**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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FORM 10-Q

x        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**ForThe Quarterly Period Ended June 30, 2004**

**OR**

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

**CommissionFile Number 001-15951**

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AVAYA INC.

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

 

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

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Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

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

Asof June 30, 2004, 452,639,566 common shares were outstanding.

 

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**TABLE OF CONTENTS**
| Item                                   | ** **                                                                                  | ** ** | ** ** | **Description** | ** ** | ** ** | **Page** | ** ** |
|----------------------------------------|---------------------------------------------------------------------------------------------|------------|------------|-----------------|------------|------------|----------|------------|
| **PART I FINANCIAL  INFORMATION** |
| 1.                                     | Financial  Statements                                                                       |       | 3          |            |
| 2.                                     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 34         |            |
| 3.                                     | Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 59         |            |
| 4.                                     | Controls and  Procedures                                                                    |       | 59         |            |
| **PART II OTHER INFORMATION**     |
| 1.                                     | Legal Proceedings                                                                           |       | 60         |            |
| 2.                                     | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities           |       | 60         |            |
| 3.                                     | Defaults  Upon Senior Securities                                                            |       | 60         |            |
| 4.                                     | Submission  of Matters to a Vote of Security Holders                                        |       | 60         |            |
| 5.                                     | Other Information                                                                           |       | 60         |            |
| 6.                                     | Exhibits  and Reports on Form 8-K                                                      |       | 60         |            |
|                                   | Signatures                                                                                  |       | 61         |            |

 

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.

2

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**PART I**

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

**AVAYA INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(unaudited; dollars in millions, except per share amounts)**
| ** **                                                                                                                                                                | ** ** | **Three Months  Ended  June 30,** | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                                                | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUE                                                                                                                                                                   |       |                                        |       |                                       |       |   |   |   |   |
| Products                                                                                                                                                                  |       | $                                           | 506        |                                       | $          | 455 |   | $ | 1,483 |   | $ | 1,385 |   |
| Services                                                                                                                                                                  |       | 510                                         |       | 474                                        |       | 1,510 |   | 1,440 |   |
|                                                                                                                                                                      |       | 1,016                                       |       | 929                                        |       | 2,993 |   | 2,825 |   |
| COSTS                                                                                                                                                                     |       |                                        |       |                                       |       |   |   |   |   |
| Products                                                                                                                                                                  |       | 233                                         |       | 226                                        |       | 691 |   | 694 |   |
| Services                                                                                                                                                                  |       | 295                                         |       | 299                                        |       | 895 |   | 913 |   |
|                                                                                                                                                                      |       | 528                                         |       | 525                                        |       | 1,586 |   | 1,607 |   |
| GROSS MARGIN                                                                                                                                                              |       | 488                                         |       | 404                                        |       | 1,407 |   | 1,218 |   |
| OPERATING EXPENSES                                                                                                                                                        |       |                                        |       |                                       |       |   |   |   |   |
| Selling, general and administrative                                                                                                                                       |       | 307                                         |       | 315                                        |       | 948 |   | 966 |   |
| Research and development                                                                                                                                                  |       | 89                                          |       | 85                                         |       | 255 |   | 259 |   |
| TOTAL OPERATING EXPENSES                                                                                                                                                  |       | 396                                         |       | 400                                        |       | 1,203 |   | 1,225 |   |
| OPERATING INCOME  (LOSS)                                                                                                                                                  |       | 92                                          |       | 4                                          |       | 204 |   | (7 | ) |
| Other income (expense), net                                                                                                                                               |       | (11                                         | )          | 18                                         |       | (24 | ) | (36 | ) |
| Interest expense                                                                                                                                                          |       | (14                                         | )          | (21                                        | )          | (54 | ) | (57 | ) |
| INCOME (LOSS)  FROM CONTINUING OPERATIONS BEFORE INCOME TAXES                                                                                                             |       | 67                                          |       | 1                                          |       | 126 |   | (100 | ) |
| Provision (benefit) for income taxes                                                                                                                                      |       | 9                                           |       | 4                                          |       | (65 | ) | 83 |   |
| INCOME (LOSS)  FROM CONTINUING OPERATIONS                                                                                                                                 |       | 58                                          |       | (3                                         | )          | 191 |   | (183 | ) |
| DISCONTINUED  OPERATIONS                                                                                                                                                  |       |                                        |       |                                       |       |   |   |   |   |
| Income from discontinued operations, (including gain  on sale of discontinued operations of $3 and $84, for the three and nine  months ended June 30, 2004, respectively) |       | 3                                           |       | 12                                         |       | 6 |   | 33 |   |
| Provision for income taxes                                                                                                                                                |       | —                                      |       | 1                                          |       | 1 |   | 4 |   |
| INCOME FROM  DISCONTINUED OPERATIONS                                                                                                                                      |       | 3                                           |       | 11                                         |       | 5 |   | 29 |   |
| NET INCOME (LOSS)                                                                                                                                                         |       | $                                           | 61         |                                       | $          | 8 |   | $ | 196 |   | $ | (154 | ) |
| Earnings (Loss)  Per Common Share—Basic:                                                                                                                             |       |                                        |       |                                       |       |   |   |   |   |
| Earnings (loss) per share from continuing operations                                                                                                                      |       | $                                           | 0.13       |                                       | $          | (0.01 | ) | $ | 0.44 |   | $ | (0.49 | ) |
| Earnings per share from discontinued operations                                                                                                                           |       | 0.01                                        |       | 0.03                                       |       | 0.01 |   | 0.08 |   |
| Earnings (loss) per share                                                                                                                                                 |       | $                                           | 0.14       |                                       | $          | 0.02 |   | $ | 0.45 |   | $ | (0.41 | ) |
| Earnings (Loss)  Per Common Share—Diluted:                                                                                                                           |       |                                        |       |                                       |       |   |   |   |   |
| Earnings (loss) per share from continuing operations                                                                                                                      |       | $                                           | 0.12       |                                       | $          | (0.01 | ) | $ | 0.42 |   | $ | (0.49 | ) |
| Earnings per share from discontinued operations                                                                                                                           |       | 0.01                                        |       | 0.03                                       |       | 0.01 |   | 0.08 |   |
| Earnings (loss)  per share                                                                                                                                                |       | $                                           | 0.13       |                                       | $          | 0.02 |   | $ | 0.43 |   | $ | (0.41 | ) |

                                                

See Notes to Consolidated Financial Statements.

3

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**AVAYA INC. ANDSUBSIDIARIESCONSOLIDATED BALANCE SHEETS(unaudited; dollars in millions, except per share amounts)**
| ** **                                                                                                                                                                                                         | ** ** | **June 30, 2004** | ** ** | **September 30, 2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                         |       |                        |       |                             |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                    |       |                        |       |                             |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                          |       |                        | $          | 1,523                            |       |   |   | $ | 1,192 |   |   |
| Receivables, less allowances of $72 and $86 as of  June 30, 2004 and September 30, 2003, respectively                                                                                                         |       |                        | 617        |                             |       |   | 642 |   |   |
| Inventory                                                                                                                                                                                                          |       |                        | 227        |                             |       |   | 264 |   |   |
| Deferred income taxes, net                                                                                                                                                                                         |       |                        | 69         |                             |       |   | 69 |   |   |
| Other current assets                                                                                                                                                                                               |       |                        | 156        |                             |       |   | 190 |   |   |
| Current assets of discontinued operations                                                                                                                                                                          |       |                        | —     |                             |       |   | 212 |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                              |       |                        | 2,592      |                             |       |   | 2,569 |   |   |
| Property, plant and equipment, net                                                                                                                                                                                 |       |                        | 577        |                             |       |   | 604 |   |   |
| Deferred income taxes, net                                                                                                                                                                                         |       |                        | 362        |                             |       |   | 370 |   |   |
| Goodwill                                                                                                                                                                                                           |       |                        | 247        |                             |       |   | 146 |   |   |
| Other assets                                                                                                                                                                                                       |       |                        | 215        |                             |       |   | 178 |   |   |
| Other assets of discontinued operations                                                                                                                                                                            |       |                        | —     |                             |       |   | 190 |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                  |       |                        | $          | 3,993                            |       |   |   | $ | 4,057 |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                     |       |                        |       |                             |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                               |       |                        |       |                             |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                   |       |                        | $          | 347                              |       |   |   | $ | 305 |   |   |
| Business restructuring reserve                                                                                                                                                                                     |       |                        | 45         |                             |       |   | 66 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                    |       |                        | 280        |                             |       |   | 261 |   |   |
| Current portion of long-term debt                                                                                                                                                                                  |       |                        | 295        |                             |       |   | — |   |   |
| Deferred revenue                                                                                                                                                                                                   |       |                        | 150        |                             |       |   | 142 |   |   |
| Other current liabilities                                                                                                                                                                                          |       |                        | 270        |                             |       |   | 307 |   |   |
| Current liabilities of discontinued operations                                                                                                                                                                     |       |                        | —     |                             |       |   | 88 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                         |       |                        | 1,387      |                             |       |   | 1,169 |   |   |
| Long-term debt                                                                                                                                                                                                     |       |                        | 289        |                             |       |   | 953 |   |   |
| Benefit obligations                                                                                                                                                                                                |       |                        | 1,068      |                             |       |   | 1,224 |   |   |
| Other liabilities                                                                                                                                                                                                  |       |                        | 391        |                             |       |   | 490 |   |   |
| Other liabilities of discontinued operations                                                                                                                                                                       |       |                        | —     |                             |       |   | 21 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                     |       |                        | 1,748      |                             |       |   | 2,688 |   |   |
| Commitments and contingencies                                                                                                                                                                                      |       |                        |       |                             |       |   |   |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                                                      |       |                        |       |                             |       |   |   |   |   |
| Series A junior participating preferred stock, par  value $1.00 per share, 7.5 million shares authorized; none issued and  outstanding                                                                             |       |                        | —     |                             |       |   | — |   |   |
| Common stock, par value $0.01 per share, 1.5 billion  shares authorized, 452,639,828 and 419,434,414 issued (including 262 and  878,254 treasury shares) as of June 30, 2004 and September 30, 2003,  respectively |       |                        | 5          |                             |       |   | 4 |   |   |
| Additional paid-in capital                                                                                                                                                                                         |       |                        | 2,565      |                             |       |   | 2,151 |   |   |
| Accumulated deficit                                                                                                                                                                                                |       |                        | (1,074     | )                                |       |   | (1,270 | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                               |       |                        | (638       | )                                |       |   | (679 | ) |   |
| Less treasury stock at cost                                                                                                                                                                                        |       |                        | —     |                             |       |   | (6 | ) |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                                                                                                                                                   |       |                        | 858        |                             |       |   | 200 |   |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                               |       |                        | $          | 3,993                            |       |   |   | $ | 4,057 |   |   |

 

See Notes to Consolidated Financial Statements.

4

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**AVAYA INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited; dollars in millions)**
| ** **                                                                                                                                     | ** ** | **Nine Months  EndedJune 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| OPERATING ACTIVITIES:                                                                                                                          |       |                                     |       |   |   |
| Net income (loss)                                                                                                                              |       | $                                        | 196        |   | $ | (154 | ) |
| Less: Income from  discontinued operations                                                                                                     |       | 5                                        |       | 29 |   |
| Income (loss) from  continuing operations                                                                                                      |       | 191                                      |       | (183 | ) |
| Adjustments to  reconcile net income (loss) from continuing operations to net cash provided  by operating activities of continuing operations: |       |                                     |       |   |   |
| Depreciation and  amortization                                                                                                                 |       | 113                                      |       | 130 |   |
| Business  restructuring reversals                                                                                                              |       | (1                                       | )          | (17 | ) |
| Provision for  uncollectible receivables                                                                                                       |       | 9                                        |       | 11 |   |
| Deferred income  taxes                                                                                                                         |       | 16                                       |       | (38 | ) |
| Deferred tax  valuation allowance                                                                                                              |       | (12                                      | )          | 119 |   |
| Reversal of  liabilities related to tax settlement                                                                                        |       | (47                                      | )          | — |   |
| Lucent securities  litigation charge                                                                                                           |       | —                                   |       | 25 |   |
| Loss on  extinguishment of debt, net                                                                                                           |       | 42                                       |       | 34 |   |
| Adjustments for  other non-cash items, net                                                                                                     |       | 54                                       |       | 45 |   |
| Changes in  operating assets and liabilities, net of effects of acquired businesses:                                                           |       |                                     |       |   |   |
| Receivables                                                                                                                                    |       | 60                                       |       | 154 |   |
| Inventory                                                                                                                                      |       | 37                                       |       | 62 |   |
| Restricted cash                                                                                                                                |       | 28                                       |       | (24 | ) |
| Interest rate swap  termination                                                                                                                |       | (1                                       | )          | 19 |   |
| Accounts payable                                                                                                                               |       | 7                                        |       | (79 | ) |
| Payroll and  benefits, net                                                                                                                     |       | 35                                       |       | (30 | ) |
| Accrued interest  payable on long-term debt                                                                                                    |       | (70                                      | )          | (49 | ) |
| Business  restructuring reserve                                                                                                                |       | (20                                      | )          | (72 | ) |
| Other assets and  liabilities                                                                                                                  |       | (86                                      | )          | 17 |   |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES OF CONTINUING OPERATIONS                                                                            |       | 355                                      |       | 124 |   |
| INVESTING ACTIVITIES:                                                                                                                          |       |                                     |       |   |   |
| Capital  expenditures                                                                                                                          |       | (60                                      | )          | (42 | ) |
| Capitalized  software development costs                                                                                                        |       | (28                                      | )          | (19 | ) |
| Acquisition of  businesses, net of cash acquired                                                                                               |       | (121                                     | )          | — |   |
| Proceeds from  sales of discontinued businesses                                                                                                |       | 260                                      |       | — |   |
| Proceeds from sale  of CommScope common stock                                                                                                  |       | 28                                       |       | — |   |
| Proceeds from sale  of property, plant and equipment                                                                                           |       | —                                   |       | 21 |   |
| Investments in  marketable securities                                                                                                          |       | (18                                      | )          | — |   |
| Other investing  activities, net                                                                                                               |       | 2                                        |       | 2 |   |
| NET CASH PROVIDED  BY (USED FOR) INVESTING ACTIVITIES OF CONTINUING OPERATIONS                                                                 |       | 63                                       |       | (38 | ) |
| FINANCING ACTIVITIES:                                                                                                                          |       |                                     |       |   |   |
| Issuance of common  stock                                                                                                                      |       | 336                                      |       | 8 |   |
| Issuance of  long-term debt                                                                                                                    |       | —                                   |       | 216 |   |
| Repayment of  long-term borrowings                                                                                                             |       | (404                                     | )          | (108 | ) |
| Payment of  issuance costs related to debt and equity offering                                                                                 |       | (2                                       | )          | (6 | ) |
| NET CASH (USED  FOR) PROVIDED BY FINANCING ACTIVITIES OF CONTINUING OPERATIONS                                                                 |       | (70                                      | )          | 110 |   |
| Effect of exchange  rate changes on cash and cash equivalents                                                                                  |       | 4                                        |       | 9 |   |
| Net cash provided  by continuing operations                                                                                                    |       | 352                                      |       | 205 |   |
| Net cash (used  for) provided by discontinued operations                                                                                       |       | (21                                      | )          | 41 |   |
| Net increase in  cash and cash equivalents                                                                                                     |       | 331                                      |       | 246 |   |
| Cash and cash  equivalents at beginning of fiscal year                                                                                         |       | 1,192                                    |       | 597 |   |
| Cash and cash  equivalents at end of period                                                                                                    |       | $                                        | 1,523      |   | $ | 843 |   |

 

See Notes to Consolidated Financial Statements.

5

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

**1.**   Backgroundand Basis of Presentation

***Background***

Avaya Inc. (the “Company”or “Avaya”) provides communication systems, applications and services forenterprises, including businesses, government agencies and other organizations.The Company’s product offerings include Internet Protocol (“IP”) telephonysystems that converge voice, data and other traffic across a single unifiednetwork, traditional voice communication systems, contact center infrastructureand applications in support of customer relationship management and unifiedcommunications applications. The Company supports its broad customer base withcomprehensive global service offerings that enable customers to plan, design,implement and manage their communications networks.

***Basis of Presentation***

The accompanying unaudited consolidated financialstatements as of June 30, 2004 and for the three and nine months ended June 30,2004 and 2003, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulations ofthe Securities and Exchange Commission for interim financial statements, andshould be read in conjunction with the Company’s consolidated financialstatements and other financial information for the fiscal year endedSeptember 30, 2003, which was filed with the Securities and ExchangeCommission on February 12, 2004 on a Current Report on Form 8-K. In the Company’sopinion, 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.

In November 2003, the Company acquired substantiallyall of the assets and assumed certain liabilities of Expanets, Inc. (“Expanets”),a subsidiary of NorthWestern Corporation (“NorthWestern”) in a transactionaccounted for as a business combination. Accordingly, the results of thebusinesses acquired from Expanets have been included in the Company’sconsolidated financial statements beginning on November 25, 2003, the date ofacquisition. Upon the closing of the acquisition, the Company decided to divestthe Expanets businesses that previously distributed other vendors’ products. Forfinancial statement purposes, the assets, liabilities, results of operationsand cash flows of these businesses have been segregated from those ofcontinuing operations and are presented in the Company’s financial statementsas a component of discontinued operations (see Note 3).

In January 2004, theCompany completed the sale of substantially all of its Connectivity Solutionsbusiness, except for the sale of certain international operations. As of June30, 2004, the sale of substantially all of these international operations hasbeen completed. The Company has accounted for the Connectivity Solutionsbusiness as a discontinued operation, and accordingly, the Company’sconsolidated financial statements for all prior periods have been adjusted toreflect this presentation.

6

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**2.   Summary ofSignificant Accounting Policies and Recent Accounting Pronouncement**

***Summary of Significant Accounting Policies***

**Restrictedcash**

As of June 30, 2004 andSeptember 30, 2003, the Company had $10 million and $38 million, respectively,of restricted cash included in other current assets and other assets in theConsolidated Balance Sheets. This cash is restricted in use and has beenpledged to secure letters of credit, surety bonds and other purchase guaranteesthat ensure the Company’s performance or payment to third parties in accordancewith specified terms and conditions.

**StockCompensation**

TheCompany’s employees participate in stock option plans. The Company applies therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) andrelated interpretations in accounting for such stock compensation. Accordingly,no stock-based employee compensation cost related to stock options is reflectedin the Company’s Statements of Operations, as all options granted under theplans had an exercise price equal to or greater than the market value of theunderlying common stock on the date of grant. The Company records compensationexpense for the amortization of restricted stock units issued to employeesbased on the fair market value of the restricted stock units at the date ofgrant over the vesting period, which is typically three years. The followingtable illustrates the effect on net income (loss) and earnings (loss) per shareas if the Company had applied the fair value recognition provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accountingfor Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure.”
| ** **                                                                                                                                   | ** ** | **Three Months  Ended  June 30,**                                   | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                                                                      | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                   | ** ** | **(dollars in millions, except  per share amounts)** | ** ** |
| Net income (loss), as reported                                                                                                               |       | $                                                                             | 61         |                                       | $          | 8 |   | $ | 196 |   | $ | (154 | ) |
| Add: Stock-based  employee compensation expense included in reported net income (loss), net of  related tax effects                          |       | 2                                                                             |       | 5                                          |       | 8 |   | 13 |   |
| (Deduct) add:  Total stock-based employee compensation (expense) income determined  under fair value based method, net of related tax effect |       | (7                                                                            | )          | (14                                        | )          | (24 | ) | 33 |   |
| Net income  (loss), pro forma                                                                                                                |       | $                                                                             | 56         |                                       | $          | (1 | ) | $ | 180 |   | $ | (108 | ) |
| Earnings (Loss) Per Common Share—Basic:                                                                                                 |       |                                                                          |       |                                       |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                                                                             | 0.14       |                                       | $          | 0.02 |   | $ | 0.45 |   | $ | (0.41 | ) |
| Pro forma                                                                                                                                    |       | $                                                                             | 0.12       |                                       | $          | 0.00 |   | $ | 0.42 |   | $ | (0.29 | ) |
| Earnings (Loss) Per Common Share—Diluted:                                                                                               |       |                                                                          |       |                                       |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                                                                             | 0.13       |                                       | $          | 0.02 |   | $ | 0.43 |   | $ | (0.41 | ) |
| Pro forma                                                                                                                                    |       | $                                                                             | 0.12       |                                       | $          | 0.00 |   | $ | 0.40 |   | $ | (0.29 | ) |

 

7

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**2.**   Summary ofSignificant Accounting Policies and Recent Accounting Pronouncement(Continued)

The fair value of stockoptions used to compute pro forma net loss for the nine months ended June 30,2003 resulted in additional income as a substantial number of previouslygranted options had been forfeited and the cumulative reversal of pro formaexpense related to these options exceeded the pro forma expense related to theremaining outstanding options.

***Recent Accounting Pronouncement***

*SFAS 132*

In December 2003, theFinancial Accounting Standards Board (“FASB”) issued a revised SFAS No. 132,“Employers’ Disclosures about Pensions and Other Postretirement Benefits,” (“SFAS132”) which changed the disclosure requirements for employers’ pension plansand other postretirement benefit plans, but did not change the measurement orrecognition of those plans required by other related accounting standards. Thedisclosure requirements of SFAS 132 were effective for the Company beginning inthe second quarter of fiscal 2004. SFAS 132 requires additional informationrelated to changes in the benefit obligations and fair values of plan assets. SeeNote 9 for the components of net periodic benefit costs (credits) recognized. Additionaldisclosures required by SFAS 132 will be included in the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2004, includinginformation describing the types of plan assets, investment strategy,measurement date(s), plan obligations and cash flows.

**3.**   Acquisitions andDivestitures

***Acquisition of a Majority Interest in Tata Telecom***

On April 2, 2004, the Company announced anagreement with the Tata Group to acquire its shares of Tata Telecom Ltd. (“TataTelecom”), a leading voice communications solutions provider in India,representing 25.1 percent ownership of Tata Telecom. As of the date of theagreement, the Company owned a 25.5 percent interest in Tata Telecom.Under the terms of the agreement, the Company was required to pay 220 Rupeesper share. Statutory requirements in India mandated the Company to conduct apublic tender offer to purchase, in addition, a minimum of 20 percent ofthe outstanding shares of Tata Telecom at a price of 220 Rupees per share.

***Acquisition of Expanets***

On November 25, 2003, the Company acquiredsubstantially all of the assets and assumed certain liabilities of Expanets. Expanetswas a nationwide provider of networked communications and data products andservices to small and mid-sized businesses and prior to the acquisition was oneof the Company’s largest dealers. The acquisition will allow the Company tocontinue providing quality sales and service support for Expanets’ customersand grow its small and mid-sized business. Under the terms of the assetpurchase agreement, the Company paid a purchase price at the closing of $97million, consisting of (i) $55 million in cash paid to Expanets, (ii) $27million paid to a creditor of Expanets to satisfy a debt obligation ofExpanets, and (iii) $15 million deposited into an escrow account to satisfycertain liabilities of Expanets. The results of the Expanets businesses theCompany acquired have been included in the Company’s consolidated financialstatements from the date of acquisition on November 25, 2003. During 

8

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**3.**   Acquisitions and Divestitures(Continued)

the second quarter offiscal 2004, the Company recorded an additional $2 million in businesscombination costs. During the third quarter of fiscal 2004, the Companyfinalized the working capital adjustments with NorthWestern and paid anadditional $18 million to NorthWestern.

At the date of acquisition, in accordance with SFASNo. 141, “Business Combinations,” the Company recorded Expanets’ accountsreceivables, inventory, liabilities and identified intangibles at estimatedfair value and fixed assets at estimated replacement cost. The remainder of thepurchase price in excess of the net assets acquired was recorded as goodwill. Duringthe second and third quarters of fiscal 2004, the Company made adjustments tothe initial purchase price allocation based upon a review of the detailedbalances included in Expanets’ financial statements.

The following tablesummarizes the estimated fair values of the assets acquired and liabilities assumedas of the acquisition date, adjusted for items identified during the second andthird quarters of fiscal 2004:
| ** **                              | ** ** | **Initial  Purchase  Price  Allocation** | ** ** | **Purchase  Price  Adjustments** | ** ** | **Revised  Purchase  Price  Allocation** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|----------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **(dollars in millions)**      | ** ** |
| Cash                                    |       |                                     | $          | 3                                |       |                                     |       | $ | — |   |   |   | $ | 3 |   |   |
| Accounts  receivable                    |       |                                     | 45         |                             |       |                                     | 5          |   |   |   | 50 |   |   |
| Inventory                               |       |                                     | 24         |                             |       |                                     | (3         | ) |   |   | 21 |   |   |
| Other assets                            |       |                                     | 10         |                             |       |                                     | (2         | ) |   |   | 8 |   |   |
| Fixed assets                            |       |                                     | 17         |                             |       |                                     | (13        | ) |   |   | 4 |   |   |
| Intangibles                             |       |                                     | 32         |                             |       |                                     | —     |   |   |   | 32 |   |   |
| Goodwill                                |       |                                     | 63         |                             |       |                                     | 34         |   |   |   | 97 |   |   |
| Accounts payable                        |       |                                     | (45        | )                                |       |                                     | —     |   |   |   | (45 | ) |   |
| Termination  obligations                |       |                                     | (21        | )                                |       |                                     | (1         | ) |   |   | (22 | ) |   |
| Other liabilities                       |       |                                     | (41        | )                                |       |                                     | —     |   |   |   | (41 | ) |   |
| Net assets from discontinued operations |       |                                     | 10         |                             |       |                                     | —     |   |   |   | 10 |   |   |
| Purchase price                          |       |                                     | $          | 97                               |       |                                     |       | $ | 20 |   |   |   | $ | 117 |   |   |

 

The Company expects to complete the valuation of theassets acquired and the liabilities assumed by the end of fiscal 2004.

Identifiable intangibles consist of $21 million ofcustomer relationships, which will be amortized over 15 years, and $11 millionof agency relationships having indefinite lives. Customer relationshipsrepresent a database of information that acts as a source of repeat businessfor the Company. The information contained in the database includes thepreferences of the customer, along with the history of services provided to thecustomer. Agency relationships represent the relationship Expanets had withmultiple phone carriers across the U.S. that the Company assumed. The Companyreceives a commission for selling phone services to its customers on behalf ofthe phone carriers.

The Company recorded fixed assets of $17 million inits initial purchase price allocation. The Company determined that it had nofuture intended use for certain of these assets and adjusted the purchase priceof these assets to their net realizable value of $4 million.

9

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**3.**   Acquisitions and Divestitures(Continued)

Goodwill attributable to the businesses acquired fromExpanets of $97 million was assigned $20 million to the EnterpriseCommunications Group (“ECG”) segment, $72 million to the Services segment, and$5 million to the Small and Medium Business Solutions (“SMBS”) segment. Of thattotal amount, $80 million is expected to be deductible for tax purposes over a15-year period.

In connection with the acquisition, in accordance withEmerging Issues Task Force Issue No. 95-3, “Recognition of Liabilities inConnection with a Purchase Business Combination,” the Company recordedliabilities of $21 million for termination obligations. The Company hasrecognized these obligations as a liability assumed as of the acquisition date.These termination obligations consisted of $10 million of employee separationcosts for approximately 1,750 employees and $11 million related to the closureof redundant real estate facilities. The Company expects to have completed theseverance payments by the end of fiscal 2004 and to have substantiallycompleted the lease termination obligations by fiscal 2007.

Duringthe second and third quarters of fiscal 2004, the Company reevaluated both theemployee separation costs and lease termination obligations and determined that$2 million of the employee separation liability should be reduced, as theactual costs incurred during the period were less than the original estimate. Itwas also determined that the lease obligation needed to be increased by $3million as the actual costs incurred during the period were more than theoriginal estimate and sublease recovery assumptions were reduced. Theseadjustments are included in the purchase accounting adjustments identified inthe table above. The following table summarizes the status of the Expanets’termination obligations as of and for the period ended June 30, 2004:
| ** **                      | ** ** | **Employee  Separation  Costs**     | ** ** | **Lease  Termination  Obligations** | ** ** | **Total  Expanets’  Termination  Obligations** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **(dollars in millions)** | ** ** |
| Balance as of December 31, 2003 |       |                                | $          | 10                                  |       |                                                |       | $ | 11 |   |   |   | $ | 21 |   |   |
| Cash Payments                   |       |                                | (5         | )                                   |       |                                                | (4         | ) |   |   | (9 | ) |   |
| Adjustments                     |       |                                | (2         | )                                   |       |                                                | 3          |   |   |   | 1 |   |   |
| Balance as of June 30,  2004    |       |                                | $          | 3                                   |       |                                                |       | $ | 10 |   |   |   | $ | 13 |   |   |

 

***Sale of a Portion of Expanets’ Business***

Upon the closing of the Expanets acquisition, theCompany decided to sell the Expanets businesses that previously distributedother vendors’ products and, accordingly, accounted for this portion ofExpanets’ business as a component of discontinued operations. In the first andsecond quarters of fiscal 2004, the Company sold, in a series of transactions,certain assets and liabilities attributed to these businesses for an aggregateconsideration of $13 million, $4 million of which was cash consideration and $9million was in the form of notes receivable. As of June 30, 2004, the Companyhad divested this portion of the Expanets business and had collected $5 millionof these notes receivable.

Results from discontinued operations for thesebusinesses include revenue of $8 million and loss before income taxes of $6million for the nine months ended June 30, 2004.

10

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**3.**   Acquisitions and Divestitures(Continued)

The following unauditedpro forma financial information presents the Company’s results as if theExpanets acquisition and the discontinued operations presentation of a portionof the Expanets business referred to above had occurred at the beginning of therespective periods:
| ** **                              | ** ** | **Three Months  Ended  June 30,**                                   | ** ** | **Nine MonthsEnded  June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **2003**                                                                      | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| ** **                              | ** ** | **(dollars in millions,  except per share amounts)** | ** ** |
| Revenue                                 |       |                                                                          | $          | 1,018                                    |       |   | $ | 3,041 |   | $ | 3,057 |   |
| Net income (loss)                       |       |                                                                          | $          | 1                                        |       |   | $ | 179 |   | $ | (200 | ) |
| Earnings (loss)  per share—basic   |       |                                                                          | $          | 0.00                                     |       |   | $ | 0.41 |   | $ | (0.53 | ) |
| Earnings (loss) per  share—diluted |       |                                                                          | $          | 0.00                                     |       |   | $ | 0.40 |   | $ | (0.53 | ) |

 

These pro forma resultshave been prepared for comparative purposes only and include certainadjustments such as the elimination of intercompany revenue and costs,additional amortization expense as a result of identifiable intangible assetsarising from the acquisition, and the removal of items included in Expanets’historical results that did not relate to assets or liabilities acquired by theCompany. The pro forma results are not necessarily indicative of the results ofoperations that actually would have resulted had the acquisition been in effectat the beginning of the respective periods or of future results. Expanets isincluded in the Company’s Consolidated Statement of Operations for the threemonths ended June 30, 2004 and, therefore, actual and pro forma informationwould be the same for such period.

***Sale of Connectivity Solutions***

In January2004, the Company sold certain assets and liabilities of its ConnectivitySolutions business to CommScope, Inc. (“CommScope”). Accordingly, the Companyhas accounted for this business as a discontinued operation. On January 31,2004, the sale of substantially all of Connectivity Solutions was completed,except for the sale of certain international operations. As of June 30, 2004,the sale of substantially all of these international operations has beencompleted. The Company received $256 million of cash, and 1,761,538 shares ofCommScope common stock valued at $33 million on the closing date. The Companypaid $9 million in transaction costs relating to the sale. During the secondquarter of fiscal 2004, the Company sold all the shares of CommScope commonstock and recognized a pre-tax loss of $5 million, which is included in otherincome (expense), net. The $256 million cash portion of the purchase price issubject to post-closing adjustments. The Company is currently engaged indiscussions with CommScope relating to the final post-closing adjustments and,therefore, the cash portion of the sales price is subject to adjustment.

The Companyrecorded a $3 million and $84 million pre-tax gain during the three and ninemonths ended June 30, 2004, respectively, from the sale of ConnectivitySolutions, which is included in income from discontinued operations. Inaccordance with the asset purchase agreement between CommScope and the Company,certain liabilities recorded by the Company relating to Connectivity Solutionsemployees transferred to CommScope were not assumed by CommScope, but are nolonger obligations of theCompany. Therefore, included in the $84 million gainis a reversal of $27 million of such liabilities that primarily representemployee related costs for which the Company no longer has an obligation.

11

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**3.**   Acquisitions andDivestitures (Continued)

The $84million gain also includes the recognition of $32 million of foreigncurrency translation adjustments related to the divestiture of ConnectivitySolutions’ international operations. A corresponding decrease has been recordedin the accompanying Consolidated Balance Sheet during the second quarter offiscal 2004 through accumulated other comprehensive loss to reflect therealization of foreign currency translation adjustments upon the liquidation ofthese foreign operations. These foreign currency translation adjustmentsrepresent the net unrealized gains and losses arising from changes in exchangerates and the related effect on the translation of assets and liabilities ofthose international operations.

Listedbelow are the major classes of assets and liabilities of Connectivity Solutionsthat have been sold and transferred to CommScope as of June 30, 2004.
| ** **                          | ** ** | **Balances Transferred  During the Nine  Months Ended** | ** ** | **As of**                   | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **June 30, 2004**                                                 | ** ** | **September 30, 2003** | ** ** |
| ** **                          | ** ** | **(dollars in millions)**                                         | ** ** |
| **Assets**                          |       |                                                                        |       |                             |       |   |   |   |   |
| Receivables                         |       |                                                                        | $          | 49                               |       |   |   | $ | 68 |   |   |
| Inventory                           |       |                                                                        | 126        |                             |       |   | 142 |   |   |
| Property, plant  and equipment, net |       |                                                                        | 182        |                             |       |   | 179 |   |   |
| Other assets                        |       |                                                                        | 7          |                             |       |   | 13 |   |   |
| Total assets                        |       |                                                                        | $          | 364                              |       |   |   | $ | 402 |   |   |
| **Liabilities**                     |       |                                                                        |       |                             |       |   |   |   |   |
| Accounts payable                    |       |                                                                        | $          | 26                               |       |   |   | $ | 54 |   |   |
| Payroll and  benefit obligation     |       |                                                                        | 59         |                             |       |   | 31 |   |   |
| Other liabilities                   |       |                                                                        | 24         |                             |       |   | 24 |   |   |
| Total liabilities                   |       |                                                                        | $          | 109                              |       |   |   | $ | 109 |   |   |
| **Net  assets sold**                |       |                                                                        | $          | 255                              |       |   |   | $ | 293 |   |   |

 

Income from discontinued operations for the ninemonths ended June 30, 2004, includes $168 million of revenue and $72million of loss before income taxes related to Connectivity Solutions’operations.

In connection with the closing of the transaction, theCompany recognized a pension and postretirement curtailment loss of $24 millionand a settlement loss of $24 million upon the transfer of pension andpostretirement benefit assets and liabilities to CommScope, and recorded acorresponding increase of $48 million to the benefit obligation. These losseswere included in income from discontinued operations in the second quarter of fiscal2004. Upon the transfer of these pension and postretirement benefit assets andliabilities to CommScope, an offsetting gain of $48 million was recognized andincluded in the $84 million gain on sale of discontinued operations for theassumption of these liabilities by CommScope. These two transactions resultedin a net zero impact to income from discontinued operations for the nine monthsended June 30, 2004.

12

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**3.   Acquisitions andDivestitures (Continued)**

As a result of the transfer of Connectivity Solutionsemployees to CommScope in the second quarter of fiscal 2004, the Companyremeasured its minimum pension liability related to the pension plan forrepresented employees. In accordance with SFAS No. 87, “Employers’ Accountingfor Pensions,” the Company recorded an adjustment in the second quarter offiscal 2004 of $50 million to decrease the additional minimum pensionliability. This resulted in a $36 million decrease to accumulated othercomprehensive loss and a $14 million decrease to intangible assets.

On October 30, 2003, inexchange for the agreement of the International Brotherhood of ElectricalWorkers to withdraw numerous pending and threatened grievances and arbitrationdemands against the Company in connection with the Connectivity Solutionsbusiness, the Company agreed to provide a one-time payment of fivethousand dollars per person to certain employees and offer an enhancedretirement incentive for those employees who were pension eligible as ofDecember 2, 2003. In the first quarter of fiscal 2004, the Company recorded acharge of $7 million for the one-time payment and $4 million related tothe acceptance by 124 employees of the retirement incentive offer. Each ofthese charges is included in income from discontinued operations in theConsolidated Statement of Operations.

**4.  **Goodwilland Intangible Assets

The changes in the carryingvalue of goodwill, including the amount primarily attributed to the acquisitionof Expanets, which includes purchase accounting adjustments, for the ninemonths ended June 30, 2004 by operating segment are as follows:
| **Goodwill**                                            | ** ** | ** **                          | ** ** | **Enterprise  Communications  Group** | ** ** | **Small and  Medium  Business  Solutions** | ** ** | **Services** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|---------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------|------------|
| ** **                                              | ** ** | **(dollars in millions)** | ** ** |
| Balance as of  September 30, 2003                  |       |                                | $          | 118                                   |       |                                            |       | $            | 28         |      |       |   | $ | — |   |   | $ | 146 |   |
| Goodwill acquired                                       |       |                                | 20         |                                  |       |                                            | 5          |         |       |      | 73         |   |   | 98 |   |
| Impact of foreign  currency exchange rate  fluctuations |       |                                | —     |                                  |       |                                            | 3          |         |       |      | —     |   |   | 3 |   |
| Balance as of  June 30, 2004                       |       |                                | $          | 138                                   |       |                                            |       | $            | 36         |      |       |   | $ | 73 |   |   | $ | 247 |   |

 

Thefollowing table presents the components of the Company’s acquired intangibleassets with finite lives, which are included in other assets in theConsolidated Balance Sheets.
| ** **                                | ** ** | **June 30, 2004**         | ** ** | **September 30, 2003** | ** ** |
|-------------------------------------------|------------|-------------------------------------|------------|----------------------------------|------------|
| **Amortized Intangible Assets** | ** ** | ** **                          | ** ** | **Gross  Carrying  Amount**      | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **                                | ** ** | **(dollars in millions)** | ** ** |
| Existing technology                       |       |                                | $          | 103                              |       |   |   | $ | 101 |   |   | $ | 2 |   |   | $ | 123 |   |   |   | $ | 117 |   |   | $ | 6 |   |
| Customer  relationships                   |       |                                | 21         |                             |       |   | 1 |   |   | 20 |   |   | — |   |   |   | — |   |   | — |   |
| Total amortized  intangible assets        |       |                                | $          | 124                              |       |   |   | $ | 102 |   |   | $ | 22 |   |   | $ | 123 |   |   |   | $ | 117 |   |   | $ | 6 |   |
|                                           |            |                                     |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

13

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**4.**   Goodwill andIntangible Assets (Continued)

During the third quarter of fiscal 2004, the Companywrote off $20 million of fully-amortized existing technology. There was no netimpact to the Company’s financial position,results of operations or cash flows.

During the first quarter of fiscal 2004, the Companyacquired $21 million of intangible assets representing customer relationships,in connection with the acquisition of Expanets, as described in Note 3.

Amortization expense for the Company’s acquiredintangible assets with finite lives was $1 million and $3 million for the threemonths ended June 30, 2004 and 2003, respectively, and $5 million and $9million for the nine months ended June 30, 2004 and 2003, respectively. Estimatedamortization expense for the succeeding fiscal years as of June 30, 2004is (i) $1 million in the fourth quarter of fiscal 2004; (ii) $2million in fiscal 2005; (iii) $2 million in fiscal 2006; (iv) $1million in fiscal 2007; (v) $1 million in fiscal 2008; (vi) $1million in fiscal 2009; and (vii) $14 million thereafter.

As discussed in Note 3, in connection with theacquisition of Expanets, the Company identified $11 million of intangibleassets having indefinite lives, which are included in other assets in theConsolidated Balance Sheets. Intangible assets with indefinite lives are notsubject to amortization and, at a minimum, will be tested for impairmentannually. During the annual impairment test, the Company will evaluate theremaining useful life of these intangible assets to determine whether eventsand circumstances continue to support an indefinite useful life and willcompare the fair value of these intangible assets with their carrying amount. Tothe extent the fair value exceeds the carrying amount, an impairment chargewill be recorded.

In addition, included inother assets in the Consolidated Balance Sheets as of June 30, 2004 and September 30,2003 is an intangible asset of $49 million and $63 million, respectively,representing unrecognized prior service costs associated with the recording ofa minimum pension liability in fiscal 2003 and 2002. This intangible asset maybe eliminated or adjusted as necessary when the amount of minimum pensionliability is reassessed, which is conducted at least annually. The decrease inthe asset balance is based on the Company’s remeasurement of its minimumpension liability as a result of the transfer of Connectivity Solutionsemployees to CommScope, as discussed in Note 3.

14

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**5**.   Comprehensive Income (Loss)(Continued)

Othercomprehensive income (loss) is recorded directly to a separate section ofstockholders’ equity in accumulated other comprehensive loss and includesunrealized gains and losses excluded from the Consolidated Statements ofOperations. These unrealized gains and losses for the three and nine monthsended June 30, 2004 and 2003 consisted primarily of adjustments to theminimum pension liability, net of income taxes and valuation allowance,unrealized holding gains and losses on securities classified as available forsale, and foreign currency translation, which were not adjusted for incometaxes since they primarily relate to indefinite investments in non-U.S.subsidiaries.
| ** **                                                                                                                                                                                                                | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Nine Months Ended  June 30,**                       | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                | ** ** | **     2004     ** | ** ** | **     2003     ** | ** ** | **     2004     ** | ** ** | **     2003     ** | ** ** |
| ** **                                                                                                                                                                                                                | ** ** | **(dollars in millions)**                                  | ** ** |
| Net income (loss)                                                                                                                                                                                                         |       |                                                                 | $          | 61                                                                   |       |   |   | $ | 8 |   |   |   | $ | 196 |   |   |   | $ | (154 | ) |   |
| Other comprehensive  income (loss):                                                                                                                                                                                       |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustments                                                                                                                                                                                  |       |                                                                 | (13        | )                                                                    |       |   | 31 |   |   |   | 40 |   |   |   | 63 |   |   |
| Minimum pension liability adjustment, net of a  reversal of deferred income taxes of $14 million offset by a reversal of the  corresponding $14 million valuation allowance for the nine months ended  June 30, 2004 |       |                                                                 | —     |                                                                 |       |   | — |   |   |   | 36 |   |   |   | — |   |   |
| Unrealized holding loss on securities classified as  available for sale                                                                                                                                                   |       |                                                                 | (3         | )                                                                    |       |   | — |   |   |   | (3 | ) |   |   | — |   |   |
| Total comprehensive  income (loss)                                                                                                                                                                                        |       |                                                                 | $          | 45                                                                   |       |   |   | $ | 39 |   |   |   | $ | 269 |   |   |   | $ | (91 | ) |   |

 

**6**.   SupplementaryFinancial Information

***Balance SheetInformation***
| ** **                         | ** ** | **June 30, 2004**         | ** ** | **September 30, 2003** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **(dollars in millions)** | ** ** |
| INVENTORY                          |       |                                |       |                             |       |   |   |   |   |
| Finished goods                     |       |                                | $          | 183                              |       |   |   | $ | 198 |   |   |
| Work in-process  and raw materials |       |                                | 44         |                             |       |   | 66 |   |   |
| Total inventory                    |       |                                | $          | 227                              |       |   |   | $ | 264 |   |   |

 

15

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**6**.   SupplementaryFinancial Information (Continued)

***Statements of Operations Information (Continued)***
| ** **                                             | ** ** | **Three Months Ended  June 30,**                      | ** ** | **Nine Months Ended  June 30,**                       | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **     2004     ** | ** ** | **     2003     ** | ** ** | **     2004     ** | ** ** | **     2003     ** | ** ** |
| ** **                                             | ** ** | **(dollars in millions)**                                  | ** ** |
| OTHER INCOME (EXPENSE),  NET                           |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                        |       |                                                                 | $          | 6                                                                    |       |   |   | $ | 4 |   |   |   | $ | 13 |   |   |   | $ | 12 |   |   |
| Loss on sale of  CommScope common stock                |       |                                                                 | —     |                                                                 |       |   | — |   |   |   | (5 | ) |   |   | — |   |   |
| Loss on redemption/repurchase  of Senior Secured Notes |       |                                                                 | (21        | )                                                                    |       |   | — |   |   |   | (42 | ) |   |   | — |   |   |
| Gain (loss) on extinguishment  of LYONs                |       |                                                                 | —     |                                                                 |       |   | 1 |   |   |   | — |   |   |   | (34 | ) |   |
| Lucent securities  litigation charge                   |       |                                                                 | —     |                                                                 |       |   | — |   |   |   | — |   |   |   | (25 | ) |   |
| Gain on assets  sold                                   |       |                                                                 | —     |                                                                 |       |   | 14 |   |   |   | — |   |   |   | 14 |   |   |
| Other, net                                             |       |                                                                 | 4          |                                                                 |       |   | (1 | ) |   |   | 10 |   |   |   | (3 | ) |   |
| Total other  income (expense), net                     |       |                                                                 | $          | (11                                                                  | )          |   |   | $ | 18 |   |   |   | $ | (24 | ) |   |   | $ | (36 | ) |   |

 

***Cash Flow Information***
| ** **                                                                      | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                      | ** ** | **   2004   **   | ** ** | **   2003   ** | ** ** |
| ** **                                                                      | ** ** | **(dollars in millions)**            | ** ** |
| Non-cash  transactions:                                                         |       |                                           |       |   |   |   |   |   |   |
| Issuance of  common stock for contribution to pension plan                      |       |                                           | $          | 111 |   |   |   | $ | — |   |   |
| Investment in  equity securities                                                |       |                                           | 7          |   |   |   | — |   |   |
| CommScope common  stock received in connection with Connectivity Solutions sale |       |                                           | 33         |   |   |   | — |   |   |
| Notes received as  part of the sale of Expanets’ non-Avaya businesses      |       |                                           | 9          |   |   |   | — |   |   |
| Exchange of LYONs  for common stock                                             |       |                                           | —     |   |   |   | 18 |   |   |
| Warrants to  purchase common stock issued in LYONs Exchange Offer               |       |                                           | —     |   |   |   | 5 |   |   |
| Total non-cash  transactions                                                    |       |                                           | $          | 160 |   |   |   | $ | 23 |   |   |

 

**7**.   Business Restructuring Reserve

Thebusiness restructuring reserve reflects the remaining balance associated withthe Company’s previous business restructuring actions. The following tablesummarizes the status of the Company’s business restructuring reserve as of andfor the nine months ended June 30, 2004:
| ** **                            | ** ** | **Employee   Separation   Costs** | ** ** | **Lease  Termination   Obligations** | ** ** | **Total Business   Restructuring  Reserve** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                            | ** ** | **(dollars in millions)**         | ** ** |
| Balance as of September 30, 2003 |       |                                        | $          | 4                                         |       |                                                  |       | $ | 62 |   |   |   | $ | 66 |   |   |
| Cash payments                         |       |                                        | (3         | )                                         |       |                                                  | (17        | ) |   |   | (20 | ) |   |
| Reversal                              |       |                                        | (1         | )                                         |       |                                                  | —     |   |   |   | (1 | ) |   |
| Balance as of  June 30, 2004     |       |                                        | $          | —                                    |       |                                                  |       | $ | 45 |   |   |   | $ | 45 |   |   |

 

16

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**7**.   Business Restructuring Reserve(Continued)

Payments on leaseobligations, net of estimated sublease income, will extend through 2011because, in certain circumstances, the remaining lease payments were less thanthe termination fees. (Continued)

**8**.   Debt and Derivative FinancialInstruments

Debt outstanding consistsof the following:
| ** **                                                                                           | ** ** | **June 30, 2004**         | ** ** | **September 30, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                           | ** ** | **(dollars in millions)** | ** ** |
| Current portion  of long-term debt:                                                                  |       |                                |       |                             |       |   |   |   |   |
| LYONs convertible debt, net of discount                                                              |       |                                | $          | 295                              |       |   |   | $ | — |   |   |
| Long-term debt:                                                                                      |       |                                |       |                             |       |   |   |   |   |
| LYONs convertible debt, net of discount                                                              |       |                                | —     |                             |       |   | 287 |   |   |
| 111¤8% Senior  Secured Notes, net of discount, premium and deferred gain on interest rate  swap |       |                                | 289        | (1)                              |       |   | 666 | (2) |   |
| Total long-term debt                                                                                 |       |                                | 289        |                             |       |   | 953 |   |   |
| Total debt                                                                                           |       |                                | $          | 584                              |       |   |   | $ | 953 |   |   |

----

(1)          The carrying value ofthe 111¤8% SeniorSecured Notes due April 2009 (“Senior Secured Notes”) as of June 30,2004 of $289 million is comprised of the aggregate principal amount outstandingof $284 million increased for $4 million of unamortized premium, net ofdiscount, the net unamortized deferred gain of $5 million related to thetermination in December 2002 and June 2004 of the Company’s interestrate swap agreements that were entered into during fiscal years 2002 and 2004,respectively, offset partially by $4 million related to the decrease in thefair market value of the hedged portion of such debt. Upon termination of bothof the 2002 interest rate swap agreements, the Company received cash proceedsof $19 million, which was recorded as a deferred gain that is being amortizedas a reduction to interest expense over the remaining term of the SeniorSecured Notes. Upon termination of one of the 2004 interest rate swap agreements,the Company made cash payments of $1 million, which was recorded as adeferred loss that is being amortized as an increase to interest expense overthe remaining term of the Senior Secured Notes.

(2)          Thecarrying value of the Senior Secured Notes as of September 30, 2003 of$666 million is comprised of the aggregate principal amount outstanding of $640million increased for $10 million of unamortized premium, net of discount, andthe unamortized deferred gain of $16 million related to the termination theCompany’s interest rate swap agreements in December 2002.

***Senior Secured Notes Repurchases***

During the third quarter of fiscal 2004, the Companyrepurchased $132 million aggregate principal amount of its Senior Secured Notesin a series of open market transactions. The Company used a total of $155million in cash to repurchase these notes, and recognized a pre-tax loss of $21million, which is included in other income (expense), net. The $21 million lossconsists of (i) $23 million of open market premiums on the repurchases, (ii) thewrite-off of $3 million of deferred financing costs, offset partially by therecognition of (iii) $2 million of unamortized net premium recorded at thetime of the original debt 

17

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**8**.   Debt and Derivative FinancialInstruments (Continued)

issuances, and (iv) therecognition of a $3 million deferred gain related to the terminations in December2002 and June 2004 of certain of the Company’s interest rate swapagreements.

Upon the repurchase ofthese notes, the Company paid interest of $3 million, which had accrued from April 1,2004 through the dates of the repurchases.

***Senior Secured Notes Redemption***

On March 19, 2004, the Company redeemed $224million aggregate principal amount of its outstanding Senior Secured Notes at aprice of 111.125% per note, or $249 million in the aggregate, resulting in apremium of $25 million paid upon redemption. The Company used the entire netproceeds received from the sale in February 2004 of approximately 14million shares of the Company’s common stock to redeem these notes (see Note10). The Company recognized a loss on the early redemption of $21 million,which is included in other income (expense), net. The $21 million loss consistsof (i) the $25 million redemption premium, (ii) the write-off of $5million of deferred financing costs, offset partially by the recognition of (iii) $4million of unamortized net premium recorded at the time of the original debtissuances, and (iv) the recognition of a $5 million deferred gain relatedto the termination in December 2002 of the Company’s interest rate swapagreements.

Upon redemption of thesenotes, the Company paid interest of $12 million, which had accrued from October 1,2003 through March 19, 2004.

***LYONs Put Obligation***

The Company has classifiedthe Liquid Yield OptionTM Notes due 2021 (“LYONs”) convertible debt as a currentobligation as of June 30, 2004, since the holders may require the Companyto purchase all or a portion of their LYONs on October 31, 2004. If theLYONs are put to the Company, the Company may, at its option, elect to pay thepurchase price in cash or shares of common stock, or any combination thereof. Inaddition, the Company may redeem for cash all, or any portion, of the LYONs atany time on or after October 31, 2004.

***Credit Facility Amendments***

In January 2004, the Company and the lendersunder the Company’s five-year revolvingcredit agreement (“Credit Facility”) amended the terms of the CreditFacility to provide the Company with additional flexibility to repurchase itsdebt securities and make acquisitions.

As a result of the amendments to the Credit Facility,the Company is permitted to use up to $455 million in cash to redeem orrepurchase LYONs, other than pursuant to the October 31, 2004 put, so longas the Company holds unrestricted domestic cash and marketable securities of atleast $400 million immediately before and after such redemption or repurchase.As of June 30, 2004, the Company used $156 million in cash torepurchase LYONs and, as a result of the amendments to the Credit Facility, hasthe ability to use an additional $299 million in cash to repurchase LYONs,other than pursuant to the October 31, 2004 put.

18

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**8.**   Debt andDerivative Financial Instruments (Continued)

In connection with the October 31,2004 LYONs put obligation described above, the amended Credit Facility requiresthe Company to maintain, as of each day in the period commencing September 30,2004 until the later of (a) the date that the put obligation under theLYONs is satisfied and (b) the date upon which the Company delivers to thelenders under the amended Credit Facility a certificate certifying itscompliance with the covenants included in the amended Credit Facility for thefiscal quarter ended September 30, 2004, liquidity of not less than $300million on a pro forma basis as if the put obligation under the LYONs had beensatisfied as of such day. For purposes of this calculation, liquidity isdefined as the sum of the unused commitments under the Company’s amended CreditFacility plus unrestricted domestic cash and marketable securities. To theextent the Company can satisfy this liquidity test, it may use cash to satisfyany put obligation with respect to the LYONs.

The Credit Facility wasalso amended to permit the Company to use up to $500 million in cash to prepayor repurchase long-term debt other than the LYONs so long as the Company holdsunrestricted domestic cash and marketable securities of at least $400 millionimmediately before and after such prepayment or repurchase. The Company used$249 million of this amount to redeem 35% of the Senior Secured Notes in March 2004.Additionally, the Company used $155 million of this amount to repurchase itsSenior Secured Notes in the third quarter of fiscal 2004. The Company has theability to use an additional $96 million in cash to repurchase long-term debtother than LYONs under the amended Credit Facility.

The amendments to theCredit Facility provide that from and after the first date that the Companyrepurchases debt in accordance with the terms of the amended Credit Facility ormakes an acquisition for a purchase price of $100 million or more, the Companywill be required to have had positive free cash flow for the four fiscalquarters most recently then ended and maintain positive free cash flow for eachfour quarter period thereafter. Free cash flow is defined under the amendedCredit Facility as net cash provided by (used in) operating activities lesscapital expenditures and dividends. As a result of the redemption of the SeniorSecured Notes described above, the Company is currently required to comply withthis covenant.

The amendments to theCredit Facility provide that, in addition to debt already permitted under theCredit Facility, the Company may incur debt in an amount equal to the amount ofdebt previously repaid by the Company, so long as immediately before and aftersuch issuance, the Company has $400 million in unrestricted domestic cash andmarketable securities.

The amended Credit Facilityprovides that the Company may use up to $500 million in cash to makeacquisitions provided that the Company complies with certain financialcovenants. In August 2004, the Company used $24 million in cash tocomplete the acquisition of a majority interest in Tata Telecom and,accordingly, may use an additional $476 million in cash to make acquisitions. Furthermore,in August 2004, the Company announced an agreement to purchase Spectel Plcfor approximately $103 million, which is expected to close no later than thefirst quarter of fiscal 2005. After such acquisition is completed, the Company hasthe ability to use up to an additional $373 million in cash to makeacquisitions.

***Interest Rate Swap Agreements***

During the first and second quarters of 2004, theCompany entered into a total of five interest rate swap agreements each havinga notional amount of $50 million and a maturity date of April 2009. These 

19

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**8.**   Debt andDerivative Financial Instruments (Continued)

interest rate swapagreements were executed in order to: (i) convert a portion of the SeniorSecured Notes fixed-rate debt into floating-rate debt; (ii) maintain acapital structure containing appropriate amounts of fixed- and floating-ratedebt; and (iii) reduce interest payments and expense in the near term. Theseagreements qualify and are designated as fair value hedges in accordance withSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.” Under these agreements, the Company receives a fixed interest rateof 111¤8% and pays afloating interest rate based on the six-month LIBOR (in arrears) plus anagreed-upon spread of 6.55%, 6.8575%, 6.94%, 6.8% and 6.98%, respectively. Theinterest rate swaps effectively converted $250 million of the Senior SecuredNotes from fixed rate debt into floating rate debt. Since the relevant terms ofthe interest rate swap agreements match the corresponding terms of the SeniorSecured Notes, there is no hedge ineffectiveness. Accordingly, gains and losseson the interest rate swap agreements fully offset the losses and gains on thehedged portion of the Senior Secured Notes, which are marked to market at eachreporting date, both of which are recorded in other income (expense), net.

During the third quarterof 2004, the Company terminated the $50 million interest rate swap agreementthat paid a floating interest rate based on the six-month LIBOR (in arrears)plus an agreed-upon spread of 6.94%. The termination resulted in a reduction toother liabilities for the removal of the fair market value of the interest rateswap and a cash payment of $1 million representing the loss on termination,which is being recognized as an increase to interest expense over the remainingterm to maturity of the Senior Secured Notes. The unamortized balance of theloss is included as a reduction to long-term debt. The Company terminated thisinterest rate swap agreement in order to maintain its desired capital structureas it repurchased certain amounts of its Senior Secured Notes.

**9**.   Benefit Obligations

Thefollowing table illustrates the components of net periodic benefit (credit)cost for the Company’s pension and postretirement benefit plans:
| ** **                          | ** ** | **Pension  Benefits**                | ** ** | **Postretirement  Benefits**        | ** ** | **Pension  Benefits**            | ** ** | **Postretirement  Benefits**     | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **Three months ended June 30,** | ** ** | **Nine months ended June 30,** | ** ** |
| ** **                          | ** ** | **  2004  **     | ** ** | **  2003  **    | ** ** | **  2004  ** | ** ** | **  2003  ** | ** ** | **  2004  ** | ** ** | **  **2003   | ** ** | **  2004  ** | ** ** | **  2003  ** | ** ** |
| ** **                          | ** ** | **(dollars in millions)**  | ** ** |
| Service cost                        |       |                                 | $          | 4                                   |       |                             |       | $                                | 12         |   |   |   | $ | 1 |   |   |   | $ | 1 |   |   | $ | 12 |   | $ | 35 |   |   | $ | 3 |   |   |   | $ | 4 |   |   |
| Interest cost                       |       |                                 | 43         |                                |       |                             | 41         |                             |       |   | 10 |   |   |   | 9 |   |   | 127 |   | 122 |   |   | 30 |   |   |   | 26 |   |   |
| Expected return  on plan assets     |       |                                 | (54        | )                                   |       |                             | (50        | )                                |       |   | (4 | ) |   |   | (4 | ) |   | (160 | ) | (149 | ) |   | (12 | ) |   |   | (12 | ) |   |
| Amortization of  prior service cost |       |                                 | 2          |                                |       |                             | 1          |                             |       |   | 3 |   |   |   | — |   |   | 5 |   | 2 |   |   | 8 |   |   |   | — |   |   |
| Recognized net  actuarial loss      |       |                                 | 3          |                                |       |                             | —     |                             |       |   | 1 |   |   |   | 1 |   |   | 11 |   | — |   |   | 4 |   |   |   | 1 |   |   |
| Net periodic benefit  (credit) cost |       |                                 | $          | (2                                  | )          |                             |       | $                                | 4          |   |   |   | $ | 11 |   |   |   | $ | 7 |   |   | $ | (5 | ) | $ | 10 |   |   | $ | 33 |   |   |   | $ | 19 |   |   |

 

20

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**9.**   Benefit Obligations (Continued)

During the third quarter of fiscal 2004, the Companymade a voluntary contribution of $111 million, in the form of shares of commonstock of the Company, to pre-fund the pension obligation for salaried employees.The Company will not be required to make any contributions to its pension plansin fiscal 2004 to meet minimum statutory funding requirements.

The Company provides certain pension and retireemedical benefits for management employees, neither of which is pre-funded. Consequently,the Company makes payments as these pension and retiree medical benefits aredisbursed. For the nine months ended June 30, 2004, the Company madepayments for these pension and retiree medical benefits totaling $6 million and$18 million, respectively. For the remainder of fiscal 2004, the Company presentlyanticipates making additional payments for these pension and retiree medicalbenefits totaling $2 million and $6 million, respectively, for total paymentsduring fiscal 2004 of approximately $8 million and $24 million, respectively.

On December 8, 2003, the Medicare PrescriptionDrug, Improvement and Modernization Act of 2003 (the “Act”) was signed intolaw. The Act introduces a prescription drug benefit beginning in 2006 underMedicare (“Medicare Part D”), as well as a federal subsidy to sponsors ofretiree health care benefit plans that provide a benefit that is at leastactuarially equivalent to Medicare Part D. As permitted by FASB StaffPosition No. FAS 106-1, “Accounting and Disclosure RequirementsRelated to the Medicare Prescription Drug, Improvement and Modernization Act of2003,” the Company has elected to defer recognition of the Act until it is ableto determine whether benefits provided by its plans are actuarially equivalent.Therefore, any measures of the accumulated postretirement benefit obligation ornet periodic benefit cost in the Company’s financial statements do not reflectthe effect of the Act.

**10**.   Equity Transactions

During the third quarter of fiscal 2004, the Companymade a voluntary contribution of $111 million of its common stock to fund itspension plan (see Note 9). The contribution was funded with a combination of2,448,602 shares of treasury stock and 4,510,646 shares of newly issued commonstock. The per share value of Avaya common stock contributed to the pensionplan was $15.95, which represented the average of the opening and closing shareprice of Avaya common stock on June 9, 2004, the date of the contribution.As of the date of the contribution, the treasury stock had a carrying value of$27 million. The difference between the $27 million carrying value and the $39million fair value of the treasury stock contributed was recorded as anincrease to additional paid-in capital.

In February 2004, the Company sold 14,039,481shares of its common stock for $17.85 per share in a public offering. TheCompany received proceeds of $249 million, net of $2 million of underwritingdiscounts and commissions, which have been recorded as a reduction toadditional paid-in capital. The Company used the entire net proceeds to redeema portion of its outstanding Senior Secured Notes (see Note 8).

**11**.   Stock Compensation

During the nine months ended June 30, 2004, theCompany granted to eligible employees approximately 10 million stock options ata weighted average exercise price of $13.70 per option and approximately 532thousand restricted stock units at a weighted average market value of $13.87per unit.

Atotal of 5.1 million restricted stock units held by employees vested during thenine months ended June 30, 2004. Of this amount, 1.5 million sharesunderlying the restricted stock units were withheld for purposes of remittingfederal and state income and payroll taxes related to the vesting of the units.The

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**11**.   StockCompensation (Continued)

remaining 3.6 millionshares underlying the restricted stock units were distributed to the employeesupon vesting. The 1.5 million shares withheld for tax purposes were recorded astreasury stock at the value of the shares as of the respective vesting dates.

**12.**   Earnings(Loss) Per Share of Common Stock

Basicearnings (loss) per common share is calculated by dividing net income (loss)available to common stockholders by the weighted average number of common sharesoutstanding during the period. Diluted earnings (loss) per common share iscalculated by adjusting net income (loss) available to common stockholders andweighted average outstanding shares, assuming conversion of all potentiallydilutive securities including stock options, restricted stock units, warrants,and convertible debt.
| ** **                                                                 | ** ** | **Three Months  Ended  June 30,**                                                        | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                                                                           | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                 | ** ** | **(dollars and shares in millions,  except per share amounts)** | ** ** |
| **Earnings  (Loss) Per Common Share—Basic:**                          |       |                                                                                               |       |                                       |       |   |   |   |   |
| Income (loss) from  continuing operations                                  |       | $                                                                                                  | 58         |                                       | $          | (3 | ) | $ | 191 |   | $ | (183 | ) |
| Income from discontinued  operations                                       |       | 3                                                                                                  |       | 11                                         |       | 5 |   | 29 |   |
| Net income (loss)  available to common stockholders                        |       | $                                                                                                  | 61         |                                       | $          | 8 |   | $ | 196 |   | $ | (154 | ) |
| Weighted average shares—basic                                         |       | 446                                                                                                |       | 382                                        |       | 434 |   | 374 |   |
| Earnings (loss) per  share from continuing operations                      |       | $                                                                                                  | 0.13       |                                       | $          | (0.01 | ) | $ | 0.44 |   | $ | (0.49 | ) |
| Earnings per share from  discontinued operations                           |       | 0.01                                                                                               |       | 0.03                                       |       | 0.01 |   | 0.08 |   |
| Earnings (loss) per  share—basic                                      |       | $                                                                                                  | 0.14       |                                       | $          | 0.02 |   | $ | 0.45 |   | $ | (0.41 | ) |
| **Earnings  (Loss) Per Common Share—Diluted:**                        | ** ** |                                                                                               |       |                                       |       |   |   |   |   |
| Income (loss) from  continuing operations                                  |       | $                                                                                                  | 58         |                                       | $          | (3 | ) | $ | 191 |   | $ | (183 | ) |
| After-tax savings on the  assumed conversion of LYONs                      |       | 2                                                                                                  |       | —                                     |       | 7 |   | — |   |
| Income (loss) from  continuing operations available to common stockholders |       | 60                                                                                                 |       | (3                                         | )          | 198 |   | (183 | ) |
| Income from discontinued  operations                                       |       | 3                                                                                                  |       | 11                                         |       | 5 |   | 29 |   |
| Net income (loss)  available to common stockholders                        |       | $                                                                                                  | 63         |                                       | $          | 8 |   | $ | 203 |   | $ | (154 | ) |
| Weighted average  shares—basic                                        |       | 446                                                                                                |       | 382                                        |       | 434 |   | 374 |   |
| Potential dilutive  securities:                                            |       |                                                                                               |       |                                       |       |   |   |   |   |
| Assumed exercise of  stock options                                         |       | 9                                                                                                  |       | 4                                          |       | 9 |   | — |   |
| Assumed vesting of  restricted stock units                                 |       | 1                                                                                                  |       | 3                                          |       | 2 |   | — |   |
| Assumed exercise of  warrants                                              |       | 6                                                                                                  |       | 2                                          |       | 6 |   | — |   |
| Assumed conversion of  LYONs                                               |       | 21                                                                                                 |       | 83                                         |       | 21 |   | — |   |
| Weighted average  shares—diluted                                      |       | 483                                                                                                |       | 474                                        |       | 472 |   | 374 |   |
| Earnings (loss) per  share from continuing operations                      |       | $                                                                                                  | 0.12       |                                       | $          | (0.01 | ) | $ | 0.42 |   | $ | (0.49 | ) |
| Earnings per share from  discontinued operations                           |       | 0.01                                                                                               |       | 0.03                                       |       | 0.01 |   | 0.08 |   |
| Earnings (loss) per  share—diluted                                    |       | $                                                                                                  | 0.13       |                                       | $          | 0.02 |   | $ | 0.43 |   | $ | (0.41 | ) |

 

22

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**12.**   Earnings (Loss) Per Share of Common Stock (Continued)
| ** **                                                                                       | ** ** | **Three Months  Ended  June 30,** | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                       | ** ** | **(shares in millions)**                    | ** ** |
| **Securities  excluded from the computation of diluted earnings (loss) per common  share:** |       |                                        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Options(1)                                                                                       |       |                                        | 10         |                                       |       |   | 40 |   |   |   | 25 |   |   | 43 |   |
| Restricted stock  units(1)                                                                       |       |                                        | —     |                                       |       |   | — |   |   |   | — |   |   | 1 |   |
| Warrants(1)                                                                                      |       |                                        | 6          |                                       |       |   | 6 |   |   |   | 6 |   |   | 14 |   |
| Common shares issuable upon  conversion of LYONs:                                                |       |                                        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Settled in common  shares(2)                                                                     |       |                                        | —     |                                       |       |   | — |   |   |   | — |   |   | 175 |   |
| Settled in cash(3)                                                                               |       |                                        | —     |                                       |       |   | 37 |   |   |   | — |   |   | 20 |   |
| Total                                                                                            |       |                                        | 16         |                                       |       |   | 83 |   |   |   | 31 |   |   | 253 |   |

----

(1)          These securities havebeen excluded from the diluted earnings (loss) per common share calculationeither because the respective exercise prices are greater than the averagemarket value of the underlying stock or their inclusion would have beenantidilutive.

(2)          For the nine monthsended June 30, 2003, the securities listed represent the average number ofshares issuable by the Company if it were required to purchase LYONsoutstanding as of June 30, 2003 on the initial October 31, 2004 putdate and if the Company elected to satisfy the put obligation in shares ofcommon stock. Such securities were excluded from the diluted loss per commonshare calculation as their inclusion would have been antidilutive.

(3)          Thesesecurities have been excluded from the diluted earnings (loss) per common sharecalculation due to the assumption that this portion of the debt would have beensettled in cash.

**13.**   OperatingSegments

The Company reports its operations in three segments—ECG,SMBS, and Services. The ECG segment develops, markets and sells communicationsproducts and applications primarily to large enterprises and includes IPtelephony systems, traditional voice communications systems, multi-mediacontact center infrastructure and applications in support of customerrelationship management, unified communications applications, and appliances,such as telephone sets. The SMBS segment develops, markets and sellscommunications products and applications, including IP telephony systems,traditional voice communications systems, and unified communication and contactcenter applications, for small and medium-sized businesses. The Servicessegment offers a comprehensive portfolio of global services that enablecustomers to plan, design, build and manage their communications networks. Services’operating results also include the professional services organization asexplained below.

As described in Note 3, as a result of the sale ofConnectivity Solutions, the Company has classified the results of operations ofConnectivity Solutions as a discontinued operation. This business waspreviously disclosed as a separate operating segment. The segment data includedbelow has been restated

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**13.**   OperatingSegments (Continued)

to exclude the results ofConnectivity Solutions and to reallocate Connectivity Solutions’ portion ofcorporate related expenses to the remaining operating segments. During thefirst quarter of fiscal 2004, the Company moved its professional servicesorganization from ECG to the Services segment to properly reflect theprofessional service organization’s ability to service products other thanAvaya’s. The Company’s professional services organization provides servicesrequired to customize communication application solutions for individualcustomer needs. The Company also allocated a portion of the results attributedto the Company’s third-party financing arrangement from ECG to SMBS based onthe relative contribution of the arrangement to the sale of each segment’sproducts. Accordingly, prior period amounts have been reclassified to reflectthese changes.

The segments are managed as three individual businessesand, as a result, include certain allocated costs and expenses of sharedservices, such as information technology, human resources, legal and finance.Costs remaining in the other unallocated category represent expenses that arenot identified with the operating segments and include costs incurred tomaintain vacant real estate facilities and the under or over estimated portionsof expenses not charged to the segments, as these expenses are allocated on afixed basis. Intersegment sales approximate fair market value and are notsignificant.

The Company has outsourcedall of its manufacturing operations related to ECG and SMBS segments primarilyto Celestica Inc. All manufacturing of the Company’s products is performed inaccordance with detailed specifications and product design furnished by theCompany and is subject to quality control standards.

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**13.**   Operating Segments (Continued)

***Reportable Segments***

Summarizedfinancial information relating to the Company’s reportable segments is shown inthe following table:
| ** **                                          | ** ** | **Reportable Segments**          | ** ** | **Corporate**                                   | ** ** | ** **   | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|
| ** **                                          | ** ** | **Enterprise  Communications  Group** | ** ** | **Small and  Medium  Business  Solutions** | ** ** | **Services** | ** ** | **Business  Restructuring  Reversals, Net** | ** ** | **Other  Unallocated  Amounts** | ** ** | **Total** | ** ** |
| ** **                                          | ** ** | **(dollars in millions)**   | ** ** |
| **Three Months Ended June 30, 2004**           |       |                                  |       |                                            |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       |                                  | $          | 439                                             |       |         |       | $ | 67 |   |   | $ | 510 |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,016 |   |
| Operating income  from continuing operations        |       |                                  | 11         |                                            |       |         | 6          |   |   | 68 |   |   | — |   |   |   | 7 |   |   | 92 |   |
| **Three Months Ended June 30, 2003**           |       |                                  |       |                                            |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       |                                  | $          | 396                                             |       |         |       | $ | 59 |   |   | $ | 474 |   |   | $ | — |   |   |   | $ | — |   |   | $ | 929 |   |
| Operating income  (loss) from continuing operations |       |                                  | (24        | )                                               |       |         | —     |   |   | 42 |   |   | (7 | ) |   |   | (7 | ) |   | 4 |   |
| **Nine Months Ended June 30, 2004**            |       |                                  |       |                                            |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       |                                  | $          | 1,283                                           |       |         |       | $ | 196 |   |   | $ | 1,510 |   |   | $ | — |   |   |   | $ | 4 |   |   | $ | 2,993 |   |
| Operating income  (loss) from continuing operations |       |                                  | (1         | )                                               |       |         | 17         |   |   | 184 |   |   | 1 |   |   |   | 3 |   |   | 204 |   |
| **Nine Months Ended June 30, 2003**            |       |                                  |       |                                            |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                             |       |                                  | $          | 1,211                                           |       |         |       | $ | 174 |   |   | $ | 1,440 |   |   | $ | — |   |   |   | $ | — |   |   | $ | 2,825 |   |
| Operating income (loss)  from continuing operations |       |                                  | (108       | )                                               |       |         | (3         | ) |   | 123 |   |   | 3 |   |   |   | (22 | ) |   | (7 | ) |

 

***GeographicInformation***

Financialinformation relating to the Company’s revenues by geographic area was asfollows:
| ** **     | ** ** | **Three Months  Ended  June 30,** | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|----------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **     | ** ** | **(dollars in millions)**         | ** ** |
| **Revenue(1)** |       |                                        |       |                                       |       |   |   |   |   |
| U.S.           |       | $                                           | 769        |                                       | $          | 724 |   | $ | 2,267 |   | $ | 2,157 |   |
| International  |       | 247                                         |       | 205                                        |       | 726 |   | 668 |   |
| Total          |       | $                                           | 1,016      |                                       | $          | 929 |   | $ | 2,993 |   | $ | 2,825 |   |

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(1)          Revenueis attributed to geographic areas based on the location of customers.

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.   Commitments andContingencies**

**LegalProceedings**

From time to time, theCompany is involved in legal proceedings arising in the ordinary course ofbusiness. Other than as described below, the Company believes there is nolitigation pending against it that could have, individually or in theaggregate, a material adverse effect on its financial position, results ofoperations or cash flows.

***Year 2000 Actions***

Three separate purported class action lawsuits arepending against Lucent Technologies, Inc. (“Lucent”), the Company’s formerparent, one in state court in West Virginia, one in federal court in theSouthern District of New York and another in federal court in the SouthernDistrict of California. The case in New York was filed in January 1999 and,after being dismissed, was refiled in September 2000. The case in WestVirginia was filed in April 1999 and the case in California was filed inJune 1999, and amended in 2000 to include the Company as a defendant. TheCompany may also be named a party to the other actions and, in any event, hasassumed the obligations of Lucent for all of these cases under the Contributionand Distribution Agreement, as described in “Transactions with Lucent” belowbetween the Company and Lucent. All three actions are based upon claims thatLucent sold products that were not Year 2000 compliant, meaning that theproducts were designed and developed without considering the possible impact ofthe change in the calendar from December 31, 1999 to January 1, 2000.The complaints allege that the sale of these products violated statutoryconsumer protection laws and constituted breaches of implied warranties.

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

In May 2004, the Company entered into asettlement agreement with the plaintiffs in all of the above-described actions.Under the general terms of the agreement, eligible class members who acquiredcertain products between 1990 and 1999 may receive credits up to $110 millionor a cash alternative. The credits are valid for a three-year period and can beapplied toward a 45 percent discount on purchases of new Avaya products and/ora 30 percent discount on Avaya maintenance services. Alternatively, eligibleclass members may receive a one-time cash payment equal to 25 percent of thecredits to which they may be entitled. The state court in West Virginiarecently held a fairness hearing and issued an order of final 

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments andContingencies (Continued)

approval of thesettlement. The claims process is expected to commence in the fourth fiscalquarter of 2004.

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

***Lucent SecuritiesLitigation***

In November 2000, three purported class actionswere filed against Lucent in the Federal District Court for the District of NewJersey alleging violations of the federal securities laws as a result of thefacts disclosed in Lucent’s announcement on November 21, 2000 that it hadidentified a revenue recognition issue affecting its financial results for thefourth quarter of fiscal 2000. The actions purport to be filed on behalf ofpurchasers of Lucent common stock during the period from October 10, 2000(the date Lucent originally reported these financial results) throughNovember 21, 2000.

The above actions have been consolidated with otherpurported class actions filed against Lucent on behalf of its stockholders inJanuary 2000 and are pending in the Federal District Court for theDistrict of New Jersey. The consolidated cases were initially filed on behalfof stockholders of Lucent who bought Lucent common stock between October 26,1999 and January 6, 2000, but the consolidated complaint was amended toinclude purported class members who purchased Lucent common stock up toDecember 20, 2000. A class has not yet been certified in the consolidatedactions. The plaintiffs in all of these stockholder class actions seekcompensatory damages plus interest and attorneys’ fees.

In March 2003, Lucentannounced that it had entered into a $420 million settlement of allpending shareholder and related litigation. Certain cases which are the subjectof the settlement are shared contingent liabilities under the Contribution andDistribution Agreement and accordingly, the Company is responsible for 10% ofthe liabilities attributable to those cases, including 10% of the legal costsassociated with the portion of the litigation for which the Company sharesliability. In the second quarter of fiscal 2003, the Company recorded a chargeof $25 million representing the Company’s estimate of its liability inthis matter. The Company recently reached agreement with Lucent to pay$24 million in shares of the Company’s common stock in full satisfactionof its obligations under the settlement. The terms of the settlement wereapproved by the Federal District Court for the District of New Jersey inDecember 2003. The Company understands the administration of claims iscurrently in process and expects to issue the shares in the next severalmonths.

***Commissions Arbitration Demand***

In July 2002,Communications Development Corporation (“CDC”), a British Virgin Islands corporation,made formal demand for arbitration for alleged unpaid commissions in an amountin excess of $10 million, stemming from the sale of products from theCompany’s businesses that were formerly 

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments andContingencies (Continued)

owned byLucent involving the Ministry of Russian Railways. In April 2003, CDCinitiated the arbitration before the American Arbitration Association. Theplaintiff alleges that as a result of agreements entered into between theplaintiff and the Company, it is owed commissions on sales by the Company tothe Ministry of Russian Railways on a continuing basis. The Company believesthat the agreements relating to their claim have expired or do not apply to theproducts in question. As the sales of products continue, CDC may likelyincrease its commission demand. The parties have selected arbitrators in thismatter. A hearing date has not yet been set.

***Lucent Consumer Products Class Actions***

In several class action cases (the first of which wasfiled on June 24, 1996), plaintiffs claim that AT&T and Lucent engagedin fraud and deceit in continuing to lease residential telephones to consumerswithout adequate notice that the consumers would pay well in excess of the purchaseprice of a telephone by continuing to lease. The cases were removed andconsolidated in federal court in Alabama, and were subsequently remanded totheir respective state courts (Illinois, Alabama, New Jersey, New York andCalifornia). In July 2001, the Illinois state court certified a nationwideclass of plaintiffs. The case in Illinois was scheduled for trial onAugust 5, 2002. Prior to commencement of trial, however, the partiesagreed to a settlement of the claims on a class-wide basis. The settlement was approvedby the court on November 4, 2002. Claims from Class members wererequired to be filed on or about January 15, 2003.

Any liability incurred byLucent in connection with these class action cases will be considered anexclusive Lucent liability under the Contribution and Distribution Agreementbetween Lucent and the Company and, as a result, the Company would beresponsible for 10% of any such liability in excess of $50 million. TheCompany recently agreed with Lucent to pay $6 million in satisfaction ofits liability in this matter, although Lucent has notified the Company that itmay be responsible for some additional costs that may be incurred in connectionwith the conclusion of the claims administration. Based on the Company’sdiscussions with Lucent, it does not expect those additional costs to bematerial.

***Patent Infringement Claim***

AudioFAX IP, LLC has filedan action against the Company in the U.S. District Court for the NorthernDistrict of Georgia, alleging that the Company has infringed five of itspatents relating to facsimile products in violation of federal patent laws.This matter is in the early stages of litigation and the Company cannotdetermine whether the outcome of this action will have a material adverseeffect on its financial position, results of operations or cash flows.

***Variable Workforce Grievances***

The Communications Workersof America and the International Brotherhood of Electrical Workers, unionsrepresenting the Company’s technicians, have filed grievances regarding aninterpretation of the variable workforce agreements (“Agreements”) entered intobetween the Company and the unions in June 2003. The unions allege thatthe Company has violated the agreements by activating some, but not all,variable workforce employees (approximately 850 in total) for duty fromAugust 2003, and not paying such employees for the minimum amount of weeksto which they claim entitlement under their interpretation of 

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments andContingencies (Continued)

theAgreements. The Company has denied the grievances relating to these cases. Atthis time, the Company cannot determine whether these disputes will have amaterial adverse effect on the Company’s 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, governing the cleanup of soil and groundwater contamination.Such provisions impose liability for the costs of investigating and remediatingreleases of hazardous materials at currently or formerly owned or operatedsites. In certain circumstances, this liability may also include the cost ofcleaning up historical contamination, whether or not caused by the Company. TheCompany is currently conducting investigation and/or cleanup of knowncontamination at approximately seven of its current or former facilities eithervoluntarily or pursuant to government directives. None of the sites isreasonably likely to generate environmental costs that will be individuallymaterial nor will environmental costs for all sites in the aggregate bematerial. There are no known third parties who may be responsible forinvestigation and/or cleanup at these sites and therefore, for purposes ofassessing the adequacy of financial reserves for these liabilities, the Companyhas not assumed that it will recover amounts from any third party, includingunder any insurance coverage or indemnification arrangement. Although theCompany 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 theextent of contamination and the type of required cleanup. The Company is notaware 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 movementof contaminants are accurate. In addition, estimates of environmental costs maybe affected by changes in law and regulation, including the willingness ofregulatory authorities to conclude that remediation and/or monitoring performedby the Company is adequate.

The Company assesses theadequacy of environmental reserves on a quarterly basis. For each of the threeand nine month periods ended June 30, 2004 and 2003, no amounts werecharged to the Statements of Operations for environmental costs as reserveswere deemed to be adequate. Expenditures for environmental matters each of thethree and nine month periods ended June 30, 2004 and 2003 were notmaterial to the Company’s financial position, results of operations or cashflows. Payment for the environmental costs covered by the reserves may be madeover a 30-year period.

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments and Contingencies (Continued)

**Product Warranties**

The Company recognizes a liability for the estimatedcosts that may be incurred to remedy certain deficiencies of quality orperformance of the Company’s products. These product warranties extend over aspecified period of time generally ranging up to one year from the date of saledepending upon the product subject to the warranty. The Company accrues aprovision for estimated future warranty costs based upon the historicalrelationship of warranty claims to sales. The Company periodically reviews theadequacy of its product warranties and adjusts, if necessary, the warrantypercentage and accrued warranty reserve, which is included in other currentliabilities in the Consolidated Balance Sheets, for actual experience.

Thefollowing table reconciles the changes in the Company’s product warrantyliability for the nine months ended June 30, 2004:
| ** **                                                          | ** ** | **(dollars in  millions)** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------|------------|
| Balance as of September 30, 2003                               |       |                            | $          | 30 |   |   |
| Warranties  accrued during the nine months ended June 30, 2004 |       |                            | 30         |   |   |
| Less: actual  warranty expenses incurred during the period          |       |                            | (39        | ) |   |
| Balance as of June 30,  2004                                   |       |                            | $          | 21 |   |   |

 

The decrease in theaccrued balance for product warranty is primarily attributable to moreefficient handling of warranty claims, as well as the overall shift in theCompany’s product offerings.

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

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $139 million forthe purpose of securing third party financial guarantees such as letters ofcredit which ensure the Company’s performance or payment to third parties. Asof June 30, 2004, the Company had outstanding an aggregate of $84 millionin irrevocable letters of credit and similar third party financial guarantees,of which $10 million are collateralized.

***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. If the Company fails to performunder its obligations, the maximum potential payment under these surety bondsis approximately $21 million as of June 30, 2004. Historically, nosurety bonds have been drawn upon and there is no future expectation that thesesurety bonds will be drawn upon.

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments andContingencies (Continued)

***PurchaseCommitments and Termination Fees***

The Company has commitmentcontracts with certain suppliers in which it is obligated to purchase aspecified amount of inventory based on its forecasts, or pay a charge in theevent the Company does not meet its designated purchase commitments. Additionally,certain agreements call for an early termination fee, obligating the Company tomake a payment to the supplier. As of June 30, 2004, the maximum potentialpayment under these commitments was approximately $63 million. Historically,the Company has not been required to pay a charge for not meeting itsdesignated purchase commitments with these suppliers.

***Product FinancingArrangements***

The Company sells productsto various resellers that may obtain financing from certain unaffiliated thirdparty lending institutions.

The Company has a productfinancing arrangement with one U.S. reseller. Avaya is obligated under certaincircumstances to repurchase inventory previously sold to this reseller, in theevent the lending institution, which financed the transaction, repossesses thereseller’s inventory of the Company’s products. The Company’s obligation torepurchase inventory from the lending institution terminates 180 days fromthe date of invoicing by the Company to the reseller. The repurchase amount isequal to the price originally paid to the Company by the lending institutionfor the inventory. This reseller has financed $66 million of inventorypurchases under this arrangement as of June 30, 2004. There have not beenany repurchases made by Avaya since the Company entered into this agreement in March 2001.The Company has estimated the fair value of this guarantee as of June 30,2004, and has adequately provided for this guarantee in its financialstatements at June 30, 2004. The fair value of the guarantee is notsignificant. There can be no assurance that the Company will not be obligatedto repurchase inventory under this arrangement in the future.

For the Company’s productfinancing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guarantee repayment amount reported tothe Company from the lending institution was approximately $5 million asof June 30, 2004. The Company reviews and sets the maximum credit limitfor each reseller participating in this financing arrangement. There have notbeen any guarantee repayments by Avaya since the Company entered in thisarrangement in October 2000. The Company has estimated the fair value ofthis guarantee as of June 30, 2004, and has adequately provided for thisguarantee in its financial statements at June 30, 2004. The fair value ofthe guarantee is not significant. There can be no assurance that the Companywill not be obligated to repurchase inventory under this arrangement in thefuture.

***PerformanceGuarantee***

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 nine years. While the Company is nolonger the primary obligor under these leases, the lessor has not 

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments and Contingencies (Continued)

completelyreleased the Company from its obligation, and holds it secondarily liable inthe event that the assignees default on these leases. The maximum potentialfuture payments the Company could be required to make, if all of the assigneeswere to default as of June 30, 2004, would be approximately $25 million. TheCompany has assessed the probability of default by the assignees and hasdetermined it to be remote.

***Credit FacilityIndemnification***

In connection with itsobligations under the amended Credit Facility described in Note 8, theCompany has agreed to indemnify the third party lending institutions for costsincurred by the institutions related to changes in tax law or other legalrequirements. While there have been no amounts paid to the lenders pursuant tothis indemnity in the past, there can be no assurance that the Company will notbe obligated to indemnify the lenders under this arrangement in the future.

***Transactions withLucent***

In connection with the Company’sspin-off from Lucent in September 2000, the Company and Lucent executedand delivered the Contribution and Distribution Agreement and certain relatedagreements.

Pursuant to theContribution and Distribution Agreement, Lucent contributed to the Companysubstantially all of the assets, liabilities and operations associated with itsenterprise networking businesses (“Company’s Businesses”). The Contribution andDistribution Agreement, among other things, provides that, in general, theCompany will indemnify Lucent for all liabilities including certainpre-distribution tax obligations of Lucent relating to the Company’s Businessesand all contingent liabilities primarily relating to the Company’s Businessesor otherwise assigned to the Company. In addition, the Contribution andDistribution Agreement provides that certain contingent liabilities notallocated to one of the parties will be shared by Lucent and the Company inprescribed percentages. The Contribution and Distribution Agreement alsoprovides that each party will share specified portions of contingentliabilities based upon agreed percentages related to the business of the otherparty that exceed $50 million. See Legal Proceedings above for adiscussion of the Company’s obligations under the settlement of certainlitigation constituting shared contingent liabilities under the Contributionand Distribution Agreement. The Company is unable to determine the maximumpotential amount of other future payments, if any, that it could be required tomake under this agreement.

In addition, if theseparation from Lucent fails to qualify as a tax-free distribution under Section 355of the Internal Revenue Code because of an acquisition of the Company’s stockor assets, or some other actions of the Company, then the Company will besolely liable for any resulting corporate taxes.

In the second quarter offiscal 2004, the Company recognized an $89 million tax benefit resulting fromthe resolution of federal income tax audit matters for the years 1990 through1998 and certain state tax matters that arose prior to the Company’s separationfrom Lucent. The $89 million benefitconsisted of a $37 million net cash refund and the reversal of certain taxliabilities. The Company received the $37 million net cash refund fromLucent in accordance with the terms of a Tax Sharing Agreement that the Companyand Lucent entered into in connection with the Distribution. The Tax SharingAgreement governs Lucent’s and the Company’s respective rights,responsibilities and obligations after the distribution with respect to taxesfor the periods ending on or before the distribution. Generally,pre-distribution taxes 

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**AVAYA INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (unaudited)**

**14.**   Commitments andContingencies (Continued)

orbenefits that are clearly attributable to the business of one party will beborne solely by that party, and other pre-distribution taxes or benefits willbe shared by the parties based on a formula set forth in the Tax SharingAgreement. The Company may be subject to additional taxes or benefits pursuantto the Tax Sharing Agreement related to future settlements of audits by taxingauthorities for the periods prior to the Company’s separation from Lucent.

**15.**   SubsequentEvents

***Acquisition of aMajority Interest in Tata Telecom***

In connection with theTata Telecom transaction described in Note 3, the public tender offerclosed in July 2004 with 8.5 percent of the public shares tendering into theoffer. The sale of the shares by the Tata Group and the tendering shareholdersclosed on August 4, 2004. Avaya paid a total of $24 million in August relatedto this acquisition, of which $17 million was paid to the Tata Group, $6million was paid in relation to the public tender offer and Avaya realized a $1million loss associated with forward exchange contracts, which were used to hedgeforeign currency risk associated with the acquisition. Following theacquisition of these additional equity interests, the Company now owns 59.1percent of Tata Telecom and began consolidating its results on August 4,2004.

***Termination ofInterest Rate Swaps***

In July and August 2004,the Company terminated its remaining interest rate swap agreements, each ofwhich had a notional amount of $50 million and paid a floating interest ratebased on the six-month LIBOR (in arrears) plus an agreed-upon spread of 6.55%,6.8575%, 6.8% and 6.98%, respectively. The termination resulted in a reductionto other liabilities for the removal of the fair market value of the interestrate swaps and a net cash payment of $200 thousand representing the loss ontermination, which will be recognized as an increase to interest expense overthe remaining term to maturity of the Senior Secured Notes. The unamortizedbalance of the loss will be included as a reduction to long-term debt on theConsolidated Balance Sheet. The Company terminated these interest rate swapagreements as it anticipates further repurchases of its Senior Secured Notes.

***Acquisition ofSpectel Plc***

On August 2, 2004, theCompany entered into a share purchase agreement pursuant to which it wouldacquire all of the issued share capital of Spectel Plc, a company incorporatedin Ireland and a leading provider of audio conferencing solutions, forapproximately $103 million in cash. The acquisition is expected to close nolater than the first quarter of fiscal 2005 and is subject to regulatoryapproval, Irish laws and customary closing conditions.

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**Item 2.   *Management’s Discussionand Analysis of Financial Condition and Results of Operations***

The following section should be read in conjunctionwith the consolidated financial statements and the notes included elsewhere inthis Quarterly Report on Form 10-Q.

Our accompanying unauditedconsolidated financial statements as of June 30, 2004 and for the threeand nine months ended June 30, 2004 and 2003, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the Securities and Exchange Commission, or the SEC, for interim financialstatements, and should be read in conjunction with our consolidated financialstatements and other financial information for the fiscal year ended September 30,2003, which was filed with the SEC on February 12, 2004, on a CurrentReport on Form 8-K. In our opinion, the unaudited interim consolidatedfinancial statements reflect all adjustments, consisting of normal andrecurring adjustments, necessary for a fair presentation of the financialcondition, results of operations and cash flows for the periods indicated.Certain prior year amounts have been reclassified to conform to the currentinterim period presentation. The consolidated results of operations for theinterim periods reported are not necessarily indicative of the results to beexperienced for the entire fiscal year. 

**ExecutiveSummary**

We are a leadingprovider of communications systems, applications and services for enterprises,including businesses, government agencies and other organizations. Our productofferings include: 

·       InternetProtocol, or IP, telephony systems,

·       traditionalvoice communication systems, 

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

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

·       appliances,such as telephone sets.

We support ourbroad customer base with comprehensive global service offerings that enable ourcustomers to plan, design, implement and manage their communications networks.We believe our global service organization is an important consideration forcustomers purchasing our products and applications and is a source ofsignificant revenue for us, primarily from maintenance contracts. Our serviceofferings include:

·       outsourcingservices,

·       businessconsulting and system integration, 

·       implementation,and

·       maintenanceservices.

***Key Trends and Uncertainties Affecting Our Results***

The following is a summaryof the key trends and uncertainties that affected our financial results duringthe nine months ended June 30, 2004. Please also see “Forward LookingStatements” for a discussion of uncertainties facing our business.

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

As general economic conditions improved during fiscal2003 and continued through the first three quarters of fiscal 2004, our revenuestabilized. Our revenue for each of the quarters in fiscal 2003 and the first,second and third quarters of fiscal 2004 was $946 million, $950 million, $929million, $971 million, $971 million, $1,006 million and $1,016 million,respectively. Our revenue for the nine months ended June 30, 2004,includes revenue generated by the businesses we acquired from Expanets from thedate of acquisition (November 25, 2003) through June 30, 2004.

The following arethe key factors currently affecting our revenue:

·       *Improving economic conditions—*An importantfactor affecting our ability to generate revenue is the effect of generaleconomic conditions on our customers’ willingness to spend on informationtechnology and particularly, enterprise communication technology. As economicconditions have gradually improved over the last year, we have seen indicationsthat enterprises are more willing to spend on enterprise communicationstechnology than in the past several years. In particular, we believe acontinued increase in employment levels is an important indicator in assessingwhether enterprises will increase spending on enterprise communicationstechnology. Notwithstanding these improving economic conditions, it is notcertain whether enterprises will significantly increase spending oncommunication technology in the near term.

·       *Technology transition*—There are severalfactors that indicate that enterprises may be poised to transition theirtraditional communications systems to next-generation communications technology.First, IP telephony lines constitute a very small percentage of globalinstalled enterprise telephony lines. In addition, the average age of theseenterprise telephony systems is approximately ten years. Although these systemscontinue to operate reliably after ten years, enterprises typically willconsider a new investment in enterprise communications technology at this pointin the telephony system’s lifecycle. Accordingly, we believe that theseenterprises may consider new investments in enterprise communications and ifthey decide to make such investments, may consider IP telephony.

In addition, we have notedthat sales of our IP telephony gateways, which enable enterprises to connectremote locations to their headquarters, continue to be the fastest growing partof our IP telephony portfolio. We believe these factors indicate thatenterprises are deploying larger IP telephony systems and that early adoptersof IP telephony are now deploying this technology on a wider scale within theirbusinesses. Because our IP telephony gateways support traffic betweentraditional voice communications systems and IP telephony systems, we offer ourcustomers the flexibility to deploy a new IP telephony infrastructure or useour IP telephony gateways to “IP-enable” their traditional voicecommunications systems, thereby preserving their existing communicationstechnology investments.

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

·       *Pricing and competitive environment*—Wehave historically operated, and continue to operate, in an extremelycompetitive environment. Accordingly, we regularly face pricing pressures inthe markets in which we operate. We have been able to mitigate the effects ofpricing pressures on profitability through our actions to improve grossmargins, as described below.

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Overall, we have seen somesigns of cautious business optimism from our customers, particularly in thefinancial services and media and communications sectors. Should economic conditionscontinue to improve, we believe enterprises may be willing to increaseinformation technology spending and look to upgrade their enterprisecommunications systems.

***Acquisitionand Divestiture Transactions***

Our operatingresults for the three and nine months ended June 30, 2004 include theeffects of the following transactions:

·       Theacquisition in November 2003 of substantially all of the assets andcertain liabilities of Expanets, Inc.,

·       Thedivestiture in the first and second quarters of fiscal 2004 of the Expanetsbusinesses that previously distributed other vendors’ products, and

·       Thedivestiture in the second and third quarters of fiscal 2004 of our ConnectivitySolutions business.

See Note 3, “Acquisition and Divestitures” in theaccompanying consolidated financial statements for additional informationregarding these transactions.

***Continued Focus on Cost Structure***

As our revenue declined during fiscal 2001 and 2002,we took several actions, including business restructuring actions, designed toreduce our cost structure. Although we did not take any business restructuringactions during fiscal 2003 or the first nine months of fiscal 2004, wecontinued our focus on controlling our costs, particularly in relation to ourrevenue. As a result of the stabilization of our revenue discussed above andour continued focus on controlling costs during fiscal 2003, we returned toprofitability in the third quarter of fiscal 2003 and have been profitable ineach of the four subsequent quarters.

As discussed in more detail below, our gross marginincreased from 43.1% for the nine months ended June 30, 2003 to 47.0% forthe nine months ended June 30, 2004. The increase is attributable toefficiencies realized from our contract manufacturing initiative as well ascost management actions implemented throughout fiscal 2003 and favorableproduct and channel mix.

As a percentage ofrevenue, selling, general and administrative expenses decreased from 34.2% forthe nine months ended June 30, 2003 to 31.7% for the nine months ended June 30,2004. The decrease is attributable primarily to the impact of cost savingsactions taken during fiscal 2003 and 2004, partially offset by an increase inexpenses related to the acquisition of Expanets.

***Increase in Cash and Cash Equivalents and DebtReduction***

As more fully discussed in “Liquidity and CapitalResources,” we have been focused on increasing our cash and cash equivalentsand generating positive net cash from continuing operating activities. Cash andcash equivalents have increased from $597 million as of September 30, 2002to $1,523 million as of June 30, 2004. During fiscal 2003, we leveragedimprovements in our management of accounts receivable and inventory to generate$169 million in net cash from operating activities for continuing operations. Wegenerated $355 million of net cash from operating activities for continuingoperations during the nine months ended June 30, 2004, and expect to havepositive operating cash flow for the full fiscal year.

We have also been focusingon reducing our debt, particularly in relation to our cash and cash equivalents.As of June 30, 2003, our debt exceeded our cash and cash equivalents by$150 million and as 

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of June 30,2004, our cash and cash equivalents exceeded our debt by $939 million, animprovement of $1,089 million.

***Current and Future Profitability and its Effect onDeferred Tax Assets***

As of June 30, 2004, we had $431 million in netdeferred tax assets resulting from tax credit carryforwards, net operatinglosses and other deductible temporary differences, which are available toreduce taxable income in future periods. This amount is net of an $802 millionvaluation allowance, which was calculated in accordance with the provisions ofStatement of Financial Accounting Standard No. 109, “Accounting for IncomeTaxes.” We intend to maintain a valuation allowance until sufficient positiveevidence exists to support its reversal. 

We continue to analyze ourcurrent and future profitability and the probability of the utilization of ourdeferred tax assets in future periods as a result of profitable operations. Ifwe continue to be profitable, we may be required to reverse some or all of thedeferred tax asset valuation allowance beginning as early as the fourth quarterof fiscal 2004.

**Consolidated Results of Continuing Operations**

As a result of the sale ofour Connectivity Solutions business in the second and third quarters of fiscal2004, our results of operations for the three and nine months ended June 30,2003, have been restated to reflect the results of Connectivity Solutions as adiscontinued operation. In addition, our results for the three and nine monthsended June 30, 2004 include the results generated by the businesses weacquired from Expanets that sell Avaya products and services from the date ofacquisition on November 25, 2003. The portions of the Expanets’ businessthat distributed non-Avaya offerings, which we divested in the first and secondquarters of fiscal 2004, have been included in discontinued operations.

***Three Months Ended June 30, 2004 Compared to ThreeMonths Ended June 30, 2003***

Thefollowing table sets forth certain line items from our Consolidated Statementsof Operations as a percentage of revenue for the periods indicated: 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Change** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|
| ** **                                             | ** ** | **2004**                                        | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                             | ** ** | **(dollars in millions)**             | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Revenue                                           |       | $                                               | 769        |       | 75.7       | % | $ | 724 |   | 77.9 | % | $ | 45 |   | 6.2 | % |
| Non-U.S. Revenue                                       |       | 247                                             |       | 24.3       |       | 205 |   | 22.1 |   | 42 |   | 20.5 |   |
| Total revenue                                          |       | 1,016                                           |       | 100.0      |       | 929 |   | 100.0 |   | 87 |   | 9.4 |   |
| Costs                                                  |       | 528                                             |       | 52.0       |       | 525 |   | 56.5 |   | 3 |   | 0.6 |   |
| Gross margin                                           |       | 488                                             |       | 48.0       |       | 404 |   | 43.5 |   | 84 |   | 20.8 |   |
| Operating  expenses:                                   |       |                                            |       |       |       |   |   |   |   |   |   |   |   |
| Selling, general and administrative                    |       | 307                                             |       | 30.2       |       | 315 |   | 33.9 |   | (8 | ) | (2.5 | ) |
| Research and development                               |       | 89                                              |       | 8.8        |       | 85 |   | 9.1 |   | 4 |   | 4.7 |   |
| Total operating  expenses                              |       | 396                                             |       | 39.0       |       | 400 |   | 43.0 |   | (4 | ) | (1.0 | ) |
| Operating income                                       |       | 92                                              |       | 9.0        |       | 4 |   | 0.5 |   | 88 |   | 2,200.0 |   |
| Other income  (expense), net                           |       | (11                                             | )          | (1.1       | )          | 18 |   | 1.9 |   | (29 | ) | (161.1 | ) |
| Interest expense                                       |       | (14                                             | )          | (1.3       | )          | (21 | ) | (2.3 | ) | 7 |   | 33.0 |   |
| Income from  continuing operations before income taxes |       | 67                                              |       | 6.6        |       | 1 |   | 0.1 |   | 66 |   | 6,600.0 |   |
| Provision for  income taxes                            |       | 9                                               |       | 0.9        |       | 4 |   | 0.4 |   | 5 |   | 125.0 |   |
| Income (loss) from  continuing operations              |       | $                                               | 58         |       | 5.7        | % | $ | (3 | ) | (0.3 | )% | $ | 61 |   | 2,033.3 | % |

 

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***Revenue***—Theincrease in revenue in the third quarter of fiscal 2004, as compared with thethird quarter of fiscal 2003, occurred in both the U.S. and non-U.S. regions,and in all three segments. In the U.S., the increases were primarily due togrowth in IP telephony-related revenue, increased implementation andprofessional service revenue and Expanets’ revenue. In the non-U.S. regions,the increases primarily occurred in the Europe / Middle East / Africa region,especially in our Enterprise Communications Group, or ECG, segment.

***Costs and GrossMargin***—Our cost of products consists primarily ofmaterials and components. Our cost of services consists primarily of labor,parts and services overhead. Total costs decreased in the third quarter offiscal 2004 as compared with the same period of fiscal 2003, and gross marginpercentage increased by 4.5 percentage points. Gross margin increased acrossall of our operating segments. Gross margin on products increased to 54.0% inthe third quarter of fiscal 2004 from 50.3% for the same period in fiscal 2003reflecting manufacturing efficiencies gained through our outsourcingagreements, continuing cost reductions, increased volume, favorable productmix, and a lower level of discounts. Services’ gross margin increased to 42.2%in the third quarter of fiscal 2004 from 36.9% for the same quarter of fiscal2003 due to continuing cost reductions, benefits from the Expanets acquisition,increased volume and improved utilization of the technician workforce. Ourproduct offerings benefited the most from the increase in U.S. sales, whichtypically have higher margins than sales outside the U.S.

See “Segment Results” for a discussion of segmentrevenue and operating income (loss).

***Selling, Generaland Administrative***—Our selling, general andadministrative expenses, or SG&A, consist primarily of salaries,commissions, benefits and other items. The decrease in SG&A was primarilydue to lower IT and networking expenses, including telecommunication andcomputer related service costs, which reflect a favorable renegotiatedagreement for the outsourcing of certain IT functions and lower costsassociated with our marketing function. Additionally, the third quarter offiscal 2003 included a $7 million charge for business restructuring activities,while there was no similar charge in the current quarter. Partially offsettingthese decreases were increases in expense for incentive compensation programsand employee benefit costs, as well as higher sales expenses, primarilyattributable to the acquisition of Expanets in the first quarter of fiscal2004.

***Other Income(Expense), Net***—The change in other income(expense), net was primarily attributable to a $21 million loss associated withthe repurchase of $132 million aggregate principal amount of our 111¤8% Senior SecuredNotes, or senior secured notes, in the third quarter of fiscal 2004. Additionally,the third quarter of fiscal 2003 included a $14 million gain on the sale ofassets.

***Interest Expense***—The $7 milliondecrease in interest expense is primarily a result of our redemption of $224million aggregate principal amount of our senior secured notes, in March 2004,and the repurchase of $132 million aggregate principal amount of senior securednotes, in a series of open market transactions, during the third quarter offiscal 2004. Interestexpense for the third quarter of fiscal 2004 includes $10 million ofinterest on our senior secured notes due April 2009. In addition, werecorded interest expense of $4 million for the amortization of debt discount,premium and deferred financing costs related primarily to our Liquid YieldOptionTM Notes, or LYONs, which were issued in October 2001.

Interest expense for the same period in fiscal 2003primarily included $15 million of interest expense on $440 million aggregateprincipal amount of our senior secured notes for the entire period, and an add-onpublic offering of $200 million aggregate principal amount of senior securednotes, which occurred in the third quarter of fiscal 2003, and $6 million ofamortization of debt discount, premium and deferred financing costs relatedprimarily to our LYONs.

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***Provision for Income Taxes****—*The provisionof $9 million recorded in the third quarter of fiscal 2004 relates to state andforeign income taxes. The provision of $4 million recorded in the third quarterof fiscal 2003 included a $4 million provision for state and foreign incometaxes and a $2 million provision for other adjustments, partially offset by a$2 million benefit related to a favorable audit settlement.

**Nine Months Ended June 30,2004 Compared to Nine Months Ended June 30, 2003**

Thefollowing table sets forth certain line items from our Consolidated Statementsof Operations as a percentage of revenue for the periods indicated:
| ** **                                                    | ** ** | **Nine Months Ended  June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|------------|------------|
| ** **                                                    | ** ** | **2004**                                       | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                                    | ** ** | **(dollars in millions)**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Revenue                                                  |       | $                                              | 2,267      |       | 75.7       | % | $ | 2,157 |   | 76.4 | % | $ | 110 |   | 5.1 | % |
| Non-U.S. Revenue                                              |       | 726                                            |       | 24.3       |       | 668 |   | 23.6 |   | 58 |   | 8.7 |   |
| Total revenue                                                 |       | 2,993                                          |       | 100.0      |       | 2,825 |   | 100.0 |   | 168 |   | 5.9 |   |
| Costs                                                         |       | 1,586                                          |       | 53.0       |       | 1,607 |   | 56.9 |   | (21 | ) | (1.3 | ) |
| Gross margin                                                  |       | 1,407                                          |       | 47.0       |       | 1,218 |   | 43.1 |   | 189 |   | 15.5 |   |
| Operating expenses:                                           |       |                                           |       |       |       |   |   |   |   |   |   |   |   |
| Selling, general and administrative                           |       | 948                                            |       | 31.7       |       | 966 |   | 34.2 |   | (18 | ) | (1.9 | ) |
| Research and development                                      |       | 255                                            |       | 8.5        |       | 259 |   | 9.2 |   | (4 | ) | (1.5 | ) |
| Total operating  expenses                                     |       | 1,203                                          |       | 40.2       |       | 1,225 |   | 43.4 |   | (22 | ) | (1.8 | ) |
| Operating income  (loss)                                      |       | 204                                            |       | 6.8        |       | (7 | ) | (0.3 | ) | 211 |   | 3,014.3 |   |
| Other expense,  net                                           |       | (24                                            | )          | (0.8       | )          | (36 | ) | (1.3 | ) | 12 |   | 33.3 |   |
| Interest expense                                              |       | (54                                            | )          | (1.8       | )          | (57 | ) | (2.0 | ) | 3 |   | 5.3 |   |
| Income (loss)  from continuing operations before income taxes |       | 126                                            |       | 4.2        |       | (100 | ) | (3.6 | ) | 226 |   | 226.0 |   |
| Provision  (benefit) for income taxes                         |       | (65                                            | )          | (2.2       | )          | 83 |   | 2.9 |   | (148 | ) | (178.3 | ) |
| Income (loss) from  continuing operations                     |       | $                                              | 191        |       | 6.4        | % | $ | (183 | ) | (6.5 | )% | $ | 374 |   | 204.4 | % |

 

***Revenue***—Ourrevenue for the nine months ended June 30, 2004, increased across all ofour operating segments as compared with the same period in fiscal 2003. From ageographic perspective, a majority of this increase occurred in the U.S.,however, non-U.S. revenue also increased compared to the same period of theprior year. Revenue increases were primarily attributable to stronger salesvolumes related to IP telephony systems, software, and applications, as well ashigher maintenance contract revenue associated with the acquisition of Expanets.These increases were partially offset by declines in traditional telephony systemsand per occurrence maintenance.

***Costs and GrossMargin***—Our cost of products consists primarily ofmaterials and components. Our cost of services consists primarily of labor,parts and service overhead. For the nine months ended June 30, 2004, total costs decreased while gross margin percentageincreased to 47.0% as compared with 43.1% for the same period in fiscal 2003. Grossmargin increased for both our product and service offerings. Gross margin onproducts increased to 53.4% for the nine months ended June 30, 2004 from49.9% for the same period in fiscal 2003 reflecting manufacturing efficienciesgained through our contract manufacturers, continuing cost reductions, andfavorable product mix as sales of applications and software rose as a percentageof total revenue. Services’ gross margin increased to 40.7% for the nine monthsended June 30, 2004 from 36.6% due to continuing cost reductions andimproved utilization of the technician workforce. Our product offeringsbenefited the most from the increase in U.S. sales, which typically have highermargins than sales made outside of the U.S.

See “Segment Results” for a discussion of segmentrevenue and operating income (loss).

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***Selling, Generaland Administrative***—Our selling, general andadministrative expenses consist primarily of salaries, commissions, benefitsand other items. The decrease wasprimarily due to lower compensation expense resulting from fewer employees, andlower IT and networking expenses, including telecommunication and computerrelated service costs, which reflect a favorable renegotiated agreement for theoutsourcing of certain IT functions. These decreases were partially offset byhigher sales expenses, primarily attributable to the acquisition of Expanets inthe first quarter of fiscal 2004, and by increases in expense for incentivecompensation programs and employee benefit costs.

***Other Income(Expense), Net***—For the nine months ended June 30,2004, other income (expense), net was primarily attributable to a $42 millionloss associated with the redemption of $224 million aggregate principal amountof our senior secured notes in the second quarter of fiscal 2004 and therepurchase of $132 million aggregate principal amount of our senior securednotes in the third quarter of fiscal 2004. For the nine months ended June 30,2003, other income (expense), net was primarily attributable to a net loss of$34 million on the extinguishment of a portion of our LYONs and a $25 millioncharge associated with our share of the Lucent securities litigation settlement.These losses in fiscal 2003 were partially offset by a gain of $14 million onthe sale of assets.

***Interest Expense***—The $3 milliondecrease in interest expense is primarily a result of our redemption of $224million aggregate principal amount of our senior secured notes, in March 2004,and the repurchase of $132 million aggregate principal amount of senior securednotes, in a series of open market transactions, during the third quarter offiscal 2004. Interest expense for the nine months of fiscal 2004 includes $45million of interest on our senior secured notes. In addition, we recordedinterest expense of $12 million for the amortization of debt discount, premiumand deferred financing costs related primarily to our LYONs, which were issuedin October 2001.

Interest expense for the same period in fiscal 2003primarily included $40 million of interest expense on $440 million aggregateprincipal amount of our senior secured notes for the entire period, and anadd-on public offering of $200 million aggregate principal amount of seniorsecured notes, which occurred in the third quarter of fiscal 2003, and $17million of amortization of both debt discount and deferred financing costsrelated primarily to our LYONs.

***Provision (Benefit) for Income Taxes***—Forthe nine months ended June 30, 2004, the $65 million income tax benefitincluded an $89 million income tax benefit related to the favorable settlementof certain tax matters for periods prior to the distribution in accordance withthe Tax Sharing Agreement between us and Lucent, partially offset by a $20million provision related to state and foreign income taxes and a $4 millionprovision for other adjustments. For the nine months ended June 30, 2003,the $83 million provision included an $83 million provision to increase thedeferred tax asset valuation allowance, a $13 million provision for stateand foreign income taxes, a $1 million provision for other adjustments, a $4 millionbenefit related to a favorable audit settlement and a $10 million benefitrelated to the extinguishment in January 2003 of a portion of our LYONs. The$83 million provision for the increase in the deferred tax asset valuationallowance reflects the difference between the actual and expected gainassociated with the exchange offer of LYONs, which was completed in the secondquarter of fiscal 2003.

**Results from Discontinued Operations**

As a result of the divestitures discussed above, wehave classified our Connectivity Solutions business and the portions of theExpanets business that previously distributed non-Avaya products asdiscontinued operations. The following table presents the operating results ofthe businesses included in income from discontinued operations, as well as thegain recognized on the sale of Connectivity Solutions in the second and thirdquarters of fiscal 2004. The results of operations for Connectivity Solutionsfor the nine months ended June 30, 2004 include a charge of $48 millioncomprised of a $24 million pension and postretirement 

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curtailment loss and a $24million settlement loss recognized upon the transfer of pension and postretirementbenefit assets and liabilities to CommScope.

Theamounts presented for Expanets for the nine months ended June 30, 2004,represent the results generated by the portion of the Expanets business thatpreviously distributed non-Avaya products from the date of acquisition on November 25,2003, through June 30, 2004. We divested this entire portion of theExpanets business as of June 30, 2004.
| ** **                                                     | ** ** | **Three Months  Ended  June 30,** | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **  2004  **            | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                     | ** ** | **(dollars in millions)**         | ** ** |
| Revenue from  discontinued operations:                         |       |                                        |       |                                       |       |   |   |   |   |   |   |
| Connectivity Solutions                                         |       |                                        | $          | 1                                          |       |   | $ | 143 |   | $ | 168 |   | $ | 395 |   |
| Expanets                                                       |       |                                        | —     |                                       |       | — |   | 8 |   | — |   |
| Total revenue from discontinued operations                     |       |                                        | $          | 1                                          |       |   | $ | 143 |   | $ | 176 |   | $ | 395 |   |
| Income before income taxes from discontinued operations:       |       |                                        |       |                                       |       |   |   |   |   |   |   |
| Connectivity Solutions:                                        |       |                                        |       |                                       |       |   |   |   |   |   |   |
| Results of operations                                          |       |                                        | $          | —                                     |       |   | $ | 12 |   | $ | (72 | ) | $ | 33 |   |
| Gain on sale                                                   |       |                                        | 3          |                                       |       | — |   | 84 |   | — |   |
| Total income before income taxes for Connectivity  Solutions   |       |                                        | 3          |                                       |       | 12 |   | 12 |   | 33 |   |
| Expanets                                                       |       |                                        | —     |                                       |       | — |   | (6 | ) | — |   |
| Total income  before income taxes from discontinued operations |       |                                        | $          | 3                                          |       |   | $ | 12 |   | $ | 6 |   | $ | 33 |   |

 

**SegmentResults**

***Operating Segments***

As described previously, we have accounted for theresults of operations of Connectivity Solutions as a discontinued operation. Thisbusiness was previously disclosed as a separate operating segment. Accordingly,the segment data presented below has been adjusted to exclude the results ofConnectivity Solutions and to reallocate Connectivity’s portion ofcorporate-related expenses to the remaining operating segments.

Our three operating segments are the EnterpriseCommunications Group, or ECG, Small and Medium Business Solutions, or SMBS, andServices. During the first quarter of fiscal 2004,we moved our professional service organization from ECG to the Services segmentto expand the organization’s focus on these services and expansion into amulti-vendor environment. We also allocated a portion of theresults attributed to our third-party financing arrangement from ECG to SMBSbased on the relative contribution of the arrangement to the sale of eachsegment’s products. Accordingly, we have restated the priorperiod amounts to reflect these changes. We describe our three operating segments as follows:

·       *ECG*—Our ECG segment develops, markets andsells communications products and applications primarily to our largeenterprise customers. Our primary offerings for this segment include IPtelephony systems, traditional voice communications systems, multi-mediacontact center infrastructure and applications in support of customerrelationship management, unified communications applications, and appliances,such as telephone sets.

·       *SMBS*—Our SMBS segment develops, marketsand sells communications products and applications for small and medium-sizedbusinesses including IP telephony systems, traditional voice communicationssystems, and unified communication and contact center applications. Traditional

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voice communicationssystems designed for small and medium-sized businesses are also known as keyand hybrid telephony systems.

·       *Services*—Our Services segment offers acomprehensive portfolio of global services that enable customers to plan,design, build and manage their communications networks. Services’ operatingresults also include our professional services organization that providesservices required to customize communication application solutions forindividual customer needs.

**Three Months Ended June 30,2004 Compared to Three Months Ended June 30, 2003**

Thefollowing tables set forth revenue and operating income (loss) by segment forthe third quarter of fiscal 2004 and 2003:
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|------------|------------|
| ** **                           | ** ** | **2004**                                        | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                             |       |                                            |       |       |       |   |   |   |   |   |   |   |   |
| Enterprise  Communications Group     |       | $                                               | 439        |       | 43.2       | % | $ | 396 |   | 42.6 | % | $ | 43 |   | 10.9 | % |
| Small and Medium  Business Solutions |       | 67                                              |       | 6.6        |       | 59 |   | 6.4 |   | 8 |   | 13.6 |   |
| Services                             |       | 510                                             |       | 50.2       |       | 474 |   | 51.0 |   | 36 |   | 7.6 |   |
| Total revenue                        |       | $                                               | 1,016      |       | 100.0      | % | $ | 929 |   | 100.0 | % | $ | 87 |   | 9.4 | % |

 
| ** **                           | ** ** | **Three Months Ended  June 30,**          | ** ** | ** **                                               | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                           | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** | **$ Change** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**                      | ** ** | ** **                                               | ** ** |
| Operating Income (Loss):             |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Enterprise  Communications Group     |       |                                                     | $          | 11                                                       |       |   |   | $ | (24 | ) |   |   | $ | 35 |   |   |
| Small and Medium  Business Solutions |       |                                                     | 6          |                                                     |       |   | — |   |   |   | 6 |   |   |
| Services                             |       |                                                     | 68         |                                                     |       |   | 42 |   |   |   | 26 |   |   |
| Total segment operating income       |       |                                                     | 85         |                                                     |       |   | 18 |   |   |   | 67 |   |   |
| Corporate:                           |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Business restructuring charges, net  |       |                                                     | —     |                                                     |       |   | (7 | ) |   |   | 7 |   |   |
| Other unallocated amounts            |       |                                                     | 7          |                                                     |       |   | (7 | ) |   |   | 14 |   |   |
| Total operating  income              |       |                                                     | $          | 92                                                       |       |   |   | $ | 4 |   |   |   | $ | 88 |   |   |

 

**ECG**

ECG’s revenue increased by $43 million in the thirdquarter of fiscal 2004 as compared with the third quarter of fiscal 2003 dueprimarily to stronger sales growth rates internationally. Revenue from IPtelephony systems, software, and applications continued to grow, more thanoffsetting the declines in our traditional telephony systems business. Thischange in product mix reflects the transition our customers are making toIP-based telecommunication systems. In the third quarter of fiscal 2004, ECG’ssales through the direct channel increased to 49.4% of ECG’s total revenue from49.1% in the third quarter of fiscal 2003.

ECG had operating incomeof $11 million in the third quarter of fiscal 2004, as compared to an operatingloss of $24 million in the third quarter of fiscal 2003. This improvement wasprimarily attributable to an increase in gross margin resulting fromefficiencies gained in our manufacturing processes related to our outsourcingagreements, continued improvements in product cost reductions, a more favorableproduct mix with respect to software and applications, and lower discountlevels. R&D expenses decreased due primarily to savings associated with ourbusiness restructuring initiatives related to 

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headcountand a continued focus on core initiatives. SG&A expenses increased as aresult of absorbing the increased sales headcount associated with the Expanetsacquisition.

**SMBS**

SMBS’ revenue increased by $8 million in the thirdquarter of fiscal 2004 as compared with the same quarter of fiscal 2003 dueprimarily to growth in sales of IP Office, our IP telephony offering for thesmall and medium-sized business market, in the Europe/Middle East/Africa andAsia Pacific regions. Revenue for the third quarter of fiscal 2004 includesrevenue from Expanets, which was acquired on November 25, 2003. SMBS’sales are mainly generated through the indirect channel.

SMBS generated operatingincome of $6 million in the third quarter of fiscal 2004 compared to breakevenin the same quarter of fiscal 2003. This improvement was due primarily to anincrease in gross margin resulting from manufacturing efficiencies gainedthrough outsourcing of manufacturing and favorable product mix. SG&Aexpenses increased due to incremental sales expenses associated with theintegration of the Expanets’ business, as well as enhancements made to the salespresence outside of the U.S.

**Services**

Services’ revenue increased by $36 million in thethird quarter of fiscal 2004 as compared with the third quarter of fiscal 2003.The contract-related business growth primarily resulted from the Expanetsacquisition as well as the ongoing initiatives to improve take rates, renewalrates and retention rates for maintenance contracts with some contracts havingbeen renegotiated to change the term, scope and associated pricing on renewalor extension. Revenue from the transactional based businesses not associatedwith a long-term maintenance contract remained flat. A decline in peroccurrence (time and materials based) maintenance revenue was essentiallyoffset by increases in revenues from implementation and professional services,primarily driven by increased direct sales of ECG products in the U.S. versusthe same period in the prior year.

Services generatedoperating income of $68 million in the third quarter of fiscal 2004, which isan increase of $26 million as compared with the same quarter of fiscal 2003 dueprimarily to an improvement in gross margin. This increase reflects continuedcost reduction initiatives in the first half of fiscal 2004, improvedutilization of our technician workforce as a result of the integration ofExpanets and an adjustment to a long-term contract loss reserve due tofavorable projected performance, partially offset by a write-down of inventory.The acquisition of Expanets contributed to a stronger presence in the U.S.direct channel. Sales through our direct channel consequently increased,representing 89.1% in the third quarter of fiscal 2004 as compared with 84.5%in the same period of fiscal 2003, which favorably impacted gross margin. SG&Aexpenses increased primarily due to additional selling expense associated withthe integration of Expanets. R&D expenses decreased slightly in comparisonto the same period in the prior year.

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**Nine Months Ended June 30,2004 Compared to Nine Months Ended June 30, 2003**

Thefollowing tables set forth revenue and operating income (loss) by segment forthe nine months ended June 30, 2004 and 2003:
| ** **                           | ** ** | **Nine Months Ended  June 30,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------------------------------------------|------------|------------|------------|
| ** **                           | ** ** | **2004**                                       | ** ** | **2003**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                           | ** ** | **(dollars in millions)**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                             |       |                                           |       |       |       |   |   |   |   |   |   |   |   |
| Enterprise  Communications Group     |       | $                                              | 1,283      |       | 42.9       | % | $ | 1,211 |   | 42.9 | % | $ | 72 |   | 5.9 | % |
| Small and Medium  Business Solutions |       | 196                                            |       | 6.5        |       | 174 |   | 6.2 |   | 22 |   | 12.6 |   |
| Services                             |       | 1,510                                          |       | 50.5       |       | 1,440 |   | 50.9 |   | 70 |   | 4.9 |   |
| Other unallocated  revenue           |       | 4                                              |       | 0.1        |       | — |   | — |   | 4 |   | N/A |   |
| Total revenue                        |       | $                                              | 2,993      |       | 100.0      | % | $ | 2,825 |   | 100.0 | % | $ | 168 |   | 5.9 | % |

 
| ** **                            | ** ** | **Nine Months Ended  June 30,** | ** ** | ** **                                                           | ** ** |
|---------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                            | ** ** | **   2004   **   | ** ** | **     2003     ** | ** ** | **$ Change** | ** ** |
| ** **                            | ** ** | **(dollars in millions)**            | ** ** | ** **                                                           | ** ** |
| Operating Income (Loss):              |       |                                           |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Enterprise  Communications Group      |       |                                           | $          | (1                                                                   | )          |   |   | $ | (108 | ) |   |   | $ | 107 |   |   |
| Small and Medium  Business Solutions  |       |                                           | 17         |                                                                 |       |   | (3 | ) |   |   | 20 |   |   |
| Services                              |       |                                           | 184        |                                                                 |       |   | 123 |   |   |   | 61 |   |   |
| Total segment operating income        |       |                                           | 200        |                                                                 |       |   | 12 |   |   |   | 188 |   |   |
| Corporate:                            |       |                                           |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Business restructuring reversals, net |       |                                           | 1          |                                                                 |       |   | 3 |   |   |   | (2 | ) |   |
| Other unallocated amounts             |       |                                           | 3          |                                                                 |       |   | (22 | ) |   |   | 25 |   |   |
| Total operating  income (loss)        |       |                                           | $          | 204                                                                  |       |   |   | $ | (7 | ) |   |   | $ | 211 |   |   |

 

**ECG**

ECG’s revenue increased by $72 million for the ninemonths ended June 30, 2004 as compared with the same period of fiscal 2003due primarily to stronger sales volume in the U.S. and internationally, ofwhich international revenue grew at a faster rate than domestic revenue, butrepresented a smaller percentage of overall sales. Revenue from IP telephonysystems, software, and applications continued to show growth, more thanoffsetting the expected declines in the traditional telephony systems business.This change in product mix reflects the transition our customers are making toIP-based telecommunication systems. Revenue for the nine months ended June 30,2004 includes revenue from Expanets. In the first nine months of fiscal 2004,ECG’s sales through the direct channel decreased slightly to 48.7% of ECG’srevenue from 49.0% in the first nine months of fiscal 2003.

ECG’s operating loss forthe nine months ended June 30, 2004 was $1 million as compared with a lossof $108 million for the nine-month period ended June 30, 2003. This $107million improvement was primarily attributable to an increase in gross marginresulting from efficiencies gained in our manufacturing processes related toour outsourcing agreements, continued improvements in product cost reductions,and a more favorable product mix with respect to software and applications. SG&Aand R&D expenses have been reduced due primarily to savings associated withour business restructuring initiatives related to headcount and a continuedfocus on core initiatives.

**SMBS**

SMBS’ revenue for the nine months ended June 30,2004, increased by $22 million in comparison to the same period in fiscal 2003due primarily to growth in sales of IP Office, our IP telephony offering for 

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the small and medium-sizedbusiness market, in the Europe/Middle East/Africa and Asia Pacific regions. Revenuefor the first nine months of fiscal 2004 includes revenue from Expanets. SMBS’sales are mainly generated through the indirect channel.

SMBS generated operatingincome of $17 million for the nine months ended June 30, 2004, compared toan operating loss of $3 million in the same period of fiscal 2003. Thisimprovement was due primarily to an increase in gross margin resulting frommanufacturing efficiencies gained through outsourcing of manufacturing andfavorable product mix. SG&A expense increased due to incremental salesexpenses associated with the integration of the Expanets business, as well asenhancements made to the sales presence outside of the U.S.

**Services**

Services’ revenue increased $70 million for the ninemonths ended June 30, 2004, as compared with the same period of fiscal2003. The contract-related business growth primarily resulted from the Expanetsacquisition, as well as the ongoing initiatives to improve take rates, renewalrates and retention rates for maintenance contracts with some contracts havingbeen renegotiated to change the term, scope and associated pricing on renewalor extension. Revenue from the transactional based businesses not associatedwith a long-term maintenance contract experienced a decline in the threequarters of fiscal 2004 compared to same period in the previous year. Additionally,per occurrence (time and materials based) maintenance revenue declined ascustomers continued cost reduction initiatives that included decreasing theamount of equipment adds, moves and changes. The implementation business alsoexperienced slightly lower revenue compared to the same period in the previousyear primarily due to lower volume implementation of data products.

Services’ operating incomeincreased by $61 million in the three quarters of fiscal 2004 as compared withthe with the same period of fiscal 2003 due primarily to an improvement ingross margin. This increase reflects continued cost reduction initiatives inthe first half of fiscal 2004, improved utilization of our technician workforceas a result of the integration of Expanets and an adjustment to a long-termcontract loss reserve due to favorable projected performance, partially offsetby a write-down of inventory. The acquisition of Expanets contributed to astronger presence in the U.S. direct channel. Sales through our direct channelconsequently increased, representing 88.1% in the first nine months of fiscal2004 as compared with 84.4% in the same period of fiscal 2003, favorablyimpacting gross margin. SG&A expenses increased primarily due to additionalselling expense associated with the integration of Expanets. R&D expensesdecreased slightly in comparison to the same period in the prior year.

**Liquidity and Capital Resources**

***Historical Sources and Uses of Cash From ContinuingOperations***

***Background***

During fiscal 2003, our primary liquidity goals wereto continue to generate net cash from operating activities and increase ourcash and cash equivalents. Our cash and cash equivalents increased each quarterin fiscal 2003, improving from $597 million at September 30, 2002 to$1,192 million at September 30, 2003. The $595 million increase in ourcash and cash equivalents resulted primarily from an increase in net cashprovided by operating and financing activities from continuing operations of$169 million and $421 million, respectively. Our $169 million of net cash fromcontinuing operating activities for fiscal 2003 was attributable primarily tocontinued improvement in the management of accounts receivable and inventory,reduced cash needs to fund our operations as a result of significantrestructuring actions taken in prior years, and reduced cash needs to fundbusiness restructuring obligations than in prior years.

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As part of our liquidity strategy, during fiscal 2003we supplemented our efforts to generate net cash flow from operating activitieswith two external financing transactions. A portion of the proceeds of eachtransaction was used to address a specific cash need and the remaining proceedscontributed to the increase in our cash and cash equivalents as of September 30,2003. Our $421 million of net cash provided by financing activities fromcontinuing operations for fiscal 2003 was attributable primarily to the netproceeds of $212 million from the add-on offering of senior secured notes in May 2003and $349 million of net proceeds from a public offering of common stock in September 2003.We used $156 million of the net proceeds from the senior secured note offeringto repurchase a portion of our LYONs and $105 million of the net proceeds ofthe common stock offering to fund a voluntary contribution to our pension plan.

During fiscal 2004, wehave continued to focus on generating net cash flow from continuing operations.In addition, we are seeking to reduce the amount of our debt, particularly inrelation to the amount of cash and cash equivalents.

***Sources and Uses ofCash for the Nine Months Ended June 30, 2004***

Cash increased from $1,192million as of September 30, 2003 to $1,523 million as of June 30,2004.

***Operating Activities***

Our net cashprovided by operating activities from continuing operations was $355 millionfor the nine months ended June 30, 2004, compared with $124 million forthe nine months ended June 30, 2003. Below is a list of the moresignificant items that contributed to our net cash provided by operatingactivities from continuing operations for the nine months ended June 30,2004:

·       *Continued improvement in the management of accountsreceivable*—We have continued to see the benefits of the processimprovements that we implemented in fiscal 2003 that have simplified ourbilling process and strengthened our collections of accounts receivable. Ourdays sales outstanding in accounts receivable were 58, 55 and 55 days for thefirst, second and third quarters, respectively, of fiscal 2004.

·       *Decrease in restricted cash*—We held lesscash in restricted accounts as of June 30, 2004 primarily as a result ofthe release of $14 million of collateral associated with a real estate location.The remainder of the decrease was associated with our improving financialcondition, which allowed us to uncollateralize certain arrangements.

·       *Federal income tax settlement*—We receivedcash from Lucent of $37 million in the second quarter of fiscal 2004 resultingfrom the favorable resolution of federal income tax audit matters for the years1990 through 1998 and certain state tax matters, which were prior to ourseparation from Lucent.

Partially offset bythe following significant items:

·       *Higher bonuses paid*—The current periodincludes payments of $67 million to employees in December 2003 forcompensation related primarily to the incentive compensation program, comparedwith $2 million in December 2002.

·       *Change in debt level*—We made interestpayments of $70 million on our senior secured notes during the nine monthsended June 30, 2004, as compared with $49 million of interest during thesame period in fiscal 2003. The $21 million increase was as a result of the$200 million add-on senior secured notes offering sold in May 2003, andaccelerated payments related to the repurchases of our senior secured notesduring the third quarter of fiscal 2004.

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***Investing Activities***

Net cash provided byinvesting activities from continuing operations was $63 million for the ninemonths ended June 30, 2004, compared with net cash used for investingactivities from continuing operations of $38 million for the nine months ended June 30,2003. The current period’s activities primarily include net cash proceeds of$256 million from the sale of our Connectivity Solutions business. Thisincrease in cash was partially offset by $88 million used for capitalexpenditures and $121 million used for acquisitions, of which $114 million wasused to acquire substantially all of the assets and certain liabilities ofExpanets. The $114 million is net of $3 million of cash acquired.

***Financing Activities***

Net cash used forfinancing activities from continuing operations was $70 million for the ninemonths ended June 30, 2004, compared with net cash provided by financingactivities from continuing operations of $110 million for the nine months endedJune 30, 2003. Net cash used for financing activities from continuingoperations consisted primarily of $249 million to redeem 35% of our seniorsecured notes during the second quarter of fiscal 2004, and $155 million torepurchase another portion of our senior secured notes in a series of openmarket transactions. These uses of cash were partially offset by $249 millionin net proceeds received in connection with the sale of 14,039,481 shares ofour common stock in February 2004 and $85 million of cash received inconnection with the issuance of common stock under our employee stock purchaseplan and stock option plans. We used the net proceeds from the February 2004sale of our common stock to fund the redemption of a portion of our seniorsecured notes, as described above.

***Cash Flows of Discontinued Operations***

Net cash used indiscontinued operations of $21 million for the nine months ended June 30,2004, was attributed to operating activities and consisted of $15 millionrelated to Connectivity Solutions and $6 million attributed to the portion ofthe Expanets business divested subsequent to the acquisition. Net cash providedby discontinued operations of $41 million in the nine months ended June 30,2003, was attributed to the operating activities of Connectivity Solutions.

**Future Cash Requirements and Sources of Cash**

***Future CashRequirements***

Our primary future cash requirements will be to fundworking capital, capital expenditures, debt service, employee benefitobligations, strategic acquisitions, and our business restructuringliabilities.

Specifically, ourprimary cash requirements for the remainder of fiscal 2004 are as follows:

·       *Capital expenditures*—We expect to make cashpayments of approximately $31 million during the remainder of fiscal 2004 forcapital expenditures. We expect that more than half of our capital expendituresfor fiscal 2004 will be related to information technology investments.

·       *Acquisitions*—We have made cash payments ofapproximately $24 million associated with the Tata acquisition during thefourth quarter of fiscal 2004.

·       *Settlement Costs*—We expect to payplaintiff’s counsel fees of approximately $22 million in connection with thesettlement of the Year 2000 actions.

Our primary cashrequirements for fiscal 2005 include:

·       As more fully describedunder “Uncertainties Related to Our Liquidity and Capital Resources—LYONs Put,”we may have a significant cash requirement during the first quarter of fiscal2005 if a 

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significant portion of ourcurrently outstanding LYONs are put to us and we elect to satisfy such putobligation in cash.

·       If our performance meetsthe objectives required under our management incentive plan for fiscal 2004, wemay have significant cash requirements in the first quarter of fiscal 2005 inconnection with the payment of management incentives for fiscal 2004.

·       Wemay from time to time seek to retire additional amounts of our outstanding debtthrough cash purchases and/or exchanges for equity securities, in open marketpurchases, privately negotiated transactions or otherwise. Such repurchases orexchanges, if any, will depend on the prevailing market conditions, ourliquidity requirements, contractual restrictions and other factors. The amountsinvolved may be material.

·       Weexpect to make a cash payment of approximately $103 million associated with theacquisition of Spectel Plc, which is expected to close no later than the firstquarter of fiscal 2005.

·       Weexpect to make cash payments of approximately $14 million during fiscal 2005for costs related to our business restructuring initiatives. Estimated costscould differ from actual amounts.

·       Basedon our current amount of outstanding senior secured notes, we expect to make interestpayments of approximately $32 million.

·       Weexpect to make cash payments for capital expenditures in key areas.

***Future Sources of Cash***

***Internal Sources of Cash***

We expect our primary source of cash during the fourthquarter of fiscal 2004, in addition to our $1,523 million of cash and cashequivalents as of June 30, 2004, to be positive net cash provided byoperating activities. Weexpect that stabilization or growth in our revenues and continued focus onaccounts receivable and inventory management and cost containment will enableus to generate positive net cash from operating activities for the fourthquarter of fiscal 2004.

We believe that our existing cash and cash equivalentsand our net cash provided by operating activities during the fourth quarter offiscal 2004 will be sufficient to meet our future cash requirements describedabove, including any cash requirements related to the LYONs put in October 2004,our management incentive plan in December 2004 and for the acquisition ofSpectel.

Our existing cash and cashequivalents and net cash provided by operating activities may be insufficientif we face unanticipated cash needs such as the funding of a future acquisitionor other capital investment. Further, if we acquire a business in the futurethat has existing debt, our debt service requirements may increase, therebyincreasing our cash needs.

***Ability to Access External Financing***

If we do not generate sufficient cash from operationsor do not otherwise have sufficient cash and cash equivalents, we may need toincur additional debt or issue equity. In order to meet our cash needs we may,from time to time, borrow under our credit facility or issue other long- orshort-term debt or equity, if the market and the terms of our existing debtinstruments permit.

*AmendedCredit Facility.**  *As of June 30, 2004 and September 30,2003, there were no amounts outstanding under our credit facility, and we havenot borrowed under our credit facility since the second quarter of fiscal 2002.We believe our credit facility provides us with an important source of backupliquidity. Our credit facility expires in September 2005. In January 2004,we and the lenders under our five-

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year revolving creditagreement amended the credit facility to provide us with additional flexibilityto make acquisitions and repurchase our debt securities.

The credit facility contains covenants, including arequirement that we maintain certain financial covenants relating to a minimumamount of earnings before interest, taxes, depreciation and amortization, orEBITDA, adjusted for exclusions for certain business restructuring charges andrelated expenses and non-cash charges, or adjusted EBITDA, and a minimum ratioof adjusted EBITDA to interest expense.

For the four quarter period ending June 30, 2004,we were required to maintain a minimum adjusted EBITDA of $270 million and aratio of adjusted EBITDA to interest expense of 3.10 to 1. We were incompliance with all required covenants as of June 30, 2004, and expect tobe in compliance with all such covenants as of September 30, 2004.

Theamended credit facility requires us to maintain a ratio of consolidatedadjusted EBITDA to interest expense and consolidated adjusted EBITDA, each asadjusted for the closing of the sale of our Connectivity Solutions business,of:
| **For the Four Quarter Period Ended:** | ** ** | ** ** | ** ** | **Ratio of Adjusted  EBITDA to Interest  Expense** | ** ** | **Consolidated  Adjusted EBITDA** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | **(dollars in millions)**                                    | ** ** |
| June 30,  2004                                             |       |       | 3.10 to 1  |                                                                   |       |                                   | $          | 270 |   |   |
| September 30,  2004                                        |       |       | 3.40 to 1  |                                                                   |       |                                   | $          | 285 |   |   |
| Each four quarter period  thereafter                            |       |       | 3.20 to 1  |                                                                   |       |                                   | $          | 290 |   |   |

 

As a result of the January 2004 amendments to thecredit facility, we are permitted to use up to $455 million in cash to redeemor repurchase LYONs, other than pursuant to the October 31, 2004 put, solong as we hold unrestricted domestic cash and marketable securities of atleast $400 million immediately before and after such redemption or repurchase.As of June 30, 2004, we had used approximately $156 million in cashto repurchase LYONs and, as a result of the amendments to the credit facility,we have the ability under the amended credit facility to use an additional $299million in cash to repurchase LYONs, other than pursuant to the October 31,2004 put.

In connection with the October 31, 2004 LYONs putobligation described, the amended credit facility requires us to maintain, asof each day in the period commencing September 30, 2004 until the later of(a) the date that the put obligation under the LYONs is satisfied and (b) thedate upon which we deliver to the lenders under the amended credit facility acertificate certifying our compliance with the covenants included in theamended credit facility for the fiscal quarter ended September 30, 2004,liquidity of not less than $300 million on a pro forma basis as if the putobligation under the LYONs had been satisfied as of such day. For purposes ofthis calculation, liquidity is defined as the sum of the unused commitmentsunder our amended credit facility plus unrestricted domestic cash and marketablesecurities. To the extent we can satisfythis liquidity test, we may use cash to satisfy any put obligation with respectto the LYONs.

The credit facility was also amended to permit us to useup to $500 million in cash to prepay or repurchase long-term debt other thanthe LYONs so long as we hold unrestricted domestic cash and marketablesecurities of at least $400 million immediately before and after suchprepayment or repurchase. We used $249 million of this amount to redeem a portionof our senior secured notes in March 2004. Additionally, we used $155million of this amount to repurchase another portion of our senior securednotes in the third quarter of fiscal 2004. We may use an additional $96 millionin cash to repurchase long-term debt other than the LYONs under the amendedcredit facility.

The amended credit facility provides that from andafter the first date that we repurchase debt in accordance with the terms ofthe amended credit facility or make an acquisition for a purchase price of $100million or more, we will be required to have had positive free cash flow forthe four fiscal quarters 

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most recently then endedand maintain positive free cash flow for each four quarter period thereafter. Freecash flow is defined under the amended credit facility as net cash provided by(used in) operating activities less capital expenditures and dividends. As aresult of the redemption of the senior secured notes described above, we arecurrently required to comply with this covenant.

The amended credit facility provides that we may useup to $500 million in cash to make acquisitions provided that we comply withcertain financial covenants. In August 2004, we used $24 millionin cash to complete the acquisition of a majority interest in Tata Telecom and,accordingly, may use an additional $476 million in cash to make acquisitions. Furthermore,in August 2004, we announced an agreement to purchase Spectel Plc forapproximately $103 million, which is expected to close no later than the firstquarter of fiscal 2005. After such acquisition is completed, we have theability to use up to an additional $373 million in cash to make acquisitions.

The amended creditfacility includes restrictions on our ability to incur additional debt in thefuture. Under the amended credit facility, we are generally permitted to incurthe following categories of debt other than debt under the credit facility:

·       debtincurred to refinance existing debt,

·       debtin an amount equal to the amount of debt we have previously repaid, so long asimmediately before and after such issuance, we have $400 million inunrestricted cash,

·       debtsecured by real property in an amount not to exceed $130 million, and

·       otherdebt in an amount not to exceed $50 million.

We are currently in compliance with all of thecovenants in the amended credit facility.

*Senior Secured Notes.**  *We currently have outstanding $284million aggregate principal amount of senior secured notes. The terms of theindenture governing the senior secured notes limits our ability to incuradditional debt. Under the indenture, we may incur debt so long as the ratio ofEBITDA to interest expense, as defined under the indenture and after givingeffect to the issuance of the debt on a pro forma basis, exceeds 2.25. Inaddition, we may incur debt under certain circumstances even if we cannot meetthe incurrence test described in the proceeding sentence. Notwithstanding ourability to incur debt under the indenture, we cannot incur any such debt if weare not permitted to incur it under our amended credit facility.

***Uncertainties Related to Our Liquidity and Capital Resources***

The following are the principal uncertainties relatedto our liquidity and capital resources:

*DebtRatings.*   Ourability to obtain external financing and the related cost of borrowing isaffected by our debt ratings, which are periodically reviewed by the majorcredit rating agencies. As of May 2004, our long-term senior unsecureddebt is rated B2 by Moody’s, with a positive outlook. Our long-term seniorunsecured debt is currently rated B by Standard & Poor’s, unchangedsince May 2003, with a positive outlook. This outlook was recently revisedfrom stable. These changes reflect our increased financial flexibility, ourliquidity profile and improved operating performance and cash flow.

Any increase in our level of indebtedness ordeterioration of our operating results may cause a reduction in our currentdebt ratings. A reduction in our current long-term debt rating by Moody’s orStandard & Poor’s could affect our ability to access the long-termdebt markets, significantly increase our cost of external financing, and resultin additional restrictions on the way we operate and finance our business.

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A debt rating by the major credit rating agencies isnot a recommendation to buy, sell or hold securities and may be subject torevision or withdrawal at any time by the rating agencies. Each rating shouldbe evaluated independently of any other rating.

*LYONsPut.*   Holders of our LYONs may require us topurchase all or a portion of their LYONs on October 31, 2004 at a priceper LYON of $542.95, the accreted value of a LYON as of such date. Theaggregate accreted value of LYONs currently outstanding as of October 31,2004 will be approximately $298 million. We cannot predict whether all or anyportion of these LYONs will be put to us on the put date. In the event anyLYONs are put to us on the put date, we have the option to settle the putobligation in cash or shares of our common stock. In addition, we may redeemfor cash all or any portion of the LYONs at any time on or after October 31,2004.

The currently outstandingLYONs are convertible into an aggregate of 20,557,415 shares, all of which arereflected in the diluted share calculations for the three and nine monthperiods ended June 30, 2004, as more fully described in Note 12, “Earnings(Loss) Per Share of Common Stock,” to the accompanying consolidated financialstatements. Based on the applicable conversion rate of 37.4437 shares of ourcommon stock per LYON, if the trading price of our common stock exceeds $14.50per share on or about the date that we may exercise the call option, we expectthat many holders of LYONs will convert their LYONs into common stock.

***Fair Value of Financial Instruments***

Thefollowing table summarizes the number of outstanding LYONs and senior securednotes, their aggregate accreted value, and their related fair market values asof June 30, 2004 and September 30, 2003:
| ** **           | ** ** | **June 30, 2004**            | ** ** | **September 30, 2003** | ** ** |
|----------------------|------------|----------------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **Number of  Notes  Outstanding** | ** ** | **Accreted  Value**              | ** ** | **Fair  Value** | ** ** | **Number of  Notes  Outstanding** | ** ** | **Accreted  Value** | ** ** | **Fair  Value** | ** ** |
| ** **           | ** ** | **(dollars in millions)**    | ** ** |
| LYONs                |       |                                   | 549,022    |                             |       |   | $ | 295 |   |   | $ | 348 |   |   | 549,022 |   |   |   | $ | 287 |   |   | $ | 305 |   |
| Senior secured notes |       |                                   | 284,395    |                             |       |   | $ | 289 |   |   | $ | 334 |   |   | 640,000 |   |   |   | $ | 650 |   |   | $ | 742 |   |

 

The accreted value of the debt instruments listedabove reflects the aggregate principal amount outstanding adjusted for theunamortized discount and premium related to each debt security.

The fair market value of the debt instruments listedabove 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.

As of June 30, 2004 and September 30, 2003,the estimated fair values of our foreign currency forward contracts and optionswere an obligation of $4 million and an asset of $13 million, respectively. Theestimated fair values of these forward contracts and options were based onmarket quotes obtained through independent pricing sources.

As of June 30, 2004,the fair value of our interest rate swap agreements was an obligation ofapproximately $4 million based upon a mark-to-market valuation performed by anindependent financial institution.

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**Financial Instruments**

***Interest Rate SwapAgreements***

During the nine months ended June 30, 2004, weentered into five interest rate swap agreements each having a notional amountof $50 million and a maturity date of April 2009. These interest rate swapagreements were executed in order to: (i) convert a portion of the seniorsecured notes fixed-rate debt into floating-rate debt; (ii) maintain acapital structure containing appropriate amounts of fixed- and floating-ratedebt; and (iii) reduce interest payments and expense in the near term. Underthese agreements, we receive a fixed interest rate of 111¤8% and pay afloating interest rate based on the six-month LIBOR (in arrears) plus anagreed-upon spread of 6.55%, 6.8575%, 6.94%, 6.8% and 6.98%, respectively. Theinterest rate swaps effectively convert $250 million of our senior securednotes from fixed rate debt into floating rate debt.

During the third quarter of 2004, we terminated the$50 million interest rate swap agreement that paid a floating interest ratebased on the six-month LIBOR (in arrears) plus an agreed-upon spread of 6.94%. Thetermination resulted in a reduction to other liabilities for the removal of thefair market value of the applicable portion of the interest rate swap and acash payment of $1 million representing the loss on termination, which is beingrecognized as an increase to interest expense over the remaining term tomaturity of the senior secured notes. The unamortized balance of the loss isincluded as a reduction in long-term debt on the Consolidated Balance Sheet. Weterminated this interest rate swap agreement in order to maintain our desiredcapital structure as we repurchased certain amounts of our senior securednotes.

In July and August 2004,we terminated our remaining interest rate swap agreements, each of which had anotional amount of $50 million and paid a floating interest rate based on thesix-month LIBOR (in arrears) plus an agreed-upon spread of 6.55%, 6.8575%, 6.8%and 6.98%, respectively. The termination resulted in a reduction to otherliabilities for the removal of the fair market value of the interest rate swapsand a net cash payment of $200 thousand representing the loss ontermination, which will be recognized as an increase to interest expense overthe remaining term to maturity of the senior secured notes. The unamortizedbalance of the loss will be included as a reduction to long-term debt. Weterminated these interest rate swap agreements as we anticipatefurther repurchases of our senior secured notes.

**Forward Looking Statements**

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

Our disclosure and analysis in this quarterly reportcontain some forward-looking statements. Forward-looking statementsgive our current expectations or forecasts of future events. You can identifythese statements 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 quarterly report and in any other public statements we make *may turn out to be wrong*. They can beaffected by inaccurate assumptions we might make or by known or unknown risksand uncertainties. Many factors mentioned in the discussion below will beimportant in determining future results. Consequently, no forward-lookingstatement can be guaranteed. Actual future results 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 filings with 

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the SEC. Also note that weprovide the following cautionary discussion of risks, uncertainties andpossibly inaccurate assumptions relevant to our businesses. These are factorsthat we think could cause our actual results to differ materially from expectedand historical results. Other factors besides those listed here could alsoadversely affect us. This discussion is provided as permitted by the PrivateSecurities Litigation Reform Act of 1995.

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

·       priceand product competition,

·       rapidtechnological development,

·       dependenceon new product development,

·       themix of our products and services,

·       customerdemand for our products and services,

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

·       theability to successfully integrate acquired companies,

·       theability to attract and retain qualified employees,

·       controlof costs and expenses,

·       theability to form and implement alliances,

·       theeconomic, political and other risks associated with international sales andoperations,

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

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

Set forth below is 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 To Our Revenue and Business Strategy***

**Although ourrevenue has increased from 2003 to 2004, we did experience significant revenuedeclines during 2001, 2002 and 2003, and if business capital spending,particularly for enterprise communications products, applications and services,does not improve or deteriorates, our revenue may not grow or may decline, andour operating results may be adversely affected.**

Our revenue for the fiscal years ended September 30,2001, 2002 and 2003 was $5,473 million, $4,387 million and $3,796 million,respectively. The decline in revenue over this period is attributable to, amongother things, declines in the market for our traditional business, enterprisevoice communications systems, and the effect of general economic conditions onour customers’ willingness to spend on enterprise communications technologyduring the last several years. The decline in revenue has contributed to ournet losses for the fiscal years ended September 30, 2001, 2002 and 2003 of$352 million, $666 million and $88 million, respectively, andour accumulated deficit in the amount of $1,270 million as of September 30,2003.

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Our revenue for each of the quarters in fiscal 2003and the first three quarters of fiscal 2004 was $946 million, $950 million,$929 million, $971 million, $971 million, $1,006 million and $1,016 million,respectively. Our revenue for the nine months ended June 30, 2004 includesrevenue generated by the businesses we acquired from Expanets from the date ofacquisition on November 25, 2003 until June 30, 2004.

Our operating results are significantly affected bythe impact of economic conditions on the willingness of enterprises to makecapital investments, particularly in enterprise communications technology andrelated services. Although general economic conditions have improved recentlyand our revenue for the third quarter increased $10 million, or approximately1%, compared to the second quarter of fiscal 2004, we believe that enterprisescontinue to be concerned about their ability to increase revenues and therebyincrease their profitability. Accordingly, they have tried to maintain orimprove profitability through cost reduction and reduced capital spending.Because it is not certain whether enterprises will increase spending onenterprise communications technology significantly in the near term, there maybe continued pressure on our ability to increase our revenue.

In addition, because our product sales and sales ofmaintenance contracts for those products were significantly higher in prioryears, the aggregate value of maintenance contracts and the related revenue forour Services segment that are subject to renewal in fiscal 2004 are larger thanin prior years. If we are unable to renew a significant portion of thesecontracts, our revenue will be adversely affected.

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

**Revenue generatedby our traditional business, enterprise voice communications systems, has beendeclining for the last several years and if we do not successfully execute ourstrategy to expand our sales in market segments with higher growth rates, ourrevenue and operating results may continue to be adversely affected.**

We have been experiencing declines in revenue from ourtraditional business, enterprise voice communications systems. We expect, basedon various industry reports, the market segments for these traditional systemsto continue to decline. We are executing a strategy to capitalize on the highergrowth opportunities in our market, including IP telephony systems thatconverge voice, data and other traffic across a single network. Many of theseproducts and applications, including IP telephony systems, have not yet beenwidely adopted by enterprises.

Increases in revenue from sales of IP telephonysystems have not always exceeded the decline in revenue from sales ofenterprise voice communications systems in prior quarters. Even if we aresuccessful in increasing our revenue from sales of IP telephony systems, ifrevenue from sales of enterprise voice communications systems declines fasterthan revenue from sales of IP telephony systems increases, our overall revenueand operating results may be adversely affected.

Our traditional enterprise voice communications systemsand the advanced communications products and applications described above are apart of our Enterprise Communications Group and Small and Medium BusinessSolutions segments. If we are unsuccessful in executing our strategy, thecontribution to our results from these segments may fail to grow or maydecline, reducing our overall operating results and thereby requiring a greaterneed for external capital resources. Our Services segment may also be adverselyaffected to the extent that Services revenues are related to sales of theseproducts and applications.

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**A key component of our strategy is our focus on thedevelopment and marketing of advanced communications products and applications,including IP telephony systems, and this strategy may not be successful or mayadversely affect our business.**

We are focused onthe development and sales of IP telephony systems and other advancedcommunications products and applications. In order to execute this strategysuccessfully, we must continue to:

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

·       researchand develop more IP telephony systems and other products and applications usingmodes of communications other than voice, which has historically been our corearea of expertise;

·       retrainour Services employees to service the new products and applications, and takeother measures to ensure we can deliver consistent levels of service globallyto 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 distribution partners;

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

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

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

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

·       newtechnologies or new competitors will cause the market to evolve in a mannerdifferent than we expect; or

·       wewill be able to maintain a leadership or profitable position as thisopportunity develops.

**We face intense competitionfrom our historical competitors and recent entrants into the enterprisecommunications market.**

Historically, our product businesses have competedagainst other providers of enterprise voice communications systems such asNortel Networks Corporation, Siemens Aktiengesellschaft, Alcatel S.A. and NECCorporation. As we focus on the development and marketing of advancedcommunications systems, such as IP telephony systems that converge voice, dataand other traffic across a single unified network, we face intense competitionfrom these providers of voice communications systems as well as from datanetworking companies such as Cisco Systems, Inc. and 3Com Corp. Inaddition, because the market for our products is subject to rapid technologicalchange, as the market evolves we may face competition in the future fromcompanies that do not currently compete in the enterprise communicationsmarket, including companies that currently compete in other sectors of thetechnology, communications and software industries or communications companiesthat serve residential rather than enterprise 

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customers. Competitionfrom these potential market entrants may take many forms, including offeringproducts and applications similar to those we offer as part of a larger, bundledoffering.

Several of these existingcompetitors have, and many of our future competitors may have, greaterfinancial, personnel and other resources than we and as a result, thesecompetitors may be in a stronger position to respond quickly to potentialacquisitions and other market opportunities, new or emerging technologies andchanges in customer requirements. Competitors with greater financial resourcesalso may be able to offer lower prices, additional products or services orother incentives that we cannot match or do not offer. We cannot predict withprecision which competitors may enter our markets in the future or what formsuch competition may take. 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.

***Risks Related to Our Liquidity and Capital Resources.***

**If we do notcontinue to generate net cash flow from operations or unanticipated cash needsarise, we may not have adequate or cost-effective liquidity or capitalresources.**

Our cash needs include servicing our debt, includingany put obligation related to our LYONs that may arise in October 2004,funding working capital, capital expenditures, business restructuringliabilities, employee benefit obligations, and for general corporate purposes.We believe that our $1,523 million in existing cash and cash equivalents as of June 30,2004 and our net cash provided by operating activities during the remainder offiscal 2004 will be sufficient to meet these cash needs.

If, however, we do not continue to generate net cashfrom operations or face unanticipated cash needs, such as the funding of afuture acquisition or other capital investment, we may need to obtain externalfinancing. Under the terms of any external financing, we may incur higher thanexpected financing expenses, and become subject to additional restrictions andcovenants. In addition, our ability to obtain external financing is affected bythe terms of our debt agreements. Our existing debt agreements includecovenants that limit our ability to incur additional indebtedness. In addition,our credit facility requires us to comply with certain financial covenants. We havepreviously amended our credit facility several times in order to ensure ourcompliance with the financial covenants. If we are unable to comply with ourfinancial covenants and cannot amend or obtain a waiver of those covenants, anevent of default under the credit facility would occur. If a default occurs,the lenders under our credit facility could accelerate the maturity of our debtobligations and terminate their commitments to lend to us. Currently there areno funds drawn under our credit facility.

Our ability to obtainexternal financing and, in particular, debt financing, is also affected by ourdebt ratings, which are periodically reviewed by the major credit ratingagencies. Our corporate credit is rated B+ and our long-term seniorunsecured debt is rated B by Standard & Poor’s, each with apositive outlook, and our long-term senior unsecured debt is rated B2 by Moody’swith a positive outlook. These outlooks have been recently revised from stableto reflect our improved profitability in the current quarters as well as areduction of debt, an improvement in debt protection metrics and increasedbalance sheet liquidity. An increase in our level of indebtedness ordeterioration of our operating results, however, may cause a reduction in ourcurrent debt ratings, which, along with other factors, could impair our abilityto secure additional financing on acceptable terms.

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***Risks Related To Our Operations***

**Our acquisition activity has increased recently and ifwe are unable to effectively integrate these acquired businesses into ours, ouroperating results may be adversely affected and even if we are successful, suchintegration may require significant resources and management attention.**

Since the end of fiscal 2003, we completed theacquisition and integration of substantially all of the assets and certainliabilities of Expanets and divested our Connectivity Solutions business andthe portion of Expanets business that previously distributed other vendors’products. In August 2004, we completed the acquisition of a majorityinterest in Tata Telecom Limited, a company incorporated and operating inIndia, and agreed to acquire all of the issued share capital of Spectel plc, acompany incorporated and headquartered in Ireland.

In order to realize the intended benefits of the Tataand Spectel acquisitions, or any acquisition we make in the future, we musteffectively integrate these businesses or any future acquired business intoours. The Tata and Spectel acquisitions may be made more complicated by thefact that they are the first acquisitions we have made outside the UnitedStates. Even if we are successful in integrating these businesses or any futureacquired business, the integration may require significant resources andmanagement attention, which may, during the integration period, divert ourattention from our existing businesses or otherwise adversely affect ourrevenue and operating results.

**We depend oncontract manufacturers to produce all 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 all of our manufacturingoperations. Substantially all of these operations have been outsourced toCelestica Inc. 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 relationship with usor is unable to fill our orders on a timely basis, we may be unable to deliverthe affected products to meet our customers’ orders, which could delay ordecrease our revenue or otherwise have an adverse effect on our operations.

**If we are unable to protect our proprietary rights,our business and future prospects may be harmed.**

Although we attempt to protect our intellectualproperty through patents, trademarks, trade secrets, copyrights,confidentiality and nondisclosure agreements and other measures, intellectualproperty is difficult to protect and these measures may not provide adequateprotection for our proprietary rights. Patent filings by third parties, whethermade before or after the date of our filings, could render our intellectualproperty less valuable. Competitors may misappropriate our intellectualproperty, disputes as to ownership of intellectual property may arise and our intellectualproperty may otherwise become known or independently developed by competitors.The failure to protect our intellectual property could seriously harm ourbusiness and future prospects because we believe that developing new productsand technology that are unique to us is critical to our success. If we do notobtain sufficient international protection for our intellectual property, ourcompetitiveness in international markets could be significantly impaired, whichwould limit our growth and future revenue.

In addition, we rely onthe security of our information systems, among other things, to protect ourproprietary information and information of our customers. If we do not maintainadequate security procedures over our information systems, we may besusceptible to computer hacking, cyberterrorism or other unauthorized attemptsby third parties to access our proprietary information or that of ourcustomers. The failure to protect our proprietary information could seriouslyharm our business and future prospects or expose us to claims by our customers,employees or others that we did not adequately protect their proprietaryinformation.

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***Risks Related to Contingent Liabilities***

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

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

Please see Note 14—Commitments and Contingencies—“LegalProceedings” included in this Quarterly Report on Form 10-Q for adescription of certain matters involving Lucent for which we have assumedresponsibility under the Contribution and Distribution Agreement and adescription of other matters for which we are or may be obligated to indemnifyor share the cost with Lucent.

We cannot assure you we will not have to make otherindemnification or cost sharing payments to Lucent in connection with thesematters or that Lucent will not submit a claim for indemnification or costsharing to us in connection with any future matter. In addition, our ability toassess the impact of matters for which we may have to indemnify or share thecost with Lucent is made more difficult by the fact that we do not control thedefense of these matters.

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

We cannot assure you that others will not claim thatour proprietary or licensed products, systems and software are infringing theirintellectual property rights or that we do not in fact infringe thoseintellectual property rights. We may be unaware of intellectual property rightsof others that may cover some of our technology. If someone claimed that ourproprietary or licensed systems and software infringed their intellectualproperty rights, any resulting litigation could be costly and time consumingand would divert the attention of management and key personnel from otherbusiness issues. The complexity of the technology involved and the uncertaintyof intellectual property litigation increase these risks. Claims ofintellectual property infringement also might require us to enter into costlyroyalty or license agreements. However, we may be unable to obtain royalty orlicense agreements on terms acceptable to us or at all. We also may be subjectto significant damages or an injunction against us or our proprietary or licensedsystems. A successful claim of patent or other intellectual propertyinfringement against us could materially adversely affect our operating results.We may also be subject to additional notice and other requirements to theextent we incorporate open source software into our applications.

In addition, third parties have in the past, and mayin the future, claim that a customer’s use of our products, systems or softwareinfringes the third party’s intellectual property rights. Under certaincircumstances, we may be required to indemnify our customers for some of thecosts and damages related to such an infringement claim. Any indemnificationrequirement could have a material adverse effect on our business and ouroperating results.

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

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

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

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

**Item 3.   *Quantitative andQualitative Disclosures About Market Risk.***

See Avaya’s Annual Reportfiled on February 12, 2004 on a Current Report on Form 8-K forthe fiscal year ended September 30, 2003 (Item 7A). At June 30,2004, there has been no material change in this information other than enteringinto five interest rate swap agreements disclosed in Note 8—“Debt andDerivative Financial Instruments” to the consolidated financial statements.

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

We have established disclosure controls and proceduresto ensure that material information relating to the Company, including itsconsolidated subsidiaries, is made known to the officers who certify theCompany’s financial reports and to other members of senior management and theBoard of Directors.

Based on their evaluation as of June 30, 2004,the principal executive officer and principal financial officer of Avaya Inc.have concluded that Avaya Inc.’s disclosure controls and procedures (as definedin Rules 13a-14c and 15d-14c under the SecuritiesExchange Act of 1934) are effective to ensure that the information required tobe disclosed by Avaya Inc. in reports that it files or submits under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in SEC rules and forms.

There were no changes in Avaya Inc.’s internalcontrols or in other factors that could significantly affect those controlssubsequent to the date of their most recent evaluation.

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**PART II**

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

See Note 14—“Commitmentsand Contingencies” to the consolidated financial statements.

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

None.

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

None.

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

None.

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

We make available free ofcharge, through our investor relations’ website, investors.Avaya.com, our Form 10-K,Form 10-Q and Form 8-K reports and all amendments tothose reports as soon as reasonably practicable after such material iselectronically filed with or furnished to the Securities and ExchangeCommission.

**Item 6.   *Exhibits and Reports on Form 8-K.***

(a)                        Exhibits:

31.1                Certification ofDonald K. Peterson pursuant to Section 302 of the Sarbanes-Oxley Actof 2002.

31.2                Certification ofGarry K. McGuire Sr. pursuant to Section 302 of the Sarbanes-OxleyAct of 2002.

32.1                Certification ofDonald K. Peterson pursuant to Section 906 of the Sarbanes-Oxley Actof 2002.

32.2                Certification ofGarry K. McGuire Sr. pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.

(b)                       Reports on Form 8-K:

The followingCurrent Reports on Form 8-K were filed by the Company during thefiscal quarter ended June 30, 2004:

1.                 April 27,2004—Item 7. Financial Statements and Exhibits and Item 12. Results ofOperations and Financial Condition—The Company furnished a press releasereporting financial results for the fiscal quarter ended March 31, 2004and held a public webcast in connection with the issuance of the press release.

2.                 May 14, 2004—Item5. Other Events and Regulation FD Disclosure and Item 7. Financial Statementsand Exhibits—The Company announced the settlement of a nationwide Y2K-relatedclass action in connection with the issuance of the press release.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                      | Avaya Inc. |
|----------------------|------------|
|                 | By:        | /s/  Amarnath K. Pai |
|                 |       | Amarnath K. Pai |
|                 |       | *Vice-President  Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| August 12, 2004 |       |   |

 

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