multi-mediacontact center infrastructure and applications in support of customerrelationship management, unified communications applications and appliances,such as IP telephone sets. The term “traditional” with respect to “voicecommunications,” “enterprise voice communications,” “telephony,” “voicetelephony,” “voice systems,” or “TDM,” refers to circuit-based enterprise voicecommunications. The Company supports its broad customer base with comprehensiveglobal service offerings that enable our customers to plan, design, implement,monitor and manage their communications networks.

***Basis of Presentation***

The accompanying unauditedConsolidated Financial Statements as of March 31, 2006 and for the threeand six months ended March 31, 2006 and 2005, have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financial statements andthe rules and regulations of the United States Securities and ExchangeCommission (“SEC”) for interim financial statements, and should be read inconjunction with the Company’s Consolidated Financial Statements and otherfinancial information for the fiscal year ended September 30, 2005,included in its Annual Report on Form 10-K filed with the SEC on December 13,2005. In the Company’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.

**2. Summary ofSignificant Accounting Policies**

***Share-based Compensation***

On October 1, 2005, the Company adopted Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment,” (“SFAS 123(R)”) which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to employees anddirectors including employee stock options and employee stock purchases relatedto the Employee Stock Purchase Plan (“employee stock purchases”) based onestimated fair values. SFAS 123(R) supersedes the Company’s previousaccounting under Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006.In March 2005, the SEC issued Staff Accounting Bulletin No. 107(“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions ofSAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of October 1, 2005, the first day of the Company’sfiscal year 2006. The Company’s Consolidated Financial Statements as of and forthe three and six months ended March 31, 2006 reflect the impact of SFAS123(R). In accordance with the modified prospective 

6

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transition method, theCompany’s Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Share-basedcompensation expense recognized under SFAS 123(R) for the three and sixmonths ended March 31, 2006 was $4 million and $8 million,respectively, which was related to stock options and the discount on employeestock purchases. There was no share-based compensation expense related toemployee stock options and employee stock purchases recognized during the threeor six months ended March 31, 2005.

SFAS 123(R) requires companies to estimate thefair value of share-based payment awards on the grant-date using anoption-pricing model. The value of the portion of the award that is ultimatelyexpected to vest is recognized as expense over the requisite service periods inthe Company’s Consolidated Statements of Income. Prior to the adoption of SFAS123(R), the Company accounted for share-based awards to employees and directorsusing the intrinsic value method in accordance with APB 25 as allowed underStatement of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, noshare-based compensation expense related to stock options had been recognizedin the Company’s Consolidated Statements of Income, other than as related toacquisitions and investments, because the exercise price of the Company’s stockoptions granted to employees and directors equaled the fair market value of theunderlying stock at the grant-date.

Share-based compensation expense recognized during thecurrent period is based on the value of the portion of share-based paymentawards that is ultimately expected to vest. SFAS 123(R) requiresforfeitures to be estimated at the time of grant in order to estimate theamount of share-based awards that will ultimately vest. The estimate is basedon the Company’s historical rates of forfeiture. Share-based compensationexpense recognized in the Company’s Consolidated Statements of Income for thethree and six months ended March 31, 2006 includes (i) compensationexpense for share-based payment awards granted prior to, but not yet vested asof September 30, 2005, based on the grant-date fair value estimated in accordancewith the pro forma provisions of SFAS 123 and (ii) compensation expensefor the share-based payment awards granted subsequent to September 30,2005, based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123(R). As share-based compensation expense recognized inthe Consolidated Statements of Income for the three and six months ended March 31,2006 is based on awards ultimately expected to vest, it has been reduced forestimated forfeitures. In the Company’s pro forma information required underSFAS 123 for the periods prior to fiscal 2006, the Company accounted forforfeitures as they occurred.

Upon adoption of SFAS 123(R), the Company also changedits method of valuation for share-based awards granted beginning in fiscal 2006to a lattice-binomial option pricing model (“lattice-binomial model”) from theBlack-Scholes option pricing model which was previously used for the Company’spro forma information required under SFAS 123.

On November 10, 2005, the Financial AccountingStandards Board (“FASB”) issued FASB Staff Position No. SFAS 123(R)-3,“Transition Election Related to Accounting for Tax Effects of Share-BasedPayment Awards.” The alternative transition method includes simplified methodsto establish the beginning balance of the additional paid-in capital pool (“APICpool”) related to the tax effects of employee share-based compensation, and todetermine the subsequent impact on the APIC pool and Consolidated Statements ofCash Flows of the tax effects of employee share-based compensation awards thatare outstanding upon adoption of SFAS 123(R). The Company is in the process ofevaluating whether to adopt the provisions of SFAS 123(R)-3.

7

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Share-basedcompensation expense reduced the Company’s results of operations as follows:

| ** **                                                  | ** ** | **Three months  ended  March 31, 2006**                      | ** ** | **Six months  ended  March 31, 2006** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| Income from  continuing operations before income taxes |       |                                                                        | $          | 4                                                    |       |   |   | $ | 8 |   |   |
| Income from continuing operations                           |       |                                                                        | $          | 3                                                    |       |   |   | $ | 6 |   |   |
| Net income available to common stockholders                 |       |                                                                        | $          | 3                                                    |       |   |   | $ | 6 |   |   |
| Earnings per Common Share—Basic:                       |       |                                                                        |       |                                                 |       |   |   |   |   |
| Income from continuing operations                           |       |                                                                        | $          | 0.01                                                 |       |   |   | $ | 0.01 |   |   |
| Net income                                                  |       |                                                                        | $          | 0.01                                                 |       |   |   | $ | 0.01 |   |   |
| Earnings per Common Share—Diluted:                     |       |                                                                        |       |                                                 |       |   |   |   |   |
| Income from continuing operations                           |       |                                                                        | $          | 0.01                                                 |       |   |   | $ | 0.01 |   |   |
| Net income                                                  |       |                                                                        | $          | 0.01                                                 |       |   |   | $ | 0.01 |   |   |

 

Thefollowing table illustrates the effect on net income and earnings per share asif the Company had applied the fair value recognition provisions of SFAS No. 123,as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure” (“SFAS 148”).

| ** **                                                                                                                | ** ** | **Three months  ended  March 31, 2005**                      | ** ** | **Six months  ended  March 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| Net income  available to common stockholders, as reported                                                                 |       |                                                                        | $          | 36                                                   |       |   |   | $ | 67 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects              |       |                                                                        | 2          |                                                 |       |   | 3 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based method,  net of related tax effects |       |                                                                        | (11        | )                                                    |       |   | (19 | ) |   |
| Net income  available to common stockholders, pro forma                                                                   |       |                                                                        | $          | 27                                                   |       |   |   | $ | 51 |   |   |
| Earnings per Common Share—Basic:                                                                                     |       |                                                                        |       |                                                 |       |   |   |   |   |
| As reported                                                                                                               |       |                                                                        | $          | 0.08                                                 |       |   |   | $ | 0.14 |   |   |
| Pro forma                                                                                                                 |       |                                                                        | $          | 0.06                                                 |       |   |   | $ | 0.11 |   |   |
| Earnings per Common Share—Diluted:                                                                                   |       |                                                                        |       |                                                 |       |   |   |   |   |
| As reported                                                                                                               |       |                                                                        | $          | 0.07                                                 |       |   |   | $ | 0.14 |   |   |
| Pro forma                                                                                                                 |       |                                                                        | $          | 0.06                                                 |       |   |   | $ | 0.11 |   |   |

 

***Change in Vacation Policy***

Effective January 1,2006, the Company changed its policy with respect to vacation carryover forsubstantially all U.S. non-represented employees. For these employees, vacationcarryover into future fiscal years is no longer permitted and the Companychanged the accrual period to correspond with the Company’s fiscal, rather thancalendar, year. This change resulted in a $21 million reduction in the vacationaccrual during the six months ended March 31, 2006. This reduction iscomprised of vacation days forfeited at the end of the calendar year and areduction in the liability due to a higher than historical amount of vacationdays taken from October 1, 2005 through December 31, 2005. Thereduction was recorded in cost of goods sold and operating expenses in both ofour operating segments and corporate / other unallocated amounts based on thefunctional areas of the affected employees.

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**3. RecentAccounting Pronouncements**

**SFAS 156**

In March 2006, theFASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—anamendment of FASB Statement No. 140” (“SFAS 156”). SFAS 156 simplifies theaccounting for loan servicing rights and the financial instruments used tohedge risks associated with those rights. SFAS 156 requires that servicingrights be valued initially at fair value, and subsequently accounted for ateither fair value, or amortized over the economic life of the related lease. TheCompany will adopt the provisions of SFAS 156 beginning in fiscal 2007. Theimplementation of SFAS 156 is not expected to have a material impact on theCompany’s Consolidated Financial Statements.

**SFAS 155**

In February 2006, theFASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments—an amendment to FASB Statements No. 133 and 140” (“SFAS 155”).SFAS 155 simplifies the accounting for certain hybrid financial instrumentscontaining embedded derivatives. SFAS 155 allows fair value measurement for anyhybrid financial instrument that contains an embedded derivative that otherwisewould require bifurcation under SFAS 133. In addition, it amends SFAS 140 toeliminate the prohibition on a qualifying special-purpose entity from holding aderivative financial instrument that pertains to a beneficial interest otherthan another derivative financial instrument. The Company will adopt theprovisions of SFAS 155 beginning in fiscal 2007. The implementation of SFAS 155is not expected to have a material impact on the Company’s ConsolidatedFinancial Statements.

**SFAS 154**

In December 2004, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections—areplacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS154”). SFAS 154 changes the requirements for the accounting for, and reportingof, a change in accounting principle. SFAS 154 requires that a voluntary changein accounting principle be applied retrospectively with all prior periodfinancial statements presented using the new accounting principle. SFAS 154 iseffective for accounting changes and corrections of errors in fiscal yearsbeginning after December 15, 2005. The implementation of SFAS 154 is notexpected to have a material impact on the Company’s Consolidated FinancialStatements.

**4. BusinessCombinations**

***Acquisition of Tenovis***

On November 18, 2004, the Company completed itsacquisition of Tenovis Germany GmbH (“Tenovis”). Tenovis is the parent companyof Avaya-Tenovis GmbH & Co. KG (formerly Tenovis GmbH & Co.KG), a major European provider of enterprise communications systems andservices. The acquisition of Tenovis significantly expands the Company’sEuropean operations and increases the Company’s access to European customers,particularly in Germany. 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, which wasallocated $400 million to the Global Communications Solutions (“GCS”) segmentand $206 million to the Avaya Global Services (“AGS”) segment. None of thegoodwill, intangibles or in-process research and development amounts isexpected to be deductible for tax purposes. The Company allocated $298 millionto intangible assets (including contractual customer relationships, existingtechnology and trademarks) based on valuation studies performed with theassistance of third party valuation consultants. These intangible assets arebeing amortized over their estimated useful lives. The weighted average usefullives of the existing technology, customer relationships and trademarks are 5 years,6 years and 1.5 years, respectively. In addition, the Company allocated $1million to in-process 

9

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research and development,which was charged to research and development expense in the ConsolidatedStatements of Income during the first quarter of fiscal 2005.

Thefollowing table summarizes the estimated fair values of the acquired assets andassumed liabilities as of the acquisition date:

| ** **                                                        | ** ** | **Final**                    | ** ** |
|-------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                        | ** ** | **Purchase Price**      | ** ** |
| ** **                                                        | ** ** | **Allocation**               | ** ** |
| ** **                                                        | ** ** | **Dollars in millions** | ** ** |
| Cash                                                              |       |                         | $          | 116 |   |   |
| Rental equipment                                                  |       |                         | 132        |   |   |
| Fixed assets                                                      |       |                         | 144        |   |   |
| Intangible assets  and in-process research & development |       |                         | 299        |   |   |
| Long-term debt                                                    |       |                         | (287       | ) |   |
| Deferred tax  liability                                           |       |                         | (119       | ) |   |
| Restructuring                                                     |       |                         | (106       | ) |   |
| Pension liability                                                 |       |                         | (314       | ) |   |
| Working capital  and other assets and liabilities                 |       |                         | (90        | ) |   |
| **Net assets acquired**                                           |       |                         | (225       | ) |   |
| Goodwill                                                          |       |                         | 606        |   |   |
| **Purchase  price**                                               | ** ** | ** **                   | **$**      | **381** |   |   |

 

The Company recorded a restructuring liability of $106million in connection with the acquisition to reflect the estimate ofrestructuring-related costs in accordance with EITF 95-3, “Recognition ofLiabilities in Connection with a Purchase Business Combination.” This liabilityis for costs incurred to terminate Tenovis employees as part of the integrationof Tenovis operations. The plan, which was completed during fiscal 2005,provided for the termination of certain employees across various Tenovisfunctional groups and subsidiaries, including sales, operations, finance, humanresources, etc. Most of the positions identified in this plan have already beeneliminated. Most terminations are planned to be completed by June 30, 2006.The Company paid cash of $16 million and $28 million for termination benefitsduring the three and six months ended March 31, 2006, respectively. Duringthe second quarter of fiscal 2006, the Company increased the reserve by $5million for higher than originally expected per employee separation payments inGermany, which is included in the Consolidated Statements of Income. Theaccrual of $47 million as of March 31, 2006 reflects the estimatedremaining termination payments adjusted for foreign currency fluctuations sincethe acquisition date.

Management is responsible for estimating the fairvalue of the assets and liabilities acquired, and has conducted due diligencein determining fair values. Management has made estimates and assumptions thataffect the reported amounts of assets, liabilities and expenses resulting fromthe acquisition. Actual results could differ from these amounts.

10

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Thefollowing unaudited pro forma financial information presents the Company’sresults for the six months ended March 31, 2005 as if the Tenovis acquisitionhad occurred at the beginning of the period, as compared with the as reportedresults for the same period in fiscal 2006:

| ** **                       | ** ** | **Six months ended  March 31,**                              | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------------|------------|
| *** ***                     | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(as reported)**                                                      | ** ** | **(pro forma)** | ** ** |
| ** **                       | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| Revenue                          |       |                                                                        | $          | 2,487 |   |   |   | $ | 2,473 |   |   |
| Net income                       |       |                                                                        | $          | 109 |   |   |   | $ | 41 |   |   |
| Earnings per  share—basic   |       |                                                                        | $          | 0.23 |   |   |   | $ | 0.09 |   |   |
| Earnings per  share—diluted |       |                                                                        | $          | 0.23 |   |   |   | $ | 0.08 |   |   |

 

The pro forma results for the six months ended March 31,2005 have been prepared for comparative purposes only and include certainadjustments such as additional estimated depreciation and amortization expenseas a result of identifiable intangible assets arising from the acquisition. Thepro forma results are not necessarily indicative of the results of operationsthat actually would have resulted had the acquisition been in effect at thebeginning of the period or of future results.

In connection with the acquisition, the Companyperformed an evaluation to identify the existence of any related variableinterest entities (“VIEs”). As a result of this evaluation, the Companyidentified the existence of three VIEs, and further determined the Company wasthe primary beneficiary. However, in accordance with FIN 46(R), “Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN46(R)”), the Company is not required to apply the provisions of FIN 46(R) totwo of the VIEs because it is unable to obtain the information necessary toperform the accounting required for consolidation. Although the Company hasmade an effort to gather the required information, management of these two VIEshas formally declined to transfer any of the necessary financial data to theCompany. One of these two entities ceased to meet the definition of a VIE as ofMarch 31, 2005.

The remaining non-consolidated VIE is a non-U.S.telecommunications hardware production manufacturer and service provider. TheCompany has agreed to purchase from the VIE certain amounts of products andservices, and the VIE has contracted for the Company to provide certain ITservices and purchasing services with respect to raw materials. These contractsexpire in August 2007. During the three and six months ended March 31,2006, the Company purchased products and services aggregating $13 millionand $21 million, respectively. Additionally, the Company is required to paymonthly rental subsidies on the VIE’s premises, and in the event the VIE isunable to pay its portion of the rental payments, the Company is liable fortheir portion as well. During the six months ended March 31, 2006, theCompany paid $0.5 million in connection with rental subsidies. The maximumexposure to loss as of March 31, 2006 for the remainder of the agreementis the minimum purchase order commitments and the minimum service levels forservice contracts of $9 million and the guarantee for rents to be paid by theVIE of $1 million.

The one consolidated VIEwas related to secured floating rate notes assumed with the acquisition, ofwhich all were repaid during fiscal 2005. Therefore, this VIE no longer exists.

***Discontinued Operations***

There was no revenue orincome before income taxes from discontinued operations for the three or sixmonths ended March 31, 2006. During the six months ended March 31,2005, the Company incurred a $2 millionloss on the sale of the Company’s Connectivity Solutions business primarily asthe result of the finalization of the working capital adjustment in accordancewith the terms of the asset purchase agreement.

11

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**5. Goodwill andIntangible Assets**

Thechanges in the carrying value of goodwill for the six months ended March 31,2006 by operating segment are as follows:

| ** **                                             | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|------------|------------|
| ** **                                             | ** ** | **Communications**                | ** ** | **Global**   | ** ** | ** ** | ** ** |
| *** ***                                           | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Total**  | ** ** |
| ** **                                             | ** ** | **Dollars in millions** | ** ** |
| **Balance  as of September 30, 2005**             | ** ** |                              | **$**      | **642**      | ** ** |       |       | **$** | **272** | ** ** |   | **$** | **914** | ** ** |
| Impact of foreign currency exchange rate  fluctuations |       |                              | —     | ** **   |       |       | 2          | ** ** |   | 2 |   |
| **Balance as of March 31,  2006**                 | ** ** |                              | **$**      | **642**      | ** ** |       |       | **$** | **274** | ** ** |   | **$** | **916** | ** ** |

 

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

| ** **                                    | ** ** | **March 31, 2006**      | ** ** | **September 30, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **Gross  Carrying  Amount**       | ** ** | **Accumulated  Amortization**    | ** ** | **Net** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **                                    | ** ** | **Dollars in millions** | ** ** |
| Existing  technology                          |       |                              | $          | 101                              |       |   |   | $ | 49 |   |   | $ | 52 |   |   | $ | 101 |   |   |   | $ | 41 |   |   | $ | 60 |   |
| Customer relationships  and other intangibles |       |                              | 292        |                             |       |   | 70 |   |   | 222 |   |   | 288 |   |   |   | 45 |   |   | 243 |   |
| **Total  amortizable intangible assets**      | ** ** | ** **                        | **$**      | **393**                          |       | ** ** | ** ** | **$** | **119** |   | ** ** | **$** | **274** | ** ** | ** ** | **$** | **389** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **303** | ** ** |
| Minimum pension  adjustment, net of tax       |       |                              | 33         |                             |       |   | — |   |   | 33 |   |   | 34 |   |   |   | — |   |   | 34 |   |
| **Total intangible assets**                   | ** ** | ** **                        | **$**      | **426**                          |       | ** ** | ** ** | **$** | **119** |   | ** ** | **$** | **307** | ** ** | ** ** | **$** | **423** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **337** | ** ** |

 

During the six months ended March 31, 2006,amortization and the impact of foreign currency fluctuations resulted in adecrease of $30 million in the net intangible assets balance. The weightedaverage useful life of the technology, customer relationships, and trademarksare 5 years, 6 years and 5 years, respectively.

Amortizationexpense for the Company’s acquired intangible assets was $17 million and $33million for the three and six months ended March 31, 2006, respectivelyand was $15 million and $26 million for the three and six monthsended March 31, 2005, respectively. The majority of future estimatedamortization expense is associated with intangible assets acquired in theTenovis acquisition. Estimated future amortization expense is shown in thefollowing table.

| ** **                      | ** ** | **Expected future**          | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **amortization expense**     | ** ** |
| ** **                      | ** ** | **Dollars in millions** | ** ** |
| Remainder of fiscal 2006        |       |                              | $          | 31 |   |   |
| 2007                            |       |                              | 59         |   |   |
| 2008                            |       |                              | 59         |   |   |
| 2009                            |       |                              | 57         |   |   |
| 2010                            |       |                              | 45         |   |   |
| 2011 and thereafter             |       |                              | 23         |   |   |
| **Future amortization expense** | ** ** | ** **                        | **$**      | **274** |   |   |

 

The minimum pension adjustment, net of tax, representsunrecognized prior service costs associated with the recording of a minimumpension liability in prior fiscal years. This intangible asset may beeliminated or adjusted as necessary when the amount of minimum pensionliability is reassessed, which is conducted at least annually.

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**6. SupplementaryFinancial Information**

***Statement of IncomeInformation***

| ** **                                   | ** ** | **Three months ended  March 31,**         | ** ** | **Six months ended  March 31,**           | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                   | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| ** **                                   | ** ** | **Dollars in millions**                        | ** ** |
| **OTHER  INCOME (EXPENSE), NET**             | ** ** |                                                     | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Interest income                              |       |                                                     | $          | 8                                                        |       |   |   | $ | 6 |   |   |   | $ | 15 |   |   |   | $ | 12 |   |   |
| (Loss) gain on foreign currency transactions |       |                                                     | (1         | )                                                        |       |   | 1 |   |   |   | (2 | ) |   |   | (2 | ) |   |
| Loss on long-term debt extinguishment, net   |       |                                                     | —     |                                                     |       |   | (2 | ) |   |   | — |   |   |   | (43 | ) |   |
| Other, net                                   |       |                                                     | (1         | )                                                        |       |   | (5 | ) |   |   | (2 | ) |   |   | (5 | ) |   |
| **Total other income (expense),  net**       | ** ** |                                                     | **$**      | **6**                                                    | ** ** |   |   | **$** | **—** | ** ** |   |   | **$** | **11** | ** ** |   |   | **$** | **(38** | **)** |   |

 

***Balance SheetInformation***

| ** **                                                              | ** ** | **March 31,  2006**          | ** ** | **September 30,  2005** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                                              | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY:**                                                          | ** ** |                              | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Finished goods                                                          |       |                              | $          | 275                          |       |   |   | $ | 274 |   |   |
| Raw materials                                                           |       |                              | 17         |                         |       |   | 14 |   |   |
| **Total  inventory**                                                    | ** ** |                              | **$**      | **292**                      | ** ** |   |   | **$** | **288** | ** ** |   |
| **PROPERTY, PLANT AND EQUIPMENT, NET:**                                 | ** ** |                              | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Land and improvements                                                   |       |                              | $          | 53                           |       |   |   | $ | 41 |   |   |
| Buildings and improvements                                              |       |                              | 449        |                         |       |   | 430 |   |   |
| Machinery and equipment                                                 |       |                              | 623        |                         |       |   | 640 |   |   |
| Rental equipment                                                        |       |                              | 220        |                         |       |   | 210 |   |   |
| Assets under construction                                               |       |                              | 5          |                         |       |   | 7 |   |   |
| Internal use software                                                   |       |                              | 245        |                         |       |   | 237 |   |   |
| Total property,  plant and equipment                                    |       |                              | 1,595      |                         |       |   | 1,565 |   |   |
| Less: Accumulated  depreciation and amortization                        |       |                              | (887       | )                            |       |   | (827 | ) |   |
| **Property,  plant and equipment, net**                                 | ** ** |                              | **$**      | **708**                      | ** ** |   |   | **$** | **738** | ** ** |   |
| **ACCUMULATED OTHER COMPREHENSIVE LOSS:**                               | ** ** |                              | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Cumulative translation adjustment                                       |       |                              | $          | 49                           |       |   |   | $ | 48 |   |   |
| Minimum pension liability, net of tax of $15 million               |       |                              | (928       | )                            |       |   | (928 | ) |   |
| Unrealized holding loss on securities classified as  available for sale |       |                              | (3         | )                            |       |   | (3 | ) |   |
| **Accumulated other comprehensive  loss**                               | ** ** |                              | **$**      | **(882**                     | **)**      |   |   | **$** | **(883** | **)** |   |

 

***Cash FlowInformation***

| ** **                                                  | ** ** | **Six months ended**    | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                  | ** ** | **March 31, 2005**      | ** ** |
| ** **                                                  | ** ** | **Dollars in millions** | ** ** |
| **CASH USED FOR ACQUISITIONS**                              | ** ** |                              | ** ** | ** ** |   |
| Working capital, other than cash                            |       |                              | $          | (83 | ) |   |
| Property, plant and equipment                               |       |                              | 282        |   |   |
| Goodwill                                                    |       |                              | 677        |   |   |
| Intangibles assets and in process research and  development |       |                              | 349        |   |   |
| Long-term debt                                              |       |                              | (287       | ) |   |
| Other liabilities                                           |       |                              | (555       | ) |   |
| **Net cash used to acquire businesses**                     | ** ** |                              | **$**      | **383** | ** ** |   |

 

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**7. RestructuringPrograms**

***Second Quarter 2006 EMEA Restructuring Plan***

During the second quarterof fiscal 2006, the Company recorded a $15 million restructuring charge foremployee separations in Germany, which is included in “Restructuring Charges” in the Consolidated Statements of Income for thethree months ended March 31, 2006. This restructuring plan is aresult of the Company’s continuing efforts to improve the region’s operationalperformance. As of March 31, 2006, there have been no significant cashpayments to terminated employees as a result of this plan.

***EITF 95-3 Reserve***

This reserve reflects the remaining balance associatedwith employee separation charges related to the acquisition of Tenovis. Thisbalance is included in other liabilities in the Company’s Consolidated BalanceSheets. The following table summarizes the components of this reserve duringthe six months ended March 31, 2006:

| ** **                             | ** ** | **Employee**                  | ** ** |
|----------------------------------------|------------|-------------------------------|------------|
| ** **                             | ** ** | **Separation**                | ** ** |
| ** **                             | ** ** | **Costs**                     | ** ** |
| ** **                             | ** ** | **Dollars in  millions** | ** ** |
| Balance as of  September 30, 2005 |       |                          | $          | 70 |   |   |
| Cash payments                          |       |                          | (28        | ) |   |
| Restructuring charge                   |       |                          | 5          |   |   |
| **Balance as of March 31,  2006** | ** ** | ** **                    | **$**      | **47** |   |   |

 

The restructuring chargeof $5 million relates to higher than expected per employee separation costs inGermany and is included within “Restructuring Charges” in the ConsolidatedStatements of Income for the three months ended March 31, 2006.

***Fourth Quarter 2005 Restructuring Plan***

Duringthe fourth quarter of fiscal 2005, the Company recorded a $22 millionrestructuring charge to reorganize its North American sales and serviceorganizations, consolidate facilities and reduce the workforce in order tooptimize the cost structure. As of September 30, 2005, the balance of thereserve recorded in the fourth quarter of fiscal 2005 was $17 million. Thefollowing table summarizes the activity related to this restructuring liabilityrecorded in accordance with SFAS 146, “Accounting for Costs Associated withExit or Disposal Activities” for the six months ended March 31, 2006:

| ** **                             | ** ** | **Employee**                      | ** ** | **Lease**       | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                             | ** ** | **Separation**                    | ** ** | **Termination** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2005 |       |                              | $          | 7               |       |       |       | $ | 10 |   |   |   | $ | 17 |   |   |
| Cash payments                          |       |                              | (4         | )               |       |       | (3         | ) |   |   | (7 | ) |   |
| **Balance as of March 31, 2006**  | ** ** | ** **                        | **$**      | **3**           |       | ** ** | ** ** | **$** | **7** |   | ** ** | ** ** | **$** | **10** |   |   |

 

***EITF 94-3 Reserve***

Thisrestructuring reserve reflects the remaining balance associated with thebusiness restructuring charges related to lease terminations recorded in fiscal2000 through 2002 in accordance with EITF 94-3, “Liability Recognitionfor Certain Employee Termination Benefits and Other Costs to Exit an Activity(including Certain Costs Incurred in a Restructuring)” and is included in otherliabilities in the Company’s 

14

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Consolidated Balance Sheets. The changes in estimatesare included in selling, general and administrative expenses in the Company’sConsolidated Statements of Income. The following table summarizes thecomponents of this restructuring reserve during the six months ended March 31,2006:

| ** **                             | ** ** | **Lease**                         | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|
| ** **                             | ** ** | **Termination**                   | ** ** |
| ** **                             | ** ** | **Obligations**                   | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2005 |       |                              | $          | 24 |   |   |
| Cash payments                          |       |                              | (5         | ) |   |
| **Balance as of March 31,  2006** | ** ** | ** **                        | **$**      | **19** |   |   |

 

**8. Long-Term Debt**

Debtoutstanding consists of the following:

| ** **                                                                                      | ** ** | **March 31,  2006**          | ** ** | **September 30,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                                                                      | ** ** | **Dollars in millions** | ** ** |
| Debt maturing  within one year:                                                                 |       |                              |       |                         |       |   |   |   |   |
| Capital lease obligations                                                                       |       |                              | $          | 5                            |       |   |   | $ | 5 |   |   |
| Long-term debt:                                                                                 |       |                              |       |                         |       |   |   |   |   |
| 111¤8% Senior  Notes, net of discount, premium and net deferred gain on interest rate swap |       |                              | 13         |                         |       |   | 14 |   |   |
| Capital lease obligations                                                                       |       |                              | 11         |                         |       |   | 11 |   |   |
| Total long-term debt                                                                            |       |                              | 24         |                         |       |   | 25 |   |   |
| **Total debt**                                                                                  | ** ** | ** **                        | **$**      | **29**                       |       | ** ** | ** ** | **$** | **30** |   |   |

 

Through a series oftransactions during fiscal 2005, the Company reduced the carrying value of the 111¤8%Senior Notes due April 2009(“Senior Notes”) from $294 million as of September 30, 2004 to $14 millionas of September 30, 2005. The remaining 13,205 notes were redeemed at theCompany’s option in April 2006 for $1,056 each, for a total payment of $14million.

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

Thefollowing table summarizes the number of outstanding Senior Notes, theiraggregate carrying value, and their related fair value as of March 31,2006 and September 30, 2005:

| ** **   | ** ** | **March 31, 2006**      | ** ** | **September 30, 2005** | ** ** |
|--------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **   | ** ** | **Number**                        | ** ** | ** **                       | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **   | ** ** | **of Notes**                 | ** ** | **Carrying**                     | ** ** | **Fair** | ** ** | **of Notes** | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| *** *** | ** ** | **Outstanding**                   | ** ** | **Value**                        | ** ** | **Value** | ** ** | **Outstanding** | ** ** | **Value** | ** ** | **Value** | ** ** |
| ** **   | ** ** | **Dollars in millions** | ** ** |
| Senior Notes |       |                              | 13,205     |                             |       |   | $ | 13 |   |   |   | $ | 15 |   |   |   | 13,205 |   |   |   | $ | 14 |   |   |   | $ | 15 |   |   |
|              |            |                                   |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The carrying value as ofSeptember 30, 2005 of $14 million is comprised of the aggregate principalamount outstanding of $13 million increased for $1 million of unamortizedpremium, net of discount and the net unamortized deferred gain related to thetermination of interest rate swap agreements. The reduction in carrying valueas of March 31, 2006 is due to the amortization of the net premium anddeferred gain.

The fair value of theSenior Notes is based upon quoted market prices and yields obtained throughindependent pricing sources for the same or similar types of borrowingarrangements taking into consideration the underlying terms of the debt.

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***Credit Facility Amendments***

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

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can be outstandingat any time is $400 million, of which $150 million may be in the form ofletters of credit. The credit facility is a five-year revolving facility (withan expiration date of February 23, 2010) and is not secured by any of theCompany’s assets. The credit facility contains affirmative and restrictivecovenants, including: (a) periodic financial reporting requirements, (b) maintaininga maximum ratio of consolidated debt to earnings before interest, taxes,depreciation and amortization, adjusted for certain business restructuringcharges and related expenses and non-cash charges, referred to as adjustedEBITDA, of 2.00 to 1.00, (c) maintaining a minimum ratio of adjustedEBITDA to interest expense of 4.00 to 1.00, (d) limitations on theincurrence 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 2006, the credit facility allows the Company to repurchase,redeem or otherwise acquire shares of its common stock up to an amount not toexceed $461 million. As of March 31, 2006, 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 February 23, 2005, 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 theCompany and its subsidiaries for any period of twelve consecutive months equalsor exceeds $750 million.

There are currently $46 million of letters ofcredit issued under the credit facility. There are no other outstandingborrowings under the facility. The Company believes the credit facilityprovides it with an important source of backup liquidity.

From time to time, certainof the lenders provide customary commercial and investment banking services tothe Company.

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**9. Earnings Per 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 convertible debt.

| ** **                                                                            | ** ** | **Three months ended**                                            | ** ** | **Six months ended**                           | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **March 31,**                                                          | ** ** | **March 31,**                                       | ** ** |
| ** **                                                                            | ** ** | **    2006    **                    | ** ** | **    2005    ** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** |
| ** **                                                                            | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| ***Earnings  Per Common Share—Basic:***                                          | ** ** |                                                                        | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                        | $          | 38                                                       | ** ** |   |   | $ | 36 | ** ** |   |   | $ | 109 | ** ** |   |   | $ | 69 |   |   |
| Loss from  discontinued operations                                                    |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | (2 | ) |   |
| Net income                                                                            |       |                                                                        | $          | 38                                                       | ** ** |   |   | $ | 36 | ** ** |   |   | $ | 109 | ** ** |   |   | $ | 67 |   |   |
| Earnings per share  from continuing operations                                        |       |                                                                        | $          | 0.08                                                     | ** ** |   |   | $ | 0.08 | ** ** |   |   | $ | 0.23 | ** ** |   |   | $ | 0.15 |   |   |
| Loss per share  from discontinued operations                                          |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | (0.01 | ) |   |
| Earnings per  share—basic                                                        |       |                                                                        | $          | 0.08                                                     | ** ** |   |   | $ | 0.08 | ** ** |   |   | $ | 0.23 | ** ** |   |   | $ | 0.14 |   |   |
| Weighted average  shares outstanding—basic                                       |       |                                                                        | 466        | ** **                                               |       |   | 480 | ** ** |   |   | 469 | ** ** |   |   | 470 |   |   |
| ***Earnings  Per Common Share—Diluted:***                                        | ** ** |                                                                        | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                        | $          | 38                                                       | ** ** |   |   | $ | 36 | ** ** |   |   | $ | 109 | ** ** |   |   | $ | 69 |   |   |
| Interest charges  associated with LYONs convertible debt, net of tax effects          |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | 2 |   |   |
| Income from  continuing operations after assumed conversion of LYONs debt        |       |                                                                        | 38         | ** **                                               |       |   | 36 | ** ** |   |   | 109 | ** ** |   |   | 71 |   |   |
| Loss from  discontinued operations                                                    |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | (2 | ) |   |
| Net income after  assumed conversion of LYONs debt                                    |       |                                                                        | $          | 38                                                       | ** ** |   |   | $ | 36 | ** ** |   |   | $ | 109 | ** ** |   |   | $ | 69 |   |   |
| Earnings per share  from continuing operations                                        |       |                                                                        | $          | 0.08                                                     | ** ** |   |   | $ | 0.07 | ** ** |   |   | $ | 0.23 | ** ** |   |   | $ | 0.15 |   |   |
| Loss per share  from discontinued operations                                          |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | (0.01 | ) |   |
| Earnings per share—diluted                                                       |       |                                                                        | $          | 0.08                                                     | ** ** |   |   | $ | 0.07 | ** ** |   |   | $ | 0.23 | ** ** |   |   | $ | 0.14 |   |   |
| ***Diluted  Weighted Average Shares Outstanding:***                                   | ** ** |                                                                        | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |
| Weighted average  shares outstanding—basic                                       |       |                                                                        | 466        | ** **                                               |       |   | 480 | ** ** |   |   | 469 | ** ** |   |   | 470 |   |   |
| Dilutive Potential Common  Shares:                                                    |       |                                                                        |       | ** **                                               |       |   |   | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |
| Stock Options                                                                         |       |                                                                        | 5          | ** **                                               |       |   | 7 | ** ** |   |   | 5 | ** ** |   |   | 7 |   |   |
| Restricted Stock Units                                                                |       |                                                                        | 1          | ** **                                               |       |   | 1 | ** ** |   |   | 1 | ** ** |   |   | 1 |   |   |
| Warrants                                                                              |       |                                                                        | —     | ** **                                               |       |   | 5 | ** ** |   |   | — | ** ** |   |   | 6 |   |   |
| LYONs Convertible Debt                                                                |       |                                                                        | —     | ** **                                               |       |   | — | ** ** |   |   | — | ** ** |   |   | 9 |   |   |
| Weighted average  shares outstanding—diluted                                     |       |                                                                        | 472        | ** **                                               |       |   | 493 | ** ** |   |   | 475 | ** ** |   |   | 493 |   |   |
| ***Securities  excluded from the computation of diluted earnings per common share:*** | ** ** |                                                                        | ** ** | ** **                                               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   |   |   |   |
| Stock options(1)                                                                      |       |                                                                        | 41         | ** **                                               |       |   | 29 | ** ** |   |   | 41 | ** ** |   |   | 27 |   |   |
| Warrants(1)                                                                           |       |                                                                        | —     | ** **                                               |       |   | 5 | ** ** |   |   | — | ** ** |   |   | 5 |   |   |
|                                                                                  |       |                                                                        | 41         | ** **                                               |       |   | 34 | ** ** |   |   | 41 | ** ** |   |   | 32 |   |   |

----

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

On April 19, 2005,the Board of Directors authorized a share repurchase plan (the “plan”). Underthe provisions of the plan, Avaya may use up to $500 million of cash to repurchaseshares of its outstanding common stock through April 2007. For fiscal2006, the credit facility limits the Company’s ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquire sharesof Avaya common stock to $461 million (which represents 50% of net income forthe Company for fiscal 2005). During the six months ended March 31, 2006,the Company repurchased and retired 17,416,800 shares of common stock at anaverage purchase price of $11.09 per share, for a total of $193 million. From April 1,2006 through May 9, 2006, the Company repurchased and retired 5,117,400shares at an average purchase price of $12.32 per share, for an additional $63million. Approximately $137 million is available through April 2007 for furthershare repurchases under the plan. These repurchases are made at management’s 

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discretionin the open market or in privately negotiated transactions in compliance withapplicable securities laws and other legal requirements and are subject tomarket conditions, share price, the terms of Avaya’s credit facility and otherfactors.

**10. Income Taxes**

The provisions for income taxes for the three andsix months ended March 31, 2006 were****based oneffective tax rates of 33.3% and 35.1%, respectively. The tax provisions arecomprised of U.S. federal, state and non-U.S. taxes. The provisions for incometaxes for the three and six months ended March 31, 2005 were comprised ofstate and non-U.S. taxes.

On October 22, 2004,the American Jobs Creation Act of 2004 (“the Act”), was signed into law. TheAct includes a deduction of 85% of certain foreign earnings that arerepatriated, as defined in the Act. With respect to the repatriation provision,the Company continues to evaluate the potential benefits as compared to thecosts and expects to make a determination regarding its impact to the Companyby the end of fiscal 2006.

**11. BenefitObligations**

The components of net periodic benefit cost for thethree and six months ended March 31, 2006 and 2005 are provided in the tablebelow:

| ** **                                           | ** ** | **Pension Benefits—**                          | ** ** | **Pension Benefits—**                          | ** ** | **Postretirement**                                       | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                           | ** ** | **U.S.**                                                 | ** ** | **Non-U.S.**                                             | ** ** | **Benefits—U.S.**                                   | ** ** |
| ** **                                           | ** ** | **Three months ended**                         | ** ** | **Three months ended**                         | ** ** | **Three months ended**                         | ** ** |
| ** **                                           | ** ** | **March 31,**                                       | ** ** | **March 31,**                                       | ** ** | **March 31,**                                       | ** ** |
| ** **                                           | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| ** **                                           | ** ** | **Dollars in millions**                        | ** ** |
| **Components of Net Periodic  Benefit Cost**         | ** ** |                                                     | ** ** | ** **                                               |       |                                                     | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                         |       |                                                     | $          | 5                                                        |       |                                                     |       | $ | 4 |   |   |   | $ | 3 | ** ** |   |   | $ | 3 | ** ** |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                        |       |                                                     | 42         |                                                     |       |                                                     | 42         |   |   |   | 4 | ** ** |   |   | 4 | ** ** |   |   | 9 |   |   |   | 10 |   |   |
| Expected return on plan assets                       |       |                                                     | (51        | )                                                        |       |                                                     | (54        | ) |   |   | — | ** ** |   |   | — | ** ** |   |   | (1 | ) |   |   | (3 | ) |   |
| Amortization of unrecognized prior service cost |       |                                                     | 1          |                                                     |       |                                                     | 2          |   |   |   | — | ** ** |   |   | — | ** ** |   |   | 4 |   |   |   | 2 |   |   |
| Recognized net actuarial loss                        |       |                                                     | 14         |                                                     |       |                                                     | 9          |   |   |   | — | ** ** |   |   | — | ** ** |   |   | — |   |   |   | 1 |   |   |
| **Net periodic benefit cost**                        | ** ** |                                                     | **$**      | **11**                                                   | ** ** |                                                     |       | **$** | **3** | ** ** |   |   | **$** | **7** | ** ** |   |   | **$** | **7** | ** ** |   |   | **$** | **13** | ** ** |   |   | **$** | **11** | ** ** |   |

 

| ** **                                                           | ** ** | **Pension Benefits—  U.S.**                                                                                   | ** ** | **Pension Benefits—  Non-U.S.**                                                                               | ** ** | **Postretirement  Benefits—U.S.**                                                                             | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Six months ended**                                                                                     | ** ** | **Six months ended**                                                                                     | ** ** | **Six months ended**                                                                                     | ** ** |
| ** **                                                           | ** ** | **        March 31,        ** | ** ** | **        March 31,        ** | ** ** | **        March 31,        ** | ** ** |
| ** **                                                           | ** ** | **    2006    **                                                           | ** ** | **    2005    **                                                           | ** ** | **    2006    **                                                           | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |   |
| ** **                                                           | ** ** | **Dollars in millions**                                                                                  | ** ** |                                                                                                               |
| **Components of Net Periodic Benefit Cost** | ** ** |                                                                                                               |       |                                                                                                               |       |                                                                                                               | ** ** | ** ** |   |   |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   | ** ** | ** ** |   |   |
| Service cost                                                         |       |                                                                                                               | $          | 9                                                                                                                  |       |                                                                                                               |       | $ | 8 |   |   |   | $ | 5 |   |   |   | $ | 5 | ** ** |   |   | $ | 2 |   |   |   | $ | 2 |   |   |   |
| Interest cost                                                        |       |                                                                                                               | 83         |                                                                                                               |       |                                                                                                               | 84         |   |   |   | 8 |   |   |   | 6 | ** ** |   |   | 17 |   |   |   | 20 |   |   |   |
| Expected return on plan assets                                       |       |                                                                                                               | (102       | )                                                                                                                  |       |                                                                                                               | (108       | ) |   |   | — |   |   |   | — | ** ** |   |   | (3 | ) |   |   | (5 | ) |   |   |
| Amortization of unrecognized prior service cost                 |       |                                                                                                               | 3          |                                                                                                               |       |                                                                                                               | 3          |   |   |   | — |   |   |   | — | ** ** |   |   | 8 |   |   |   | 5 |   |   |   |
| Recognized net actuarial loss                                        |       |                                                                                                               | 28         |                                                                                                               |       |                                                                                                               | 18         |   |   |   | — |   |   |   | — | ** ** |   |   | 1 |   |   |   | 3 |   |   |   |
| **Net periodic benefit cost**                                        | ** ** | ** **                                                                                                         | **$**      | **21**                                                                                                             |       |                                                                                                               |       | **$** | **5** | ** ** | ** ** | ** ** | **$** | **13** |   |   |   | **$** | **11** | ** ** | ** ** | ** ** | **$** | **25** |   |   |   | **$** | **25** | ** ** |   |   |

 

The Company provides certain pension benefits for U.S.and non-U.S. employees, which are not pre-funded. Consequently, the Companymakes payments as these benefits are disbursed. For the six months ended March 31,2006, the Company made payments for these U.S. and non-U.S. pension benefitstotaling 

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$3 million and $7 million,respectively. Estimated payments for these U.S. and non-U.S. pension benefitsfor the remainder of fiscal 2006 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, 2006, the Company made payments totaling$25 million for these retiree medical benefits. Estimated payments for theseretiree medical benefits for the remainder of fiscal 2006 are $22 million.

**12. StockCompensation Plans**

The Company has a stockcompensation plan, which provides for the issuance to eligible employees ofnonqualified stock options and restricted stock units representing Avaya commonstock. In addition, the Company has an employee stock purchase plan under whicheligible employees have the ability to purchase shares of Avaya common stock at85% of average of the high and low per share trading price of Avaya’s commonstock on the New York Stock Exchange on the last trading day of the month.

**Stock Options**

Stock options are generally granted with an exerciseprice equal to or above the market value of a share of common stock on the dateof grant. Stock options granted prior to fiscal 2004 are for a contractual termof ten years or fewer and generally vest within four years from the grant-date.Options granted in fiscal 2004 or afterwards have a contractual term of sevenyears and vest in three years. For the six months ended March 31, 2006,approximately $6.6 million of compensation expense related to stock options wasrecorded. At the 2004 Annual Meeting of Shareholders, the Avaya Inc. 2004 LongTerm Incentive Plan (the “Plan”) was approved. The Plan became the successorplan to, and no further grants have been made from, the Company’s four previousexisting plans: the 2000 Long Term Incentive Plan, the 2000 Stock CompensationPlan for Non-employee Directors, the Broad Based Stock Option Plan and the LongTerm Incentive Plan for Management Employees (the “Existing Plans”). Theconsolidation of the Existing Plans into the Plan resulted in an aggregatereduction in the number of shares eligible for awards under the existing plans.As of March 31, 2006, there were 15 million stock options authorizedfor grant to purchase Avaya common stock under the Company’s stock compensationplan.

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

The company calculates expected volatility based onimplied and historical volatility of the company’s common stock, and otherfactors. The risk-free interest rate assumption is based upon observed interestrates appropriate for the term of the Company’s employee stock options. Thedividend yield assumption is based on the Company’s intent not to issue adividend under its dividend policy. The expected holding period assumption wasestimated based on the Company’s historical experience.

As stock-based compensation expense recognized in theConsolidated Statement of Income for the six months ended March 31, 2006is based on awards ultimately expected to vest, it had been reduced forestimated forfeitures. SFAS 123(R) requires forfeitures to be estimated atthe time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. Forfeitures were estimated based onthe Company’s historical experience. In the Company’s pro forma informationrequired under SFAS 123 for the periods prior to fiscal 2006, the Companyaccounted for forfeitures as they occurred.

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Thefair value of each stock option grant made during fiscal 2006 was estimated onthe grant-date using the lattice-binomial model with the following weightedaverage assumptions:

| ** **                          | ** ** | **Six months ended** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **March 31, 2006**   | ** ** |
| WEIGHTED AVERAGE  ASSUMPTIONS:      |       |                           |       |   |   |
| Dividend yield                      |       |                           | 0.00       | % |   |
| Expected volatility                 |       |                           | 58.69      | % |   |
| Risk-free interest rate             |       |                           | 4.37       | % |   |
| Annual forfeiture rate              |       |                           | 5.73       | % |   |
| Expected holding  period (in years) |       |                           | 3.49       |   |   |

 

Thefollowing table summarizes information concerning options outstanding includingthe related transactions under the plan for the six months ended March 31,2006 and the year ended September 30, 2005:

| ** **                                     | ** ** | **Shares**       | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------------------|------------|------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | **(000’s)** | ** ** | ** **                                     | ** ** |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2004  |       | 48,540           |       |                                           | $          | 13.35 |   |   |
| Granted                                        |       | 7,189            |       |                                           | 14.90      |   |   |
| Exercised                                      |       | (4,421           | )          |                                           | 7.84       |   |   |
| Forfeited and Expired                          |       | (2,783           | )          |                                           | 15.72      |   |   |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2005  |       | 48,525           |       |                                           | 13.95      |   |   |
| Granted                                        |       | 4,813            |       |                                           | 11.16      |   |   |
| Exercised                                      |       | (1,562           | )          |                                           | 4.35       |   |   |
| Forfeited and Expired                          |       | (1,111           | )          |                                           | 16.19      |   |   |
| OPTIONS OUTSTANDING AS  OF MARCH 31, 2006 |       | 50,665           |       |                                           | $          | 13.93 |   |   |

 

The weighted-average grant date fair value of optionsgranted during the six months ended March 31, 2006 was $4.62 per share. Thetotal intrinsic value of options exercised during the six months ended March 31,2006 was $11 million.

Thefollowing table summarizes the status of the Company’s stock options as of March 31,2006:

| ** **               | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | ** **                              | ** ** | **Average**                             | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **Remaining**                           | ** ** | **Average** | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Average** | ** ** | **Aggregate** | ** ** |
| **Range of**        | ** ** | ** **                              | ** ** | **Contractual**                         | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** |
| **Exercise Prices** | ** ** | ** **                              | ** ** | **Shares**                              | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Value** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **(000’s)**                        | ** ** | ** ** | ** ** | ** ** | ** ** | **(000’s)** | ** ** | **(000’s)** | ** ** | ** ** | ** ** | **(000’s)** | ** ** |
| $0.01 to $9.70           |       | 9,494                                   |       |                                    | 3.52       |   |   |   | $ | 4.42 |   |   |   | $ | 66,107 |   |   | 8,322 |   |   | $ | 4.49 |   |   |   | $ | 57,418 |   |   |
| $9.71 to $14.79          |       | 15,318                                  |       |                                    | 5.20       |   |   |   | 12.40 |   |   |   | 2,409 |   |   | 9,803 |   |   | 13.16 |   |   |   | 479 |   |   |
| $14.80 to $15.19         |       | 12,252                                  |       |                                    | 4.51       |   |   |   | 14.84 |   |   |   | — |   |   | 12,251 |   |   | 14.84 |   |   |   | — |   |   |
| $15.20 to $19.36         |       | 6,867                                   |       |                                    | 5.31       |   |   |   | 16.17 |   |   |   | — |   |   | 6,867 |   |   | 16.17 |   |   |   | — |   |   |
| $19.36 to $51.21         |       | 6,734                                   |       |                                    | 2.91       |   |   |   | 26.86 |   |   |   | — |   |   | 6,734 |   |   | 26.86 |   |   |   | — |   |   |
| Total                    |       | 50,665                                  |       |                                    |       |   |   |   | $ | 13.93 |   |   |   | $ | 68,516 |   |   | 43,977 |   |   | $ | 14.55 |   |   |   | $ | 57,897 |   |   |

 

The aggregate intrinsicvalue in the preceding table represents the total pretax intrinsic value, basedon the Company’s average stock price on March 31, 2006, which would havebeen received by the option holders had all option holders exercised theiroptions as of that date. The total number of in-the-money 

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optionsexercisable on March 31, 2006 was approximately nine million. The weightedaverage remaining contractual life on March 31, 2006 for outstanding andexercisable options is 4.43 and 4.18 years, respectively.

**Restricted StockUnits**

The Company’s Plan permits the granting of restrictedstock units to eligible employees and non-employee Directors at the fair marketvalue of the Company’s common stock at the date of grant and typically becomefully vested over a four-year period. Restricted stock units are payable inshares of the Company’s common stock upon vesting.

Thefollowing table presents a summary of the status of the Company’s nonvestedresticted stock units as of September 30, 2005 and changes during the sixmonths ended March 31, 2006:

| ** **                                   | ** ** | ** **       | ** ** | **Weighted-Average** | ** ** |
|----------------------------------------------|------------|------------------|------------|----------------------|------------|
| ** **                                   | ** ** | ** **       | ** ** | **Grant-Date**       | ** ** |
| **Nonvested Shares**                    | ** ** | ** **       | ** ** | **Shares**           | ** ** | **Fair Value** | ** ** |
| ** **                                   | ** ** | **(000’s)** | ** ** | ** **           | ** ** |
| Nonvested shares  at September 30, 2005 |       |             | 3,708      |                 |       |   | $ | 12.08 |   |   |
| Granted                                      |       |             | 2,083      |                 |       |   | 11.06 |   |   |
| Vested                                       |       |             | (451       | )                    |       |   | 2.92 |   |   |
| Forfeited                                    |       |             | (192       | )                    |       |   | 12.50 |   |   |
| Nonvested shares at  March 31, 2006     |       |             | 5,148      |                 |       |   | $ | 12.41 |   |   |
|                                              |            |                  |            |                      |            |  |  |  |  |  |  |  |

 

As of March 31, 2006,there was approximately $43 million of total unrecognized compensation costrelated to nonvested share-based compensation arrangements granted under thePlan. That cost is expected to be recognized over a weighted average period offour years. Compensation expense related to restricted stock units was $4million and $3 million for the three months ended March 31, 2006 and 2005,respectively, and was $8 million and $5 million for the six months ended March 31,2006 and 2005, respectively.

**Performance-BasedRestricted Stock Units**

Performance-based restricted stock units vest upon theachievement of certain targets and are payable in shares of the Company’scommon stock upon vesting, typically over a three-year period. The fair valueis based on the market price of the Company’s common stock on the grant-dateand assumes that the target payout level will be achieved. Compensation cost isadjusted for subsequent changes in the expected outcome of performance-relatedconditions until the vesting date.

On December 15, 2005,the Compensation Committee of the Board of Directors approved awards of 350,000performance-vesting restricted stock units to executive officers of the Companypursuant to the terms of the Plan.

**Employee StockPurchase Plan**

Under the terms of theemployee stock purchase plan, eligible employees may have up to 10% of theireligible compensation deducted from their pay to purchase shares of Avayacommon stock. The per share purchase price is 85% of the average high and lowper share trading price of Avaya’s common stock on the New York Stock Exchangeon the last trading day of each month. For the three and six months ended March 31,2006, approximately $0.6 million and $1.2 million, respectively, ofcompensation expense related to the employee stock purchase plan was recorded.

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**13. OperatingSegments**

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

The GCS segment includes the portion of the rental andmanaged services revenue attributed to the equipment portion used in connectionwith the customer contracts. The portions of the customer rental and managedservices contracts attributed to maintenance and other services are included inthe AGS 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(collectively, “corporate overhead expenses”). At the beginning of each fiscal year, the amount of certain corporateoverhead expenses, including targeted annual incentive awards, to be charged tooperating segments is determined and fixed for the entire year in the annualplan. The annual incentive award accrual is adjusted quarterly based on actualyear to date results and those estimated for the remainder of the year. Thisadjustment of the annual incentive award accrual, as well as any otherover/under absorption of corporate overhead expenses against plan is recordedand reported within the Corporate/Other Unallocated Amounts caption. Restructuringcharges are also recorded and reported within the Corporate/Other UnallocatedAmounts caption.

The Company has outsourced substantially all of itsmanufacturing operations to a number of contract manufacturers. Allmanufacturing of the Company’s products is performed in accordance withdetailed specifications and product designs furnished by the Company and issubject to quality control standards. 

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

| ** **                                  | ** ** | **Reportable Segments**      | ** ** | ** **   | ** ** | ** **          | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                  | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Communications**                | ** ** | **Global**   | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| *** ***                                | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Amounts**         | ** ** | **Total** | ** ** |
| *** ***                                | ** ** | **Dollars in millions** | ** ** |
| **Three months ended  March 31, 2006** |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                     |       |                              | $          | 661          |       |                |       | $ | 577 |   |   |   | $ | — |   |   | $ | 1,238 |   |
| Operating income  (loss)                    |       |                              | 32         |         |       |                | 41         |   |   |   | (20 | ) |   | 53 |   |
| **Three  months ended March 31, 2005** |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                     |       |                              | $          | 625          |       |                |       | $ | 597 |   |   |   | $ | — |   |   | $ | 1,222 |   |
| Operating (loss)  income                    |       |                              | (12        | )            |       |                | 27         |   |   |   | 37 |   |   | 52 |   |
| **Six  months ended March 31, 2006**   |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                     |       |                              | $          | 1,322        |       |                |       | $ | 1,165 |   |   |   | $ | — |   |   | $ | 2,487 |   |
| Operating income  (loss)                    |       |                              | 75         |         |       |                | 101        |   |   |   | (16 | ) |   | 160 |   |
| **Six  months ended March 31, 2005**   |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                     |       |                              | $          | 1,217        |       |                |       | $ | 1,153 |   |   |   | $ | — |   |   | $ | 2,370 |   |
| Operating income                            |       |                              | 13         |         |       |                | 83         |   |   |   | 44 |   |   | 140 |   |

 

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

| ** **                                                   | ** ** | **March 31,  2006**          | ** ** | **September 30,  2005** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                                   | ** ** | **Dollars in millions** | ** ** |
| U.S.                                                         |       |                              | $          | 434                          |       |   |   | $ | 453 |   |   |
| Outside the U.S.:                                            |       |                              |       |                         |       |   |   |   |   |
| Germany                                                      |       |                              | 205        |                         |       |   | 214 |   |   |
| EMEA—Europe / Middle East / Africa (excluding  Germany) |       |                              | 50         |                         |       |   | 52 |   |   |
| APAC—Asia Pacific                                       |       |                              | 15         |                         |       |   | 14 |   |   |
| Americas, non-U.S.                                           |       |                              | 4          |                         |       |   | 5 |   |   |
| Total outside the U.S.                                       |       |                              | 274        |                         |       |   | 285 |   |   |
| Total                                                        |       |                              | $          | 708                          |       |   |   | $ | 738 |   |   |

 

**14. Commitments andContingencies**

**Legal Proceedings**

In the ordinary course ofbusiness the Company is involved in lawsuits, claims, government inquiries,investigations, charges and proceedings, including, but not limited to, thoseidentified below, relating to intellectual property, commercial, securities,employment, employee benefits, environmental and regulatory matters. Oftenthese issues are subject to substantial uncertainties and, therefore, theprobability of loss and an estimation of damages are difficult to ascertain. Itis difficult to reasonably estimate the maximum potential exposure or the rangeof possible loss. These assessments can involve a series of complex judgmentsabout future events and can rely heavily on estimates and assumptions. Ourassessments are based on estimates and assumptions that have been deemed reasonableby management. In accordance with SFAS No. 5, “Accounting forContingencies,” the Company makes a provision for a liability when it is bothprobable that a liability has been incurred and the amount of the loss can bereasonably estimated. Other than as described below, the Company believes thereis no litigation pending against the Company that could have, individually orin the aggregate, a material adverse effect on the Company’s financialposition, results of operations or cash flows.

**Commissions ArbitrationDemand**

In July 2002, Communications DevelopmentCorporation (“CDC”), a British Virgin Islands corporation, made formal demandfor arbitration for alleged unpaid commissions in an amount in excess of $10million, stemming from the sale of products from Avaya’s businesses that wereformerly owned by Lucent Technologies Inc. (“Lucent”) involving the Ministry ofRussian Railways. In April 2003, CDC initiated the arbitration before theAmerican Arbitration Association. The plaintiff alleges that as a result ofagreements entered into between the plaintiff and the Company, it is owedcommissions on sales by the Company to the Ministry of Russian Railways on acontinuing basis. The Company believes that the agreements relating to theplaintiff’s claim have expired or do not apply to the products in question. Asthe sales of products continue, CDC may likely increase its commission demand.An arbitration hearing commenced in December 2005, with the partiesexpecting to reconvene for further arbitration proceedings some time in mid2006.

As the hearing in thematter is not yet completed, an outcome cannot be predicted and, as a result,we cannot be assured that these cases will not have a material adverse effecton our financial position, results of operations or cash flows.

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**SecuritiesLitigation**

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 a number of these complaints. No class has been certified in the actions.The complaints seek compensatory damages plus interest and attorneys’ fees. In August 2005,the court entered an order identifying a lead plaintiff and lead plaintiffs’counsel. A consolidated amended complaint was filed in October 2005.Pursuant to a scheduling order issue by the District Court, defendants filedtheir motion to dismiss the consolidated complaint in December 2005.

This consolidated matteris still in the early stages of litigation and an outcome cannot be predictedand, as a result, we cannot be assured that these cases will not have amaterial adverse effect on our financial position, results of operations orcash flows.

**DerivativeLitigation**

In May and July of 2005, three derivativecomplaints were filed against certain officers and the Board of Directors (“Board”)of the Company. Two complaints were filed in the United States District Court,District of New Jersey, and one was filed in the Superior Court of New Jersey,Somerset County. The allegations in each of the complaints are substantiallysimilar and include the Company as a nominal defendant. The complaints allege,among other things, that defendants violated their fiduciary duties by failingto disclose material information and/or by misleading the investing publicabout the Company’s business, asserting claims substantially similar to thoseasserted in the actions described above under “Securities Litigation.” Thecomplaints seek contribution from the defendants to the Company for allegedviolations of the securities laws, restitution to the Company and disgorgementof profits earned by defendants, and fees and costs.

These actions are in the early stages oflitigation and an outcome cannot be predicted and, as a result, we cannot beassured that these cases will not have a material adverse effect on ourfinancial position, results of operations or cash flows.

**ERISA Class Action—SecuritiesLitigation**

In July 2005, a purported class action lawsuitwas filed in the United States District Court for the District of New Jerseyagainst us and certain of our officers, employees and members of the Board ofDirectors (the “Board”) of the Company, alleging violations of certain lawsunder the Employee Retirement Income Security Act of 1974 (“ERISA”). On October 17,2005, an amended purported class action was filed against us and certain of ourofficers, employees and members of the Board. Like the initial complaint, theamended complaint purports to be filed on behalf of all participants andbeneficiaries of the Avaya Inc. Savings Plan, the Avaya Inc. Savings Plan forSalaried Employees and the Avaya Inc. Savings Plan for the Variable Workforce(collectively, the “Plans”), during the period from October 5, 2004through July 20, 2005. It contains factual allegations substantiallysimilar to those asserted in the matters under the heading of “SecuritiesLitigation.”

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The complaint alleged, among other things,that the named defendants breached their fiduciary duties owed to participantsand beneficiaries of the Plans and failed to act in the interests of the Plans’participants and beneficiaries in offering Avaya common stock as an investmentoption, purchasing Avaya common stock for the Plans and communicatinginformation to the Plans’ participants and beneficiaries. The complaint soughta monetary payment to the plans to make them whole for the alleged breaches,costs and attorneys’ fees. The Defendants filed a motion to dismiss the amendedcomplaint in December 2005. In an order and opinion dated April 24,2006, the District Court judge granted the Defendant’s motion and dismissed theamended complaint in its entirety.

**ERISA Class Action—Stock Funds**

In April 2006, a purported class action was filed in the United StatesDistrict Court, District Court of New Jersey, alleging that Avaya Inc.,certain employees and the Pension and Employee Benefits Investment Committeeviolated the Employee Retirement Income Security Act of 1974 (“ERISA”), byincluding in the Avaya Inc. Savings Plan for Salaried Employees, the Avaya Inc.Savings Plan and the Avaya Inc. Savings Plan for the Variable Workforce (“Plans”),investment options for the Lucent Technologies Inc. Stock Fund (“Lucent Fund”)and the Avaya Inc. Stock Fund (“Avaya Fund”) for the period of October 2000to April 2003 (“Alleged Class Period”). The complaint asserts, amongother things, that during the Alleged Class Period defendants breachedtheir fiduciary duties under ERISA by violating ERISA’s provisions againstprohibited transactions; offering the Lucent Fund and Avaya Fund imprudently asinvestment options; failing properly to monitor the funds; and, failingproperly to monitor the actions of other plan fiduciaries, thus causing thePlans to suffer damages. The complaint seeks monetary relief on behalf of thePlans and its participants, and also seeks injunctive relief and costs,including attorneys’ fees.

This matter is in the early stages oflitigation, and an outcome cannot be predicted and, as a result, we cannot beassured that this case will not have a material adverse effect on our financialposition, results of operations or cash flows.

**GovernmentSubpoenas**

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, the Company received a subpoenafrom the Office of Inspector General, U.S. General ServicesAdministration, relating to a federal investigation of billing by the Companyfor telecommunications equipment and maintenance services. The 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.

The Company is cooperatingwith the relevant government entities with respect to these subpoenas.

**Antitrust Lawsuit**

In August 2005, United Asset Coverage, Inc.(“UAC”), filed a verified complaint against the Company in the United StatesDistrict Court, Northern District of Illinois, alleging, among other things,violations of federal and state antitrust laws, in the manner in which theCompany seeks to protect its proprietary information. The verified complaintsought a temporary restraining order against the Company 

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to enjoin immediately itspractice of limiting the use of its proprietary information in a manner whichUAC believes is in violation of its contracts and licensing agreements. Thecourt denied UAC’s motion for temporary restraints. A preliminary injunctionhearing began on October 25, 2005, and after several adjournments of thehearing based on the District Court’s schedule, concluded on November 22,2005. The parties submitted post-hearing briefs in support of their respectivepositions in mid December 2005. In early January 2006, the District Courtissued its decision, denying in its entirety plaintiff’s motion for apreliminary injunction. The District Court also entered an order regardingscheduling in the matter.

Even though Avayaprevailed in the preliminary injunction proceeding, an outcome in this mattercannot be predicted at this time, and we cannot be assured that this case willnot have a material adverse effect on our financial position, results ofoperations or cash flows.

**Environmental,Health and Safety Matters**

The Company is subject to a wide range of governmentalrequirements relating to employee safety and health and to the handling andemission into the environment of various substances used in its operations. TheCompany is subject to certain provisions of environmental laws, particularly inthe United States and Germany, governing the cleanup of soil and groundwatercontamination. Such provisions impose liability for the costs of investigatingand remediating releases of hazardous materials at currently or formerly ownedor operated sites. In certain circumstances, this liability may also includethe cost of cleaning up historical contamination, whether or not caused by theCompany. The Company is currently conducting investigation and/or cleanup ofknown contamination at nine of its current or former facilities eithervoluntarily or pursuant to government directives. Based on currently availableinformation, none of the sites is reasonably likely to generate environmentalcosts that will be individually material nor will environmental costs for allsites in the aggregate be material for fiscal 2006. There are no known thirdparties who may be responsible for investigation and/or cleanup at these sitesand therefore, for purposes of assessing the adequacy of accruals for these liabilities,the Company has not assumed that it will recover amounts from any third party,including under any insurance coverage or indemnification arrangement. Althoughthe Company does not separately track recurring costs of managing hazardoussubstances and pollutants in ongoing operations, it does not believe them to bematerial.

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

The reliability and precision of estimates of theCompany’s environmental costs may be affected by a variety of factors,including whether the remediation treatment will be effective, contaminationsources have been accurately identified and assumptions regarding the 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 three and six monthsended March 31, 2006 and 2005 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.

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**Product Warranties**

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

| ** **                                           | ** ** | **Dollars in  millions** | ** ** |
|------------------------------------------------------|------------|-------------------------------|------------|
| Balance as of  September 30, 2005               |       |                          | $          | 30 |   |   |
| Reductions for  payments and costs to satisfy claims |       |                          | (26        | ) |   |
| Accruals for  warranties issued during the period    |       |                          | 23         |   |   |
| Balance as of  March 31, 2006                   |       |                          | $          | 27 |   |   |

 

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

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $127 million asof March 31, 2006, for the purpose of securing third party financialguarantees such as letters of credit which ensure the Company’s performance orpayment to third parties. Additionally, the Company has a $400 millioncommitted credit facility, which is discussed in Note 8 “Long-Term Debt.” As ofMarch 31, 2006, the Company had outstanding an aggregate of $119 millionin irrevocable letters of credit under the committed and uncommitted creditfacilities (including $46 million under its $400 million committed creditfacility).

***Surety Bonds***

The Company arranges forthe issuance of various types of surety bonds, such as license, permit, bid andperformance bonds, which are agreements under which the surety companyguarantees that the Company will perform in accordance with contractual orlegal obligations. These bonds vary in duration although most are issued andoutstanding from six months to three years. These bonds are backed by $17 millionof our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$36 million as of March 31, 2006. Historically, no surety bonds havebeen drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchases components from a variety ofsuppliers and uses several contract manufacturers to provide manufacturingservices for its products. During the normal course of business, in order tomanage manufacturing lead times and to help assure adequate component supply,the Company enters into agreements with contract manufacturers and suppliersthat allow them to produce and procure inventory based upon forecastedrequirements provided by the Company. If the Company does not meet thesespecified purchase commitments, it could be required to purchase the inventory,or in the case of certain agreements, pay an early termination fee. As of March 31, 2006, the maximum potentialpayment under these commitments was approximately $171 million. Historically,the Company has not been required to pay a charge for not meeting itsdesignated purchase commitments with these suppliers.

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The Company’s outsourcingagreement with its most significant contract manufacturer was extended and nowexpires in November 2007. All manufacturing of the Company’s products isperformed in accordance with detailed specifications and product designsfurnished by the Company and is subject to quality control standards.

***Product Financing Arrangements***

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

The Company had a product financing arrangement withone U.S. reseller which expired in fiscal 2005. Accordingly, Avaya is no longerobligated to repurchase inventory previously sold to this reseller in the eventthe lending institution, which financed the transaction, repossesses thereseller’s inventory of the Company’s products.

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 $3 million asof March 31, 2006. The Company reviews and sets the maximum credit limitfor each reseller participating in this financing arrangement. Historically,there have not been any guarantee repayments by the Company since the foundingof Avaya Inc. in October 2000. The Company has estimated the fair value ofthis guarantee as of March 31, 2006, and has determined that it is notsignificant. There can be no assurance that the Company will not be obligatedto repurchase inventory under this arrangement in the future.

***Performance Guarantee***

In connection with 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 one year to eight years. While the Company isno longer the primary obligor under these leases, the lessors have notcompletely released the Company from its obligations, and hold 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 theassignees were to default as of March 31, 2006, would be approximately $18million. The Company has assessed the probability of default by the assigneesand has determined 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***

On September 30, 2000, Lucent contributed itsenterprise networking business to us and distributed all of the outstandingshares of our capital to its shareowners. We refer to these transactions in theQuarterly Report on form 10-Q as the “distribution.” In connection withthe distribution, 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(“Company’s Businesses”). The Contribution and Distribution Agreement, amongother things, provides that, in general, the Company will indemnify Lucent forall liabilities including certain pre-distribution tax obligations of Lucentrelating to the Company’s Businesses and all contingent liabilities primarilyrelating to the Company’s Businesses or otherwise assigned to the Company. Inaddition, the Contribution and Distribution Agreement provides that certaincontingent liabilities not allocated to one of the parties will be shared byLucent and the Company in prescribed percentages. The Contribution andDistribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to 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 Internal RevenueCode because of an acquisition of the Company’s stock or assets, or some otheractions of the Company, then the Company will be solely liable for anyresulting corporate taxes.

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

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**Item2.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*
| Overview                                            |   | 30 |
|-----------------------------------------------------|--------|----|
| Key Trends and  Uncertainties Affecting Our Results |   | 33 |
| Operating Segments                                  |   | 37 |
| Results from  Continuing Operations                 |   | 37 |
| Liquidity and  Capital Resources                    |   | 47 |
| Forward  Looking Statements                         |   | 53 |

 

“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, 2006 and for the threeand six months ended March 31, 2006 and 2005, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the United States Securities and Exchange Commission, or the SEC, forinterim financial statements, and should be read in conjunction with ourConsolidated Financial Statements and other financial information for thefiscal year ended September 30, 2005, which were included in our Annual Reporton Form 10-K filed with the SEC on December 13, 2005. In our opinion,the unaudited interim Consolidated Financial Statements reflect alladjustments, consisting of normal and recurring adjustments, necessary for afair presentation of the financial condition, results of operations and cashflows for the periods indicated. Certain prior year amounts have beenreclassified 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. 

**Overview**

***Products, Applications and Services***

We are a leading provider of communications solutions,comprised of equipment hardware, software and services that help enterprisestransform their businesses by redefining the way they work and interact withtheir customers, employees, business partners, suppliers and others. Our goalis to help our customers optimize their enterprise communications networks inorder to serve their customers better, enabling them to reduce costs and becomemore competitive while preserving the security and reliability of theirnetworks. A key component of our strategy is to leverage our substantialexperience and expertise in traditional voice communications systems tocapitalize on the transition of these traditional voice systems to InternetProtocol (“IP”) and the adoption of IP telephony solutions. We believe ourcomprehensive suite of IP telephony solutions, communications applications andappliances, as supported by our global services organization and extensivenetwork of business partners, transforms the enterprise communications systeminto a strategic asset for businesses, by enabling them to communicate to “anyone,at any place, at any time and in any way” they choose.

Our productofferings include:

·  IP telephony solutions;

·       multi-mediacontact center infrastructure and applications that facilitate and enhanceinteraction in an enterprise with customers, partners, suppliers and employees(*i.e.* supporting customer relationshipmanagement);

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·       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 services offerings that enableour customers to plan, design, implement, maintain and manage theircommunications networks. We believe our global services organization is animportant consideration for customers purchasing our products and applicationsand is a source of significant revenue for us, primarily from maintenancecontracts. The skilled professionals of our services organization, togetherwith our network of business partners and our ability to diagnose customer networkfaults remotely, can provide 24-hours-a-day, seven-days-a-week service to ourcustomers around the world. Our end-to-end portfolio of services offeringsprovides a single point of accountability and includes:

·       maintenanceservices;

·       professionalservices, consulting, design and network integration;

·       productimplementation; and

·       managed services.

***Customers and Competitive Advantages***

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

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in nearly 100 other countries. As a result of ouracquisition of Tenovis in November 2004, we have significantly increasedour presence in Europe, particularly in Germany. During the six months ended March 31,2006, approximately 42% of our revenues were generated outside the U.S.

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 applications traffic on a singlenetwork. We offer customers the flexibility to implement new IP telephonysolutions or “IP-enable” their existing voice communications systems, therebypreserving some of their existing communications technology investments andallowing them to implement IP telephony at their own pace. Converged networksoffer increased functionality and provide our enterprise customers with theability to reach the right person at the enterprise, at the right time, in theright place and in the right way, thereby optimizing business interactions andenhancing our customers’ ability to grow revenue and reduce costs. Ourproducts, applications and services are intended to drive the integration ofcommunications and business processes, making communications an importantcomponent 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, and a reputation for superior products andtechnology for voice processing and applications;

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

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

·       alarge installed global customer base;

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

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

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

***Financial and Operating Results for the Six MonthsEnded March 31, 2006***

*Revenue*—Revenue was $2,487 million and $2,370 million forthe six months of fiscal 2006 and 2005, respectively. The 4.9% revenue growthwas across both of our operating segments and all of our regions. Overallgrowth benefited by a full period’s results of the Tenovis acquisition,partially offset by $48 million of unfavorable foreign currency impact.These factors, on a net basis, benefited EMEA growth as well. The APAC regionbenefited from increased revenues associated with Avaya GlobalConnect Limited.,our majority owned subsidiary in India, which we refer to as AGC.

*Profitability*—We earned income from continuing operations of $109million during the first six months of fiscal 2006, compared to $69 millionduring the same period of fiscal 2005. We have achieved net income for each ofthe last 12 consecutive quarters and each of our operating segments has beenprofitable on an annual basis for the past two fiscal years. Our operatingincome was $160 million or 6.4% of revenue, for the six months of fiscal 2006,compared to $140 million, or 5.9% of revenue, for the same period of fiscal2005. Included in this fiscal 2006 increase is a $21 million one-time benefitarising from a change in company policy which eliminated the carryover ofvacation days applicable to substantially all of our U.S. non-representedemployees. This was mostly offset by $20 million of restructuring chargesrelated to employee separations in Germany (comprised of $15 million inorder to reduce costs and expenses and to improve Germany’s operationalperformance, and $5 million of expense related to higher than originallyexpected per employee separation costs for former Tenovis employees.)

*Liquidity*—Our debt balance is $29 million as of March 31, 2006, which iscomprised of capital lease obligations and the remaining senior notes balanceof $13 million. These notes were subsequently called on April 3, 2006 fora cash payment of $14 million. We ended the second quarter of fiscal 2006 witha cash balance of $745 million.

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**Key Trends andUncertainties Affecting Our Results**

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

The following arethe key factors currently affecting our revenue:

·       *Technologytransition*—There are several factors that indicatethat enterprises may be poised to transition their traditional communicationssystems to next-generation communications technology. First, although manylarge companies have already begun to transition to IP telephony, IP telephonylines still constitute a very small percentage of global installed enterprisetelephony lines. We have begun to see companies that have purchased IP-enabledcommunications technology start to implement IP technology across theirorganizations. In addition, the average age of non-IP enterprise telephonysystems is over ten years. Although these systems continue to operate reliablyafter ten years, enterprises typically will consider a new investment inenterprise communications technology at this point in the telephony system’slifecycle. Accordingly, we believe that enterprises may consider newinvestments in enterprise communications and if they decide to make suchinvestments, may consider IP telephony. Additionally, we believe that IPtelephony has gained widespread acceptance in the marketplace as an alternativereplacement option, and expect to see increased demand as the industry goes throughthe mainstream adoption phase in the product lifecycle. Other factorsenterprises may consider as they decide whether to deploy IP telephony includewhether IP telephony will provide the level of security and reliabilityprovided by traditional telephony systems.

As a result of the technology transition, spending byenterprises on traditional voice communication systems has been declining. Increasesin our product revenue attributable to sales of IP telephony systems continueto be offset in part by declines in product revenue attributable to traditionalvoice communication systems. 

·       *Competitive environment*—We have historically operated, andcontinue to operate, in an extremely competitive environment. One aspect ofthis environment is that we regularly face pricing pressures in the markets inwhich we operate. We have been able to mitigate the effects of pricingpressures on profitability through our actions to improve gross margins,including cost reduction initiatives. In addition, we are facing competitionfrom companies that offer similar products and applications to those we offeras part of their larger, bundled offering. For other uncertainties related tothe competitive environment in which we operate, see “Forward LookingStatements—Risks Related To Our Revenue and Business Strategy—We face intense competition from our currentcompetitors and, as the enterprise communications and information technologymarkets evolve, may face increased competition from companies that do notcurrently compete directly against us.”

·  *Pressures on servicesbusiness*—We continue to face challenges in our Avaya Global Servicessegment. A high correlation exists with respect to customers in our directchannel who purchase products also electing to purchase maintenance contractsat the time of the product purchase. The maintenance business has beennegatively affected by cancellations, subsequent contract renegotiations andchanges in scope (*i.e*. number of ports, number ofsites, or hours and levels of coverage) at the time of renewal, and pricingpressures. Our managed services business generally involves larger contractswith customers who outsource responsibility for their voice applications domainto us. We expect to face challenges in this area relating to timing and closureof new business opportunities, as well as pricing pressures and scope changessimilar to the maintenance business.

·  *Supply chain issues*—Duringfiscal 2006, we experienced disruption and delays in delivery of certainproducts from one of our contract manufacturers in meeting timelines for ourcustomer requirements. Due to the number of variables involved, it is difficultto quantify a specific impact to 

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the second quarter offiscal 2006, but we estimate that our revenue was impacted negatively by asmuch as $35 million in the second quarter of fiscal 2006. Please see“Outsourcing of Certain Manufacturing Operations” for more information relatedto issues with our outsourced manufacturing operations.

·       *Foreign currency—*With the full benefit from the Tenovisacquisition included in our results, our revenues outside of the U.S. were42% of our consolidated revenues in the six months ended March 31,2006 compared to 40% for the same period of fiscal 2005. Any weakening of theU.S. dollar against other currencies, particularly the euro, will have apositive impact on our reported revenues and profitability. Conversely, anystrengthening of the U.S. dollar will have a negative impact.

·  *Economic conditions*—Animportant factor affecting our ability to generate revenue is the effect ofgeneral economic conditions on our customers’ willingness to spend oninformation technology and, particularly, enterprise communications technology.As economic conditions have gradually improved in most of our markets over thepast few years, we have seen indications that enterprises may be more willingto spend on enterprise communications technology than in the past severalyears. While the world economy is expected to grow, variability in employment,corporate profit growth, interest rates, energy prices and other factors inspecific markets could impact corporate willingness to spend on communicationstechnology in the near term. Additionally, the country to country variabilityin worldwide economic growth could also impact our business as growth rates ofdeveloped and more stable economies tend to be lower than that of emergingeconomies, where there could be more variables affecting the economic growth.

·  *EMEA rental business model—*Underthe rental business model we have historically used in EMEA, rental revenue isrecognized over the term of the rental agreement and reported as rental andmanaged services revenue.  We areimplementing a business model through a third-party finance company under whichrevenue will be recorded separately as sale of products and  sale of services.  This will result in recognition of productrevenue at the point of sale, rather than the rental revenue being recognizedover the term of the agreement. As our current rental customers migrate to thisnew business model, we anticipate that product revenue will increase and rentaland managed services revenue will decrease.

***Continued Focus on Cost Structure***

As a result of the growth of our revenue and ourcontinued focus on controlling costs, we returned to profitability in the thirdquarter of fiscal 2003 and have been profitable in each of the elevensubsequent quarters. During fiscal 2005 and into fiscal 2006, we continued tofocus on controlling our costs, particularly in relation to our revenue. 

Aspart of our focus on controlling costs, we have reduced primarily themanagement and back office headcount in our U.S. sales organization, and havealso reduced the headcount in our services business. In addition, during fiscal2005, we reached agreements with the various Works Councils in Europe to reduceour workforce. Including these positions agreed to by the Works Councils, wereduced our workforce by approximately 800 positions in EMEA, the majority ofwhich have been eliminated. We have begun to realize the benefits of theseactions in fiscal 2006. During the second quarter of fiscal 2006, we recorded$5 million of expense related to higher than originally expected peremployee separation costs for these former Tenovis employees. In addition,during the second quarter of fiscal 2006, we recorded a restructuring charge of$15 million in order to reduce costs and expenses and to improve Germany’soperational performance. The restructuring plan includes a reduction of approximately150 positions across various business groups, with employee separation paymentsdetermined through individual negotiations. We anticipate taking furtheractions to reduce our workforce in EMEA during the third quarter of fiscal2006, and will record an additional charge, the magnitude of which is currentlybeing 

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evaluated. We will begin to partially realize thebenefits of these actions in the third and fourth quarters of fiscal 2006 andfully in fiscal 2007.

Asdiscussed in more detail below, our gross margin was roughly flat at 46.9% forthe six months ended March 31, 2006, compared to 46.7% for the same periodof fiscal 2005. Cost savings associated with headcount reductions and a $10million benefit from the reduction of a portion of our vacation accrual inconnection with a change in Company policy were offset by increased employeebenefit costs and higher product discounts.

As a percentage of revenue, our SG&A expensesdecreased from 32.2% for the six months ended March 31, 2005 to 31.5% forthe six months ended March 31, 2006. This decrease was primarily due to a$7 million benefit from the reduction of a portion of our vacation accrualin connection with a change in Company policy, as well as savings from fiscal2005 headcount reductions. These favorable items were partially offset byincreased employee benefit costs.

***StrategicUses of Cash and Cash Equivalents***

As further discussed in “Liquidity and CapitalResources,” our cash balance was reduced by $5 million to $745 million as of March 31,2006. During the six months ended March 31, 2006, we generated positivecash flow from operations of $275 million and used $193 million to repurchase17,416,800 shares of our common stock in accordance with a share repurchaseplan authorized by the Board of Directors. See Part II, Item 2, “Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities” formore information on the repurchases for the second quarter of fiscal 2006. Wealso continued to use cash for capital expenditures and software developmentcosts. 

***DeferredTax Assets***

As of March 31, 2006, we had $916 million in netdeferred tax assets resulting from tax credit carryforwards, net operatinglosses and other deductible temporary differences, which are available toreduce taxable income predominately in the U.S. in future periods. The netdeferred tax asset is net of a valuation allowance of $159 million, which wascalculated in accordance with the provisions of Statement of FinancialAccounting Standards No. 109, “Accounting for Income Taxes.” The valuationallowance is comprised of $136 million of non-U.S. deferred tax assets and $23million relating to certain U.S. federal and state deferred tax assets thatcontinue to be fully reserved. Included in the net deferred tax assets is an$83 million net deferred tax liability primarily related to the acquisition ofintangible assets in Germany.

***Employees***

As of March 31, 2006, weemployed 18,347 employees, of which 17,866 are full-time (12,130 are managementand non-represented employees and 5,736 are represented employees covered bycollective bargaining agreements or works councils) and 481 are part-timeemployees (165 are management and non-represented employees and 316are represented employees covered by collective bargaining agreements or workscouncils).

Of the 6,052 full-time andpart-time employees covered by collective bargaining agreements or workscouncils, 2,972 employees are covered by collective bargaining agreements inthe United States. Not included in the numbers above are 645 non-representedemployees employed at AGC as of March 31, 2006.

Effective June 1,2003, we renewed our collective bargaining agreements with the CommunicationsWorkers of America and the International Brotherhood of Electrical Workers. Theagreements are for a term of three years, ending May 27, 2006. In April 2006,we commenced negotiations to enter into new collective bargaining agreementswith the unions. The current agreements provide for a 3% per year wage increasefor employees during the duration of the agreements, and a 3% increase per yearto employees’ pension benefits for the duration of the agreements. Theagreements also included additional cost sharing by employees and retirees forcertain medical health benefit co-payments. Although we have historically 

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not encountered significant business disruptions inrenewing our collective bargaining agreements, failure to renew our agreementsby May 27, 2006 could result in a work stoppage or other disruptionwithin certain segments of our operations. We may not be able to resolve anyissues in a timely manner and our contingency plans may not be sufficient toavoid an impact on our business. 

***Outsourcingof Certain Manufacturing Operations***

Wehave outsourced substantially all of our product manufacturing operations. Mostof these operations have been outsourced to Celestica Inc. (“Celestica”) andare currently manufactured in Mexico, France, Malaysia and the Czech Republic,although we also have other contract manufacturers. Our outsourcing agreementwith Celestica was extended and now expires in November 2007. Theremaining sources of our manufacturing capacity are outsourced to a number ofother contract manufacturers located in the United Kingdom, France, China andIsrael. All manufacturing of the Company’s products is performed in accordancewith detailed specifications and product designs furnished by the Company andis subject to quality control standards.

Atthe end of the first quarter and through the second quarter of fiscal 2006, weexperienced disruption and delays in delivery of certain products from one ofour contract manufacturers in meeting timelines for our customer requirements. Dueto the number of variables involved, it is difficult to quantify a specificimpact to the second quarter of fiscal 2006, but we estimate that our revenuewas negatively impacted by as much as $35 million in the second quarter offiscal 2006. 

Althoughthe supply situation improved throughout the quarter in relation to our requirements,we are continuing to experience delays in some product commitments in our thirdquarter. As a result, it is likely that there will continue to be shortages ofsome key products during the third quarter. There is also the possibility that wemay lose some revenue if we cannot fulfill customer orders on schedule. We areworking closely with our contract manufacturer to resolve these issues as earlyas possible. For more information on risks related to the outsourcing ofcertain manufacturing operations, see “Forward Looking Statements—Risks RelatedTo Our Operations—We depend on contract manufacturers to produce the majorityof our products and if these manufacturers are unable to fill our orders on atimely and reliable basis, we will likely be unable to deliver our products tomeet customer orders or satisfy their requirements.” 

Wealso may from time to time be subject to various state, federal andinternational laws and regulations governing the environment, including thoserestricting the presence of certain substances in electronic products andmaking producers of those products financially responsible for the collection,treatment, recycling and disposal of certain products. For example, theEuropean Union (“EU”) has enacted the Restriction of the Use of CertainHazardous Substances in Electrical and Electronic Equipment (“RoHS”) and theWaste Electrical and Electronic Equipment (“WEEE”) directives. RoHS prohibitsthe use of certain substances, including mercury and lead, in certain productsput on the market after July 1, 2006. The WEEE directive obligates partiesthat place electrical and electronic equipment onto the market in the EU to puta clearly identifiable mark on the equipment, register with and report to EUmember countries regarding distribution of the equipment, and provide amechanism to take back and properly dispose of the equipment. Each EU membercountry has enacted, or is expected to soon enact, legislation clarifying whatis and what is not covered by the WEEE directive in that country. Similar lawsand regulations have been or may be enacted in other regions.

We face increasingcomplexity in our product design, logistics and procurement operations as we adjustto new and upcoming requirements relating to the materials composition of ourproducts. Other environmental regulations may require us to reengineer productsto utilize components which are more environmentally compatible and suchreengineering and component substitution may result in additional costs to us. Notwithstandingour ability or willingness to reengineer products or pay additional costs, westill may be adversely affected if the materials and components that we needare unavailable to us. In addition, if we were found to be in violation ofthese laws, we could be subject to governmental fines, any noncompliantproducts may be banned from European markets and our customers may incurliability. 

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Althoughwe do not anticipate any material adverse effects based on the nature of ouroperations and the effect of such laws, there is no assurance that suchexisting laws or future laws will not have an adverse effect on us. 

**Operating Segments**

Wemanage our business based on two operating segments—Global CommunicationsSolutions, or GCS, and Avaya Global Services, or AGS. The following table setsforth the allocation of our revenue among our operating segments and expressedas a percentage of total revenue: 

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** **   |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|--------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | *** *** | ** ** | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | *** *** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 625        |       | $          | 648        |       | $          | 707        |                              | $          | 661                                 |         | Global  Communications Solutions |   | $ | 661 |   | $ | 625 |   |   | 53 | % |   |   | 51 | % |   | $ | 36 |   | 5.8 | % |
| 597        |       | 588        |       | 589        |       | 588        |       | Avaya Global  Services            |       | 577                                 |         | 597 |   |   | 47 | % |   |   | 49 | % |   | (20 | ) | -3.4 | % |
| $          | 1,222      |       | $          | 1,236      |       | $          | 1,296      |                              | $          | 1,249                               |         | Total |   | $ | 1,238 |   | $ | 1,222 |   |   | 100 | % |   |   | 100 | % |   | $ | 16 |   | 1.3 | % |

 

The increase in revenuescontributed by the GCS segment for the second quarter of fiscal 2006 comparedto the second quarter of fiscal 2005 is primarily due to increases in sales oflarge communications systems to indirect customers in the U.S. The decrease inAGS revenues is primarily in the U.S. and EMEA customer maintenance businessesand the U.S. managed services business. The GCS and AGS segments were affectedby $15 million and $10 million, respectively, of unfavorable foreign currencyimpacts, particularly due to the euro exchange rate. 

**Results fromContinuing Operations**

***Three Months Ended March 31, 2006 Compared withThree Months Ended March 31, 2005***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 543        |       | $          | 566        |       | $          | 631          |                              | $          | 591                                 |       | Sales of products |   | $ | 593 |   | $ | 543 |   |   | 48 | % |   |   | 44 | % |   | $ | 50 |   | 9.2 | % |
| 498        |       | 497        |       | 499        |       | 501        |         | Services                          |       | 487                                 |       | 498 |   |   | 39 | % |   |   | 41 | % |   | (11 | ) | -2.2 | % |
| 181        |       | 173        |       | 166        |       | 157        |         | Rental and  managed services      |       | 158                                 |       | 181 |   |   | 13 | % |   |   | 15 | % |   | (23 | ) | -12.7 | % |
| $          | 1,222      |       | $          | 1,236      |       | $          | 1,296        |                              | $          | 1,249                               |       | Total revenue |   | $ | 1,238 |   | $ | 1,222 |   |   | 100 | % |   |   | 100 | % |   | $ | 16 |   | 1.3 | % |

 

Sales of products for the second quarter of fiscal2006 increased in all regions except EMEA, including a 14% increase in the U.S.when compared to the second quarter of fiscal 2005. EMEA revenue was relativelyflat, and was negatively impacted from currency fluctuations by approximately6.5%. The increase in sales of products occurred in our indirect channel,particularly related to our large enterprise customers. Services revenue forthe second quarter of fiscal 2006 decreased primarily in the EMEA maintenanceand implementation and integration services businesses, which were negativelyimpacted by customer changes in scope, cancellations and currency fluctuations.Rental and managed services revenue for the second quarter of fiscal 2006decreased in the U.S. and EMEA due to customer changes in scope, cancellationsand currency fluctuations.

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Thefollowing table sets forth a geographic comparison of revenue:

|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                                                             | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                                                             | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions**                                      | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 689        |       | $          | 717        |       | $          | 768          |                                                                   | $          | 734                                 |       | U.S. |   | $ | 719 |   | $ | 689 |   |   | 58 | % |   |   | 56 | % |   | $ | 30 |   | 4.4 | % |
|       |       |       |       |       |       |       |         | Outside the U.S.:                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 211        |       | 206        |       | 194        |       | 186        |         | Germany                                                                |       | 182                                 |       | 211 |   |   | 15 | % |   |   | 17 | % |   | (29 | ) | -13.7 | % |
| 176        |       | 171        |       | 184        |       | 178        |         | EMEA—Europe / Middle East / Africa (Excluding  Germany) |       | 174                                 |       | 176 |   |   | 14 | % |   |   | 15 | % |   | (2 | ) | -1.1 | % |
| 89         |       | 83         |       | 90         |       | 87         |         | APAC—Asia Pacific                                                 |       | 99                                  |       | 89 |   |   | 8 | % |   |   | 7 | % |   | 10 |   | 11.2 | % |
| 57         |       | 59         |       | 60         |       | 64         |         | Americas, non-U.S.                                                     |       | 64                                  |       | 57 |   |   | 5 | % |   |   | 5 | % |   | 7 |   | 12.3 | % |
| 533        |       | 519        |       | 528        |       | 515        |         | Total outside the U.S.                                                 |       | 519                                 |       | 533 |   |   | 42 | % |   |   | 44 | % |   | (14 | ) | -2.6 | % |
| $          | 1,222      |       | $          | 1,236      |       | $          | 1,296        |                                                                   | $          | 1,249                               |       | Total revenue |   | $ | 1,238 |   | $ | 1,222 |   |   | 100 | % |   |   | 100 | % |   | $ | 16 |   | 1.3 | % |

 

Revenues in the U.S. increased for the second quarterof fiscal 2006 compared to the same quarter last fiscal year due to increasesin sales of products through the indirect channel. Outside of the U.S.,revenues increased for APAC, primarily in Japan, and revenues increased forAmericas, non-U.S, primarily in Brazil and Mexico. Decreases in Germany weredue to changes in customer scope and cancellations in the services and managedservices business, while EMEA, excluding Germany, remained roughly flat. EMEA,including Germany, was affected by $28 million of unfavorable foreign currencyimpacts.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 265        |       | $          | 279        |       | $          | 322          |                              | $          | 268                                 |       | Direct |   | $ | 250 |   | $ | 265 |   |   | 42 | % |   |   | 49 | % |   | $ | (15 | ) | -5.7 | % |
| 278        |       | 287        |       | 309        |       | 323        |         | Indirect                          |       | 343                                 |       | 278 |   |   | 58 | % |   |   | 51 | % |   | 65 |   | 23.4 | % |
| $          | 543        |       | $          | 566        |       | $          | 631          |                              | $          | 591                                 |       | Total sales of products |   | $ | 593 |   | $ | 543 |   |   | 100 | % |   |   | 100 | % |   | $ | 50 |   | 9.2 | % |

 

Our mix of sales ofproducts shifted toward indirect compared to the second quarter of fiscal 2005.All regions experienced increases in sales of product and indirect channelrevenues, with the most significant in the U.S, related primarily related toour large enterprise customers.

***Gross Margin***

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| $          | 298        |       | $          | 301        |       | $          | 337          |                              | $          | 314                                 |       | On sales of  products |   | $ | 318 |   | $ | 298 |   |   | 53.6 | % |   |   | 54.9 | % |   | $ | 20 |   | 6.7 | % |
| 159        |       | 172        |       | 174        |       | 180        |         | On services                       |       | 170                                 |       | 159 |   |   | 34.9 | % |   |   | 31.9 | % |   | 11 |   | 6.9 | % |
| 106        |       | 102        |       | 105        |       | 95         |         | On rental and  managed services   |       | 90                                  |       | 106 |   |   | 57.0 | % |   |   | 58.6 | % |   | (16 | ) | -15.1 | % |
| $          | 563        |       | $          | 575        |       | $          | 616          |                              | $          | 589                                 |       | Total gross margin |   | $ | 578 |   | $ | 563 |   |   | 46.7 | % |   |   | 46.1 | % |   | $ | 15 |   | 2.7 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Overall gross margindollars and rate increased compared to the second quarter of fiscal 2005. Thegross margin on sales of products was negatively impacted by higher discountsto our large enterprise 

38

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customersin the U.S and channel mix partially offset by product cost reductions. Thegross margin on services improved due to the impact of headcount reductionsinitiated in fiscal 2005, as well as cost reductions related to improvedinventory management. The gross margin on rental and managed services declineddue to lower volumes, particularly in EMEA.

***Operating expenses***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| $          | 406        |       | $          | 406        |       | $          | 414          |                              | $          | 385                                 |       | Selling, general  and administrative |   | $ | 399 |   | $ | 406 |   |   | 32.2 | % |   |   | 33.2 | % |   | $ | (7 | ) | -1.7 | % |
| 105        |       | 93         |       | 98         |       | 97         |         | Research and  development         |       | 106                                 |       | 105 |   |   | 8.6 | % |   |   | 8.6 | % |   | 1 |   | 1.0 | % |
| —     |       | —     |       | 22         |       | —     |         | Restructuring  charges            |       | 20                                  |       | — |   |   | 1.6 | % |   |   | 0.0 | % |   | 20 |   | 100.0 | % |
| $          | 511        |       | $          | 499        |       | $          | 534          |                              | $          | 482                                 |       | Total operating expenses |   | $ | 525 |   | $ | 511 |   |   | 42.4 | % |   |   | 41.8 | % |   | $ | 14 |   | 2.7 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in SG&A expenses is primarily due tosavings from prior fiscal year headcount reductions in both the U.S. and EMEAand also due to favorable currency impact.

Research and development, or R&D, expenses wereroughly flat on a comparable basis. R&D spending increases were offset byan increase in software capitalization.

Restructuring charges forthe six months ended March 31, 2006 represent employee separation costs inGermany, comprised of $15 million in order to reduce costs and expenses and toimprove Germany’s operational performance and $5 million of expense related tohigher than originally expected per employee separation costs for formerTenovis employees.

***Other Income, Net***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|       | $          | —     |       |       |       | $          | 4          |                              |       |                                | $          | 2 |   |   |   | $ | 5 |   |   | Other income, net |   |   | $ | 6 |   |   |   | $ | — |   |   | $ | 6 |   | 100 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net for thesecond quarter of fiscal 2006 primarily represents interest income. Otherincome, net for the same quarter in fiscal 2005 is related primarily to a $2million loss on the repayment of $103 million principal amount of securedfloating rate notes, as well as $4 million of other miscellaneous expenses thatwere offset by $6 million of interest income.

***Interest Expense***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|       | $          | 5          |       |       |       | $          | 3            |                              |       |                                | $          | 1 |   |   |   | $ | 1 |   |   | Interest expense |   |   | $ | 2 |   |   |   | $ | 5 |   |   | $ | (3 | ) | -60 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the second quarter offiscal 2006, interest expense decreased as a result of a lower debt principalbalance outstanding during the period. Total debt decreased from $188 millionas of March 31, 2005 to $29 million as of March 31, 2006 due tothe retirement of Tenovis’ secured floating rate notes and the repurchase of amajority of our outstanding senior notes during fiscal 2005.

39

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|       | $          | 11         |       |       | $          | (117       | )          | $                                 | (577       | )                                   |       | $ | 40 |   |   | Provision for  (benefit from) income taxes |   |   | $ | 19 |   |   |   | $ | 11 |   |   | $ | 8 |   | 73 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes in thesecond quarter of fiscal 2006 is based on an effective tax rate of 33.3% and iscomprised of U.S. federal, state and non-U.S. taxes. The provision for incometaxes in the second quarter of fiscal 2005 was comprised of state and non-U.S.income taxes.

**Segment Results**

***Global Communications Solutions***

The GCS segment sells communications systems andconverged voice applications designed for both large and small enterprises. Ourofferings in this segment include IP telephony solutions, multi-media contactcenter infrastructure and applications in support of customer relationshipmanagement, unified communications applications and appliances, and traditionalvoice 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 solutions;

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

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

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

·       AvayaExtension to Cellular, which transparently bridges any cell phone to any Avayacommunications server.

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

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

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

·       associatedappliances, such as telephone handsets; and

·       mediaservers for voice applications used by smaller businesses.

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

·       applicationsin support of customer relationship management; and

·       messagingfor IP and traditional systems.

Other includes revenues from training, financing ofequipment sales and intellectual property licensing.

40

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Thefollowing table sets forth revenue by similar class of products within the GlobalCommunications Solutions segment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 393        |       | $          | 393        |       | $          | 445          |                              | $          | 413                                 |       | Large  Communications Systems |   | $ | 414 |   | $ | 393 |   |   | 63 | % |   |   | 63 | % |   | $ | 21 |   | 5.3 | % |
| 78         |       | 93         |       | 91         |       | 88         |         | Small  Communications Systems     |       | 94                                  |       | 78 |   |   | 14 | % |   |   | 13 | % |   | 16 |   | 20.5 | % |
| 145        |       | 151        |       | 164        |       | 151        |         | Converged Voice  Applications     |       | 141                                 |       | 145 |   |   | 21 | % |   |   | 23 | % |   | (4 | ) | -2.8 | % |
| 9          |       | 11         |       | 7          |       | 9          |         | Other                             |       | 12                                  |       | 9 |   |   | 2 | % |   |   | 1 | % |   | 3 |   | 33.3 | % |
| $          | 625        |       | $          | 648        |       | $          | 707          |                              | $          | 661                                 |       | Total GCS revenue |   | $ | 661 |   | $ | 625 |   |   | 100 | % |   |   | 100 | % |   | $ | 36 |   | 5.8 | % |

 

Revenue for GCS increased in all regions except forEMEA which was primarily affected by unfavorable foreign currency impacts. Theprimary driver for the overall increase was strengthening sales in the U.S. GCSalso benefited from an increase in indirect channel revenue.

The increase in total revenue for GCS was primarilyattributable to the continuedmigration to IP products which exceeded the decline of TDM products.Large Communication Systems benefited from increased sales of gateways andappliances partially offset by the decline of traditional TDM products in EMEA.Increased Small Communications Systems revenues are a result of greater IPOffice sales offset by lower sales of traditional products in EMEA. ConvergedVoice Applications revenues declined due to lower demand for traditionalmessaging sales attributed to the anticipated rollout of a new modularmessaging release and lower contact center application sales.

Thefollowing table sets forth operating income (loss) of the GCS segment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

| $ | (12 | ) |   | $ | 1 |   |   |   | $ | 43 |   |   |   | $ | 43 |   |   | Operating income  (loss) |   |   | $ | 32 |   |   | $ | (12 | ) |   | 4.8 | % |   |   | -1.9 | % |   | $ | 44 |   | 366.7 | % |
|---|-----|---|--------|---|---|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------------------------|--------|--------|---|----|--------|--------|---|-----|---|--------|-----|---|--------|--------|------|---|--------|---|----|--------|-------|---|

 

The increase in operatingincome was primarily due to higher product sales, partially offset by pricingpressures in the direct channel.

***Avaya Global Services***

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

Maintenance—AGS monitors and optimizes customers’network performance ensuring availability and keeps communication networkscurrent with the latest software releases. In the event of an outage, ourcustomers receive the on-site support they need to recover quickly.

Implementation and integration services—Throughoperation, implementation and integration specialists worldwide, AGS helpscustomers leverage and optimize their multi-technology, multi-vendorenvironments through the use of contact centers, unified communicationnetworks, and IP telephony.

41

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Managed services—AGS supplements our customers’in-house staff and manages complex multi-vendor, multi-technologynetworks, optimizes network performance and configurations, backs up systems,detects and resolves faults, performs moves, adds and changes, and manages ourcustomers’ trouble tickets and inventory. This category includes customers whohave chosen a bundled solution with enhanced services not provided in a basicmaintenance contract. With the acquisition of Tenovis, Avaya acquired abusiness that includes both bundled services and products that are sold tocustomers on a monthly payment or rental payment basis.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                               | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|------------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                               | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | *** *** | **Dollars in millions**        | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 377        |       | $          | 381        |       | $          | 375          |                                     | $          | 380                                 |       | Maintenance |   | $ | 366 |   | $ | 377 |   |   | 63 | % |   |   | 63 | % |   | $ | (11 | ) | -2.9 | % |
| 123        |       | 118        |       | 125        |       | 123        |         | Implementation  and integration services |       | 120                                 |       | 123 |   |   | 21 | % |   |   | 21 | % |   | (3 | ) | -2.4 | % |
| 96         |       | 88         |       | 87         |       | 85         |         | Managed services                         |       | 90                                  |       | 96 |   |   | 16 | % |   |   | 16 | % |   | (6 | ) | -6.3 | % |
| 1          |       | 1          |       | 2          |       | —     |         | Other                                    |       | 1                                   |       | 1 |   |   | 0 | % |   |   | 0 | % |   | — |   | 0.0 | % |
| $          | 597        |       | $          | 588        |       | $          | 589          |                                     | $          | 588                                 |       | Total AGS revenue |   | $ | 577 |   | $ | 597 |   |   | 100 | % |   |   | 100 | % |   | $ | (20 | ) | -3.4 | % |
|            |            |            |            |            |            |            |              |                                          |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The overall decrease in AGS revenue is due to declinesof approximately $11 million of revenue outside the U.S. and $9 million in U.S.revenue. The decrease in international revenue is primarily due to a decreaseof approximately $16 million in EMEA offset by modest increases in APAC andAmericas, non-U.S.

The decrease in AGS revenue is primarily due to adecline in the managed services revenue in the U.S. and the maintenance revenuein EMEA due to customer changes in scope and cancellations and foreign currencyfluctuations. Implementation and Integration services decreased primarily dueto the decline in EMEA product revenue partially offset by modest increases inAPAC and Americas, non-U.S. Managed services revenues in the U.S. wereunfavorably affected by customer changes in scope and cancellations as well aslower sales of telephony equipment to the U.S. managed services customers. Thesecond quarter of fiscal 2006 also included approximately $10 million ofunfavorable foreign currency impacts.

Certain services revenue generated by AGC which waspreviously categorized as “Other” has been reclassified to maintenance revenuefor all periods presented.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

|   | $ | 27 |   |   |   | $ | 37 |   |   |   | $ | 46 |   |   |   | $ | 60 |   |   | Operating income |   |   | $ | 41 |   |   |   | $ | 27 |   |   |   | 7.1 | % |   |   | 4.5 | % |   | $ | 14 |   | 51.9 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|----|--------|------|---|

 

The increase in operatingincome is due to higher gross margins primarily in the U.S. Slightly highergross margins are primarily due to the impact of cost reductions in fiscal2005, as well as improved operational efficiencies in the management ofinventory levels.

**Corporate/Other Unallocated Amounts**

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                          | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|       | $          | 37         |       |       |       | $          | 38         |                              |       |                                | $          | (7 | ) |   |   | $ | 4 |   |   | Operating (loss) income |   | $ | (20 | ) |   | $ | 37 |   |   | $ | (57 | ) | -154 | % |
|            |            |            |            |            |            |            |            |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

42

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At the beginning of each fiscal year, the amount ofcorporate overhead and certain other expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year in the annual plan. For instance, the annual incentiveaward accrual is adjusted quarterly based on actual year-to-date results andthose estimated for the remainder of the year.

During the second quarter of fiscal 2006, theoperating loss of $20 million is comprised of employee separation costs inGermany (comprised of $15 million in order to reduce costs and expensesand to improve Germany’s operational performance, and $5 million ofexpense related to higher than originally expected per employee separationcosts for former Tenovis employees), as well as certain real estate expenses,partially offset by lower accruals for employee incentive awards.

During the second quarterof fiscal 2005, the operating income of $37 million was driven primarily by theadjustment to employee incentive awards, as well as other over/under absorptionof corporate overheads against plan.

***Six Months Ended March 31, 2006 Compared with SixMonths Ended March 31, 2005***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **                   | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Sales of products            |       | $                                                  | 1,184      |   | $ | 1,097 |   |   | 47 | % |   |   | 46 | % |   |   | $ | 87 |   |   | 7.9 | % |
| Services                     |       | 988                                                |       | 975 |   |   | 40 | % |   |   | 41 | % |   |   | 13 |   |   | 1.3 | % |
| Rental and  managed services |       | 315                                                |       | 298 |   |   | 13 | % |   |   | 13 | % |   |   | 17 |   |   | 5.7 | % |
| Total revenue                |       | $                                                  | 2,487      |   | $ | 2,370 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 117 |   |   | 4.9 | % |

 

All revenue types were favorably impacted by a fullperiod of revenues associated with Tenovis in fiscal 2006 and negativelyimpacted by currency fluctuations. In addition, sales of products increasedmost significantly in the U.S., primarily due to higher sales of large andsmall communications systems. Services and rental and managed services revenuewere negatively affected by customer changes in scope, pricing pressures andcancellations in the U.S. and EMEA.

Thefollowing table sets forth a geographic comparison of revenue:

| ** **                                                   | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                                   | ** ** | **Dollars in millions**                  | ** ** |
| U.S.                                                         |       | $                                                  | 1,453      |   | $ | 1,423 |   |   | 58 | % |   |   | 60 | % |   |   | $ | 30 |   |   | 2.1 | % |
| Outside the U.S.:                                            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                      |       | 368                                                |       | 324 |   |   | 15 | % |   |   | 14 | % |   |   | 44 |   |   | 13.6 | % |
| EMEA—Europe / Middle East / Africa (Excluding  Germany) |       | 352                                                |       | 341 |   |   | 14 | % |   |   | 14 | % |   |   | 11 |   |   | 3.2 | % |
| APAC—Asia Pacific                                       |       | 186                                                |       | 163 |   |   | 8 | % |   |   | 7 | % |   |   | 23 |   |   | 14.1 | % |
| Americas, non-U.S.                                           |       | 128                                                |       | 119 |   |   | 5 | % |   |   | 5 | % |   |   | 9 |   |   | 7.6 | % |
| Total outside the U.S.                                       |       | 1,034                                              |       | 947 |   |   | 42 | % |   |   | 40 | % |   |   | 87 |   |   | 9.2 | % |
| Total revenue                                                |       | $                                                  | 2,487      |   | $ | 2,370 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 117 |   |   | 4.9 | % |

 

Revenues in all regions experienced growth compared tothe first six months of fiscal 2005. Increases in U.S. revenues were due toincreases in sales of products, particularly to our indirect customers. 

43

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Germany and EMEA, to alesser extent, increased primarily due to a full period of revenues associatedwith Tenovis compared to the same period of fiscal 2005. These favorable itemswere partially offset by $53 million of unfavorable foreign currencyimpacts EMEA, primarily related to the euro. The increase in revenues in APACrelates primarily to an increase in revenues associated with AGC and increasedproduct sales throughout the region. Revenue in Americas, non-U.S. increasedslightly compared to the first quarter of fiscal 2005 due to an increase inservices revenue and $8 million of favorable foreign currency impacts whichoffset a decline in sales of products in the region.

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

| ** **              | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**                  | ** ** |
| Direct                  |       | $                                                  | 518        |   | $ | 526 |   |   | 44 | % |   |   | 48 | % |   |   | $ | (8 | ) |   | -1.5 | % |
| Indirect                |       | 666                                                |       | 571 |   |   | 56 | % |   |   | 52 | % |   |   | 95 |   |   | 16.6 | % |
| Total sales of products |       | $                                                  | 1,184      |   | $ | 1,097 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 87 |   |   | 7.9 | % |

 

Our mix of sales ofproducts shifted toward indirect compared to the same period in fiscal 2005. Increasesin both large and small communications systems, especially in the U.S.,contributed to an increase in indirect revenue through our business partners.

***Gross Margin***

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

| ** **                      | ** ** | **Six Months Ended March 31,** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**                  | ** ** |
| On sales of  products           |       | $                                                  | 632        |   | $ | 607 |   |   | 53.4 | % |   |   | 55.3 | % |   |   | $ | 25 |   |   | 4.1 | % |
| On services                     |       | 350                                                |       | 328 |   |   | 35.4 | % |   |   | 33.6 | % |   |   | 22 |   |   | 6.7 | % |
| On rental and  managed services |       | 185                                                |       | 171 |   |   | 58.7 | % |   |   | 57.4 | % |   |   | 14 |   |   | 8.2 | % |
| Total gross margin              |       | $                                                  | 1,167      |   | $ | 1,106 |   |   | 46.9 | % |   |   | 46.7 | % |   |   | $ | 61 |   |   | 5.5 | % |

 

Gross margin dollarsincreased primarily due to the full period impact of Tenovis while the overallgross margin rate was roughly flat as compared to the same period in fiscal2005. The largest factors behind the decline in gross margin percentage on thesales of products were the full period impact of Tenovis as well as higherproduct discounting in the U.S. partially offset by cost reductions. Grossmargin on services revenue increased due to cost reductions initiated in priorperiods. The increase in gross margin dollars and rate on rental and managedservices was primarily due to the impact of a full period of Tenovis.

***Operating expenses***

| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **                           | ** ** | **Dollars in millions**                  | ** ** |
| Selling, general  and administrative |       | $                                                  | 784        |   | $ | 763 |   |   | 31.5 | % |   |   | 32.2 | % |   |   | $ | 21 |   |   | 2.8 | % |
| Research and  development            |       | 203                                                |       | 203 |   |   | 8.2 | % |   |   | 8.6 | % |   |   | — |   |   | 0.0 | % |
| Restructuring  charges               |       | 20                                                 |       | — |   |   | 0.8 | % |   |   | 0.0 | % |   |   | 20 |   |   | 100.0 | % |
| Total operating expenses             |       | $                                                  | 1,007      |   | $ | 966 |   |   | 40.5 | % |   |   | 40.8 | % |   |   | $ | 41 |   |   | 4.2 | % |

 

44

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The increase in SG&A expenses is primarily due tothe period impact of the Tenovis operations, as well as the impact of otheracquisitions made during fiscal 2005. SG&A expense for the current periodalso includes increased employee benefit costs. These items were partiallyoffset by a $7 million benefit related to the reduction of a portion of ourvacation accrual as a result of a change in company policy eliminatingcarryover vacation days for U.S. non-represented employees and favorable impactof currency fluctuations.

Research and development, or R&D, expenses wereunchanged when compared to the same period last fiscal year. The current periodincluded a $3 million benefit related to the reduction of a portion of ourvacation accrual as a result of a change in Company policy. The six monthsended March 31, 2005 included $4 million of acquired in-process R&Dexpenses recorded upon the acquisitions of Spectel and Tenovis.

Restructuring charges forthe six months ended March 31, 2006 represent employee separation costs inGermany, comprised of $15 million in order to reduce costs and expenses and toimprove Germany’s operational performance and $5 million of expense related tohigher than originally expected per employee separation costs for formerTenovis employees.

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

| ** **                   | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Other income  (expense), net |       |                                               | $          | 11 |   |   | $ | (38 | ) |   | $ | 49 |   |   | 129 | % |
|                              |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net, for thesix months ended March 31, 2006 primarily represents interest income. Otherexpense, net, for the same period in fiscal 2005 is related primarily to a $41million loss on the repurchase of $271 million aggregate principal amount ofour senior notes and a $2 million loss on the repayment of $103 millionprincipal amount of our secrued floating rate notes.

***Interest Expense***

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Interest expense |       |                                               | $          | 3 |   |   |   | $ | 15 |   |   |   | $ | (12 | ) |   | -80 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the six months endedMarch 31, 2006, interest expense decreased as a result of a lower debtprincipal balance outstanding during the period. Total debt decreased from $368million as of December 31, 2004 to $29 million as of March 31, 2006due to the conversion into common stock of our LYONs, retirement of Tenovis’secured floating rate notes and the repurchase of a majority of our outstandingsenior notes during fiscal 2005.

***Provision forIncome Taxes***

| ** **                  | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Dollars in millions**                  | ** ** |
| Provision for  income taxes |       |                                               | $          | 59 |   |   |   | $ | 18 |   |   | $ | 41 |   | 228 | % |
|                             |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provisionfor income taxes for the six months ended March 31, 2006 is****based on an an effective tax rate of 35.1%and is comprised of U.S. federal, state and non-U.S. taxes. The provision forincome taxes for the first half of fiscal 2005 was comprised of state andnon-U.S. income taxes.

45

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**Segment Results**

***Global Communications Solutions***

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

| ** **                    | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**                  | ** ** |
| Large Communications  Systems |       | $                                                  | 827        |   | $ | 747 |   |   | 62 | % |   |   | 62 | % |   |   | $ | 80 |   |   | 10.7 | % |
| Small  Communications Systems |       | 182                                                |       | 147 |   |   | 14 | % |   |   | 12 | % |   |   | 35 |   |   | 23.8 | % |
| Converged Voice  Applications |       | 292                                                |       | 295 |   |   | 22 | % |   |   | 24 | % |   |   | (3 | ) |   | -1.0 | % |
| Other                         |       | 21                                                 |       | 28 |   |   | 2 | % |   |   | 2 | % |   |   | (7 | ) |   | -25.0 | % |
| Total GCS revenue             |       | $                                                  | 1,322      |   | $ | 1,217 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 105 |   |   | 8.6 | % |

 

Revenue for GCS increased in all regions except forEMEA, which was affected by approximately $27 million of unfavorableforeign currency impacts. The primary driver for the overall increase wasstrengthening sales in the U.S. GCS also benefited from an increase in indirectchannel revenue.

The increase in total revenue for GCS was primarilyattributable to the continuedmigration to IP products which exceeded the decline of TDM products.Large Communication Systems benefited from increased sales of enterprise andbranch office gateways and higher sales of Communications Manager. IncreasedSmall Communications Systems revenues is a result of greater IP Office salesoffset by lower sales of traditional products in EMEA. Converged VoiceApplications revenues declined due to lower demand for traditional messagingsales attributed to the anticipated rollout of a new modular messaging release andlower contact center application sales.

The following table sets forth operating income of theGCS segment:

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       |                                               | $          | 75 |   |   |   | $ | 13 |   |   |   | 5.7 | % |   |   | 1.1 | % |   | $ | 62 |   | 476.9 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome was primarily due to higher product sales, partially offset by pricingpressures in the direct channel.

***Avaya Global Services***

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

| ** **                               | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                               | ** ** | **Dollars in millions**                  | ** ** |
| Maintenance                              |       | $                                                  | 746        |   | $ | 750 |   |   | 64 | % |   |   | 65 | % |   |   | $ | (4 | ) |   | -0.5 | % |
| Implementation  and integration services |       | 243                                                |       | 227 |   |   | 21 | % |   |   | 20 | % |   |   | 16 |   |   | 7.0 | % |
| Managed services                         |       | 175                                                |       | 175 |   |   | 15 | % |   |   | 15 | % |   |   | — |   |   | 0.0 | % |
| Other                                    |       | 1                                                  |       | 1 |   |   | 0 | % |   |   | 0 | % |   |   | — |   |   | 0.0 | % |
| Total AGS revenue                        |       | $                                                  | 1,165      |   | $ | 1,153 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 12 |   |   | 1.0 | % |

 

The overall increase in AGS revenue for the six monthsended March 31, 2006 is due to an increase of approximately $37 million inrevenue outside the U.S., primarily in EMEA resulting from a full period of 

46

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revenues associated withTenovis, offset by a decrease of $25 million in the U.S. revenue andapproximately $21 million of unfavorable foreign currency impacts.

The increase in AGS revenue was partially attributableto a full period of revenues associated with Tenovis in fiscal 2006 compared toa partial period in fiscal 2005, as well as an increase in implementationrevenues. This increase was partially offset by a decline in the U.S.maintenance revenue. Lower revenues in existing contract-related maintenancewere primarily due to cancellations and changes in contract scope.Implementation and integration services increased due to six months of Tenovisas well as an increase in APAC and Americas, non-U.S. Excluding the impact ofthe business associated with Tenovis, total AGS revenue would have declinedcompared to the first six months of fiscal 2005.

Prior year revenue amounts have been reclassified toconform to the six months ended March 31, 2006 reporting period.

Thefollowing table sets forth operating income of the AGS segment:

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       | $                                                  | 101        |   |   | $ | 83 |   |   |   | 8.7 | % |   |   | 7.2 | % |   |   | $ | 18 |   |   | 21.7 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome is due to higher gross margins primarily in the U.S. Slightly highergross margins are primarily due to the impact of cost reductions in fiscal2005, as well as improved operational efficiencies in the management ofinventory levels. The slightly higher gross margins were partially offset byincreased costs due to a full period of Tenovis in 2006 compared to a partialperiod in 2005.

**Corporate/Other Unallocated Amounts**

| ** **               | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------|------------|----------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions**                  | ** ** |
| Operating (loss)  income |       | $                                                  | (16        | ) |   | $ | 44 |   |   |   | $ | (60 | ) |   | -136 | % |
|                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Operating loss of $16 million was recorded inCorporate / Other Unallocated Amounts for the six months ended March 31,2006 and was primarily related to employee separation costs in Germany(comprised of $15 million in order to reduce costs and expenses and toimprove Germany’s operational performance, and $5 million of expenserelated to higher than originally expected per employee separation costs forformer Tenovis employees), as well as certain real estate expenses, partiallyoffset by lower accruals for employee incentive awards.

The primary driver of the$44 million operating income in Corporate / Other Unallocated Amounts for thesix months ended March 31, 2005 was an adjustment to employee incentiveawards due to year-to-date operating performance.

**Results ofDiscontinued Operations**

The $2 million loss fromdiscontinued operations during the six months ended March 31, 2005 wasprimarily the result of the finalization of the working capital adjustmentrelated to the sale of our Connectivity Solutions business, in accordance withthe asset purchase agreement.

47

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**Liquidity andCapital Resources**

During the six months ended March 31, 2006,we generated strong positive cash flow from operations of $275 million. We used$193 million during the six months ended March 31, 2006 to continue ourprogram to repurchase and retire our common shares. We also used $91 million toacquired capitalized assets and develop software. Cash and cash equivalentsdecreased by $5 million to $745 million over the six months ended March 31,2006.

***Sources and Uses of Cash for the Six Months Ended March 31,2006***

Acondensed statement of cash flows for the six months ended March 31, 2006and 2005 follows:

| ** **                                                    | ** ** | **Six months ended  March 31,** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **   2006   **   | ** ** | **    2005    ** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**              | ** ** |
| Net cash provided  by (used for):                             |       |                                           |       |   |   |   |   |   |   |
| Operating activities                                          |       |                                           | $          | 275 |   |   |   | $ | 60 |   |   |
| Investing activities                                          |       |                                           | (99        | ) |   |   | (450 | ) |   |
| Financing activities                                          |       |                                           | (179       | ) |   |   | (380 | ) |   |
| Effect of exchange  rate changes on cash and cash equivalents |       |                                           | (2         | ) |   |   | 8 |   |   |
| Net decrease in  cash and cash equivalents                    |       |                                           | (5         | ) |   |   | (762 | ) |   |
| Cash and cash equivalents at beginning of year                |       |                                           | 750        |   |   |   | 1,617 |   |   |
| Cash and cash  equivalents at end of period                   |       |                                           | $          | 745 |   |   |   | $ | 855 |   |   |

 

***OperatingActivities***

Our net cashprovided by operating activities was $275 million for the six months ended March 31,2006, compared to $60 million for the six months ended March 31, 2005. Theincrease in cash provided by operating activities was primarily driven byprofitable operations and improvements in working capital management. Specificitems affecting our cash flows are discussed below:

*Lower incentive payments—*During the six months ended March 31, 2006, discretionary employeeawards were paid but were lower than the management incentives paid during thesame period last fiscal year. Payments are based on the prior fiscal year’sperformance.

*Improvement in Net Income*—We generated net income of $109 million for the sixmonths ended March 31, 2006 compared to $67 million in the same period infiscal 2005, resulting in a $42 million increase. This improvement was due to a$117 million increase in revenue, with higher gross margins generated fromincreased volumes and continued cost reductions.

*Accounts Receivable, Net*—The following summarizes our accounts receivable, netand related metrics:

| ** **                                                                  | ** ** | **March 31,  2006**          | ** ** | **September 30,  2005** | ** ** | **Change** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------|------------|
| ** **                                                                  | ** ** | **Dollars in millions** | ** ** |
| Accounts  receivable, gross                                                 |       | $                                 | 850        |                         |       | $          | 920        |   |   | $ | (70 | ) |
| Allowance for  doubtful accounts                                            |       | (51                               | )          |                         | (58        | )          |       | 7 |   |
| Accounts  receivable, net                                                   |       | $                                 | 799        |                         |       | $          | 862        |   |   | $ | (63 | ) |
| Allowance for doubtful accounts as a percent of accounts  receivable, gross |       | 6.0                               | %          |                         | 6.3        | %          |       | -0.3 | % |
| Days sales outstanding (DSO)                                                |       | 58 days                           |       |                         | 60 days    |       |       | -2  days |   |
| Past due  receivables as a percent of account receivable, gross        |       | 20.9                              | %          |                         | 21.7       | %          |       | -0.8 | % |

 

48

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The decrease in accounts receivable and DSO wasprimarily a result of an improvement in our collections in North America.

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

| ** **          | ** ** | **March 31,**                | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|---------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **          | ** ** | **2006**                          | ** ** | **2005**               | ** ** | **Change** | ** ** |
| ** **          | ** ** | **Dollars in millions** | ** ** |
| Finished goods      |       | $                                 | 275        |                   |       | $          | 274        |   |   | $ | 1 |   |
| Raw materials       |       | 17                                |       |                   | 14         |       |       | 3 |   |
| Total inventory     |       | $                                 | 292        |                   |       | $          | 288        |   |   | $ | 4 |   |
| Inventory  turnover |       | 9.0 times                         |       |                   | 9.4 times  |       |       | -0.4  times |   |

 

Inventory remained roughly unchanged compared to theend of our last fiscal year.

*Accounts Payable*—The following summarizes our accounts payable:

| ** **                | ** ** | **March 31,**                | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **                | ** ** | **2006**                          | ** ** | **2005**               | ** ** | **Change** | ** ** |
| ** **                | ** ** | **Dollars in millions** | ** ** |
| Accounts payable          |       | $                                 | 383        |                   |       | $          | 402        |   |   | $ | (19 | ) |
| Days payable  outstanding |       | 52 days                           |       |                   | 53 days    |       |       | -1  day |   |
|                           |            |                                   |            |                        |            |            |            |  |  |  |  |  |

 

Accounts payable decreasedduring the six months ended March 31, 2006 due to lower spending as partof our cost saving initiatives.

***Investing Activities***

Net cash used for investingactivities was $99 million in the six months ended March 31, 2006,compared with $450 million in the same period in fiscal 2005. Activities in thecurrent period include $54 million for capital expenditures and $37million for capitalized software development costs. Activities in the comparable period in fiscal 2005 included $383million, net, used for acquisitions, primarily Tenovis and Spectel, $56 millionfor capital expenditures and $27 million for capitalized software developmentcosts.

***Financing Activities***

Net cash used forfinancing activities was $179 million in the six months ended March 31,2006, compared with $380 million in the same period in fiscal 2005. Activitiesin the current period include $193 million to repurchase our common stockpursuant to our stock repurchase plan, partially offset by $14 million ofcash received in connection with the issuance of common stock under ouremployee stock purchase plan and stock option plans. Activities in thecomparable period in fiscal 2005 included $314 million to repurchasesubstantially all of our senior notes in a public tender offer and $103 millionto repay a portion of our outstanding principal of secured floating rate notes.These uses of cash were partially offset by $40 million of cash received inconnection with the issuance of common stock under our employee stock purchaseplan and stock option plans.

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

***Future Cash Requirements***

Our primary future cash requirements will be to fundworking capital requirements and capital expenditures, share repurchases,restructuring payments, debt repayments and employee benefit obligations.

49

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Specifically, weexpect our primary cash requirements for the remainder of fiscal 2006 to be asfollows:

·       *Share repurchase plan*— In accordance with the sharerepurchase plan authorized by the Board of Directors in April 2005, we mayuse up to $500 million of cash to repurchase shares of our outstanding commonstock through April 2007. For fiscal 2006, our credit facility describedbelow limits our ability to make dividend payments or distributions or torepurchase, redeem or otherwise acquire shares of our common stock duringfiscal 2006 to $461 million (which represents 50% of net income for the Companyfor fiscal 2005). Since the start of the plan through March 31, 2006, wepaid $300 million to repurchase and retire our shares. From April 1, 2006through May 9, 2006, we paid an additional $63 million to repurchase andretire our shares, leaving approximately $137 million available forfurther share repurchases according to the limitations of the plan. Theserepurchases are made at management’s discretion in the open market or inprivately negotiated transactions in compliance with applicable securities lawsand other legal requirements and are subject to market conditions, share priceand other factors. See Note 8 “Long-Term Debt,” to our Consolidated FinancialStatements for further information.

·       *Capital expenditures*—We expect to spendapproximately $81 million for capital expenditures and approximately $28million for capitalized software development costs during the remainder offiscal 2006.

·       *Restructuring payments—*We expect to maketermination payments to former Tenovis employees aggregating approximately $21million during the remainder of fiscal 2006 in connection with the EITF 95-3restructuring liability we recorded upon the acquisition of Tenovis. We expectto make termination payments of approximately $10 million for separatedemployees identified in connection with our second quarter of fiscal 2006restructuring in Germany. We also plan to pay approximately $10 million foremployee separation and lease termination costs related to our fourth quarterof fiscal 2005 restructuring under FAS 146 and approximately $4 million forlease termination costs related to facilities accounted for under EITF 94-3.We are currently evaluating the magnitude of additional charges for additionalrestructuring actions we intend to take in the third quarter of fiscal 2006 in EMEA.

·       *Debt repayments—*We will continue to paydown our capital lease obligations on a monthly basis. As discussed in Note 8 “Long-TermDebt” we paid $14 million to redeem all of our outstanding senior notes in April 2006.

·       *Benefit Obligations*—For the remainder of fiscal 2006, weestimate we will make payments totaling $4 million for certain U.S. pensionbenefits that are not pre-funded, and contributions totaling $4 millionfor non-U.S. plans. Under current law, we will not be required to make acontribution to our U.S. pension plans in fiscal 2006 to satisfy minimumstatutory funding requirements. For the remainder of fiscal 2006, we alsoestimate we will make payments totaling$22 million for retiree medical benefits that are not pre-funded.

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 2006 to be positive net cash provided by operatingactivities. We expect that growth in our revenues outside the U.S. andcontinued focus on accounts receivable, inventory management and costcontainment will enable us to continue to generate positive net cash fromoperating activities.

We and a syndicate of lenders are currently party to a$400 million revolving credit facility (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 

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face unanticipated cashneeds such as the funding of a future acquisition or other capital investment. Furthermore,if we acquire a business in the future that has existing debt, our debt servicerequirements may increase, thereby increasing our cash needs.

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

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $745 million as of March 31, 2006 and our net cash providedby operating activities will be sufficient to meet our future cash requirementsdescribed above. We also believe we have sufficient cash and cash equivalentsfor future acquisitions. Our ability to meet these requirements will depend onour ability to generate cash in the future, which is subject to generaleconomic, financial, competitive, legislative, regulatory and other factorsthat are beyond our control.

***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 ourrevenues were to decline, our ability to generate net cash from operatingactivities in a sufficient amount to meet our cash needs could be adverselyaffected.

·       *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 acquisitions. Such acquisitions may require significant amounts of cash ormay result in increased debt service requirements to the extent we assume orincur debt in connection with such acquisitions.

·       *PensionReform* — There are various pension legislation reform proposalsbeing considered by the U.S. Congress. The reform proposals could cause asignificant increase in our required pension contributions beginning in fiscal2007.

***Fair Value of Financial Instruments***

The estimated aggregate fair value of the senior noteswas $15 million as of March 31, 2006 and September 30, 2005. The fairvalues are based upon quoted market prices and yields obtained throughindependent pricing sources for the same or similar types of borrowingarrangements taking into consideration the underlying terms of the debt.

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

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We aretherefore subject to the risk associated with foreign currency exchange ratesand interest rates that could affect our results of operations, financialposition and cash flows. We manage our exposure to these market risks throughour regular operating and financing activities and, when deemed appropriate,through the use of derivative financial instruments. We use derivativefinancial instruments to reduce earnings and cash flow volatility associatedwith foreign exchange rate changes. Derivative financial instruments are usedas risk management tools and not for speculative or trading purposes. As of March 31,2006 and September 30, 2005, the estimated fair values of our foreigncurrency forward contracts were $1 million and $6 million,respectively, and were included in other current liabilities. The 

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estimatedfair values of these forward contracts were based on market quotes obtainedthrough independent pricing sources.

***Debt Ratings***

Our ability to obtain external financing and therelated cost of borrowing is affected by our debt ratings, which areperiodically reviewed by the major credit rating agencies. As of March 31,2006, we had a long-term corporate family rating of Ba3 with a positive outlookfrom Moody’s and a corporate credit rating of BB with a stable outlook fromStandard & Poor’s.

These ratings are notrecommendations 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 facility contains affirmative andrestrictive covenants that we must comply with, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio ofconsolidated debt to earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, 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 fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. As of March 31,2006, we were in compliance with all of the covenants included in the creditfacility.

The credit facility provides that we may use up to $1billion in cash (excluding transaction fees) and assumed debt for acquisitionscompleted after February 23, 2005, provided that we are in compliance withthe terms of the agreement. The acquisition amount will be permanently increasedto $1.5 billion after consolidated EBITDA of us and our subsidiaries for anyperiod of twelve consecutive months equals or exceeds $750 million.

As of March 31, 2006,there are $46 million of letters of credit issued under the creditfacility. There are no other outstanding borrowings under the facility and theremaining availability is $354 million as of March 31, 2006. We believethe credit facility provides us with an important source of backup liquidity.

**Critical AccountingPolicies and Estimates**

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

·       Revenuerecognition;

·       Collectibilityof accounts receivable;

·       Inventories;

·       Deferredtax assets and tax liabilities;

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

·       Restructuringprograms;

·       Pensionand post-retirement benefits costs;

·       Accountingfor stock options; and

·       Commitmentsand contingencies.

We have other important accounting policies andpractices; however, once adopted, these other policies either generally do notrequire us to make significant estimates or assumptions or otherwise onlyrequire implementation of the adopted policy and not a judgment as to the policyitself. We base our estimates on our historical experience and also onassumptions that we believe are standard and reasonable. Despite our intentionto establish accurate estimates and assumptions, actual results could differfrom those estimates for various reasons including those described in “ForwardLooking Statements.”

During the six monthsended March 31, 2006, management believes there have been no significantchanges to the items that we disclosed as our critical accounting polices andestimates in Management’s Discussion and Analysis of Financial Condition andResults of Operations in our Annual Report on Form 10-K for thefiscal year ended September 30, 2005.

**Forward LookingStatements**

(Cautionary Statements Under the Private SecuritiesLitigation Reform Act of 1995)

Our disclosure and analysis in this report containssome forward-looking statements. Forward-looking statements giveour current expectations or forecasts of future events. You can identify thesestatements by the fact that they do not relate strictly to historical orcurrent facts. They use words such as “anticipate,” “estimate,” “expect,” “project,”“intend,” “plan,” “believe,” and other words and terms of similar meaning inconnection with any discussion of future operating or financial performance.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-looking statements inthis report, in the 2005 Annual Report to Shareholders and in any other publicstatements we make may turn out to bewrong. They can be affected by inaccurate assumptions we might make orby known or unknown risks and uncertainties. Many factors mentioned in thediscussion below will be important in determining future results. Consequently,no forward-looking statement can be guaranteed and you are cautioned notto place undue reliance on these forward-looking statements. Actual futureresults may vary materially.

Except as may be required under the federal securitieslaws, we undertake no obligation to publicly update forward-lookingstatements, whether as a result of new information, future events or otherwise.You are advised, however, to consult any further disclosures we make on relatedsubjects in our reports to the SEC. Also note that we provide the followingcautionary discussion of risks, uncertainties and possibly inaccurateassumptions relevant to our businesses. These are factors that we think couldcause our actual results to differ materially from expected and historicalresults. Other factors besides those listed here could also adversely affectus. This discussion is provided as permitted by the Private SecuritiesLitigation Reform Act of 1995.

The risks anduncertainties referred to above include, but are not limited to:

·       supplyissues related to our outsourced manufacturing operations;

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·       priceand product competition, including from competitors who may offer products andapplications similar to those we offer as part of a larger, bundled offering;

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

·       dependenceon new product development;

·       themix of our products and services;

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

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

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

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

·       theability to successfully integrate acquired companies, including Tenovis, whichhas required significant management time and attention;

·       theability to attract and retain qualified employees;

·       controlof costs and expenses;

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

·       theability to form and implement alliances.

Set forth below is adetailed discussion of certain of these risks and other risks affecting ourbusiness. The categorization of risks set forth below is meant to help youbetter understand the risks facing our business and is not intended to limityour consideration of the possible effects of these risks to the listedcategories. Any adverse effects related to the risks discussed below may, andlikely will, adversely affect many aspects of our business.

***Risks Related ToOur Revenue and Business Strategy***

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

We arefocused on the development and sales of IP telephony solutions 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 solutions and other products and applicationsthat use modes of communications other than voice, which has historically beenour core area of expertise;

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

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

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

·       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;

·       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 solutions, does not develop in the ways that we anticipate. The ratioof revenue attributable to IP telephony solutions versus traditional voicecommunication systems is expected to increase as more and more companiesconvert to IP telephony solutions. IP telephony lines constitute a smallpercentage of global installed enterprise telephony lines and if IP telephonydoes not gain widespread acceptance in the marketplace as an alternativereplacement option for enterprise telephony systems our overall revenue andoperating results may be adversely affected. Because this market opportunity isin its early stages, we cannot predict whether:

·       thedemand for advanced communications products, applications, and services,including IP telephony solutions, 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

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

**Revenuegenerated by our traditional enterprise voice communications systems has beendeclining for the last several years and if we do not successfully execute ourstrategy to substitute new technology or expand our sales in market segmentswith higher growth rates, our revenue and operating results may continue to beadversely affected.**

We have been experiencingdeclines in revenue from our traditional enterprise voice communicationsbusiness. We expect, based on various industry reports, that the demand forthese traditional systems will decline over time. We are executing a strategyto capitalize on products, advanced communications and devices that providehigher growth opportunities, including IP telephony solutions. Many of theproducts and applications, including IP telephony solutions, have not yet beenwidely adopted by enterprises.

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Even if we are successful in increasing our revenuefrom sales of IP telephony solutions, if revenue from sales of traditionalenterprise voice communications systems declines faster than revenue from salesof IP telephony solutions increases, our overall revenue and operating resultsmay be adversely affected.

Our traditional enterprisevoice communications systems and the advanced communications products andapplications described above are a part of our Global Communications Solutionssegment. If we are unsuccessful in executing our strategy, the contribution toour results from this segment may fail to grow or may decline and our overalloperating results may be adversely affected. Our Avaya Global Services segmentmay also be adversely affected to the extent that services revenues are relatedto sales of these products and applications.

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

Historically, our GCS businesses have competed againstother providers of enterprise voice communications solutions such as Nortel NetworksCorporation, Siemens Aktiengesellschaft, Alcatel S.A. and NEC Corporation. Aswe focus on the development and marketing of advanced communications solutions, such as IP telephonysolutions, we face intense competition from these providers of voicecommunications solutions as wellas from data networking companies such as Cisco Systems, Inc. and3Com Corp. We face competition in the small and medium business marketfrom many competitors, including Cisco, Nortel, Alcatel, NEC, MatsushitaElectric Corporation of America, Inter-Tel, Incorporated, 3Com Corp., and MitelNetworks Corp., although the market for these products is fragmented. Our AGSsegment competes primarily with NextiraOne, LLC, Black Box Corporation, Siemensand Verizon Communications Inc. as well as many consulting firms. In addition,because the market for our products is subject to rapid technological change,as the market evolves we may face competition in the future from companies thatdo not currently compete in the enterprise communications market, includingcompanies that currently compete in other sectors of the informationtechnology, communications and software industries or communications companiesthat serve residential rather than enterprise customers. In particular, as theconvergence of enterprise voice and data networks becomes more widely deployedby enterprises, the business, information technology and communicationapplications deployed on converged networks become more integrated. 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. In addition, these technologies continue to move froma proprietary environment to an open standards-based environment.

Several of these existingcompetitors have, and many of our future competitors may have, greaterfinancial, personnel, research and other resources, more well-establishedbrands or reputations and broader customer bases than we and, as a result,these competitors may be in a stronger position to respond quickly to potentialacquisitions and other market opportunities, new or emerging technologies andchanges in customer requirements. Some of these competitors may have customerbases that are more geographically balanced than ours and, therefore, may beless affected by an economic downturn in a particular region. Competitors withgreater resources also may be able to offer lower prices, additional productsor services or other incentives that we cannot match or do not offer. Inaddition, existing customers of data networking companies that compete againstus may be inclined to purchase enterprise communications solutions from their current datanetworking vendor than from us. Also, as communications and data networksconverge, we may face competition from systems integrators that weretraditionally focused on data network integration. We cannot predict withprecision which competitors may enter our markets in the future, what form suchcompetition may take or whether we will be able to 

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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.

**Although ourrevenue has continued to increase since 2003, we have recently experienceddifficulties in significantly growing our revenue other than throughacquisitions.**

Although our revenue increased from $3,796 million infiscal 2003 to $4,069 million in fiscal 2004 and to $4,902 million in fiscal2005, we have recently experienced difficulty in significantly growing ourrevenue. In addition, our operating results for fiscal 2005 include theoperating results of Tenovis from November 18, 2004, as well as otheracquisitions. Revenues for the six months ended March 31, 2006 and 2005were $2,487 million and $2,370 million, respectively.

One factor that significantly affects our operatingresults is the impact of economic conditions on the willingness of enterprisesto make capital investments, particularly in enterprise communicationstechnology and related services. Although general economic conditions haveimproved in recent years, we believe that enterprises continue to be concernedabout their ability to increase revenues and thereby increase theirprofitability. 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 otherconditions limit our ability to grow revenue or cause our revenue to declineand we cannot reduce costs on a timely basis or at all, our operating resultswill be adversely affected.

***Risks Related To Our Operations***

**If we are unable toeffectively integrate acquired businesses into ours, our operating results maybe adversely affected. Even if we are successful, the integration of thesebusinesses has required, and will likely continue to require, significantresources and management attention.**

We may not be able tosuccessfully integrate acquired businesses into ours, and therefore we may notbe able to realize the intended benefits from an acquisition. If we fail tosuccessfully integrate these acquisitions or if they fail to perform as weanticipated, our existing businesses and our revenue and operating resultscould be adversely affected. If the due diligence and audit of the operationsof these acquired businesses performed by us and by third parties on our behalfwere 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.

**We depend oncontract manufacturers to produce the majority of our products and if thesemanufacturers are unable to fill our orders on a timely and reliable basis, wewill likely be unable to deliver our products to meet customer orders orsatisfy their requirements.**

We have outsourced substantially all of ourmanufacturing operations. Our ability to realize the intended benefits of ourmanufacturing outsourcing initiative depends on the willingness and ability ofour contract manufacturers to produce our products. We may experiencesignificant disruption to our operations by outsourcing too much of ourmanufacturing. If a contract manufacturer terminates its 

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relationship with us or isunable to fill our orders on a timely basis, we may be unable to deliver theaffected products to meet our customers’ orders, which could delay or decreaseour revenue or otherwise have an adverse effect on our operations. As discussedin Item 2, “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Outsourcing of Certain Manufacturing Operations,” we haverecently experienced these types of disruptions and delays and they haveimpacted our ability to meet timelines for our customer requirements. Inaddition, we periodically review our product manufacturing operations andconsider appropriate changes as necessary. Although we endeavor toappropriately manage any disruption in transitioning from one contractmanufacturer to another contract manufacturer, we may experience significantdisruption to our operations during any contract manufacturer transition, anddid experience such a disruption recently while making this type of transition.

We rely on outside sources for the supply of thecomponents of our products and for the finished products that we purchase fromthird parties. Delays or shortages associated with these components could causesignificant disruption to our operations.

Our success depends on the willingness and ability ofcontract manufacturers to produce our products. We may experience significantdisruption to our operations by outsourcing so much of our manufacturing. Ifour contract manufacturers terminate their relationships with us or are unableto fill our orders on a timely basis, or if we do not accurately forecast ourrequirements, we may be unable to deliver our products to meet our customers’orders, which could delay or decrease our revenue.

For more information concerning the risks associated with ourcontract manufacturers operating internationally, please see “Forward LookingStatements—Risks Related To Our Operations—As our international business hasgrown significantly in the last fiscal year, changes in economic or politicalconditions in a specific country or region could negatively affect our revenue,costs, expenses and financial condition.”

**If we are unable toprotect our proprietary rights, our business and future prospects may beharmed.**

We protect our intellectual property through patents,trademarks, trade secrets, copyrights, confidentiality and nondisclosureagreements and other measures. Despite our efforts, protecting our intellectualproperty is difficult and not always certain, and the measures we take may notprovide adequate protection for our proprietary rights, particularly incountries that do not have well-developed judicial systems or laws thatadequately protect intellectual property rights. Patent filings by thirdparties, whether made before or after the date of our filings, could render ourintellectual property less valuable. Competitors may misappropriate ourintellectual property, disputes as to ownership of intellectual property mayarise and our intellectual property may otherwise fall into the public domainor be independently developed by competitors. We believe that developing newproducts and technology that are unique to Avaya is critical to our success.

We rely on the security ofour information systems, among other things, to protect our proprietaryinformation and information of our customers. If we do not maintain adequatesecurity procedures over our information systems, we may be susceptible tocomputer hacking, cyberterrorism or other unauthorized attempts by thirdparties to access our proprietary information or that of our customers. Even ifwe are able to maintain procedures that are adequate to address currentsecurity risks, hackers, cyberterrorists or other unauthorized users maydevelop new techniques that will enable them to successfully circumvent ourcurrent security procedures. The failure to protect our proprietary informationcould 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.

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**As ourinternational business has grown significantly in the last fiscal year, changesin economic or political conditions in a specific country or region couldnegatively affect our revenue, costs, expenses and financial condition.**

We conduct significant sales and customer supportoperations in countries outside of the United States and also depend onnon-U.S. operations of our contract manufacturers and our distributionpartners. For the six months ended March 31, 2006 and 2005, we derived 42%and 40% of our revenue, respectively, from sales outside the United States. Ourfuture international operating results, including our ability to import ourproducts to, export our products from, or sell our products in variouscountries, could be materially adversely affected by a variety ofuncontrollable and changing factors. These factors include politicalconditions, economic conditions, legal and regulatory constraints, currencyregulations, health or similar issues, natural disasters and other matters in anyof the countries or regions in which we currently operate or intend to operatein the future. Currently, we have concerns about weakness and uncertainty inEuropean economies, including high unemployment levels and low economic growthforecasts, particularly in Germany where we have a high concentration of ourbusiness resulting from the Tenovis acquisition.

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

Additional risks inherent in our internationaloperations generally include, among others, the costs and difficulties ofmanaging international operations, adverse tax consequences, includingimposition of withholding or other taxes on payments by subsidiaries, andgreater difficulty in enforcing intellectual property rights. Our effective tax rates in the future could be adversely affected if thegeographical distribution of our earnings and losses is unfavorable in thefuture, by changes in the valuation of our deferred tax assets or liabilities,or by changes in tax laws, regulations, accounting principles, orinterpretations thereof. The various risks inherent in doing business inthe United States generally also exist when doing business outside of theUnited States, and may be exaggerated by the difficulty of doing business innumerous sovereign jurisdictions due to differences in culture, laws andregulations.

In addition, foreigncurrency exchange rates and fluctuations may have an impact on our futurerevenue, costs or cash flows from our international operations, which couldadversely affect our financial performance. Because a significant portion ofour business is conducted outside the United States, we face exposure tomovements in foreign currency exchange rates which can be adverse. Theseexposures may change over time as business practices evolve, and they couldhave a material adverse impact on our financial results and cash flows. Anincrease in the value of the dollar could increase the real cost to ourcustomers of our products in those markets outside the United States, and aweakened dollar could increase the cost of local operating expenses andprocurement of raw materials.

***Risks Related to Contingent Liabilities***

**We may incurliabilities as a result of our obligation to indemnify, and to share certainliabilities with, Lucent in connection with our spin-off from Lucent in September 2000.**

Pursuant to the Contribution and DistributionAgreement, Lucent contributed to us substantially all of the assets,liabilities and operations associated with its enterprise networking businessesand distributed all of the outstanding shares of our common stock to itsstockholders. The Contribution and Distribution Agreement, among other things,provides that, in general, we will indemnify Lucent for all liabilitiesincluding certain pre-distribution tax obligations of Lucent relating to ourbusinesses and all contingent liabilities primarily relating to our businessesor otherwise assigned to us. In addition, the Contribution and 

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Distribution Agreementprovides that certain contingent liabilities not directly identifiable with oneof the parties will be shared in the proportion of 90% by Lucent and 10% by us.The Contribution and Distribution Agreement also provides that contingentliabilities in excess of $50 million that are primarily related to Lucent’sbusinesses shall be borne 90% by Lucent and 10% by us and contingentliabilities in excess of $50 million that are primarily related to ourbusinesses shall be borne equally by the parties.

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

**We may be subjectto litigation and infringement claims, which could cause us to incursignificant expenses or prevent us from selling our products or services.**

From time to time, we receive notices from thirdparties asserting that our proprietary or licensed products, systems andsoftware infringe their intellectual property rights. We cannot assure you thatthe number of these notices will not increase in the future and that otherswill not claim that our proprietary or licensed products, systems and softwareare infringing their intellectual property rights or that we do not in factinfringe those intellectual property rights. We may be unaware of intellectualproperty rights of others that may cover some of our technology. Irrespectiveof the merits of these claims, if someone claimed that our proprietary orlicensed systems and software infringed their intellectual property rights, anyresulting litigation could be costly and time consuming and would divert theattention of management and key personnel from other business issues. Thecomplexity of the technology involved and the uncertainty of intellectualproperty litigation increase these risks. These matters may result in anynumber of outcomes for us, including entering into licensing agreements,redesigning our products to avoid infringement, being enjoined fromselling products that are found to infringe, paying damages if products arefound to infringe, and indemnifying customers from claims as part of ourcontractual obligations. Royalty or license agreements may be very costly or wemay be unable to obtain royalty or license agreements on terms acceptable to usor at all. We also may be subject to significant damages or an injunctionagainst us or our proprietary or licensed systems. A successful claim of patentor other intellectual property infringement against us could materiallyadversely affect our operating results. We have made and will likely continueto make investments to license and/or acquire the use of third partyintellectual property rights and technology as part of our strategy to managethis risk, but we cannot assure you that we will be successful. We may also besubject to additional notice and other requirements to the extent weincorporate open source software into our applications.

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

**If the distributiondoes not qualify for tax-free treatment, we could be required to pay Lucent orthe Internal Revenue Service a substantial amount of money.**

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

We could be liable for all or a portion of any taxesowed for the following reasons. First, as part of the distribution, we andLucent entered into the Tax Sharing Agreement, which generally allocatesbetween 

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Lucent and us the taxesand liabilities relating to the failure of the distribution to be tax-free.Under the Tax Sharing Agreement, if the distribution fails to qualify as atax-free distribution because of an issuance or an acquisition of our stock or anacquisition of our assets, or some other actions of ours, then we will besolely liable for any resulting taxes to Lucent.

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

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

See Avaya’s Annual Reporton Form 10-K for the fiscal year ended September 30, 2005 filed withthe SEC on December 13, 2005. As of March 31, 2006, there has been nomaterial change in this information.

**Item 4.        Controls and Procedures.**

*Evaluation ofDisclosure Controls and Procedures.*   Based onour management’s evaluation (with the participation of our principal executiveofficer and principal financial officer), as of the end of the period coveredby this Quarterly Report, our principal executive officer and principalfinancial officer have concluded that our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) were noteffective at the reasonable assurance level.

As described below, management identified a “material weakness” in theCompany’s internal control over financial reporting as of March 31, 2006.A “material weakness” is a control deficiency, or a combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of our interim or annual financial statements will not beprevented or detected. The controls over communication between the HumanResources and Finance organizations within the Company were not effective toensure that information related to business restructuring activities within theEMEA region were appropriately communicated and the related liability recordedin the proper amount and period in accordance with accounting principlesgenerally accepted in the United States of America (“U.S. GAAP”). This controldeficiency could have resulted in a misstatement of employee severance costs,related liabilities and financial statement disclosures. This matter did not,in fact, have any impact on the Company’s financial statements as these issueswere identified and properly accounted for within the Company’s unauditedinterim consolidated financial statements for the second fiscal quarter of 2006. TheCompany believes that the unaudited interim consolidated financial statementsincluded in this Quarterly Report present fairly, in all material respects, ourfinancial position, results of operations and cash flows for the periodspresented in conformity with U.S. GAAP.

From the date of the Tenovis acquisition inNovember 2004 through part of the second quarter of fiscal 2006, allemployees separated from the business under the plan established in connectionwith the acquisition were separated pursuant to EITF 95-3 (“Recognitionof Liabilities in Connection with a Purchase Business Combination”) andseverance costs were applied against that reserve. In February 2006, EMEAmanagement was asked to develop a plan to take additional headcount reductionswithin the region, which would be accounted for under SFAS 146 (“Accountingfor Costs Associated with Exit or Disposal Activities”). Our registeredindependent public accounting firm identified certain employee terminationcontracts that had been signed with employees in Germany during the Company’ssecond fiscal quarter, which should have been accrued for under SFAS 146. Aftercommunication from our registered independent public accounting firm, wedetermined that a total of approximately 150 employee 

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termination contracts hadbeen signed with employees in Germany during the Company’s second fiscalquarter. Charges related to these termination contracts are reflected in the unauditedinterim consolidated financial statements included in this Quarterly Report.See Note 7, “Restructuring Programs—Second Quarter 2006 EMEA RestructuringPlan” to our Consolidated Financial Statements.

*Remediation of Material Weakness.*   Inresponse to the identified material weakness discussed above, our management,with oversight from the Company’s Audit Committee, has dedicated resources tosupport the Company’s efforts to improve its internal control over financialreporting in this area. We expect our remediation efforts to include additionaltraining to the Human Resources and Finance organizations in Germany on keyissues under U.S. GAAP, cross-functional management of restructuring activitiesand related reserves with enhanced Finance oversight and improvement of theCompany’s existing internal representation letter process to provide additionalassurances as to the adequacy of severance/restructuring reserves andassociated internal controls over such reserves. We believe that theseremediation efforts will improve our internal control over financial reporting,as well as our disclosure controls and procedures.

*Changes inInternal Control over Financial Reporting.*   Therewere no changes in our internal control over financial reporting during the secondquarter of fiscal 2006, other than the material weakness described above, thathave materially affected, or are reasonably likely to materially affect ourability to record, process, summarize and report financial information.

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**PART II. OtherInformation**

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

See Note 14, “Commitmentsand Contingencies” to the Consolidated Financial Statements.

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

**See Part I, Item 2. “*Management’s Discussion and Analysis of Financial Condition and Resultsof Operation*”**

**Item 2.**                        *Unregistered Sales of Equity Securities and Use of Proceeds.*

(c) IssuerPurchases of Equity Securities 

| ** **                     | ** ** | ** **            | ** ** | ** **          | ** ** | ** **            | ** ** | **Approximate**                        | ** ** |
|--------------------------------|------------|-----------------------|------------|---------------------|------------|-----------------------|------------|----------------------------------------|------------|
| ** **                     | ** ** | ** **            | ** ** | ** **          | ** ** | **Total number** | ** ** | **dollar value of**          | ** ** |
| ** **                     | ** ** | **Total Number** | ** ** | **Average**         | ** ** | **of shares**    | ** ** | **shares that may**          | ** ** |
| ** **                     | ** ** | **of shares**    | ** ** | **price paid** | ** ** | **purchased as** | ** ** | **yet be purchased as** | ** ** |
| **Period**                     | ** ** | ** **            | ** ** | **purchased**       | ** ** | **per share**    | ** ** | **part of program**          | ** ** | **part of program** | ** ** |
| January 1 -  31           |       |                  | 1,300,000  |                |       |                  | $          | 10.38                                  |       |   |   | 20,772,600 |   |   |   | $ | 289,706,752 |   |   |
| February 1 -  28          |       |                  | 3,581,200  |                |       |                  | $          | 10.52                                  |       |   |   | 24,353,800 |   |   |   | $ | 252,020,398 |   |   |
| March 1 - 31              |       |                  | 4,588,000  |                |       |                  | $          | 11.35                                  |       |   |   | 28,941,800 |   |   |   | $ | 199,968,395 |   |   |
| Second quarter of  fiscal 2006 |       |                  | 9,469,200  |                |       |                  |       |                                   |       |   |   |   |   |   |   |   |   |
|                                |            |                       |            |                     |            |                       |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

From April 1, 2006through May 9, 2006, we repurchased and retired 5,117,400 shares at anaverage purchase price of $12.32 per share, for an additional $63 million,leaving approximately $137 million available under the limitations of the plan.

**Item 3.**                        *Defaults Upon Senior Securities.*

None.

**Item 4.**                        *Submission of Matters to a Vote of Security Holders.*

Avayaheld its Annual Meeting of Stockholders on February 10, 2006. At thatmeeting, shareholders elected Bruce R. Bond and Ronald L. Zarrella as Class 2Directors of the Company for a term to expire at the 2009 Annual Meeting. Theresults of the voting are as follows:

| ** **         | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|--------------------|------------|--------------------|------------|-------------------------|------------|
| Bruce R. Bond      |       | 380,667,255        |       |                    | 12,048,537 |   |   |
| Ronald L. Zarrella |       | 380,730,170        |       |                    | 11,985,622 |   |   |

 

The following Directors also have terms in office thatcontinue after the Annual Meeting: Donald K. Peterson, Joseph P. Landy, Mark Leslie, Philip A. Odeen,Hellene S. Runtagh, Paula Stern, Anthony P. Terracciano and Richard F. Wallman.

Inaddition, at the 2006 Annual Meeting, shareholders ratified the selection ofPricewaterhouseCoopers LLP as Avaya’s independent auditor for fiscal 2006. Theresults of the voting were as follows:

| ** **                                                                                                                          | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | **Abstained** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------------|------------|---------------|------------|
| Director’s Proposal—Ratification  of the Selection of Pricewaterhouse Coopers LLP as Independent Auditor for  Fiscal 2006 |       | 384,392,715        |       |                    | 4,644,575  |          |       | 3,678,500 |   |
|                                                                                                                                     |            |                    |            |                         |            |               |            |  |  |

 

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

Information required by Form 8-KItem 2.05 “Costs Associated with Exit or Disposal Activities” with respect tothe second quarter 2006 EMEA restructuring plan is set forth in Note 7, “RestructuringPrograms—Second Quarter 2006 EMEA Restructuring Plan” to the ConsolidatedFinancial Statements and in Part 1, Item 2. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Overview—ContinuedFocus on Cost Structure.”

**Item6.**                        *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**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                  |   |   | AVAYA INC. |
|------------------|--------|--------|------------|
|             |   |   | By:        | /s/  AMARNATH K. PAI |
|             |   |   |       | Amarnath K. Pai |
|             |   |   |       | *Vice-President  Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| May 9, 2006 |   |   |       |   |

 

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