SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-Q

|ý                                             | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|--------------------------------------------- | ----------------------------------------------------------------------------------------
|For the Quarterly Period Ended March 31, 2004
|OR                                           
|o                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-15951

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AVAYA INC.

|A DELAWARE
CORPORATION                                                             |  | I.R.S. EMPLOYER NO. 22-3713430
|---------------------------------------------------------------------------------- |  | ------------------------------
|                                                                                   |  |                               
|211 Mount Airy Road, Basking Ridge, New Jersey 07920
Telephone Number 908-953-6000

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Indicate
by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past
90 days.    Yes ý    No o

Indicate by check mark whether the registrant is an accelerated filer (as defined by 12(b)-2 of the Securities and Exchange Act of
1934).    Yes ý    No o

At March 31, 2004, 443,695,799 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 |  | 32  
|3.   |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 56  
|4.   |  | Controls and Procedures                                                               |  | 56  
|     |  | PART II OTHER INFORMATION                                                             |  |     
|1.   |  | Legal Proceedings                                                                     |  | 57  
|2.   |  | Changes in Securities and Use of Proceeds                                             |  | 57  
|3.   |  | Defaults Upon Senior Securities                                                       |  | 57  
|4.   |  | Submission of Matters to a Vote of Security Holders                                   |  | 57  
|5.   |  | Other Information                                                                     |  | 57  
|6.   |  | Exhibits and Reports on Form 8-K                                                      |  | 58  
|     |  | Signatures                                                                            |  | 59  

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

2

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PART I

Item 1.Financial Statements.

AVAYA INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF OPERATIONS  (unaudited, dollars in millions, except per share amounts)

|                                                             |                                                                                                                                                   | Three Months Ended
March 31, |       | Six Months
Ended
March 31, |  
|------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------- | ----- | -------------------------- | -
|
|REVENUE                                                      |                                                                                                                                                   |                              |       |                            |  
|                                                             | Products                                                                                                                                          |                              | $     | 495                        |  
|                                                             | Services                                                                                                                                          |                              |       | 511                        |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|                                                             |                                                                                                                                                   |                              | 1,006 |                            |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|COSTS                                                        |                                                                                                                                                   |                              |       |                            |  
|                                                             | Products                                                                                                                                          |                              |       | 236                        |  
|                                                             | Services                                                                                                                                          |                              |       | 299                        |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|                                                             |                                                                                                                                                   |                              | 535   |                            |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|GROSS MARGIN                                                 |                                                                                                                                                   |                              | 471   |                            |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|OPERATING EXPENSES                                           |                                                                                                                                                   |                              |       |                            |  
|                                                             | Selling, general and administrative                                                                                                               |                              |       | 328                        |  
|                                                             | Research and development                                                                                                                          |                              |       | 83                         |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|                                                             | TOTAL OPERATING EXPENSES                                                                                                                          |                              |       | 411                        |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|OPERATING INCOME (LOSS)                                      |                                                                                                                                                   |                              | 60    |                            |  
|                                                             | Other expense, net                                                                                                                                |                              |       | (19                        | )
|                                                             | Interest expense                                                                                                                                  |                              |       | (19                        | )
|                                                             |                                                                                                                                                   |                              |       |                            |  
|INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES |                                                                                                                                                   |                              | 22    |                            |  
|                                                             | Provision (benefit) for income taxes                                                                                                              |                              |       | (81                        | )
|                                                             |                                                                                                                                                   |                              |       |                            |  
|INCOME (LOSS) FROM CONTINUING OPERATIONS                     |                                                                                                                                                   |                              | 103   |                            |  
|DISCONTINUED OPERATIONS                                      |                                                                                                                                                   |                              |       |                            |  
|                                                             | Income from discontinued operations, (including gain on sale of discontinued operations of $81 for the three and six months ended March 31, 2004) |                              |       | 21                         |  
|                                                             | Provision (benefit) for income taxes                                                                                                              |                              |       | (1                         | )
|                                                             |                                                                                                                                                   |                              |       |                            |  
|INCOME FROM DISCONTINUED OPERATIONS                          |                                                                                                                                                   |                              | 22    |                            |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|NET INCOME (LOSS)                                            |                                                                                                                                                   | $                            | 125   |                            | $
|                                                             |                                                                                                                                                   |                              |       |                            |  
|Earnings (Loss) Per Common ShareBasic:                      |                                                                                                                                                   |                              |       |                            |  
|                                                             | Earnings (loss) per share from continuing operations                                                                                              |                              | $     | 0.24                       |  
|                                                             | Earnings per share from discontinued operations                                                                                                   |                              |       | 0.05                       |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|                                                             | Earnings (loss) per share                                                                                                                         |                              | $     | 0.29                       |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|Earnings (Loss) Per Common ShareDiluted:                    |                                                                                                                                                   |                              |       |                            |  
|                                                             | Earnings (loss) per share from continuing operations                                                                                              |                              | $     | 0.22                       |  
|                                                             | Earnings per share from discontinued operations                                                                                                   |                              |       | 0.05                       |  
|                                                             |                                                                                                                                                   |                              |       |                            |  
|                                                             | Earnings (loss) per share                                                                                                                         |                              | $     | 0.27                       |  
|                                                             |                                                                                                                                                   |                              |       |                            |  

See
Notes to Consolidated Financial Statements.

3

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AVAYA INC. AND SUBSIDIARIES  CONSOLIDATED BALANCE SHEETS  (unaudited, dollars in millions, except per share amounts)

|                                           |                                                                                                                                                                                                                        | As of
March 31, 2004 |       | As of
September 30, 2003 |  
|------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------- | ----- | ------------------------ | -
|ASSETS                                     |                                                                                                                                                                                                                        |                      |       |                          |  
|Current assets:                            |                                                                                                                                                                                                                        |                      |       |                          |  
|                                           | Cash and cash equivalents                                                                                                                                                                                              |                      | $     | 1,516                    |  
|                                           | Receivables, less allowances of $96 and $86 as of March 31, 2004 and September 30, 2003, respectively                                                                                                                  |                      |       | 619                      |  
|                                           | Inventory                                                                                                                                                                                                              |                      |       | 265                      |  
|                                           | Deferred income taxes, net                                                                                                                                                                                             |                      |       | 45                       |  
|                                           | Other current assets                                                                                                                                                                                                   |                      |       | 182                      |  
|                                           | Current assets of discontinued operations                                                                                                                                                                              |                      |       | 7                        |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL CURRENT ASSETS                       |                                                                                                                                                                                                                        |                      | 2,634 |                          |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|                                           | Property, plant and equipment, net                                                                                                                                                                                     |                      |       | 578                      |  
|                                           | Deferred income taxes, net                                                                                                                                                                                             |                      |       | 386                      |  
|                                           | Goodwill                                                                                                                                                                                                               |                      |       | 234                      |  
|                                           | Other assets                                                                                                                                                                                                           |                      |       | 254                      |  
|                                           | Other assets of discontinued operations                                                                                                                                                                                |                      |       | 2                        |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL ASSETS                               |                                                                                                                                                                                                                        | $                    | 4,088 |                          | $
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|LIABILITIES AND STOCKHOLDERS' EQUITY       |                                                                                                                                                                                                                        |                      |       |                          |  
|Current liabilities:                       |                                                                                                                                                                                                                        |                      |       |                          |  
|                                           | Accounts payable                                                                                                                                                                                                       |                      | $     | 313                      |  
|                                           | Business restructuring reserve                                                                                                                                                                                         |                      |       | 50                       |  
|                                           | Payroll and benefit obligations                                                                                                                                                                                        |                      |       | 271                      |  
|                                           | Current portion of long-term debt                                                                                                                                                                                      |                      |       | 292                      |  
|                                           | Deferred revenue                                                                                                                                                                                                       |                      |       | 161                      |  
|                                           | Other current liabilities                                                                                                                                                                                              |                      |       | 272                      |  
|                                           | Current liabilities of discontinued operations                                                                                                                                                                         |                      |       | 1                        |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL CURRENT LIABILITIES                  |                                                                                                                                                                                                                        |                      | 1,360 |                          |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|                                           | Long-term debt                                                                                                                                                                                                         |                      |       | 437                      |  
|                                           | Benefit obligations                                                                                                                                                                                                    |                      |       | 1,163                    |  
|                                           | Other liabilities                                                                                                                                                                                                      |                      |       | 444                      |  
|                                           | Other liabilities of discontinued operations                                                                                                                                                                           |                      |       | 3                        |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL NON-CURRENT LIABILITIES              |                                                                                                                                                                                                                        |                      | 2,047 |                          |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|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, 446,075,426 and 419,434,414 issued (including 2,379,627 and 878,254 treasury shares) as of March 31, 2004 and September 30, 2003,
respectively |                      |       | 4                        |  
|                                           | Additional paid-in capital                                                                                                                                                                                             |                      |       | 2,461                    |  
|                                           | Accumulated deficit                                                                                                                                                                                                    |                      |       | (1,135                   | )
|                                           | Accumulated other comprehensive loss                                                                                                                                                                                   |                      |       | (622                     | )
|                                           | Less treasury stock at cost                                                                                                                                                                                            |                      |       | (27                      | )
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL STOCKHOLDERS' EQUITY                 |                                                                                                                                                                                                                        |                      | 681   |                          |  
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  
|TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY |                                                                                                                                                                                                                        | $                    | 4,088 |                          | $
|                                           |                                                                                                                                                                                                                        |                      |       |                          |  

See
Notes to Consolidated Financial Statements.

4

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AVAYA INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF CASH FLOWS  (unaudited, dollars in millions)

|                                                                              |                                                                                                                                              | Six Months Ended
March 31,                                                          |                                            
|----------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | -------------------------------------------
|
|OPERATING ACTIVITIES:                                                         |                                                                                                                                              |                                                                                     |                                            
|                                                                              | Net income (loss)                                                                                                                            |                                                                                     | $                                          
|                                                                              | Less: Income from discontinued operations, net                                                                                               |                                                                                     |                                            
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|                                                                              | Income (loss) from continuing operations                                                                                                     |                                                                                     |                                            
|                                                                              | Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities of continuing operations: |                                                                                     |                                            
|                                                                              |                                                                                                                                              | Depreciation and amortization                                                       |                                            
|                                                                              |                                                                                                                                              | Business restructuring reversals                                                    |                                            
|                                                                              |                                                                                                                                              | Provision for uncollectible receivables                                             |                                            
|                                                                              |                                                                                                                                              | Deferred income taxes                                                               |                                            
|                                                                              |                                                                                                                                              | Deferred tax valuation allowance                                                    |                                            
|                                                                              |                                                                                                                                              | Reversal of liabilities related to tax settlement                                   |                                            
|                                                                              |                                                                                                                                              | Lucent securities litigation charge                                                 |                                            
|                                                                              |                                                                                                                                              | Loss on extinguishment of debt, net                                                 |                                            
|                                                                              |                                                                                                                                              | Adjustments for other non-cash items, net                                           |                                            
|                                                                              |                                                                                                                                              | Changes in operating assets and liabilities, net of effects of acquired businesses: |                                            
|                                                                              |                                                                                                                                              |                                                                                     | Receivables                                
|                                                                              |                                                                                                                                              |                                                                                     | Inventory                                  
|                                                                              |                                                                                                                                              |                                                                                     | Interest rate swap termination             
|                                                                              |                                                                                                                                              |                                                                                     | Restricted cash                            
|                                                                              |                                                                                                                                              |                                                                                     | Accounts payable                           
|                                                                              |                                                                                                                                              |                                                                                     | Business restructuring reserve             
|                                                                              |                                                                                                                                              |                                                                                     | Accrued interest payments on long-term debt
|                                                                              |                                                                                                                                              |                                                                                     | Other assets and liabilities               
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|NET CASH PROVIDED BY OPERATING ACTIVITIES OF CONTINUING OPERATIONS            |                                                                                                                                              |                                                                                     | 121                                        
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|INVESTING ACTIVITIES:                                                         |                                                                                                                                              |                                                                                     |                                            
|                                                                              | Capital expenditures                                                                                                                         |                                                                                     |                                            
|                                                                              | Acquisition of businesses, net of cash acquired                                                                                              |                                                                                     |                                            
|                                                                              | Proceeds from sales of discontinued businesses                                                                                               |                                                                                     |                                            
|                                                                              | Proceeds from sale of CommScope common stock                                                                                                 |                                                                                     |                                            
|                                                                              | Proceeds from collection of notes receivable                                                                                                 |                                                                                     |                                            
|                                                                              | Other investing activities, net                                                                                                              |                                                                                     |                                            
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES OF CONTINUING OPERATIONS |                                                                                                                                              |                                                                                     | 150                                        
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|FINANCING ACTIVITIES:                                                         |                                                                                                                                              |                                                                                     |                                            
|                                                                              | Issuance of common stock                                                                                                                     |                                                                                     |                                            
|                                                                              | Repayment of long-term borrowings                                                                                                            |                                                                                     |                                            
|                                                                              | Payment of issuance costs related to equity offering                                                                                         |                                                                                     |                                            
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|NET CASH PROVIDED BY FINANCING ACTIVITIES OF CONTINUING OPERATIONS            |                                                                                                                                              |                                                                                     | 68                                         
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|Effect of exchange rate changes on cash and cash equivalents                  |                                                                                                                                              |                                                                                     | 9                                          
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|Net cash provided by continuing operations                                    |                                                                                                                                              |                                                                                     | 348                                        
|Net cash provided by (used in) discontinued operations                        |                                                                                                                                              |                                                                                     | (24                                        
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|Net increase in cash and cash equivalents                                     |                                                                                                                                              |                                                                                     | 324                                        
|Cash and cash equivalents at beginning of fiscal year                         |                                                                                                                                              |                                                                                     | 1,192                                      
|                                                                              |                                                                                                                                              |                                                                                     |                                            
|Cash and cash equivalents at end of period                                    |                                                                                                                                              | $                                                                                   | 1,516                                      
|                                                                              |                                                                                                                                              |                                                                                     |                                            

See Notes to Consolidated Financial Statements.

5

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

1.    Background and Basis of Presentation

Background

Avaya Inc. (the "Company" or "Avaya") provides communication systems, applications and services for enterprises, including businesses, government agencies
and other organizations. The Company's product offerings include Internet Protocol ("IP") telephony systems that converge voice, data and other traffic across a single unified network, traditional
voice communication systems, contact center infrastructure and applications in support of customer relationship management and unified communications applications. The Company supports its broad
customer base with comprehensive global service offerings that enable customers to plan, design, implement and manage their communications networks.

Basis of Presentation

The accompanying unaudited consolidated financial statements as of March 31, 2004 and for the three and six months ended March 31, 2004 and 2003,
have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and
Exchange Commission for interim financial statements, and should be read in conjunction with the Company's consolidated financial statements and other financial information for the fiscal year ended
September 30, 2003, which was filed with the Securities and
Exchange Commission on February 12, 2004 on a Current Report on Form 8-K. In the Company's opinion, the unaudited interim consolidated financial statements reflect all
adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the periods indicated. Certain prior
year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are not necessarily indicative of the
results to be experienced for the entire fiscal year.

In
November 2003, the Company acquired substantially all of the assets and assumed certain liabilities of Expanets, Inc. ("Expanets"), a subsidiary of NorthWestern
Corporation ("NorthWestern") in a transaction accounted for as a business combination. Accordingly, the results of the businesses acquired from Expanets have been included in the Company's
consolidated financial statements beginning on November 25, 2003, the date of acquisition. Upon the closing of the acquisition, the Company decided to divest the Expanets businesses that
previously distributed other vendors' products. For financial statement purposes, the assets, liabilities, results of operations and cash flows of these businesses have been segregated from those of
continuing operations and are presented in the Company's financial statements as a component of discontinued operations (see Note 3).

In
January 2004, the Company completed the sale of essentially all of its Connectivity Solutions business, except for the sale of certain remaining international operations that
have subsequently been completed or are expected to be completed by the end of fiscal 2004. Accordingly, the Company has accounted for the Connectivity Solutions business as a discontinued operation.
The Company's consolidated financial statements for all prior periods have been adjusted to reflect this presentation.

6

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2.    Summary of Significant Accounting Policies and Recent Accounting Pronouncement

Summary of Significant Accounting Policies

Restricted cash

As of March 31, 2004 and September 30, 2003, the Company had $80 million and $38 million, respectively, of restricted cash included in
other current assets and other assets in the Consolidated Balance Sheets. This cash is restricted in use and has been pledged to secure letters of credit, surety bonds and other purchase guarantees
that ensure the Company's performance or payment to third parties in accordance with specified terms and conditions.

Stock Compensation

The Company's employees participate in stock option plans. The Company applies the recognition and measurement principles of Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for such stock compensation. Accordingly, no stock-based employee compensation
cost related to stock options is reflected in the Company's Statements of Operations, as all options granted under the plans had an exercise price equal to or greater than the market value of the
underlying common stock on the date of grant. The Company records compensation expense for the amortization of restricted stock units issued to employees based on the fair market value of the
restricted stock units at the date of grant over the vesting period, which is typically three years. The following table illustrates the effect on net income (loss) and earnings (loss) per share as if
the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS
No. 148, "Accounting for Stock-Based CompensationTransition and Disclosure."

|                                                                                                                             |  | Three Months Ended
March 31, |      | Six Months
Ended
March 31, |  
|---------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ---- | -------------------------- | -
|
|
|Net income (loss), as reported                                                                                               |  | $                            | 125  |                            | $
|Total stock-based employee compensation income (expense) determined under fair value based method, net of related tax effect |  |                              | (5   | )                          |  
|                                                                                                                             |  |                              |      |                            |  
|Pro forma net income (loss)                                                                                                  |  | $                            | 120  |                            | $
|                                                                                                                             |  |                              |      |                            |  
|Earnings (Loss) Per Common Share- Basic                                                                                      |  |                              |      |                            |  
|As reported                                                                                                                  |  | $                            | 0.29 |                            | $
|                                                                                                                             |  |                              |      |                            |  
|Pro forma                                                                                                                    |  | $                            | 0.27 |                            | $
|                                                                                                                             |  |                              |      |                            |  
|Earnings (Loss) Per Common Share- Diluted                                                                                    |  |                              |      |                            |  
|As reported                                                                                                                  |  | $                            | 0.27 |                            | $
|                                                                                                                             |  |                              |      |                            |  
|Pro forma                                                                                                                    |  | $                            | 0.26 |                            | $
|                                                                                                                             |  |                              |      |                            |  

7

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The
fair value of stock options used to compute pro forma net loss for the three and six months ended March 31, 2003 resulted in additional income because a substantial number of
previously granted options had been forfeited and the cumulative reversal of pro forma expense related to these options exceeded the pro forma expense related to the remaining outstanding options.

Recent Accounting Pronouncement

SFAS 132

In December 2003, the Financial Accounting Standards Board issued a revised SFAS No. 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits" ("SFAS 132"), which changed the disclosure requirements for employers' pension plans and other postretirement benefit plans, but did not change the measurement or
recognition of those plans required by other related accounting standards. The disclosure requirements of SFAS 132 are effective for the Company beginning in the second quarter of fiscal 2004.
SFAS 132 requires additional information related to changes in the benefit obligations and fair values of plan assets. See Note 9, "Benefit Obligations" for the components of net
periodic benefit costs recognized. Additional disclosures required by SFAS 132 will be included in the Company's Annual Report on Form 10-K for the fiscal year ending
September 30, 2004, including information describing the types of plan assets, investment strategy, measurement date(s), plan obligations and cash flows.

3.    Acquisition and Divestitures

Acquisition of Expanets

On November 25, 2003, the Company acquired substantially all of the assets and assumed certain liabilities of Expanets. Expanets was a nationwide provider
of networked communications and data products and services to small and mid-sized businesses and prior to the acquisition was one of the Company's largest dealers. The acquisition will
allow the Company to continue providing quality sales and service support for Expanets' customers and grow its small and mid-sized business. Under the terms of the asset purchase
agreement, the Company paid a purchase price at the closing of $97 million, consisting of (i) approximately $55 million in cash paid to Expanets, (ii) approximately
$27 million paid to a creditor of Expanets to satisfy a debt obligation of Expanets, and (iii) approximately $15 million deposited into an escrow account to satisfy certain
liabilities of Expanets. The Company also made a payment of approximately $12 million to secure a letter of credit on behalf of Expanets, which is classified as restricted cash. The results of
the Expanets businesses the Company acquired have been included in the Company's consolidated financial statements from the date of acquisition on November 25, 2003. During the second quarter
of fiscal 2004,
the Company recorded an additional $2 million in business combination costs, which increased the purchase price to $99 million.

At
the date of acquisition, the Company recorded Expanets' accounts receivables, inventory, liabilities and identified intangibles at estimated fair value and fixed assets at estimated
replacement cost. The remainder of the purchase price in excess of the net assets acquired was recorded as goodwill. During the second quarter of fiscal 2004, the Company made adjustments to the
initial purchase price allocation based upon a review of the detailed balances included in Expanets' financial statements. The following table summarizes the estimated fair values of the assets
acquired and

8

---



liabilities
assumed as of the acquisition date, adjusted for items identified during the second quarter of fiscal 2004:

Initial
Purchase
Price
Allocation

Purchase
Price
Adjustments

Revised
Purchase
Price
Allocation(dollars in millions)Cash

$
3

$


$
3Accounts receivable


45





45Inventory


24


(3
)

21Other assets


10


(2
)

8Fixed assets


17


(13
)

4Intangibles


32





32Goodwill


63


21


84Accounts payable


(45
)




(45
)Termination obligations


(21
)

1


(20
)Other liabilities


(41
)

(2
)

(43
)Net assets from discontinued operations


10





10Purchase price

$
97

$
2

$
99


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

In
April 2004, the Company finalized the working capital adjustments with NorthWestern. Based upon the final working capital adjustments, the purchase price was increased by
approximately $18 million, which the Company paid to NorthWestern in April 2004. The Company will adjust the purchase price allocation to reflect this adjustment in the third quarter of
fiscal 2004, which will increase goodwill by $18 million.

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

The
Company recorded fixed assets of $17 million in its initial purchase price allocation. The Company determined that it had no future intended use for certain of these assets
and adjusted the purchase price of these assets to their net realizable value of $4 million.

Goodwill
attributable to the businesses acquired from Expanets of $84 million was assigned $17 million to the Enterprise Communications Group segment ("ECG"),
$62 million to the Services segment, and $5 million to the Small and Medium Business Solutions ("SMBS") segment. Of that total amount, $69 million is expected to be deductible for
tax purposes over a 15 year period.

9

---



In
connection with the acquisition, the Company recorded liabilities of $21 million for termination obligations. The Company has recognized these obligations as a liability
assumed as of the acquisition date. These termination obligations consisted of $10 million of employee separation costs for approximately 1,750 employees and $11 million related to the
closure of redundant real estate facilities. The Company expects to have completed the severance payments by the end of fiscal 2004 and to have substantially completed the lease termination
obligations by fiscal 2007.

During
the second quarter of fiscal 2004, the Company reevaluated both the employee separation costs and lease termination obligations and determined that $1 million of the
employee separation liability should be reduced, as the actual costs incurred during the period were less than the original estimate. This reduction is included in the purchase accounting adjustments
identified in the table above. The following table summarizes the status of the Expanets' termination obligations as of and for the three months ended March 31, 2004:

Employee
Separation
Costs

Lease
Termination
Obligations

Total
Expanets'
Termination
Obligations(dollars in millions)Balance as of December 31, 2003

$
10

$
11

$
21Cash Payments


(3
)

(2
)

(5
)Adjustment


(1
)




(1
)Balance as of March 31, 2004

$
6

$
9

$
15


Sale of a Portion of Expanets' Business

Upon the closing of the Expanets acquisition, the Company decided to sell the Expanets businesses that previously distributed other vendors' products and,
accordingly, accounted for this portion of Expanets' business as a component of discontinued operations. In the first and second quarters of fiscal 2004, the Company sold, in a series of transactions,
certain assets and liabilities attributed to these businesses for an aggregate consideration of $13 million, $4 million of which was cash consideration and $9 million was in the
form of notes receivable. As of March 31, 2004, the Company had substantially divested this portion of the Expanets business and had collected $5 million of these notes receivable.

Income
from discontinued operations for these businesses for the three and six months ended March 31, 2004, includes revenue of $1 million and $8 million,
respectively, and loss before income taxes of $1 million and $6 million, respectively.

10

---



The
following unaudited pro forma financial information presents the Company's results as if the Expanets acquisition and the discontinued operations presentation of a portion of the
Expanets business referred to above had occurred at the beginning of the respective periods:

Three Months
Ended
March 31,

Six Months
Ended
March 31,2003

2004

2003(unaudited; dollars in millions,
except per share amounts)Revenue

$
1,049

$
2,025

$
2,039Net income (loss)

$
(18
)
$
119

$
(201
)Earnings (loss) per sharebasic

$
(0.05
)
$
0.28

$
(0.54
)Earnings (loss) per sharediluted

$
(0.05
)
$
0.26

$
(0.54
)


These
pro forma results have been prepared for comparative purposes only and include certain adjustments such as the elimination of intercompany revenue and costs, additional
amortization expense as a result of identifiable intangible assets arising from the acquisition, and the removal of items included in Expanets' historical results that did not relate to assets or
liabilities acquired by the Company. The pro forma results are not necessarily indicative of the results of operations that actually would have resulted had the acquisition been in effect at the
beginning of the respective periods or of future results. Expanets is included in the Company's Consolidated Statement of Operations for the three months ended March 31, 2004 and, therefore,
actual and pro forma information would be the same for such period.

Sale of Connectivity Solutions

In January 2004, the Company sold certain assets and liabilities of its Connectivity Solutions business to CommScope, Inc. ("CommScope").
Accordingly, the Company has accounted for this business as a discontinued operation. Because the products offered by Connectivity Solutions did not fit strategically with the rest of the Company's
product portfolio, the Company believes the sale will enable it to strengthen its focus on its core product offerings.

On
January 31, 2004, the sale of essentially all of Connectivity Solutions was completed, except for the sale of certain remaining international operations that have subsequently
been completed or are expected to be completed by the end of fiscal 2004 upon, among other things, obtaining certain foreign regulatory approvals. The net book value of these remaining international
operations amounted to $5 million as of March 31, 2004. The Company received approximately $248 million of cash, and 1,761,538 shares of CommScope common stock valued at
approximately $33 million on the closing date. The Company paid $8 million in transaction costs relating to the sale. During the second quarter of fiscal 2004, the Company sold all the
shares of CommScope common stock and recognized a pre-tax loss of $5 million, which is included in other expense, net. The $248 million cash portion of the purchase price is
subject to post-closing adjustments. The Company is currently engaged in discussions with CommScope relating to the final post-closing adjustments and, therefore, the cash
portion of the sales price is subject to adjustment.

The
Company recorded an $81 million pre-tax gain in the second quarter of fiscal 2004 from the sale of Connectivity Solutions, which is included in income from
discontinued operations. Any

11

---



additional
gain or partially offsetting loss from the sale resulting from the completion of the sale of the remaining international operations or the finalization of the post-closing
adjustments will be recorded as discontinued operations in future periods. In accordance with the asset purchase agreement between CommScope and the Company, certain liabilities recorded by the
Company relating to Connectivity Solutions employees transferred to CommScope were not assumed by CommScope, but are no longer obligations of the Company. Therefore, included in the $81 million
gain is a reversal of $26 million of such liabilities that represent primarily employee related costs for which the Company no longer has an obligation.

The
$81 million gain also includes the recognition of $32 million of foreign currency translation adjustments related to the divestiture of Connectivity Solutions'
international operations. A corresponding decrease has been recorded in the accompanying Consolidated Balance Sheet as of March 31, 2004 through accumulated other comprehensive loss to reflect
the realization of foreign currency translation adjustments upon the liquidation of these foreign operations. These foreign currency translation adjustments represent the net unrealized gains and
losses arising from changes in exchange rates and the related effect on the translation of assets and liabilities of those international operations.

Listed
below are the major classes of assets and liabilities of Connectivity Solutions that have been sold and transferred to CommScope. These amounts will be adjusted upon the sale of
the remaining international operations and for post-closing adjustments.

|                                   |  | Balances
Transferred During the Three Months Ended
March 31, 2004 |     | As of
September 30, 2003
|---------------------------------- |  | ----------------------------------------------------------------- | --- | ------------------------
|
|Assets                             |  |                                                                   |     |                         
|Receivables                        |  | $                                                                 | 47  |                         
|Inventory                          |  |                                                                   | 124 |                         
|Property, plant and equipment, net |  |                                                                   | 180 |                         
|Other assets                       |  |                                                                   | 4   |                         
|                                   |  |                                                                   |     |                         
|Total assets                       |  | $                                                                 | 355 |                         
|                                   |  |                                                                   |     |                         
|Liabilities                        |  |                                                                   |     |                         
|Accounts payable                   |  | $                                                                 | 25  |                         
|Payroll and benefit obligation     |  |                                                                   | 59  |                         
|Other liabilities                  |  |                                                                   | 21  |                         
|                                   |  |                                                                   |     |                         
|Total liabilities                  |  | $                                                                 | 105 |                         
|                                   |  |                                                                   |     |                         
|Net assets sold                    |  | $                                                                 | 250 |                         
|                                   |  |                                                                   |     |                         

Income
from discontinued operations from January 1, 2004 through the closing date of January 31, 2004, includes $29 million of revenue and $59 million of loss
before income taxes related to Connectivity Solutions' operations. Income from discontinued operations for the period from

12

---



October 1,
2003 through the closing date, includes $167 million of revenue and $72 million of loss before income taxes related to Connectivity Solutions' operations.

In
connection with the closing of the transaction, the Company recognized a pension and postretirement curtailment loss of $24 million and a settlement loss of $24 million
upon the transfer of pension and postretirement benefit assets and liabilities to CommScope, and recorded a corresponding increase of $48 million to the benefit obligation. These losses were
included in income from discontinued operations in the second quarter of fiscal 2004. Upon the transfer of these pension and postretirement benefit assets and liabilities to CommScope as of
March 31, 2004, an offsetting gain of $48 million was recognized and included in the $81 million gain on sale of discontinued operations for
the assumption of these liabilities by CommScope. These two transactions resulted in a net zero impact to income from discontinued operations for the three and six months ended March 31, 2004.

As
a result of the transfer of Connectivity Solutions employees to CommScope, the Company remeasured its minimum pension liability related to the pension plan for represented employees.
In accordance with SFAS No. 87, "Employers' Accounting for Pensions," the Company recorded an adjustment in the second quarter of fiscal 2004 of $50 million to decrease the additional
minimum pension liability from $813 million as of September 30, 2003, to $763 million as of March 31, 2004. This resulted in a $36 million decrease to accumulated
other comprehensive loss and a $14 million decrease to intangible assets as of March 31, 2004.

On
October 30, 2003, in exchange for the agreement of the International Brotherhood of Electrical Workers to withdraw numerous pending and threatened grievances and arbitration
demands against the Company in connection with the Connectivity Solutions business, the Company agreed to provide a one-time payment of five thousand dollars per person to certain
employees and offer an enhanced retirement incentive for those employees who were pension eligible as of December 2, 2003. In the first quarter of fiscal 2004, the Company recorded a charge of
approximately $7 million for the one-time payment and $4 million related to the acceptance by 124 employees of the retirement incentive offer. Each of these charges is
included in income from discontinued operations in the Consolidated Statement of Operations.

4.    Goodwill and Intangible Assets

The changes in the carrying value of goodwill, including the amount primarily attributed to the acquisition of Expanets, which includes purchase accounting
adjustments, for the six months ended March 31, 2004 by operating segment are as follows:

|                                                      |  | Enterprise
Communications Group |     | Small and
Medium Business
Solutions |   | Services |  | Total
|----------------------------------------------------- |  | ------------------------------- | --- | ----------------------------------- | - | -------- |  | -----
|
|Balance as of September 30, 2003                      |  | $                               | 118 |                                     | $ | 28       |  | $    
|Goodwill acquired                                     |  |                                 | 17  |                                     |   | 5        |  |      
|Impact of foreign currency exchange rate fluctuations |  |                                 |    |                                     |   | 3        |  |      
|                                                      |  |                                 |     |                                     |   |          |  |      
|Balance as of March 31, 2004                          |  | $                               | 135 |                                     | $ | 36       |  | $    
|                                                      |  |                                 |     |                                     |   |          |  |      

13

---





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

The
following table presents the components of the Company's acquired intangible assets with definitive lives, which are included in other assets in the Consolidated Balance Sheets.

|                        |  | As of March 31, 2004 |     | As of September 30, 2003
|----------------------- |  | -------------------- | --- | ------------------------
|
|
|Existing technology     |  | $                    | 123 |                         
|Customer relationships  |  |                      | 21  |                         
|                        |  |                      |     |                         
|Total intangible assets |  | $                    | 144 |                         
|                        |  |                      |     |                         

Amortization
expense for the Company's acquired intangible assets with definitive lives was $2 million and $3 million for the three months ended March 31, 2004 and
2003, respectively, and $4 million and $6 million for the six months ended March 31, 2004 and 2003, respectively. Estimated amortization expense for the succeeding fiscal years as
of March 31, 2004 is (i) $1 million for the remaining six months in fiscal 2004; (ii) $2 million in 2005; (iii) $2 million in 2006;
(iv) $2 million in 2007; (v) $1 million in 2008; and (vi) $15 million thereafter.

As
discussed in Note 3, in connection with the acquisition of Expanets, the Company identified $11 million of intangible assets having indefinite lives, which are included
in other assets in the Consolidated Balance Sheets. Intangible assets with indefinite lives are not subject to amortization and will be tested for impairment annually. The Company will evaluate the
remaining useful life of these intangible assets to determine whether events and circumstances continue to support an indefinite useful life and will compare the fair value of these intangible assets
with their carrying amount. To the extent the fair value exceeds the carrying amount, an impairment charge will be recorded.

In
addition, included in other assets in the Consolidated Balance Sheets as of March 31, 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 of a minimum pension liability in fiscal 2003 and 2002. This intangible asset may be
eliminated or adjusted as necessary when the amount of minimum pension liability is reassessed, which is conducted at least annually. Based on the Company's remeasurement of its minimum pension
liability as a result of the transfer of Connectivity Solutions employees to CommScope, as discussed in Note 3, the intangible asset decreased by $14 million.

5.    Comprehensive Income (Loss)

Other comprehensive income (loss) is recorded directly to a separate section of stockholders' equity in accumulated other comprehensive loss and includes
unrealized gains and losses excluded from the Consolidated Statements of Operations. These unrealized gains and losses for the three and six months ended March 31, 2004 and 2003 consisted
primarily of adjustments to the minimum pension liability, net of income taxes and valuation allowance, and foreign currency translation, which were not adjusted for income taxes since they primarily
relate to indefinite investments in non-U.S. subsidiaries.

14

---



|                                  |                                                                                                                                                                                                                             | Three Months
Ended
March 31, |     | Six Months
Ended
March 31, |  
|--------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------- | --- | -------------------------- | -
|
|
|Net income (loss)                 |                                                                                                                                                                                                                             | $                            | 125 |                            | $
|Other comprehensive income:       |                                                                                                                                                                                                                             |                              |     |                            |  
|                                  | Foreign currency translation adjustments                                                                                                                                                                                    |                              |     | 4                          |  
|                                  | Minimum pension liability adjustment, net of a reversal of deferred income taxes of $14 million offset by a reversal of the corresponding $14 million valuation allowance for the three and six months ended March 31,
2004 |                              |     | 36                         |  
|                                  |                                                                                                                                                                                                                             |                              |     |                            |  
|Total comprehensive income (loss) |                                                                                                                                                                                                                             | $                            | 165 |                            | $
|                                  |                                                                                                                                                                                                                             |                              |     |                            |  

6.    Supplementary Financial Information

Balance Sheet Information

|                                  |                 | As of
March 31, 2004 |     | As of
September 30, 2003
|--------------------------------- | --------------- | -------------------- | --- | ------------------------
|
|INVENTORY                         |                 |                      |     |                         
|Finished goods                    |                 | $                    | 211 |                         
|Work in-process and raw materials |                 |                      | 54  |                         
|                                  |                 |                      |     |                         
|                                  | Total inventory |                      | $   | 265                     
|                                  |                 |                      |     |                         

Statements of Operations Information

|                                               |                          | Three Months
Ended
March 31, |     | Six Months
Ended
March 31, |  
|---------------------------------------------- | ------------------------ | ---------------------------- | --- | -------------------------- | -
|
|
|OTHER EXPENSE, NET                             |                          |                              |     |                            |  
|Interest income                                |                          | $                            | 4   |                            | $
|Loss on sale of CommScope common stock         |                          |                              | (5  | )                          |  
|Loss on extinguishment of Senior Secured Notes |                          |                              | (21 | )                          |  
|Loss on extinguishment of LYONs                |                          |                              |    |                            |  
|Lucent securities litigation charge            |                          |                              |    |                            |  
|Other, net                                     |                          |                              | 3   |                            |  
|                                               |                          |                              |     |                            |  
|                                               | Total other expense, net |                              | $   | (19                        | )
|                                               |                          |                              |     |                            |  

15

---



Cash Flow Information

|                                                                               |                             | Six Months Ended
March 31,
|------------------------------------------------------------------------------ | --------------------------- | --------------------------
|
|
|Non-cash transactions:                                                         |                             |                           
|Investment in equity securities                                                |                             | $                         
|CommScope common stock received in connection with Connectivity Solutions sale |                             |                           
|Notes received as part of Expanets' sale                                       |                             |                           
|Exchange of LYONs for common stock                                             |                             |                           
|Warrants to purchase common stock issued in LYONs Exchange Offer               |                             |                           
|                                                                               |                             |                           
|                                                                               | Total non-cash transactions |                           
|                                                                               |                             |                           

7.    Business Restructuring Reserve

The business restructuring reserve reflects the remaining balance associated with the Company's previous business restructuring actions. The following table
summarizes the status of the Company's business restructuring reserve as of and for the six months ended March 31, 2004:

|                                 |  | Employee
Separation
Costs |    | Lease
Termination
Obligations |   | Total Business
Restructuring
Reserve |  
|-------------------------------- |  | ------------------------- | -- | ----------------------------- | - | ------------------------------------ | -
|
|Balance as of September 30, 2003 |  | $                         | 4  |                               | $ | 62                                   |  
|Cash payments                    |  |                           | (3 | )                             |   | (12                                  | )
|Reversals                        |  |                           | (1 | )                             |   |                                     |  
|                                 |  |                           |    |                               |   |                                      |  
|Balance as of March 31, 2004     |  | $                         |   |                               | $ | 50                                   |  
|                                 |  |                           |    |                               |   |                                      |  

Payments
on lease obligations, net of estimated sublease income, will extend through 2011 because, in certain circumstances, the remaining lease payments were less than the termination
fees.

16

---



8.    Debt and Derivative Financial Instruments

Debt outstanding consists of the following:

|                                                                                              |                                         | As of
March 31, 2004 |     | As of
September 30, 2003 |    
|--------------------------------------------------------------------------------------------- | --------------------------------------- | -------------------- | --- | ------------------------ | ---
|
|Current portion of long-term debt:                                                            |                                         |                      |     |                          |    
|                                                                                              | LYONs convertible debt, net of discount |                      | $   | 292                      |    
|                                                                                              |                                         |                      |     |                          |    
|Long-term debt:                                                                               |                                         |                      |     |                          |    
|LYONs convertible debt, net of discount                                                       |                                         |                      |    |                          |    
|111/8% Senior Secured Notes, net of discount, premium and deferred gain on interest rate swap |                                         |                      | 437 | (1)                      |    
|                                                                                              |                                         |                      |     |                          |    
|                                                                                              | Total long-term debt                    |                      |     | 437                      |    
|                                                                                              |                                         |                      |     |                          |    
|                                                                                              |                                         | Total debt           |     | $                        | 729
|                                                                                              |                                         |                      |     |                          |    

---

Senior Secured Notes

On March 19, 2004, the Company redeemed $224 million aggregate principal amount of its outstanding Senior Secured Notes at a price of 111.125% per
note, or approximately $249 million in the aggregate, resulting in a premium paid upon redemption of $25 million. The Company used the entire net proceeds received from the sale in
February 2004 of approximately 14 million shares of the Company's common stock to redeem these notes (see Note 10). The Company recognized a loss on the early redemption of
$21 million, which is included in other expense, net. The $21 million loss consists of (i) the $25 million redemption premium, (ii) the write-off of
$5 million of deferred financing costs, offset partially by the recognition of (iii) $4 million of unamortized net premium recorded at the time of the original debt issuances, and
(iv) a $5 million deferred gain related to the termination in December 2002 of the Company's interest rate swap agreements.

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

LYONs Put Obligation

The Company has classified the Liquid Yield Option Notes due 2021 ("LYONs") convertible debt as a current obligation as of March 31, 2004
since the holders may require the Company to purchase all or a portion of their LYONs on October 31, 2004. If the LYONs are put to the Company,

17

---



the
Company may, at its option, elect to pay the purchase price in cash or shares of common stock, or any combination thereof.

Credit Facility Amendment

In January 2004, the Company and the lenders under the Company's five-year revolving credit agreement ("Credit Facility") amended the terms of
the Credit Facility to provide the Company with additional flexibility to repurchase its debt 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 or repurchase LYONs, other than pursuant to the
October 31, 2004 put, so long as the Company holds unrestricted domestic cash and marketable securities of at least $400 million immediately before and after such redemption or
repurchase. As of March 31, 2004, the Company used approximately $156 million in cash to repurchase LYONs and, as a result of the amendments to the Credit Facility, has the ability under
the amended Credit Facility to use an additional $299 million in cash to repurchase LYONs, other than pursuant to the October 31, 2004 put.

In
connection with the October 31, 2004 put obligation described in respect to the LYONs, the amended Credit Facility requires the 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 the LYONs is satisfied and (b) the date upon which the Company delivers to the
lenders under the amended Credit Facility a certificate certifying its compliance with the covenants included in the amended 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 put obligation under the LYONs had been satisfied as of such day. For purposes of this calculation, liquidity is defined
as the sum of the unused commitments under the Company's amended Credit Facility plus unrestricted domestic cash and marketable securities. To the extent the Company can satisfy this liquidity test,
it may use cash to satisfy any put obligation with respect to the LYONs.

The
Credit Facility was also amended to permit the Company to prepay or repurchase up to $500 million of long-term debt other than the LYONs so long as the Company
holds unrestricted domestic cash and marketable securities of at least $400 million immediately 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. The Company has the ability to use an additional $251 million in cash to repurchase long-term debt other than
LYONs under the amended Credit Facility.

The
amendments to the Credit Facility provide that from and after the first date that the Company repurchases debt in accordance with the terms of the amended Credit Facility or makes an
acquisition for a purchase price of $100 million or more, the Company will be required to have had positive free cash flow for the four fiscal quarters most recently then ended and maintain
positive free cash flow for each four quarter period thereafter. Free cash flow is defined under the amended Credit Facility as net cash provided by (used in) operating activities less capital
expenditures and dividends. As a result of the redemption of the Senior Secured Notes described above, the Company is currently required to comply with this covenant.

The
amendments to the Credit Facility provide that, in addition to debt already permitted under the Credit Facility, the Company may incur debt in an amount equal to the amount of debt
previously

18

---



repaid
by the Company, so long as immediately before and after such issuance, the Company has $400 million in unrestricted domestic cash and marketable securities.

The
January 2004 amendments to the Credit Facility provided that the Company may use up to $500 million in cash to make acquisitions provided that the Company complies with
certain financial covenants and so long as no more than $250 million in cash is used in any single acquisition. In February 2004, the Credit Facility was further amended to eliminate the
$250 million limitation on a single acquisition.

Interest Rate Swap Agreements

During the six months ended March 31, 2004, the Company entered into five interest rate swap agreements each having a notional amount of $50 million
and a maturity date of April 2009. Under these agreements, the Company receives a fixed interest rate of 111/8% and pays a floating interest rate based on the
six-month LIBOR (in arrears) plus an agreed-upon spread of 6.55%, 6.8575%, 6.94%, 6.8% and 6.98%, respectively. The interest rate swaps effectively convert $250 million
of the Senior Secured Notes from fixed rate debt into floating rate debt.

9.    Benefit Obligations

The following table illustrates the components of net periodic benefit cost for the Company's pension and postretirement benefit plans:

|                                   |  | Pension
Benefits |     | Postretirement Benefits |   | Pension
Benefits |   | Postretirement Benefits |   
|---------------------------------- |  | ---------------- | --- | ----------------------- | - | ---------------- | - | ----------------------- | --
|
|
|
|Service cost                       |  | $                | 4   |                         | $ | 14               |   | $                       | 1 
|Interest cost                      |  |                  | 43  |                         |   | 43               |   |                         | 10
|Expected return on plan assets     |  |                  | (54 | )                       |   | (52              | ) |                         | (4
|Amortization of prior service cost |  |                  | 2   |                         |   | 1                |   |                         | 3 
|Recognized net actuarial loss      |  |                  | 4   |                         |   |                 |   |                         | 2 
|Curtailment loss                   |  |                  | 10  |                         |   |                 |   |                         | 14
|Settlement loss                    |  |                  | 16  |                         |   |                 |   |                         | 8 
|Special termination benefits       |  |                  |    |                         |   |                 |   |                         |  
|                                   |  |                  |     |                         |   |                  |   |                         |   
|Net periodic benefit cost          |  | $                | 25  |                         | $ | 6                |   | $                       | 34
|                                   |  |                  |     |                         |   |                  |   |                         |   

As
previously disclosed in its financial statements for the year ended September 30, 2003, the Company will not be required to make any contributions to fund its
pension obligation in fiscal 2004.

The
Company provides certain pension benefits and retiree medical benefits for management employees, neither of which is pre-funded. Consequently, the Company makes payments
as these pension and retiree medical benefits are disbursed. For the six months ended March 31, 2004, the Company made payments for these pension and retiree medical benefits totaling
$3 million and $12 million, respectively. For the remainder of fiscal 2004, the Company presently anticipates making

19

---



additional
payments for these pension and retiree medical benefits totaling $5 million and $12 million, respectively, for a total during fiscal 2004 of approximately $8 million
and $24 million, respectively.

10.    Equity Transaction

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

11.    Stock Compensation

During the six months ending March 31, 2004, the Company granted to eligible employees approximately 9 million stock options at a weighted average
exercise price of $13.61 and approximately 507 thousand restricted stock units at a weighted average market value of $13.79.

A
total of approximately 5 million restricted stock units held by employees vested during the six months ended March 31, 2004. Of this amount, approximately
1.5 million shares underlying the restricted stock units were withheld for purposes of remitting federal and state income and payroll taxes related to the vesting of the units. The remaining
approximately 3.5 million shares underlying the restricted stock units were distributed to the employees upon vesting. The 1.5 million shares withheld for tax purposes are recorded as
treasury stock at the value of the shares as of the respective vesting dates and account for the $21 million increase in treasury stock from September 30, 2003 to March 31, 2004.

12.    Earnings (Loss) Per Share of Common Stock

Basic earnings (loss) per common share is calculated by dividing net income (loss) available to common stockholders by the weighted average number of common
shares outstanding during the year. Diluted earnings (loss) per common share is calculated by adjusting net income (loss) available to

20

---



common
stockholders and weighted average outstanding shares, assuming conversion of all potentially dilutive securities including stock options, restricted stock units, warrants, and convertible debt.

|                                                                          |                                           | Three Months Ended
March 31, |      | Six Months Ended
March 31, |  
|------------------------------------------------------------------------- | ----------------------------------------- | ---------------------------- | ---- | -------------------------- | -
|
|
|Earnings (Loss) Per Common ShareBasic:                                   |                                           |                              |      |                            |  
|Income (loss) from continuing operations                                  |                                           | $                            | 103  |                            | $
|Income from discontinued operations                                       |                                           |                              | 22   |                            |  
|                                                                          |                                           |                              |      |                            |  
|Net income (loss) available to common stockholders                        |                                           | $                            | 125  |                            | $
|                                                                          |                                           |                              |      |                            |  
|Weighted average sharesbasic                                             |                                           |                              | 435  |                            |  
|                                                                          |                                           |                              |      |                            |  
|Earnings (loss) per share from continuing operations                      |                                           | $                            | 0.24 |                            | $
|Earnings per share from discontinued operations                           |                                           |                              | 0.05 |                            |  
|                                                                          |                                           |                              |      |                            |  
|Earnings (loss) per sharebasic                                           |                                           | $                            | 0.29 |                            | $
|                                                                          |                                           |                              |      |                            |  
|Earnings (Loss) Per Common ShareDiluted:                                 |                                           |                              |      |                            |  
|Income (loss) from continuing operations                                  |                                           | $                            | 103  |                            | $
|After-tax savings on the assumed conversion of LYONs                      |                                           |                              | 1    |                            |  
|                                                                          |                                           |                              |      |                            |  
|Income (loss) from continuing operations available to common stockholders |                                           |                              | 104  |                            |  
|Income from discontinued operations                                       |                                           |                              | 22   |                            |  
|                                                                          |                                           |                              |      |                            |  
|Net income (loss) available to common stockholders                        |                                           | $                            | 126  |                            | $
|                                                                          |                                           |                              |      |                            |  
|Weighted average sharesbasic                                             |                                           |                              | 435  |                            |  
|Potential dilutive securities:                                            |                                           |                              |      |                            |  
|                                                                          | Assumed exercise of stock options         |                              |      | 10                         |  
|                                                                          | Assumed vesting of restricted stock units |                              |      | 1                          |  
|                                                                          | Assumed exercise of warrants              |                              |      | 6                          |  
|                                                                          | Assumed conversion of LYONs               |                              |      | 21                         |  
|                                                                          |                                           |                              |      |                            |  
|Weighted average sharesdiluted                                           |                                           |                              | 473  |                            |  
|                                                                          |                                           |                              |      |                            |  
|Earnings (loss) per share from continuing operations                      |                                           | $                            | 0.22 |                            | $
|Earnings per share from discontinued operations                           |                                           |                              | 0.05 |                            |  
|                                                                          |                                           |                              |      |                            |  
|Earnings (loss) per sharediluted                                         |                                           | $                            | 0.27 |                            | $
|                                                                          |                                           |                              |      |                            |  
|                                                                          |                                           |                              |      |                            |  

21

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|Securities excluded from the computation of diluted earnings (loss) per common share: |                              |  |    |   |  |     |     |  |    |   |  |     |    
|------------------------------------------------------------------------------------- | ---------------------------- |  | -- | - |  | --- | --- |  | -- | - |  | --- | ---
|Options (1)                                                                           |                              |  | 9  |   |  | 54  |     |  | 25 |   |  | 51  |    
|Warrants (1)                                                                          |                              |  | 7  |   |  | 16  |     |  | 7  |   |  | 14  |    
|Common shares issuable upon conversion of LYONs:                                      |                              |  |    |   |  |     |     |  |    |   |  |     |    
|                                                                                      | Settled in common shares (2) |  |    |  |  |     | 177 |  |    |  |  |     | 222
|                                                                                      | Settled in cash (3)          |  |    |  |  |     | 22  |  |    |  |  |     | 11 
|                                                                                      |                              |  |    |   |  |     |     |  |   
|Total                                                                                 |                              |  | 16 |   |  | 269 |     |  | 32 |   |  | 298 |    
|                                                                                      |                              |  |    |   |  |     |     |  |   

---

13.    Operating Segments

The Company reports its operations in three segmentsECG, SMBS, and Services. The ECG segment develops, markets and sells communications products and
applications primarily to large enterprises and includes IP telephony systems, traditional voice communications systems, multi-media contact center infrastructure and applications in support of
customer relationship management, unified communications applications, and appliances, such as telephone sets. The SMBS segment develops, markets and sells communications products and applications,
including IP telephony systems, traditional voice communications systems, unified communication and contact center applications, for small and medium-sized businesses. The Services segment offers a
comprehensive portfolio of global services that enable customers to plan, design, build and manage their communications networks. Services' operating results also include the professional services
organization as explained below.

As
described in Note 3, as a result of the sale of Connectivity Solutions, the Company has classified the results of operations of Connectivity Solutions as a discontinued
operation. This business was previously disclosed as a separate operating segment. The segment data included below has been restated to exclude the results of Connectivity Solutions and to reallocate
Connectivity Solutions' portion of corporate related expenses to the remaining operating segments. During the first quarter of

22

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fiscal
2004, the Company moved its professional services organization from ECG to the Services segment to more properly reflect the professional service organization's ability to service products
other than Avaya's. The Company's professional services organization provides services required to customize the Company's communication application solutions for individual customer needs. The
Company also allocated a portion of the results attributed to the Company's third-party financing arrangement from ECG to SMBS based on the relative contribution of the arrangement to the sale of each
segment's products. Accordingly, prior period amounts have been reclassified to reflect these changes.

The
segments are managed as three functional businesses and, as a result, include certain allocated costs and expenses of shared services, such as information technology, human
resources, legal and finance. Costs remaining in the other unallocated category represent expenses that are not identified with the operating segments and include costs incurred to maintain vacant
real estate facilities. Intersegment sales approximate fair market value and are not significant.

The
Company has outsourced all of its manufacturing operations related to ECG and SMBS segments primarily to Celestica Inc. All manufacturing of the Company's products is
performed in accordance with detailed specifications and product design furnished by the Company and is subject to quality control standards.

23

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Reportable Segments

Summarized financial information relating to the Company's reportable segments is shown in the following table:

|                                                   |  | Reportable Segments |     | Corporate |   |     |  
|-------------------------------------------------- |  | ------------------- | --- | --------- | - | --- | -
|
|
|Three Months Ended
March 31, 2004                  |  |                     |     |           |   |     |  
|Revenue                                            |  | $                   | 427 |           | $ | 66  |  
|Operating income (loss) from continuing operations |  |                     | (8  | )         |   | 5   |  
|Three Months Ended
March 31, 2003                  |  |                     |     |           |   |     |  
|Revenue                                            |  | $                   | 413 |           | $ | 58  |  
|Operating income (loss) from continuing operations |  |                     | (31 | )         |   | (2  | )
|Six Months Ended
March 31, 2004                    |  |                     |     |           |   |     |  
|Revenue                                            |  | $                   | 844 |           | $ | 129 |  
|Operating income (loss) from continuing operations |  |                     | (12 | )         |   | 11  |  
|Six Months Ended
March 31, 2003                    |  |                     |     |           |   |     |  
|Revenue                                            |  | $                   | 815 |           | $ | 115 |  
|Operating income (loss) from continuing operations |  |                     | (84 | )         |   | (3  | )

Geographic Information

Financial information relating to the Company's revenues by geographic area was as follows:

Three Months
Ended
March 31,

Six Months
Ended
March 31,2004

2003

2004

2003(dollars in millions)Revenue(1)U.S.

$
760

$
719

$
1,498

$
1,433International


246


231


479


463Total

$
1,006

$
950

$
1,977

$
1,896


---

24

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14.    Commitments and Contingencies

Legal Proceedings

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

Year 2000 Actions

Three separate purported class action lawsuits are pending against Lucent Technologies, Inc. ("Lucent"), the Company's former parent, one in state court in
West Virginia, one in federal court in the Southern District of New York and another in federal court in the Southern District of California. The case in New York was filed in January 1999 and,
after being dismissed, was refiled in September 2000. The case in West Virginia was filed in April 1999 and the case in California was filed in June 1999, and amended in 2000 to
include the Company as a defendant. The Company may also be named a party to the other actions and, in any event, has assumed the obligations of Lucent for all of these cases under the Contribution
and Distribution Agreement, as described in "Transactions with Lucent" below between the Company and Lucent. All three actions are based upon claims that Lucent sold products that were not Year 2000
compliant, meaning that the products were designed and developed without considering the possible impact of the change in the calendar from December 31, 1999 to January 1, 2000. The
complaints allege that the sale of these products violated statutory consumer protection laws and constituted breaches of implied warranties.

A
class has been certified in the West Virginia state court matter. The certified class in the West Virginia matter includes those persons or entities that purchased, leased or financed
the products in question. In addition, the court also certified as a subclass all class members who had service protection plans or other service or extended warranty contracts with Lucent in effect
as of April 1, 1998, as to which Lucent failed to offer a free Year 2000-compliant solution. The Fourth Circuit Court of Appeals recently denied the defendant's attempt to have the
Federal District Court in West Virginia retain jurisdiction in this matter. The federal court in the New York action has issued a decision and order denying class certification, dismissing all but
certain fraud claims by one representative plaintiff. No class claims remain in this case at this time.

The
federal court in the California action has issued an opinion and order granting class certification. The class includes any entities that purchased or leased certain products on or
after January 1, 1990, excluding those entities who did not have a New Jersey choice of law provision in their contracts and those who did not purchase equipment directly from defendants. The
federal court in the California action has issued an order staying the action pending the outcome of the West Virginia matter. The complaints seek, among other remedies, compensatory damages, punitive
damages and counsel fees in amounts that have not yet been specified.

Lucent Securities Litigation

In November 2000, three purported class actions were filed against Lucent in the Federal District Court for the District of New Jersey alleging violations
of the federal securities laws as a result of the

25

---



facts
disclosed in Lucent's announcement on November 21, 2000 that it had identified a revenue recognition issue affecting its financial results for the fourth quarter of fiscal 2000. The
actions purport to be filed on behalf of purchasers of Lucent common stock during the period from October 10, 2000 (the date Lucent originally reported these financial results) through
November 21, 2000.

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

In
March 2003, Lucent announced that it had entered into a $420 million settlement of all pending shareholder and related litigation. Certain cases which are the subject of
the settlement are shared contingent liabilities under the Contribution and Distribution Agreement and accordingly, the Company is responsible for 10% of the liabilities attributable to those cases,
including 10% of the legal costs associated with the portion of the litigation for which the Company shares liability. In the second quarter of fiscal 2003, the Company recorded a charge of
$25 million representing the Company's estimate of its liability in this matter. The Company recently reached agreement with Lucent to pay $24 million in shares of the Company's common
stock in full satisfaction of its obligations under the settlement. The terms of the settlement were approved by the Federal District Court for the District of New Jersey in December 2003. The
Company understands the administration of claims is currently in process.

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 amount in excess of $10 million, stemming from the sale of products from the Company's businesses that were formerly owned by Lucent involving the Ministry of Russian
Railways. In April 2003, CDC initiated the arbitration before the American Arbitration Association. The plaintiff alleges that as a result of agreements entered into between the plaintiff and
the Company, it is owed commissions on sales by the Company to the Ministry of Russian Railways on a continuing basis. The Company believes that the agreements relating to their claim have expired or
do not apply to the products in question. As the sales of products continue, CDC may likely increase its commission demand. The parties are in the process of selecting arbitrators.

Lucent Consumer Products Class Actions

In several class action cases (the first of which was filed on June 24, 1996), plaintiffs claim that AT&T and Lucent engaged in fraud and deceit in
continuing to lease residential telephones to consumers without adequate notice that the consumers would pay well in excess of the purchase price of a telephone by continuing to lease. The cases were
removed and consolidated in federal court in Alabama, and were subsequently remanded to their respective state courts (Illinois, Alabama, New

26

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Jersey,
New York and California). In July 2001, the Illinois state court certified a nationwide class of plaintiffs. The case in Illinois was scheduled for trial on August 5, 2002. Prior
to commencement of trial, however, the parties agreed to a settlement of the claims on a class-wide basis. The settlement was approved by the court on November 4, 2002. Claims from
Class members were required to be filed on or about January 15, 2003.

Any
liability incurred by Lucent in connection with these class action cases will be considered an exclusive Lucent liability under the Contribution and Distribution Agreement between
Lucent and the Company and, as a result, the Company would be responsible for 10% of any such liability in excess of $50 million. The Company recently agreed with Lucent to pay
$6 million in satisfaction of its liability in this matter, although Lucent has notified the Company that it may be responsible for some additional costs that may be incurred in connection with
the conclusion of the claims administration. Based on the Company's discussions with Lucent, it does not expect those additional costs to be material.

Patent Infringement Claim

AudioFAX IP, LLC has filed an action against the Company in the U.S. District Court for the Northern District of Georgia, alleging that the Company has infringed
five of its patents relating to facsimile products in violation of federal patent laws. This matter is in the early stages of litigation and the Company cannot determine whether the outcome of this
action will have a material adverse effect on its financial position, results of operations or cash flows.

Variable Workforce Grievances

The Communications Workers of America and the International Brotherhood of Electrical Workers, unions representing the Company's technicians, have filed
grievances regarding an interpretation of the variable workforce agreements ("Agreements") entered into between the Company and the unions in June 2003. The unions allege that the Company has
violated the agreements by activating some, but not all, variable workforce employees (approximately 850 in total) for duty from August 2003, and not paying such employees for the minimum
amount of weeks to which they claim entitlement under their interpretation of the Agreements. The Company has denied the grievances relating to these cases. At this time, the Company cannot determine
whether these disputes will have a material adverse effect on the Company's financial position, results of operations or cash flows.

Environmental, Health and Safety Matters

The Company is subject to a wide range of governmental requirements relating to employee safety and health and to the handling and emission into the environment
of various substances used in its operations. The Company is subject to certain provisions of environmental laws, particularly in the United States, governing the cleanup of soil and groundwater
contamination. Such provisions impose liability for the costs of investigating and remediating releases of hazardous materials at currently or formerly owned or operated sites. In certain
circumstances, this liability may also include the cost of cleaning up historical contamination, whether or not caused by the Company. The Company is currently conducting investigation and/or cleanup
of known contamination at approximately seven of its current or former facilities either voluntarily or pursuant to government directives. None of the sites is

27

---



reasonably
likely to generate environmental costs that will be individually material nor will environmental costs for all sites in the aggregate be material. There are no known third parties who may
be responsible for investigation and/or cleanup at these sites and therefore, for purposes of assessing the adequacy of financial reserves for these liabilities, the Company has not assumed that it
will recover amounts from any third party, including under any insurance coverage or indemnification arrangement. Although the Company does not separately track recurring costs of managing hazardous
substances and pollutants in ongoing operations, it does not believe them to be material.

It
is often difficult to estimate the future impact of environmental matters, including potential liabilities. The Company has established financial reserves to cover environmental
liabilities where they are probable and reasonably estimable. Reserves for estimated losses from environmental matters are undiscounted and consist primarily of estimated remediation and monitoring
costs and are, depending on the site, based primarily upon internal or third-party environmental studies and the extent of contamination and the type of required cleanup. The Company is not aware of,
and has not included in reserves any provision for, any unasserted environmental claims.

The
reliability and precision of estimates of the Company's environmental costs may be affected by a variety of factors, including whether the remediation treatment will be effective,
contamination sources have been accurately identified and assumptions regarding the movement of contaminants are accurate. In addition, estimates of environmental costs may be affected by changes in
law and regulation, including the willingness of regulatory authorities to conclude that remediation and/or monitoring performed by the Company is adequate.

The
Company assesses the adequacy of environmental reserves on a quarterly basis. For each of the three and six month periods ended March 31, 2004 and 2003, no amounts were
charged to the Statements of Operations for environmental costs as reserves were deemed to be adequate. Expenditures for environmental matters each of the three and six month periods ended
March 31, 2004 and 2003 were not material to the Company's financial position, results of operations or cash flows.
Payment for the environmental costs covered by the reserves may be made over a 30-year period.

Product Warranties

The Company recognizes a liability for the estimated costs that may be incurred to remedy certain deficiencies of quality or performance of the Company's
products. These product warranties extend over a specified period of time generally ranging up to one year from the date of sale depending upon the product subject to the warranty. The Company accrues
a provision for estimated future warranty costs based upon the historical relationship of warranty claims to sales. The Company periodically reviews the adequacy of its product warranties and adjusts,
if necessary, the warranty percentage and accrued warranty reserve, which is included in other current liabilities in the Consolidated Balance Sheets, for actual experience.

28

---



The
following table reconciles the changes in the Company's product warranty reserve as of and for the six months ended March 31, 2004:

(dollars in
millions)Balance as of September 30, 2003

$
30Warranties accrued during the six months ended March 31, 2004


23Less actual warranty expenses incurred during the period


(28
)Balance as of March 31, 2004

$
25


Guarantees of Indebtedness and Other Off-Balance Sheet Arrangements

Letters of Credit

The Company has entered into uncommitted credit facilities that vary in term totaling $151 million for the purpose of securing third party financial
guarantees such as letters of credit which ensure the Company's performance or payment to third parties. As of March 31, 2004, the Company had outstanding an aggregate of $90 million in
irrevocable letters of credit and similar third party financial guarantees. The Company has secured lower bank fees by cash collateralizing $70 million of these outstanding letters of credit
with the issuing financial institutions and has securitized $10 million for other collateral requirements relating to casualty claims. This restricted cash is included in other assets on the
Company's Consolidated Balance Sheets.

Surety Bonds

The Company acquires various types of surety bonds, such as license, permit, bid and performance bonds, which are agreements under which the surety company
guarantees that the Company will perform in accordance with contractual or legal obligations. These bonds vary in duration although most are issued and outstanding from six months to three years. If
the Company fails to perform under its obligations, the maximum potential payment under these surety bonds is approximately $19 million as of March 31, 2004. Historically, no surety
bonds have been drawn upon and there is no future expectation that these surety bonds will be drawn upon.

Purchase Commitments and Termination Fees

The Company has commitment contracts with certain suppliers in which it is obligated to purchase a specified amount of inventory based on its forecasts, or pay a
charge in the event the Company does not meet its designated purchase commitments. Additionally, certain agreements call for an early termination fee, obligating the Company to make a payment to the
supplier. As of March 31, 2004, the maximum potential payment under these commitments was approximately $65 million. Historically, the Company has not been required to pay a charge for
not meeting its designated purchase commitments with these suppliers.

29

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Product Financing Arrangements

The Company sells products to various resellers that may obtain financing from certain unaffiliated third party lending institutions.

The
Company has a product financing arrangement with one U.S. reseller. Avaya is obligated under certain circumstances to repurchase inventory previously sold to this reseller, in the
event the lending institution, which financed the transaction, repossesses the reseller's inventory of the Company's products. The Company's obligation to repurchase inventory from the lending
institution terminates 180 days from the date of invoicing by the Company to the reseller. The repurchase amount is equal to the price originally paid to the Company by the lending institution
for the inventory. This reseller has financed $63 million of inventory purchases under this arrangement as of March 31, 2004. There have not been any 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 March 31, 2004 and has adequately provided for this guarantee in its
financial statements at March 31, 2004. The fair value of the guarantee is not significant. There can be no assurance that the Company will not be obligated to repurchase inventory under this
arrangement in the future.

For
the Company's product financing arrangement with resellers outside the U.S., in the event participating resellers default on their payment obligations to the lending institution, the
Company is obligated under certain circumstances to guarantee repayment to the lending institution. The repayment amount fluctuates with the level of product financing activity. The guarantee
repayment amount reported to the Company from the lending institution was approximately $6 million as of March 31, 2004. The Company reviews and sets the maximum credit limit for each
reseller participating in this financing arrangement. There have not been any guarantee repayments by Avaya since the Company entered in this arrangement in October 2000. The Company has
estimated the fair value of this guarantee as of March 31, 2004 and has adequately provided for this guarantee in its financial
statements at March 31, 2004. The fair value of the guarantee is not significant. There can be no assurance that the Company will not be obligated to repurchase inventory under this arrangement
in the future.

Credit Facility Indemnification

In connection with its obligations under the amended Credit Facility described in Note 8, the Company has agreed to indemnify the third party lending
institutions for costs incurred by the institutions related to changes in tax law or other legal requirements. While there have been no amounts paid to the lenders pursuant to this indemnity in the
past, there can be no assurance that the Company will not be obligated to indemnify the lenders under this arrangement in the future.

Transactions with Lucent

In connection with the Company's spin-off from Lucent in September 2000, the Company and Lucent executed and delivered the Contribution and
Distribution Agreement and certain related agreements.

30

---



Pursuant
to the Contribution and Distribution Agreement, Lucent contributed to the Company substantially all of the assets, liabilities and operations associated with its enterprise
networking businesses ("Company's Businesses"). The Contribution and Distribution Agreement, among other things, provides that, in general, the Company will indemnify Lucent for all liabilities
including certain pre-distribution tax obligations of Lucent relating to the Company's Businesses and all contingent liabilities primarily relating to the Company's Businesses or otherwise
assigned to the Company. In addition, the Contribution and Distribution Agreement provides that certain contingent liabilities not allocated to one of the parties will be shared by Lucent and the
Company in prescribed percentages. The Contribution and Distribution Agreement also provides that each party will share specified portions of contingent liabilities based upon agreed percentages
related to the business of the other party that exceed $50 million. SeeLucent Securities Litigationincluded in Legal Proceedings above for a
discussion of the Company's obligations under the settlement of such litigation. The Company is unable to determine the maximum potential amount of other future payments, if any, that it could be
required to make under this agreement.

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

In
the second quarter of fiscal 2004, the Company recognized an $89 million tax benefit resulting from the resolution of federal income tax audit matters for the years 1990
through 1998 and certain state tax matters that arose prior to the Company's separation from Lucent. The $89 million benefit consisted of a $37 million net cash refund and the reversal
of certain tax liabilities. The Company received the $37 million net cash refund from Lucent in accordance with the terms of a Tax Sharing Agreement that the Company and Lucent entered into in
connection with the Distribution. The Tax Sharing Agreement governs Lucent's and the Company's respective rights, responsibilities and obligations after the distribution with respect to taxes for the
periods ending on or before the distribution. Generally, pre-distribution taxes or benefits that are clearly attributable to the business of one party will be borne solely by that party,
and other pre-distribution taxes or benefits will be shared by the parties based on a formula set forth in the Tax Sharing Agreement. The Company may be subject to additional taxes or
benefits pursuant to the Tax Sharing Agreement related to future settlements of audits by taxing authorities for the periods prior to the Company's separation from Lucent.

15.    Subsequent Event

On April 2, 2004, the Company announced an agreement with the Tata Group to acquire its shares of Tata Telecom Ltd. ("Tata Telecom"), a leading
voice communications solutions provider in India, representing 25.1 percent ownership of Tata Telecom. The Company currently owns a 25.5 percent interest in Tata Telecom. Under the terms
of the agreement, the Company will pay 220 rupees per share, or approximately $18 million in cash. The transaction is expected to close by September 30, 2004, and is subject to statutory
requirements and regulatory approval, including a public tender offer to purchase a minimum of 20 percent additional outstanding shares of Tata Telecom at a price of 220 rupees per share. Upon
the completion of the acquisition of these additional equity interests, the Company will own at least 50.6 percent and as much as 70.6 percent of Tata Telecom and will begin
consolidating their results.

31

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

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

Our
accompanying unaudited consolidated financial statements as of March 31, 2004 and for the three and six months ended March 31, 2004 and 2003, have been prepared in
accordance with accounting principles generally accepted in the United States of America for interim financial statements and the rules and regulations of the Securities and Exchange Commission, or
the SEC, for interim financial statements, and should be read in conjunction with our consolidated financial statements and other financial information for the fiscal year ended September 30,
2003, which was filed with the Securities and Exchange Commission on February 12, 2004 on a Current Report on Form 8-K. In our opinion, the unaudited interim consolidated
financial statements reflect all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial condition, results of operations and cash flows for the
periods indicated. Certain prior year amounts have been reclassified to conform to the current interim period presentation. The consolidated results of operations for the interim periods reported are
not necessarily indicative of the results to be experienced for the entire fiscal year.

Forward Looking Statements

(Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)

Our
disclosure and analysis in this quarterly report contain some forward-looking statements. Forward-looking statements give our current expectations or forecasts of future events. You
can identify these statements by the fact that they do not relate strictly to historical or current facts. They use words such as "anticipate," "estimate," "expect," "project," "intend," "plan,"
"believe," and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. From time to time, we also may provide oral or written
forward-looking statements in other materials we release to the public.

Any
or all of our forward-looking statements in this quarterly report and in any other public statements we makemay turn out to be wrong.
They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in the discussion below will be important in determining future
results. Consequently, no forward-looking statement can be guaranteed. Actual future results may vary materially.

Except
as may be required under the federal securities laws, we undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future
events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our filings with the SEC. Also note that we provide the following cautionary discussion
of risks, uncertainties and possibly inaccurate assumptions relevant to our businesses. These are factors that we think could cause our actual results to differ materially from expected and historical
results. Other factors besides those listed here could also adversely affect us. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.

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



32

---





Set
forth below is a detailed discussion of certain of these risks and other risks affecting our business. The categorization of risks set forth below is meant to help you better
understand the risks facing our business and is not intended to limit your consideration of the possible effects of these risks to the listed categories. Any adverse effects related to the risks
discussed below may, and likely will, adversely affect many aspects of our business.



Although our revenue increased from the first quarter of fiscal 2004 to the second quarter of fiscal 2004, we did experience significant
revenue declines during the past several years 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, and our 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, among other things, declines in the market for our traditional business, enterprise voice communications systems, and the effect of general economic
conditions on our customers' willingness to spend on enterprise communications technology during the last several years. The decline in revenue has contributed to our net losses for the fiscal years
ended September 30, 2001, 2002 and 2003 of $352 million, $666 million and $88 million, respectively, and our accumulated deficit in the amount of $1,270 million as
of September 30, 2003.

Our
revenue for each of the quarters in fiscal 2003 and the first and second quarters of fiscal 2004 was $946 million, $950 million, $929 million,
$971 million, $971 million and $1,006 million, respectively. Our revenue for the first six months of fiscal 2004 includes revenue generated by the businesses we acquired from
Expanets from the date of acquisition on November 25, 2003 until March 31, 2004.

Our
operating results are significantly affected by the impact of economic conditions on the willingness of enterprises to make capital investments, particularly in enterprise
communications technology and related services. Although general economic conditions have improved recently and our revenue for the second quarter increased $35 million, or 3.6%, compared to
the first quarter of fiscal 2004, we believe that enterprises continue to be concerned about their ability to increase revenues and

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thereby
increase their profitability. Accordingly, they have tried to maintain or improve profitability through cost reduction and reduced capital spending. Because it is not certain whether
enterprises will increase spending on enterprise communications technology significantly in the near term, there may be continued pressure on our ability to increase our revenue.

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

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

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

We
have been experiencing declines in revenue from our traditional business, enterprise voice communications systems. We expect, based on various industry reports, the market segments
for these traditional systems to continue to decline. We are executing a strategy to capitalize on the higher growth opportunities in our market, including Internet Protocol, or IP, telephony systems
that converge voice, data and other traffic across a single network. Many of these products and applications, including IP telephony systems, have not yet been widely adopted by enterprises.

Increases
in revenue from sales of IP telephony systems have not always exceeded the decline in revenue from sales of enterprise voice communications systems in prior quarters. Even if
we are successful in increasing our revenue from sales of IP telephony systems, if revenue from sales of enterprise voice communications systems declines faster than revenue from sales of IP telephony
systems increases, our overall revenue and operating results may be adversely affected.

Our
traditional enterprise voice communications systems and the advanced communications products and applications described above are a part of our Enterprise Communications Group and
Small and Medium Business Solutions segments. If we are unsuccessful in executing our strategy, the contribution to our results from these segments may fail to grow or may decline, reducing our
overall operating results and thereby requiring a greater need for external capital resources. Our Services segment may also be adversely affected to the extent that Services revenues are related to
sales of these products and applications.

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

We
are focused on the development and sales of IP telephony systems and other advanced communications products and applications. In order to execute this strategy successfully, we must
continue to:



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



We face intense competition from our historical competitors and recent entrants into the enterprise communications market.

Historically,
our product businesses have competed against other providers of enterprise voice communications systems such as Nortel Networks Corporation, Siemens Aktiengesellschaft,
Alcatel S.A. and NEC Corporation. As we focus on the development and marketing of advanced communications systems, such as IP telephony systems that converge voice, data and other traffic across a
single unified
network, we face intense competition from these providers of voice communications systems as well as from data networking companies such as Cisco Systems, Inc. and 3Com Corp. In addition,
because the market for our products is subject to rapid technological change, as the market evolves we may face competition in the future from companies that do not currently compete in the enterprise
communications market, including companies that currently compete in other sectors of the technology, communications and software industries. Competition from these potential market entrants may take
many forms, including offering products and applications similar to those we offer as part of a larger, bundled offering.

Several
of these existing competitors have, and many of our future competitors may have, greater financial, personnel and capacity resources than we and as a result, these competitors
may be in a stronger position to respond quickly to potential acquisitions and other market opportunities, new or emerging technologies and changes in customer requirements. Competitors with greater
financial resources also may be able to offer lower prices, additional products or services or other incentives that we cannot match or do not offer. We cannot predict with precision which competitors
may enter our markets in the future or what form such competition may take. In order to effectively compete with any new market entrant, we may need to make additional investments in our business or
use more capital resources than our business currently requires.

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If we do not continue to generate net cash flow from operations or unanticipated cash needs arise, we may not have adequate or
cost-effective liquidity or capital resources.

Our
cash needs include servicing our debt, including any put obligation related to our Liquid Yield Option Notes due 2021, or LYONs, that may arise in October 2004,
funding working capital, capital expenditures, business restructuring liabilities, employee benefit obligations, the purchase price for our acquisition of a majority interest in Tata Telecom Limited
and for general corporate purposes. We believe that our $1,516 million in existing cash and cash equivalents as of March 31, 2004 and our net cash provided by operating activities during
the remainder of fiscal 2004 will be sufficient to meet these cash needs.

If,
however, we do not continue to generate net cash from operations or face unanticipated cash needs, such as the funding of a future acquisition or other capital investment, we may
need to obtain external financing. Under the terms of any external financing, we may incur higher than expected financing expenses, and become subject to additional restrictions and covenants. In
addition, our ability to obtain external financing is affected by the terms of our debt agreements. Our existing debt agreements
include covenants that limit our ability to incur additional indebtedness. In addition, our credit facility requires us to comply with certain financial covenants. We have previously amended our
credit facility several times in order to ensure our compliance with the financial covenants. If we are unable to comply with our financial covenants and cannot amend or obtain a waiver of those
covenants, an event of default under the credit facility would occur. If a default occurs, the lenders under our credit facility could accelerate the maturity of our debt obligations and terminate
their commitments to lend to us. Currently there are no funds drawn under our credit facility.

Our
ability to obtain external financing and, in particular, debt financing, is also affected by our debt ratings, which are periodically reviewed by the major credit rating agencies.
Our corporate credit is rated B+ and our long-term senior unsecured debt is rated B by Standard & Poor's, each with a positive outlook, and our long-term senior
unsecured debt is rated B3 by Moody's with a stable outlook. These outlooks have been recently revised from stable and negative, respectively, to reflect our improved profitability in the current
quarters as well as a reduction of debt, an improvement in debt protection metrics and increased balance sheet liquidity. An increase in our level of indebtedness or deterioration of our operating
results, however, may cause a reduction in our current debt ratings which, along with other factors, could impair our ability to secure additional financing on acceptable terms.



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

We
have outsourced all of our manufacturing operations. Substantially all of these operations have been outsourced to Celestica Inc. Our ability to realize the intended benefits
of our manufacturing outsourcing initiative depends on the willingness and ability of our contract manufacturers to produce our products. We may experience significant disruption to our operations by
outsourcing too much of our manufacturing. If a contract manufacturer terminates its relationship with us or is unable to fill our orders on a timely basis, we may be unable to deliver the affected
products to meet our customers' orders, which could delay or decrease our revenue or otherwise have an adverse effect on our operations.

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

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

In
addition, we rely on the security of our information systems, among other things, to protect our proprietary information and information of our customers. If we do not maintain
adequate security procedures over our information systems, we may be susceptible to computer hacking, cyberterrorism or other unauthorized attempts by third parties to access our proprietary
information or that of our customers. The failure to protect our proprietary information could seriously harm our business and future prospects or expose us to claims by our customers that we did not
adequately protect their proprietary information.



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

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

Please
see Note 14Commitments and Contingencies"Legal Proceedings" included in this Quarterly Report on Form 10-Q for a description of
certain matters involving Lucent for which we have assumed responsibility under the Contribution and Distribution Agreement and a description of other matters for which we are or may be obligated to
indemnify or share the cost with Lucent.

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

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We may be subject to litigation and infringement claims, which could cause us to incur significant expenses or prevent us from selling our products or
services.

We
cannot assure you that others will not claim that our proprietary or licensed products, systems and software are infringing their intellectual property rights or that we do not in
fact infringe those intellectual property rights. We may be unaware of intellectual property rights of others that may cover some of our technology. If someone claimed that our proprietary or licensed
systems and software infringed their intellectual property rights, any resulting litigation could be costly and time consuming and would divert the attention of management and key personnel from other
business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement also might require
us to enter into costly royalty or license agreements. However, we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to significant
damages or an injunction against us or our proprietary or licensed systems. A successful claim of patent or other intellectual property infringement against us could materially adversely affect our
operating results.

In
addition, third parties have in the past, and may in the future, claim that a customer's use of our products, systems or software infringes the third party's intellectual property
rights. Under certain circumstances, we may be required to indemnify our customers for some of the costs and damages related to such an infringement claim. Any indemnification requirement could have a
material adverse effect on our business and our operating results.

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

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

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

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

Overview

We are a leading provider of communications systems, applications and services for enterprises, including businesses, government agencies and other organizations.
Our product offerings include:



38

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We
support our broad customer base with comprehensive global service offerings that enable our customers to plan, design, implement and manage their communications networks. We believe
our global service organization is an important consideration for customers purchasing our products and applications and is a source of significant revenue for us, primarily from maintenance
contracts.



The following is a summary of the key trends and uncertainties that affected our financial results during the six months ended March 31, 2004. Please also
see "Forward Looking Statements" for a discussion of uncertainties facing our business.



As general economic conditions improved during fiscal 2003 and continued through the first and second quarters of fiscal 2004, our revenue stabilized. Our revenue
for each of the quarters in fiscal 2003 and the first and second quarters of fiscal 2004 was $946 million, $950 million, $929 million, $971 million, $971 million and
$1,006 million, respectively. Our revenue for the first six months of fiscal 2004 includes revenue generated by the businesses we acquired from Expanets from the date of acquisition
(November 25, 2003) through March 31, 2004. Our revenue for the second quarter of fiscal 2004 includes revenue generated by the Expanets businesses for the entire period.

The
following are the key factors currently affecting our revenue:



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Overall,
we have seen some signs of cautious business optimism from our customers, particularly in the financial services and media and communications sectors. Should economic conditions
continue to improve, we believe enterprises may be willing to increase information technology spending and look to upgrade their enterprise communications systems.



Our operating results for the three and six months ended March 31, 2004 include the effects of the following transactions:



See
Note 3, "Acquisition and Divestitures" in the accompanying unaudited interim consolidated financial statements for additional information regarding these transactions.



As our revenue declined during fiscal 2001 and 2002, we took several actions, including business restructuring actions, designed to reduce our cost structure.
Although we did not take any business restructuring actions during fiscal 2003 or the first six months of fiscal 2004, we continued our focus on controlling our costs, particularly in relation to our
revenue. As a result of the stabilization of our revenue discussed above and our continued focus on controlling costs during fiscal 2003, we returned to profitability in the third quarter of fiscal
2003 and have been profitable in each of the three subsequent quarters.

As
discussed in more detail below, our gross margin increased from 42.9% for the six months ended March 31, 2003 to 46.5% for the six months ended March 31, 2004. The
increase is attributable to efficiencies realized from our contract manufacturing initiative as well as cost management actions implemented throughout fiscal 2003, the incremental gross margin
attributable to the vertical integration of Expanets into our business, and favorable product and channel mix.

As
a percentage of revenue, selling, general and administrative expenses decreased from 34.3% for the six months ended March 31, 2003 to 32.4% for the six months ended
March 31, 2004. The decrease is attributable primarily to the impact of cost savings actions taken during fiscal 2003 and the first quarter of fiscal 2004, partially offset by an increase in
expenses related to the acquisition of Expanets.



As more fully discussed in "Liquidity and Capital Resources," we have been focused on increasing our cash and cash equivalents and generating positive net cash
from continuing operating activities.

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Cash
and cash equivalents have increased from $597 million as of September 30, 2002 to $1,516 million as of March 31, 2004. During fiscal 2003, we leveraged improvements in
our management of accounts receivable and inventory to generate $140 million in net cash from operating activities for continuing operations. We generated $121 million of net cash from
operating activities for continuing operations during the six months ended March 31, 2004. We expect to generate net cash from continuing operating activities for each of the remaining quarters
of fiscal 2004 and expect to be operating cash flow positive for the full fiscal year.

We
have also been focusing on reducing our debt, particularly in relation to our cash and cash equivalents. As of March 31, 2003, our long-term debt exceeded our cash
and cash equivalents by $162 million and as of March 31, 2004, our cash and cash equivalents exceeded our long-term debt by $787 million, an improvement of
$949 million.

Consolidated Results of Continuing Operations

As a result of the sale of our Connectivity Solutions business in the second quarter of fiscal 2004, our results of operations for the three and six months ended
March 31, 2003 have been restated to reflect the results of Connectivity Solutions as a discontinued operation. In addition, our results for the three and six months ended March 31, 2004
include the results generated by the businesses we acquired from Expanets that sell Avaya products and services from the date of acquisition on November 25, 2003. The portions of the Expanets'
business that distributed non-Avaya offerings have been included in discontinued operations.

Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

The following table sets forth certain line items from our Consolidated Statements of Operations as a percentage of revenue for the periods indicated:

|                                                             |                                     | Three Months Ended
March 31, |       | Change |      
|------------------------------------------------------------ | ----------------------------------- | ---------------------------- | ----- | ------ | -----
|
|
|                                                             | U.S. Revenue                        |                              | $     | 760    |      
|                                                             | Non-U.S. Revenue                    |                              |       | 246    |      
|                                                             |                                     |                              |       |        |      
|Total revenue                                                |                                     |                              | 1,006 |        | 100.0
|Costs                                                        |                                     |                              | 535   |        | 53.2 
|                                                             |                                     |                              |       |        |      
|Gross margin                                                 |                                     |                              | 471   |        | 46.8 
|                                                             |                                     |                              |       |        |      
|Operating expenses:                                          |                                     |                              |       |        |      
|                                                             | Selling, general and administrative |                              |       | 328    |      
|                                                             | Research and development            |                              |       | 83     |      
|                                                             |                                     |                              |       |        |      
|Total operating expenses                                     |                                     |                              | 411   |        | 40.8 
|                                                             |                                     |                              |       |        |      
|Operating income                                             |                                     |                              | 60    |        | 6.0  
|Other expense, net                                           |                                     |                              | (19   | )      | (1.9 
|Interest expense                                             |                                     |                              | (19   | )      | (1.9 
|                                                             |                                     |                              |       |        |      
|Income (loss) from continuing operations before income taxes |                                     |                              | 22    |        | 2.2  
|Provision for income taxes                                   |                                     |                              | (81   | )      | (8.0 
|                                                             |                                     |                              |       |        |      
|Income (loss) from continuing operations                     |                                     | $                            | 103   |        | 10.2 
|                                                             |                                     |                              |       |        |      

RevenueThe increase in revenue in the second quarter of fiscal 2004 was seen primarily in the U.S. and was attributed mostly
to our Services segment, and to a lesser extent, to our Enterprise

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Communications
Group, or ECG, segment. This increase also reflects a full quarter of revenue generated from our acquisition of Expanets which occurred on November 25, 2003.

Costs and Gross MarginOur costs of products consist primarily of materials and components, labor and manufacturing overhead.
Our costs of services consist primarily of labor, parts and service overhead. Total costs increased slightly in the second quarter of fiscal 2004 as compared with the same period in fiscal 2003, while
gross margin percentage increased by 2.8 percentage points. Gross margin increased across all of our operating segments. Gross margin on products increased to 52.3% in the second quarter of
fiscal 2004 from 51.2% for the same period in fiscal 2003 reflecting manufacturing efficiencies gained through our outsourcing agreements, continuing cost reductions, and favorable product mix with
respect to software applications. Services' gross margin increased to 41.5% in the second quarter of fiscal 2004 from 37.0% for the same quarter of fiscal 2003 due to continuing cost reductions and
improved utilization of the technician workforce. Our product offerings benefited the most from the increase in U.S. sales, which typically have higher margins than sales made outside of the U.S.

See
"Segment Results" for a discussion of segment revenue and operating income (loss).

Selling, General and AdministrativeOur selling, general and administrative expenses consist primarily of salaries,
commissions, benefits and other items. The increase in SG&A was primarily due to the fact that the second quarter of fiscal 2004 includes a full quarter of expenses related to the acquisition of
Expanets. In addition, the second quarter of fiscal 2004 includes a reversal of $1 million of business restructuring related liabilities as compared with a $14 million reversal in the
same quarter of fiscal 2003. The second quarter of fiscal 2004 also includes an increase in expenses associated with awards, commission and benefit expenses primarily associated with post retirement
expenses. These increases were offset by lower compensation expense resulting from fewer employees and lower IT, telecommunication and computer related service costs reflecting a favorable
renegotiated agreement for the outsourcing of certain IT functions. In addition, we incurred lower building services expense and less depreciation and amortization.

Interest ExpenseInterest expense for the second quarter of fiscal 2004 includes $17 million of interest on
$640 million aggregate principal amount of 111/8% Senior Secured Notes due April 2009, or senior secured notes, of which $224 million aggregate principal amount was
redeemed in March 2004. In addition, we recorded interest expense of $4 million for the amortization of debt discount, premium and deferred financing costs related primarily to our
LYONs, which were issued in October 2001, and $1 million of interest expense related to commitment fees on our credit facility. Interest expense was partially offset by a
$2 million favorable impact resulting from our interest rate swap agreements entered into during the first and second quarters of fiscal 2004 and $1 million of income related to the
amortization of a gain resulting from the termination in December 2002 of our interest rate swaps that were entered into in April 2002.

Interest
expense for the same period in fiscal 2003 included primarily $12 million of interest expense on $440 million aggregate principal amount of our senior secured
notes and $6 million of amortization of both debt discount and deferred financing costs related primarily to our LYONs. Interest expense was partially offset by $1 million of income
related to the amortization of a gain resulting from the termination of our interest rate swaps in December 2002.

Provision (Benefit) for Income TaxesWe recorded a benefit for income taxes on continuing operations of $81 million in
the second quarter of fiscal 2004 as compared with a benefit of $6 million in the same quarter last year.

The
benefit of $81 million recorded in the second quarter of fiscal 2004 includes an $89 million income tax benefit related to the favorable settlement of certain tax
matters for the periods prior to the Distribution in accordance with the Tax Sharing Agreement between us and Lucent, partially offset by a

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$6 million
provision related to state and foreign income taxes and a $2 million provision for other adjustments. The $89 million benefit for income taxes related to the favorable
settlement consisted of a $37 million net cash refund and a reversal of certain tax liabilities for the remaining amount.

The
benefit of $6 million recorded in the second quarter of fiscal 2003 included a $10 million benefit related to the extinguishment in January 2003 of a portion of
our LYONs, a $2 million benefit related to an audit settlement, and a $6 million provision for state and foreign income taxes.

Six Months Ended March 31, 2004 Compared to Six Months Ended March 31, 2003

The following table sets forth certain line items from our Consolidated Statements of Operations as a percentage of revenue for the periods indicated:

|                                                             |                                     | Six Months Ended
March 31, |       | Change |      
|------------------------------------------------------------ | ----------------------------------- | -------------------------- | ----- | ------ | -----
|
|
|                                                             | U.S. Revenue                        |                            | $     | 1,498  |      
|                                                             | Non-U.S. Revenue                    |                            |       | 479    |      
|                                                             |                                     |                            |       |        |      
|Total revenue                                                |                                     |                            | 1,977 |        | 100.0
|Costs                                                        |                                     |                            | 1,058 |        | 53.5 
|                                                             |                                     |                            |       |        |      
|Gross margin                                                 |                                     |                            | 919   |        | 46.5 
|                                                             |                                     |                            |       |        |      
|Operating expenses:                                          |                                     |                            |       |        |      
|                                                             | Selling, general and administrative |                            |       | 641    |      
|                                                             | Research and development            |                            |       | 166    |      
|                                                             |                                     |                            |       |        |      
|Total operating expenses                                     |                                     |                            | 807   |        | 40.8 
|                                                             |                                     |                            |       |        |      
|Operating income (loss)                                      |                                     |                            | 112   |        | 5.7  
|Other expense, net                                           |                                     |                            | (13   | )      | (0.7 
|Interest expense                                             |                                     |                            | (40   | )      | (2.0 
|                                                             |                                     |                            |       |        |      
|Income (loss) from continuing operations before income taxes |                                     |                            | 59    |        | 3.0  
|Provision (benefit) for income taxes                         |                                     |                            | (74   | )      | (3.7 
|                                                             |                                     |                            |       |        |      
|Income (loss) from continuing operations                     |                                     | $                          | 133   |        | 6.7  
|                                                             |                                     |                            |       |        |      

RevenueOur revenue for the six months ended March 31, 2004 increased across all of our operating segments as compared
with the same period in fiscal 2003. From a geographic perspective, a majority of this increase was seen in the U.S. This overall increase also reflects revenue generated from
our acquisition of Expanets, and includes such revenue beginning on November 25, 2003 through March 31, 2004. In fiscal 2003, our revenue generally stabilized on a quarterly basis and
ended the year at its highest level. Revenue for the first quarter of fiscal 2004 was level with our last quarter of fiscal 2003, but increased to just over $1.0 billion in the second quarter
of fiscal 2004.

Costs and Gross MarginOur costs of products consist primarily of materials and components, labor and manufacturing overhead.
Our costs of services consist primarily of labor, parts and service overhead. Total costs decreased while gross margin percentage increased in the first half of fiscal 2004 to 46.5% as compared with
42.9% for the same period in fiscal 2003. Gross margin increased for both our product and service offerings. Gross margin on products increased to 53.1% for the six months ended March 31, 2004
from 49.7% for the same period in fiscal 2003 reflecting manufacturing efficiencies gained through our contract manufacturers, continuing cost reductions, and favorable product mix as sales of
applications and software rose as a percentage of total revenue. Services' gross margin increased to 40.0% for the six months ended March 31, 2004 from 36.4% due to continuing

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cost
reductions and improved utilization of the technician workforce. Our product offerings benefited the most from the increase in U.S. sales, which typically have higher margins than sales made
outside of the U.S.

See
"Segment Results" for a discussion of segment revenue and operating income (loss).

Selling, General and AdministrativeOur selling, general and administrative expenses consist primarily of salaries,
commissions, benefits and other items. SG&A expenses decreased by $10 million in the first half of fiscal 2004 as compared with the same period of fiscal 2003. This decrease was primarily due
to lower compensation expense resulting from fewer employees, and lower IT and networking expenses, including telecommunication and computer related service costs, which reflect a favorable
renegotiated agreement for the outsourcing of certain IT functions. In addition, we incurred less depreciation and amortization related to our owned buildings and infrastructure, and a reduction in
advertising and marketing expense. These decreases were partially offset by an increase in awards expense, and less reversals of business restructuring related liabilities. The first half of fiscal
2004 includes a reversal of $1 million of business restructuring related liabilities compared with a $10 million reversal in the same period of fiscal 2003.

Interest ExpenseInterest expense increased by $4 million for the six months ended March 31, 2004. Interest
expense for the six months ended March 31, 2004 includes $35 million of interest on $640 million aggregate principal amount of our senior secured notes, of which
$224 million aggregate principal amount was redeemed in March 2004. In addition, we recorded interest expense of $8 million for the amortization of debt discount, premium and
deferred financing costs related primarily to our LYONs, which were issued in October 2001, and $1 million of interest expense related to commitment fees on our credit facility. Interest
expense was partially offset by a $2 million favorable impact resulting from our interest rate swap agreements entered into during the first and second
quarters of fiscal 2004 and $2 million of income related to the amortization of a gain resulting from the termination in December 2002 of our interest rate swaps that were entered into
in April 2002.

Interest
expense for the same period in fiscal 2003 included primarily $25 million of interest expense on $440 million aggregate principal amount of our senior secured
notes and $12 million of amortization of both debt discount and deferred financing costs related primarily to our LYONs. Interest expense was partially offset by $1 million of income
related to the amortization of a gain resulting from the termination of our interest rate swaps in December 2002.

Provision (Benefit) for Income TaxesWe recorded a benefit for income taxes of $74 million for the six months ended
March 31, 2004, as compared with an income tax provision of $79 million for the same period of fiscal 2003.

For
the six months ended March 31, 2004, the $74 million benefit included an $89 million income tax benefit related to the favorable settlement of certain tax
matters for periods prior to the distribution in accordance with the Tax Sharing Agreement between us and Lucent, partially offset by an $11 million provision related to state and foreign
income taxes and a $4 million provision for other adjustments.

For
the six months ended March 31, 2003, the tax provision of $79 million included an $83 million provision to increase the deferred tax asset valuation allowance
and an $8 million provision for state and foreign income taxes, partially offset by a $2 million benefit related to an audit settlement and a $10 million benefit related to the
extinguishment in January 2003 of a portion of our LYONs. The $83 million provision for the increase in the deferred tax asset valuation allowance reflects the difference between the
actual and expected gain associated with the LYONs Exchange Offer.

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Results from Discontinued Operations

As a result of the divestitures discussed above, we have classified our Connectivity Solutions business and the portions of the Expanets business that previously
distributed non-Avaya products as discontinued operations. The following table presents the operating results of the businesses included in income from discontinued operations, as well as
the gain recognized on the sale of Connectivity Solutions in the second quarter of fiscal 2004. The amounts presented for Connectivity Solutions for the three and six months ended March 31,
2004, represent the results from January 1, 2004 and October 1, 2003, respectively, through January 31, 2004, the date on which we completed the sale of essentially all of the
Connectivity Solutions business. The results of certain international entities that have subsequently been transferred to CommScope or are expected to be transferred to CommScope
by the end of fiscal 2004 are also included in these results. The results of operations for Connectivity Solutions for the three and six months ended March 31, 2004 include a charge of
$48 million comprised of a $24 million pension and postretirement curtailment loss and a $24 million settlement loss recognized upon the transfer of pension and postretirement
benefit assets and liabilities to CommScope.

The
amounts presented for Expanets for the six months ended March 31, 2004 represent the results generated by the portion of the Expanets business that previously distributed
non-Avaya products from the date of acquisition on November 25, 2003 through March 31, 2004. We had substantially divested of this portion of the Expanets business by
March 31, 2004.

|                                                                |                         | Three Months Ended
March 31,               |                                                             | Six Months Ended
March 31,
|--------------------------------------------------------------- | ----------------------- | ------------------------------------------ | ----------------------------------------------------------- | --------------------------
|
|
|Revenue from discontinued operations:                           |                         |                                            |                                                             |                           
|                                                                | Connectivity Solutions  |                                            | $                                                           | 29                        
|                                                                | Expanets                |                                            |                                                             | 1                         
|                                                                |                         |                                            |                                                             |                           
|                                                                |                         | Total revenue from discontinued operations |                                                             | $                         
|                                                                |                         |                                            |                                                             |                           
|Income (loss) before income taxes from discontinued operations: |                         |                                            |                                                             |                           
|                                                                | Connectivity Solutions: |                                            |                                                             |                           
|                                                                |                         | Results of operations                      |                                                             | $                         
|                                                                |                         | Gain on sale                               |                                                             |                           
|                                                                |                         |                                            |                                                             |                           
|                                                                |                         |                                            | Total income before income taxes for Connectivity Solutions |                           
|                                                                |                         |                                            |                                                             |                           
|Expanets                                                        |                         |                                            | (1                                                          | )                         
|                                                                |                         |                                            |                                                             |                           
|Total income before income taxes from discontinued operations   |                         | $                                          | 21                                                          |                           
|                                                                |                         |                                            |                                                             |                           

Segment Results

Operating Segments

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

45

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Our three operating segments are the Enterprise Communications Group, or ECG, Small and Medium Business Solutions, or SMBS, and Services. During the first quarter of fiscal 2004, we
moved our professional service organization from ECG to the Services segment to expand the organization's focus on these services and expansion into a multi-vendor environment. We also allocated a
portion of the results attributed to our third-party financing arrangement from ECG to SMBS based on the relative contribution of the arrangement to the sale of each segment's products. Accordingly,
we have restated the prior period amounts to reflect these changes. We describe our three operating segments as follows:



Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

The following tables set forth revenue and operating income (loss) by segment for the second quarter of fiscal 2004 and 2003:

|                                    |               | Three Months Ended
March 31, |     | Change |     
|----------------------------------- | ------------- | ---------------------------- | --- | ------ | ----
|
|
|Revenue:                            |               |                              |     |        |     
|Enterprise Communications Group     |               | $                            | 427 |        | 42.4
|Small and Medium Business Solutions |               |                              | 66  |        | 6.6 
|Services                            |               |                              | 511 |        | 50.8
|Other unallocated revenue           |               |                              | 2   |        | 0.2 
|                                    |               |                              |     |        |     
|                                    | Total revenue |                              | $   | 1,006  |     
|                                    |               |                              |     |        |     

46

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|                                    |                                       | Three Months Ended March 31, |    |    |  
|----------------------------------- | ------------------------------------- | ---------------------------- | -- | -- | -
|
|
|Operating Income (Loss):            |                                       |                              |    |    |  
|Enterprise Communications Group     |                                       | $                            | (8 | )  | $
|Small and Medium Business Solutions |                                       |                              | 5  |    |  
|Services                            |                                       |                              | 63 |    |  
|                                    |                                       |                              |    |    |  
|                                    | Total segment operating income        |                              |    | 60 |  
|                                    | Corporate:                            |                              |    |    |  
|                                    | Business restructuring reversals, net |                              |    | 1  |  
|                                    | Other unallocated amounts             |                              |    | (1 | )
|                                    |                                       |                              |    |    |  
|                                    | Total operating income                |                              | $  | 60 |  
|                                    |                                       |                              |    |    |  

ECG

ECG's revenue increased by $14 million in the second quarter of fiscal 2004 as compared with the second quarter of fiscal 2003 due primarily to stronger
sales internationally. Revenue from IP telephony systems, software, and applications continued to grow, fully offsetting declines in our traditional telephony systems business. This change in product
mix reflects the transition our customers are making to IP-based telecommunication systems. In the second quarter of fiscal 2004, ECG's sales through the direct channel decreased to 47.5%
of ECG's total revenue from 49.4% in the second quarter of fiscal 2003.

ECG's
operating loss was reduced by $23 million from the second quarter of fiscal 2003. This improvement was attributable primarily to an increase in gross margin resulting from
efficiencies gained in our manufacturing processes from our outsourcing agreements, continued improvements in product cost reductions, and a more favorable product mix with respect to software and
applications. R&D expenses decreased due primarily to savings associated with our business restructuring initiatives related to headcount and a continued focus on core initiatives. As a result of cost
reduction efforts, SG&A expenses improved despite absorbing the increased headcount associated with the Expanets acquisition.

SMBS

SMBS' revenue increased by $8 million in the second quarter of fiscal 2004 as compared with the same quarter of fiscal 2003 due primarily to growth in
sales of IP Office, our IP telephony offering for the small and medium-sized business market, in the Europe/Middle East/Africa and Asia Pacific regions, as well as the inclusion of Expanets. Revenue
for the second quarter of fiscal 2004 includes revenue from Expanets, which was acquired on November 25, 2003. SMBS' sales are mainly generated through the indirect channel.

SMBS
generated operating income of $5 million in the second quarter of fiscal 2004 compared to an operating loss of $2 million in the same quarter of fiscal 2003. This
improvement was due primarily to an increase in gross margin resulting from manufacturing efficiencies gained through outsourcing of manufacturing and favorable product mix. SG&A expense increased due
to incremental sales expenses associated with the integration of the Expanets business as well as enhancements made to the sales presence outside of the U.S.

Services

Services' revenue increased by $32 million in the second quarter of fiscal 2004 as compared with the second quarter of fiscal 2003. Maintenance contract
revenue grew as a result of the Expanets acquisition as well as the ongoing initiatives to improve contract take rates, renewal rates and retention

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rates.
Revenue from per occurrence and transactional based businesses declined as customers continued cost reduction initiatives that included decreasing the amount of equipment adds, moves and
changes. Implementation related business declined resulting from the timing of large data implementation projects.

Services'
operating income increased by $22 million in the second quarter of fiscal 2004 as compared with the same quarter of fiscal 2003 due primarily to an improvement in gross
margin. This increase reflects continued cost reduction initiatives including headcount reductions and improved utilization of our technician workforce as a result of the integration of Expanets. The
acquisition of Expanets contributed to a stronger presence in the direct channel; sales through our direct channel consequently increased, representing 87.9% in the second quarter of fiscal 2004 as
compared with 84.3% in the same period of fiscal 2003, favorably impacting gross margin. SG&A expenses increased primarily due to additional selling expense associated with the integration of
Expanets. R&D expenses remained relatively flat in comparison to the same period in the prior year.

Six Months Ended March 31, 2004 Compared to Six Months Ended March 31, 2003

The following tables set forth revenue and operating income (loss) by segment for the six months ended March 31, 2004 and 2003:

|                                    |               | Six Months Ended
March 31, |       | Change |     
|----------------------------------- | ------------- | -------------------------- | ----- | ------ | ----
|
|
|Revenue:                            |               |                            |       |        |     
|Enterprise Communications Group     |               | $                          | 844   |        | 42.7
|Small and Medium Business Solutions |               |                            | 129   |        | 6.5 
|Services                            |               |                            | 1,000 |        | 50.6
|Other unallocated revenue           |               |                            | 4     |        | 0.2 
|                                    |               |                            |       |        |     
|                                    | Total revenue |                            | $     | 1,977  |     
|                                    |               |                            |       |        |     

|                                    |                                       | Six Months Ended
March 31, |     |     |  
|----------------------------------- | ------------------------------------- | -------------------------- | --- | --- | -
|
|
|Operating Income (Loss):            |                                       |                            |     |     |  
|Enterprise Communications Group     |                                       | $                          | (12 | )   | $
|Small and Medium Business Solutions |                                       |                            | 11  |     |  
|Services                            |                                       |                            | 116 |     |  
|                                    |                                       |                            |     |     |  
|                                    | Total segment operating income (loss) |                            |     | 115 |  
|                                    | Corporate:                            |                            |     |     |  
|                                    | Business restructuring reversals, net |                            |     | 1   |  
|                                    | Other unallocated amounts             |                            |     | (4  | )
|                                    |                                       |                            |     |     |  
|                                    | Total operating income (loss)         |                            | $   | 112 |  
|                                    |                                       |                            |     |     |  

ECG

ECG's revenue increased by $29 million for the six months ended March 31, 2004 as compared with the same period of fiscal 2003 due primarily to
stronger sales in the U.S. Revenue from IP telephony systems, software, and applications continued to show significant growth, offsetting the planned declines in the traditional telephony systems
business. This change in product mix reflects the transition our customers are making to IP-based telecommunication systems. Revenue for the six

48

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months
ended March 31, 2004 includes revenue from Expanets, which was acquired on November 25, 2003. In the first half of fiscal 2004, ECG's sales through the direct channel decreased
slightly to 48.3% of ECG's revenue from 49.0% in the first half of fiscal 2003.

ECG's
operating loss for the six months ended March 31, 2004 was reduced favorably by $72 million from the six month period ended March 31, 2003. This improvement
was attributable primarily to an increase in gross margin resulting from efficiencies gained in our manufacturing processes from our outsourcing agreements, continued improvements in product cost
reductions, and a more favorable product mix with respect to software and applications. SG&A and R&D expenses have been reduced due primarily to savings associated with our business restructuring
initiatives related to headcount and a continued focus on core initiatives.

SMBS

SMBS revenue for the six months ended March 31, 2004 increased by $14 million in comparison to the same period in fiscal 2003 due to an increase in
IP revenue predominantly in our Europe/Middle East/Africa region and growth in traditional telephony product sales. Revenue for the first half of fiscal 2004 includes revenue from Expanets, which was
acquired on November 25, 2003. SMBS' sales are mainly generated through the indirect channel.

SMBS
generated operating income of $11 million for the six months ended March 31, 2004 compared to an operating loss of $3 million in the same period of fiscal 2003.
This improvement was due primarily to an increase in gross margin resulting from manufacturing efficiencies gained through outsourcing of manufacturing and favorable product mix. SG&A expense
increased due to incremental sales expenses associated with the integration of the Expanets business as well as enhancements made to the sales presence outside of the U.S.

Services

Services' revenue increased $34 million for the six months ended March 31, 2004 as compared with the same period of fiscal 2003. Maintenance
contract revenue grew as a result of the Expanets acquisition as well as the ongoing initiatives to improve contract take rates, renewal rates and retention rates. Per occurrence and transactional
based business declined as customers continued cost reduction initiatives that included decreasing the amount of equipment adds, moves and changes. Professional Services revenue declined, but was
partially offset by growth in network security consulting services. Our Implementation business saw lower revenue compared to the same period in the previous year primarily due to the timing of large
data implementation projects.

Services'
operating income increased by $35 million in the first half of fiscal 2004 as compared with the first half of fiscal 2003 due primarily to an improvement in gross
margin. This increase reflects continued cost reduction initiatives including headcount reductions and improved utilization of the technician workforce as a result of the integration of Expanets. The
acquisition of Expanets contributed to a stronger presence in the direct channel; sales through our direct channel consequently increased, representing 87.6% in the first six months of fiscal 2004 as
compared with 84.3% in the same period of fiscal 2003, favorably impacting gross margin. SG&A expenses increased primarily due to additional selling expense associated with Expanets. R&D expenses
remained relatively flat over these two periods.

49

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Liquidity and Capital Resources

Historical Sources and Uses of Cash From Continuing Operations



During fiscal 2003, our primary liquidity goals were to continue to generate net cash from operating activities and increase our cash and cash equivalents. Our
cash and cash equivalents increased each quarter in fiscal 2003, improving from $597 million at September 30, 2002 to $1,192 million at September 30, 2003. The
$595 million increase in our cash and cash equivalents resulted primarily from an increase in net cash provided by operating and financing activities from continuing operations of
$140 million and $421 million, respectively. Our $140 million of net cash from continuing operating activities for fiscal 2003 was attributable primarily to continued improvement
in the management of accounts receivable and inventory, reduced cash needs to fund our operations as a result of significant restructuring actions taken in prior years, and reduced cash needs to fund
business restructuring obligations than in prior years.

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

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

Sources and Uses of Cash for the Six Months Ended March 31, 2004

Cash increased from $1,192 million as of September 30, 2003 to $1,516 million as of March 31, 2004.



Our net cash provided by operating activities from continuing operations was $121 million for the six months ended March 31, 2004 compared with
$101 million for the six months ended March 31, 2003. Below is a list of the more significant items that contributed to our cash provided by operating activities for the six months ended
March 31, 2004:



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Our
days sales of inventory on-hand for the first and second quarters of fiscal 2004 was 51 and 45 days, respectively, versus 51 and 50 days, respectively, for
the same periods in fiscal 2003.



Net cash provided by investing activities from continuing operations was $150 million for the six months ended March 31, 2004 compared with net cash
used for investing activities from continuing operations of $13 million for the six months ended March 31, 2003. Net cash provided by investing activities for the current period of
$252 million was comprised principally of net cash proceeds of $248 million from the sale of our Connectivity Solutions business in January 2004. This increase in cash was
partially offset by the use of cash of $32 million for capital expenditures and $103 million for acquisitions, of which $96 million was used to acquire substantially all of the
assets and certain liabilities of Expanets. The $96 million is net of $3 million of cash acquired.



Net cash provided by financing activities from continuing operations was $68 million for the six months ended March 31, 2004 compared with
$5 million for the six months ended March 31, 2003. Net cash provided by financing activities from continuing operations consisted primarily of $249 million in net proceeds
received in connection with the sale of 14,039,481 shares of our common stock in February 2004 and $68 million of cash received in connection with the issuance of common stock under our
employee stock purchase plan and stock option plans. This increase in cash was partially offset by the use of the $249 million in net proceeds from the February 2004 sale of our common
stock to redeem 35% of our senior secured notes.

Cash Flows of Discontinued Operations

Net cash used in discontinued operations of $24 million for the six months ended March 31, 2004 was attributed to operating activities and consisted
of $18 million related to Connectivity Solutions and $6 million attributed to the portion of the disposal group from the Expanets acquisition. Net cash provided by discontinued
operations of $31 million in the six months ended March 31, 2003 was attributed to the operating activities of Connectivity Solutions.

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Future Cash Requirements and Sources of Cash

Future Cash Requirements

Our primary future cash requirements will be to fund working capital, capital expenditures, debt service, employee benefit obligations, strategic acquisitions,
and our business restructuring liabilities. Specifically, our primary cash requirements for the remainder of fiscal 2004 are as follows:



As
more fully described under "Uncertainties Related to Our Liquidity and Capital ResourcesLYONs Put," we may have a significant cash requirement during the first quarter of
fiscal 2005 if a significant portion of our currently outstanding LYONs are put to us and we elect to satisfy such put obligation in cash. In addition, if our company's performance meets the
objectives required under our management incentive plan for fiscal 2004, we may have significant cash requirements in the first quarter of fiscal 2005 in connection with the payment of management
incentives for fiscal 2004.

In
addition, we may from time to time seek to retire additional amounts of our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases,
privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on the prevailing market conditions, our liquidity requirements, contractual restrictions and other
factors. The amounts involved may be material.

Future Sources of Cash



We expect our primary source of cash during the remainder of fiscal 2004, in addition to our $1,516 million of cash and cash equivalents as of
March 31, 2004, to be positive net cash provided by operating activities. We expect that stabilization or growth in our revenues and continued focus on accounts receivable and inventory
management and cost containment will enable us to generate positive net cash from operating activities for each of the remaining quarters of fiscal 2004.

We
believe that our existing cash and cash equivalents and our net cash provided by operating activities during the remainder of fiscal 2004 will be sufficient to meet our future cash
requirements described above, including any cash requirements related to the LYONs put and our management incentive plan.

52

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If we do not generate sufficient cash from operations, we may need to incur additional debt or issue equity. In order to meet our cash needs we may, from time to
time, borrow under our credit facility or issue other long- or short-term debt or equity, if the market and the terms of our existing debt instruments permit.

Amended Credit Facility.As of March 31, 2004 and September 30, 2003, there were no amounts outstanding under
our credit facility, and we have not borrowed under our credit facility since the second quarter of fiscal 2002. We believe our credit facility provides us with an important source of backup
liquidity. Our credit facility expires in September 2005. In January 2004, we and the lenders under our five-year revolving credit agreement amended the credit facility to
provide us with additional flexibility to make acquisitions and repurchase our debt securities.

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

For
the four quarter period ending March 31, 2004, we were required to maintain a minimum adjusted EBITDA of $255 million and a ratio of adjusted EBITDA to interest expense
of 3.00 to 1. We were in compliance with all required covenants as of March 31, 2004 and expect to be in compliance with all such covenants as of June 30, 2004.

The
amended credit facility requires us to maintain a ratio of consolidated adjusted EBITDA to interest expense and consolidated adjusted EBITDA, each as adjusted 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)March 31, 2004

3.00 to 1

$
255June 30, 2004

3.10 to 1

$
270September 30, 2004

3.40 to 1

$
285Each four quarter period thereafter

3.20 to 1

$
290


As
a result of the January 2004 amendments to the credit facility, we are permitted to use up to $455 million in cash to redeem or repurchase LYONs, other than pursuant to
the October 31, 2004 put, so long as we hold unrestricted domestic cash and marketable securities of at least $400 million immediately before and after such redemption or repurchase. As
of March 31, 2004, we had used approximately $156 million in cash to 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 $299 million in cash to repurchase LYONs, other than pursuant to the October 31, 2004 put.

In
connection with the October 31, 2004 put obligation described in respect to the LYONs, the amended credit facility requires us 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 the LYONs is satisfied and (b) the date upon which we deliver to the lenders under the
amended credit facility a certificate certifying our compliance with the covenants included in the amended 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 put obligation under the LYONs had been satisfied as of such day. For purposes of this calculation, liquidity is defined as the sum of the
unused commitments under our amended credit facility plus

53

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unrestricted
domestic cash and marketable securities. To the extent we can satisfy this liquidity test, we may use cash to satisfy any put obligation with respect to the LYONs.

The
credit facility was also amended to permit us to prepay or repurchase up to $500 million of long-term debt other than the LYONs so long as we hold unrestricted
domestic cash and marketable securities of at least $400 million immediately before and after such prepayment or repurchase. We used $249 million of this amount to redeem 35% of our
senior secured notes in March 2004. We may use an additional $251 million in cash to repurchase long-term debt other than the LYONs under the amended credit facility.

The
amended credit facility provides that from and after the first date that we repurchase debt in accordance with the terms of the amended credit facility or make an acquisition for a
purchase price of $100 million or more, we will be required to have had positive free cash flow for the four fiscal quarters most recently then ended and maintain positive free cash flow for
each four quarter period thereafter. Free cash flow is defined under the amended credit facility as net cash provided by (used in) operating activities less capital expenditures and dividends. As a
result of the redemption of the senior secured notes described above, we are currently required to comply with this covenant.

The
amended credit facility provides that we may use up to $500 million in cash to make acquisitions provided that we comply with certain financial covenants. In
February 2004, the credit facility was further amended to eliminate the provision in the January 2004 amendment that no more than $250 million in cash can be used in a single
acquisition.

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



Senior Secured Notes.We currently have outstanding $416 million aggregate principal amount of 111/8%
senior secured notes due April 2009. The terms of the indenture governing the senior secured notes limits our ability to incur additional debt. Under the indenture, we may incur debt so long as the
ratio of EBITDA to interest expense, as defined under the indenture and after giving effect to the issuance of the debt on a pro forma basis, exceeds 2.25. In addition, we may incur debt under certain
circumstances even if we cannot meet the incurrence test described in the proceeding sentence. Notwithstanding our ability to incur debt under the indenture, we cannot incur any such debt if we are
not permitted to incur it under our amended credit facility.

Uncertainties Related to Our Liquidity and Capital Resources

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

Debt Ratings.Our ability to obtain external financing and the related cost of borrowing is affected by our debt ratings,
which are periodically reviewed by the major credit rating agencies. Our long-term senior unsecured debt is currently rated B3 by Moody's, with a stable outlook, and B by Standard &
Poor's, with a positive outlook. These ratings have remained unchanged since May 2003. The outlooks were recently revised from negative and stable, respectively, to reflect our improved
profitability in the current quarters as well as a reduction of debt, an improvement in debt protection metrics and increased balance sheet liquidity.

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

A
debt rating by the major credit rating agencies is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the rating agencies.
Each rating should be evaluated independently of any other rating.

LYONs Put.Holders of our LYONs may require us to purchase all or a portion of their LYONs on October 31, 2004 at a
price per LYON of $542.95, or the accreted value of a LYON as of such date. The aggregate accreted value of LYONs currently outstanding as of October 31, 2004 will be approximately
$298 million. We cannot predict whether all or any portion of these LYONs will be put to us on the put date. In the event any LYONs are put to us on the put date, we have the option to settle
the put obligation in cash or shares of our common stock. In addition, we may redeem for cash all or any portion of the LYONs at anytime on or after October 31, 2004.

Fair Value of Financial Instruments

The following table summarizes the number of outstanding LYONs and senior secured notes, their aggregate accreted value, and their related fair market values as
of March 31, 2004 and September 30, 2003:

|                            |  | As of March 31, 2004 |  | As of September 30, 2003
|--------------------------- |  | -------------------- |  | ------------------------
|
|
|LYONs                       |  | 549,022              |  | $                       
|111/8% Senior Secured Notes |  | 416,000              |  | $                       

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

The
fair market values of the debt instruments listed above are based upon quoted market prices and yields obtained through independent pricing sources for the same or similar types of
borrowing arrangements 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 fair value because of their short-term maturity
and variable rates of interest.

As
of March 31, 2004 and September 30, 2003, the estimated fair values of our foreign currency forward contracts and options were $4 million and $13 million,
respectively. The estimated fair values of these forward contracts and options were based on market quotes obtained through independent pricing sources.

As
of March 31, 2004, the fair value of our interest rate swap agreements was approximately $8 million based upon a mark-to-market valuation
performed by an independent financial institution.

Financial Instruments

Interest Rate Swap Agreements

During the six months ended March 31, 2004, we entered into five interest rate swap agreements each having a notional amount of $50 million and a
maturity date of April 2009. Under these

55

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agreements,
we receive a fixed interest rate of 111/8% and pay a floating interest rate based on the six-month LIBOR (in arrears) plus an agreed-upon spread of
6.55%, 6.8575%, 6.94%, 6.8% and 6.98%, respectively. The interest rate swaps effectively convert $250 million of our senior secured notes from fixed rate debt into floating rate debt.

Item 3.Quantitative and Qualitative Disclosures About Market Risk.

See Avaya's Annual Report filed on February 12, 2004 on a Current Report on Form 8-K for the fiscal year ended September 30, 2003 (Item 7A). At
March 31, 2004, there has been no material change in this information other than entering into five interest rate swap agreements disclosed in Note 8"Debt and Derivative
Financial Instruments" to the unaudited interim consolidated financial statements.

Item 4.Controls and Procedures.

We have established disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is
made known to the officers who certify the Company's financial reports and to other members of senior management and the Board of Directors.

Based
on their evaluation as of March 31, 2004, the principal executive officer and principal financial officer of Avaya Inc. have concluded that Avaya Inc.'s
disclosure controls and procedures (as defined in Rules 13a-14c and 15d-14c under the Securities Exchange Act of 1934) are effective to ensure that the information
required to be disclosed by Avaya Inc. in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods
specified in SEC rules and forms.

There
were no changes in Avaya Inc.'s internal controls or in other factors that could significantly affect those controls subsequent to the date of their most recent evaluation.

56

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PART II

Item 1.Legal Proceedings.

See Note 14"Commitments and Contingencies" to the unaudited interim consolidated financial statements.

Item 2.Changes in Securities and Use of Proceeds.

None.

Item 3.Defaults Upon Senior Securities.

None.

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

Avaya held its Annual Meeting of Stockholders on February 26, 2004. At that meeting, shareholders elected Joseph P. Landy, Mark Leslie,
Donald K. Peterson and Anthony P. Terracciano as Class 3 Directors of the Company for a term to expire at the Annual Meeting to be held in year 2007. In addition, shareholders
approved one Directors' proposal. The directors elected and the results of the voting are as follows:

Votes for

Votes
WithheldJoseph P. Landy

340,984,518

37,197,394Mark Leslie

350,513,431

27,668,481Donald K. Peterson

353,492,901

24,689,011Anthony P. Terracciano

350,155,345

28,026,567


|                                  |  | Votes for   |  | Votes Against |  | Abstain   |  | Broker
Non-Votes
|--------------------------------- |  | ----------- |  | ------------- |  | --------- |  | ----------------
|Approve the Avaya Inc. 2004 Long  |  |             |  |               |  |           |  |                 
|Term Incentive Plan, which is the |  |             |  |               |  |           |  |                 
|amended and restated Long Term    |  |             |  |               |  |           |  |                 
|Incentive Plan for Management     |  |             |  |               |  |           |  |                 
|Employees                         |  | 196,552,068 |  | 111,211,097   |  | 3,581,429 |  | 66,837,318      

Item 5.Other Information.

We make available free of charge, through our investor relations' website, investors.Avaya.com, our Form 10-K, Form 10-Q and
Form 8-K reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange
Commission.

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

|(a)  |  | Exhibits:                                                                                       
|---- |  | ------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Donald K. Peterson pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.  
|31.2 |  | Certification of Garry K. McGuire Sr. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|32.1 |  | Certification of Donald K. Peterson pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  
|32.2 |  | Certification of Garry K. McGuire Sr. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|(b)  |  | Reports on Form 8-K:                                                                            

The
following Current Reports on Form 8-K were filed by us during the fiscal quarter ended March 31, 2004:

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SIGNATURES

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

| |  | AVAYA INC.
| |  | ----------
| |  | By:       

May 12, 2004

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