**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2007**

**or**

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

**Forthe transition period from                   to                   **

**CommissionFile Number 001-15951**

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**AVAYA INC.**

(Exact name of registrantas specified in its charter)

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

 

**(908) 953-6000**

(Registrant’s telephonenumber, including area code)

**None**

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

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes  x   No  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

Large accelerated filer  x   Acceleratedfiler  o   Non-acceleratedfiler  o

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

Asof April 30, 2007, 449,860,687 shares of Common Stock, $.01 par value ofAvaya Inc. were outstanding.

 

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**TABLEOF CONTENTS**

| **Item** | ** ** | ** **                                                                                   | **Description** | ** ** | ** ** | **Page** | ** ** |
|----------|------------|----------------------------------------------------------------------------------------------|-----------------|------------|------------|----------|------------|
|     |       | **PART I–FINANCIAL INFORMATION**                                                   |            |       |       |
| 1.       |       | Financial  Statements.                                                                       |            | 3          |       |
| 2.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations. |            | 26         |       |
| 3.       |       | Quantitative and Qualitative Disclosures About Market  Risk.                                 |            | 46         |       |
| 4.       |       | Controls and Procedures.                                                                     |            | 46         |       |
|     |       | **PART II–OTHER INFORMATION**                                                      |            |       |       |
| 1.       |       | Legal  Proceedings.                                                                          |            | 47         |       |
| 1A.      | * *   | Risk Factors.                                                                                |            | 47         |       |
| 2.       | * *   | Unregistered Sales of Equity Securities and Use of  Proceeds.                                |            | 55         |       |
| 3.       |       | Defaults Upon Senior Securities.                                                             |            | 56         |       |
| 4.       |       | Submission of Matters to a Vote of Security Holders.                                         |            | 56         |       |
| 5.       |       | Other  Information.                                                                          |            | 56         |       |
| 6.       |       | Exhibits.                                                                                    |            | 57         |       |
|     |       | Signatures                                                                                   |            | 58         |       |

 

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

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**PART IFINANCIAL INFORMATION**

**Item1. *Financial Statements*.**

**AVAYA INC.CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**

| ** **                                   | ** ** | **Three months  ended**                                                | ** ** | **Six months  ended** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **March 31,**                                                          | ** ** | **March 31,**         | ** ** |
| ** **                                   | ** ** | **2007**                                                                    | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                   | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| REVENUE                                      |       |                                                                        |       |                       |       |   |   |   |   |
| Sales of products                            |       | $                                                                           | 639        |                       | $          | 593 |   | $ | 1,258 |   | $ | 1,184 |   |
| Services                                     |       | 509                                                                         |       | 492                        |       | 1,018 |   | 996 |   |
| Rental and managed services                  |       | 146                                                                         |       | 153                        |       | 298 |   | 307 |   |
|                                         |       | 1,294                                                                       |       | 1,238                      |       | 2,574 |   | 2,487 |   |
| COSTS                                        |       |                                                                        |       |                       |       |   |   |   |   |
| Sales of products                            |       | 301                                                                         |       | 275                        |       | 590 |   | 552 |   |
| Services                                     |       | 324                                                                         |       | 319                        |       | 648 |   | 641 |   |
| Rental and managed services                  |       | 71                                                                          |       | 66                         |       | 139 |   | 127 |   |
|                                         |       | 696                                                                         |       | 660                        |       | 1,377 |   | 1,320 |   |
| GROSS MARGIN                                 |       | 598                                                                         |       | 578                        |       | 1,197 |   | 1,167 |   |
| OPERATING  EXPENSES                          |       |                                                                        |       |                       |       |   |   |   |   |
| Selling, general and administrative          |       | 393                                                                         |       | 399                        |       | 782 |   | 784 |   |
| Research and development                     |       | 114                                                                         |       | 106                        |       | 228 |   | 203 |   |
| Restructuring charges, net                   |       | 10                                                                          |       | 20                         |       | 16 |   | 20 |   |
| TOTAL OPERATING EXPENSES                     |       | 517                                                                         |       | 525                        |       | 1,026 |   | 1,007 |   |
| OPERATING INCOME                             |       | 81                                                                          |       | 53                         |       | 171 |   | 160 |   |
| Other income, net                            |       | 7                                                                           |       | 6                          |       | 13 |   | 11 |   |
| Interest expense                             |       | —                                                                      |       | (2                         | )          | — |   | (3 | ) |
| INCOME BEFORE INCOME TAXES                   |       | 88                                                                          |       | 57                         |       | 184 |   | 168 |   |
| Provision for income taxes                   |       | 31                                                                          |       | 19                         |       | 56 |   | 59 |   |
| **NET INCOME**                               | ** ** | **$**                                                                       | **57**     | ** **                 | **$**      | **38** | ** ** | **$** | **128** | ** ** | **$** | **109** | ** ** |
| **Earnings  Per Common Share—Basic:**   | ** ** | **$**                                                                       | **0.13**   | ** **                 | **$**      | **0.08** | ** ** | **$** | **0.28** | ** ** | **$** | **0.23** | ** ** |
| **Earnings Per Common  Share—Diluted:** | ** ** | **$**                                                                       | **0.13**   | ** **                 | **$**      | **0.08** | ** ** | **$** | **0.28** | ** ** | **$** | **0.23** | ** ** |

 

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

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**AVAYA INC.CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

| ** **                                                                                                                                                                                                                | ** ** | **March 31, 2007**                                                | ** ** | **September 30, 2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                                | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| **ASSETS**                                                                                                                                                                                                                |       |                                                                        |       |                             |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                           |       |                                                                        |       |                             |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                 |       |                                                                        | $          | 829                              |       |   |   | $ | 899 |   |   |
| Accounts receivable, less allowances of $52 million  and $57 million as of March 31, 2007 and September 30, 2006, respectively                                                                                            |       |                                                                        | 887        |                             |       |   | 871 |   |   |
| Inventory                                                                                                                                                                                                                 |       |                                                                        | 282        |                             |       |   | 285 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                |       |                                                                        | 162        |                             |       |   | 153 |   |   |
| Other current assets                                                                                                                                                                                                      |       |                                                                        | 204        |                             |       |   | 151 |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                                     |       |                                                                        | 2,364      |                             |       |   | 2,359 |   |   |
| Property, plant and equipment, net                                                                                                                                                                                        |       |                                                                        | 644        |                             |       |   | 668 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                |       |                                                                        | 740        |                             |       |   | 787 |   |   |
| Intangible assets                                                                                                                                                                                                         |       |                                                                        | 290        |                             |       |   | 263 |   |   |
| Goodwill                                                                                                                                                                                                                  |       |                                                                        | 1,105      |                             |       |   | 941 |   |   |
| Other assets                                                                                                                                                                                                              |       |                                                                        | 203        |                             |       |   | 182 |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                         | ** ** | ** **                                                                  | **$**      | **5,346**                        |       | ** ** | ** ** | **$** | **5,200** |   |   |
| **LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                                                                                                  | ** ** | ** **                                                                  | ** ** |                             | ** ** | ** ** | ** ** |   |   |
| Current  liabilities:                                                                                                                                                                                                     |       |                                                                        |       |                             |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                          |       |                                                                        | $          | 398                              |       |   |   | $ | 418 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                           |       |                                                                        | 365        |                             |       |   | 377 |   |   |
| Deferred revenue                                                                                                                                                                                                          |       |                                                                        | 303        |                             |       |   | 286 |   |   |
| Business restructuring reserve                                                                                                                                                                                            |       |                                                                        | 76         |                             |       |   | 98 |   |   |
| Other current liabilities                                                                                                                                                                                                 |       |                                                                        | 246        |                             |       |   | 249 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                |       |                                                                        | 1,388      |                             |       |   | 1,428 |   |   |
| Benefit obligations                                                                                                                                                                                                       |       |                                                                        | 1,349      |                             |       |   | 1,321 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                |       |                                                                        | 83         |                             |       |   | 77 |   |   |
| Other liabilities                                                                                                                                                                                                         |       |                                                                        | 267        |                             |       |   | 288 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                            |       |                                                                        | 1,699      |                             |       |   | 1,686 |   |   |
| Commitments and contingencies                                                                                                                                                                                             |       |                                                                        |       |                             |       |   |   |   |   |
| **STOCKHOLDERS' EQUITY**                                                                                                                                                                                                  | ** ** | ** **                                                                  | ** ** |                             | ** ** | ** ** | ** ** |   |   |
| Series A junior participating preferred stock, par  value $1.00 per share, 7.5 million shares authorized; none issued and  outstanding                                                                                    |       |                                                                        | —     |                             |       |   | — |   |   |
| Common stock, par value $0.01 per share, 1.5 billion  shares authorized, 450,645,215 and 452,203,778 issued (including 1,058,297  and 461,429 treasury shares) as of March 31, 2007 and September 30, 2006,  respectively |       |                                                                        | 5          |                             |       |   | 5 |   |   |
| Additional paid-in-capital                                                                                                                                                                                                |       |                                                                        | 2,622      |                             |       |   | 2,637 |   |   |
| Retained earnings                                                                                                                                                                                                         |       |                                                                        | 276        |                             |       |   | 148 |   |   |
| Accumulated other comprehensive loss                                                                                                                                                                                      |       |                                                                        | (631       | )                                |       |   | (698 | ) |   |
| Less: Treasury stock at cost                                                                                                                                                                                              |       |                                                                        | (13        | )                                |       |   | (6 | ) |   |
| TOTAL  STOCKHOLDERS' EQUITY                                                                                                                                                                                               |       |                                                                        | 2,259      |                             |       |   | 2,086 |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                                                                                           | ** ** | ** **                                                                  | **$**      | **5,346**                        |       | ** ** | ** ** | **$** | **5,200** |   |   |

 

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

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**AVAYA INC.CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

| ** **                                                                           | ** ** | **Six months ended**               | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                           | ** ** | **March 31,**                           | ** ** |
| ** **                                                                           | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** |
| ** **                                                                           | ** ** | **Dollars in millions**            | ** ** |
| **OPERATING  ACTIVITIES:**                                                           |       |                                         |       |   |   |   |   |   |   |
| Net income                                                                           |       |                                         | $          | 128 |   |   |   | $ | 109 |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:   |       |                                         |       |   |   |   |   |   |   |
| Depreciation and amortization                                                        |       |                                         | 141        |   |   |   | 134 |   |   |
| Share-based compensation                                                             |       |                                         | 18         |   |   |   | 16 |   |   |
| Deferred taxes                                                                       |       |                                         | 35         |   |   |   | 47 |   |   |
| Gain resulting from sale of real estate                                              |       |                                         | (8         | ) |   |   | — |   |   |
| Restructuring charges, net                                                           |       |                                         | 16         |   |   |   | 20 |   |   |
| Unrealized losses (gains) on foreign currency  exchange                              |       |                                         | 13         |   |   |   | (7 | ) |   |
| Adjustments for other non-cash items, net                                            |       |                                         | 4          |   |   |   | 6 |   |   |
| Changes in  operating assets and liabilities, net of effects of acquired businesses: |       |                                         |       |   |   |   |   |   |   |
| Accounts receivable                                                                  |       |                                         | (7         | ) |   |   | 55 |   |   |
| Inventory                                                                            |       |                                         | 9          |   |   |   | (4 | ) |   |
| Accounts payable                                                                     |       |                                         | (23        | ) |   |   | (20 | ) |   |
| Payroll and benefit obligations                                                      |       |                                         | (15        | ) |   |   | (12 | ) |   |
| Business restructuring reserve                                                       |       |                                         | (59        | ) |   |   | (40 | ) |   |
| Deferred revenue                                                                     |       |                                         | 37         |   |   |   | 36 |   |   |
| Other assets and liabilities                                                         |       |                                         | (67        | ) |   |   | (65 | ) |   |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES                                           |       |                                         | 222        |   |   |   | 275 |   |   |
| **INVESTING ACTIVITIES:**                                                            |       |                                         |       |   |   |   |   |   |   |
| Capital expenditures                                                                 |       |                                         | (46        | ) |   |   | (54 | ) |   |
| Capitalized software development costs                                               |       |                                         | (41        | ) |   |   | (37 | ) |   |
| Acquisitions of businesses, net of cash acquired                                     |       |                                         | (161       | ) |   |   | — |   |   |
| Proceeds from sale of real estate                                                    |       |                                         | 8          |   |   |   | — |   |   |
| Other investing activities, net                                                      |       |                                         | (5         | ) |   |   | (8 | ) |   |
| NET CASH USED FOR  INVESTING ACTIVITIES                                              |       |                                         | (245       | ) |   |   | (99 | ) |   |
| **FINANCING ACTIVITIES:**                                                            | ** ** |                                         |       |   |   |   |   |   |   |
| Issuance of common stock                                                             |       |                                         | 30         |   |   |   | 14 |   |   |
| Repurchase of common stock                                                           |       |                                         | (94        | ) |   |   | (193 | ) |   |
| Capital lease payments                                                               |       |                                         | (2         | ) |   |   | — |   |   |
| NET CASH USED FOR  FINANCING ACTIVITIES                                              |       |                                         | (66        | ) |   |   | (179 | ) |   |
| Effect of  exchange rate changes on cash and cash equivalents                        |       |                                         | 19         |   |   |   | (2 | ) |   |
| Net (decrease) in  cash and cash equivalents                                         |       |                                         | (70        | ) |   |   | (5 | ) |   |
| Cash and cash  equivalents at beginning of fiscal year                               |       |                                         | 899        |   |   |   | 750 |   |   |
| Cash and cash  equivalents at end of period                                          |       |                                         | $          | 829 |   |   |   | $ | 745 |   |   |

 

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

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

**1.**Background and Basis of Presentation

***Background***

Unless otherwise indicatedby the context in this Quarterly Report on Form 10-Q, “we,” “us,” “our,”“the Company” and “Avaya” refer to Avaya Inc. and its consolidated subsidiaries.We provide communications systems, applications and services for enterprises,including businesses, government agencies and other organizations. Our productofferings include Internet Protocol (“IP”) telephony systems and traditionalvoice communications systems, multi-media contact center infrastructure andapplications in support of customer relationship management, unifiedcommunications applications and appliances, such as IP telephone sets. The term“traditional” with respect to “voice communications,” “enterprise voicecommunications,” “telephony,” “voice telephony,” “voice systems,” or “TDM,”refers to circuit-based enterprise voice communications. We support our broadcustomer base with comprehensive global service offerings that enable ourcustomers to plan, design, implement, monitor and manage their communicationsnetworks.

***Basis ofPresentation***

The accompanying unauditedinterim Consolidated Financial Statements as of March 31, 2007 and for thethree and six months ended March 31, 2007 and 2006, have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“U.S. GAAP”),for interim financial statements and the rules and regulations of the U.S.Securities and Exchange Commission, (“the SEC”),  for interim financial statements, and shouldbe read in conjunction with our Consolidated Financial Statements and otherfinancial information for the fiscal year ended September 30, 2006, whichwere included in our Annual Report on Form 10-K filed with the SECon December 8, 2006. The significant accounting policies used in preparingthese unaudited interim Consolidated Financial Statements are the same as thosedescribed in Note 2 to our Annual Report on Form 10-K filedwith the SEC on December 8, 2006. In our opinion, the unaudited interimConsolidated Financial Statements reflect all adjustments, consisting of normaland recurring adjustments, necessary for a fair presentation of the financialcondition, results of operations and cash flows for the periods indicated.

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

**2. Recent Accounting Pronouncements**

**SFAS 159**

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

**SFAS 158**

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Post Retirement Plans—an amendment of FASB Statements No. 87,88, 106 

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and 132(R)”(“SFAS 158”). SFAS 158 improves reporting of obligations for pensionsand other post-retirement benefits by recognizing the over-funded orunder-funded status of plans as an asset or liability. The pronouncement doesnot change how plan assets and benefit obligations are measured under FAS 87and FAS 106 nor does it change the approach for measuring annual benefit costreported in earnings. Instead, it eliminates the provisions that permit planassets and obligations to be measured as of a date not more than three monthsprior to the balance sheet date, instead requiring measurement as of thereporting date. In addition, the pronouncement requires previously unrecognizeditems, such as actuarial gains or losses and unrecognized prior service costsor credits to be recognized on the balance sheet as a component of accumulatedother comprehensive income (loss). The Company will adopt the provisions ofSFAS 158 by the end of fiscal 2007. The estimated impact of adopting thisnew standard depends upon several factors, including the market discount rateat September 30, 2007 and the actual return on plan assets. The Companyestimates an increase in the liability for benefit obligations recognized onthe Consolidated Balance Sheets of approximately $150 to $200 million withan addition to accumulated other comprehensive loss. This range is an estimateand is subject to change pending the funded status of the plans as of September 30,2007, the measurement date. The Company is also assessing the potential impactthat adoption of SFAS 158 may have on the Company’s postemploymentliabilities established under SFAS No. 112, “Employers’ Accounting forPostemployment Benefits.”

**SFAS 157**

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).SFAS 157 defines fair value and establishes a framework for measuring fairvalue under U.S. GAAP. The pronouncement describes fair value as being based ona hypothetical transaction to sell an asset or transfer a liability at aspecific measurement date, as considered from the perspective of a marketparticipant who holds the asset or owes the liability. In addition, fair valueshould be viewed as a market-based measurement, not an entity-specificmeasurement. Therefore fair value should be determined based on the assumptionsthat market participants would use in pricing an asset or liability, includingall risks associated with that asset or liability. SFAS 157 will beeffective for the Company beginning in fiscal 2009. The adoption of SFAS 157is not expected to have a material impact on the Company’s ConsolidatedFinancial Statements.

**SAB 108**

In September 2006,the SEC issued SAB 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”). SAB 108provides interpretive guidance on how the effects of the carryover or reversalof prior year misstatements should be considered in quantifying a current yearmisstatement. The pronouncement prescribes an approach whereby the effect ofall unrecorded identified errors should be considered on all of the financialstatements rather than just the effect on either the balance sheet or theincome statement. The Company will adopt the provisions of SAB 108 by theend of fiscal 2007. The adoption of SAB 108 is not expected to impact theCompany’s Consolidated Financial Statements.

**FIN 48**

In July 2006, the FASB issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes (aninterpretation of FASB Statement No. 109)” (“FIN 48”). FIN 48clarifies the accounting for uncertainty in tax positions and requires thatcompanies recognize in their financial statements the impact of a tax positionif it is more likely than not that the position would be sustained on audit,based on the technical merits of the position. The Company will be required toadopt the provisions of FIN 48 beginning in fiscal 2008, with thecumulative effect of the change in accounting principle recorded as anadjustment to opening retained earnings as well as requiring additionaldisclosures. The Company is currently assessing the impact that adoption of FIN48 may have on its Consolidated Financial Statements.

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**3. Business Combinations**

***Acquisition ofUbiquity***

On January 12, 2007, theCompany announced that Avaya International Enterprises Limited (“AIEL”), awholly-owned subsidiary of the Company, commenced a conditional tenderoffer to acquire Ubiquity Software Corporation plc (“Ubiquity”). Ubiquitydevelops and markets SIP-based communications software. Ubiquity was publiclytraded on the Alternative Investment Market of the London Stock Exchange and isheadquartered in the United Kingdom. Terms of the offer provided for a purchaseprice of 37.3 pence per Ubiquity share.

On February 15, 2007,the Company announced that it received binding acceptances representing96.7 percent of the outstanding shares of Ubiquity through its tender offerand declared the offer wholly unconditional. On February 28, 2007, theCompany used $146 million of cash to acquire substantially all of theUbiquity shares. During April 2007, the Company purchased the remainingoutstanding shares.

Based upon a preliminarypurchase price allocation, the Company recognized $41 million ofintangible assets related primarily to existing technology with a weightedaverage useful life of approximately nine years, and recorded $122 millionof goodwill. Management has made estimates and assumptions in the preliminarypurchase price allocation that could affect the reported amounts of assets,liabilities and expenses resulting from this acquisition. Actual amounts coulddiffer from these estimates. Management expects to finalize its purchase priceallocation by the end of fiscal 2007. The purchase price for this acquisitionis not considered to be material to the Consolidated Financial Statements and,therefore, pro forma financial information has not been presented. Results fromUbiquity are included in the Company’s Consolidated Financial Statementsbeginning on February 28, 2007.

***Acquisition ofTraverse***

On November 9, 2006,the Company acquired Traverse Networks, Inc. (“Traverse”) for $15 millionin cash. Traverse is a U.S.-based privately-held developer of enterprisemobility solutions for unified communications. The Company acquired $3 millionin intangible assets with a weighted average useful life of 4.5 years and$4 million in other assets and recorded $8 million of goodwill aspart of the preliminary purchase price allocation. Management has madeestimates and assumptions that could affect the reported amounts of assets,liabilities and expenses resulting from this acquisition. Actual amounts coulddiffer from these estimates. The purchase price for this acquisition is notconsidered to be material to the Consolidated Financial Statements and,therefore, pro forma financial information has not been presented. Results fromTraverse are included in the Company’s Consolidated Financial Statementsbeginning on November 9, 2006.

**4. Goodwill and Intangible Assets**

Thechanges in the carrying value of goodwill for the six months ended March 31,2007 by operating segment are as follows:
|                                                        | ** ** | **Global  Communications  Solutions** | ** ** | **Avaya  Global  Services** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                             | ** ** | **Dollars in millions**     | ** ** |
| **Balance  as of September 30, 2006**                  | ** ** |                                  | **$**      | **658**                     | ** ** |      |       | **$** | **283** | ** ** |   | **$** | **941** | ** ** |
| Acquisition of Traverse                                |       |                                  | 8          | ** **                  |       |      | —     | ** ** |   | 8 |   |
| Acquisition of Ubiquity                                |       |                                  | 122        | ** **                  |       |      | —     | ** ** |   | 122 |   |
| Impact of foreign currency exchange rate  fluctuations |       |                                  | 24         | ** **                  |       |      | 10         | ** ** |   | 34 |   |
| **Balance as of March 31, 2007**                       | ** ** |                                  | **$**      | **812**                     | ** ** |      |       | **$** | **293** | ** ** |   | **$** | **1,105** | ** ** |

 

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Thefollowing table presents the components of the Company’s acquired intangibleassets:
|                                                     | ** ** | **March 31, 2007**      | ** ** | **September 30, 2006** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **Gross  Carrying  Amount**       | ** ** | **Accumulated  Amortization**    | ** ** | **Net** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulate  Amortization** | ** ** | **Net** | ** ** |
| ** **                                          | ** ** | **Dollars in millions** | ** ** |
| Existing  technology                                |       |                              | $          | 150                              |       |   |   | $ | 66 |   |   |   | $ | 84 |   |   |   | $ | 103 |   |   |   | $ | 57 |   |   | $ | 46 |   |
| Customer  relationships and other intangibles       |       |                              | 310        |                             |       |   | 123 |   |   |   | 187 |   |   |   | 292 |   |   |   | 94 |   |   | 198 |   |
| **Total  amortizable intangible assets**            | ** ** | ** **                        | **$**      | **460**                          |       | ** ** | ** ** | **$** | **189** |   | ** ** | ** ** | **$** | **271** |   | ** ** | ** ** | **$** | **395** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **244** | ** ** |
| Minimum pension  adjustment     |       |                              | 19         |                             |       |   | — |   |   |   | 19 |   |   |   | 19 |   |   |   | — |   |   | 19 |   |
| **Total intangible assets**                         | ** ** | ** **                        | **$**      | **479**                          |       | ** ** | ** ** | **$** | **189** |   | ** ** | ** ** | **$** | **290** |   | ** ** | ** ** | **$** | **414** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **263** | ** ** |

 

During the six months ended March 31, 2007, theacquisitions of Ubiquity and Traverse as well as the impact of foreign currencyfluctuations, partially offset by amortization, resulted in a net increase of$27 million in the net intangible assets balance. The weighted averageuseful lives of the existing technology and customer relationships and otherintangibles are approximately six years and seven years, respectively.

Amortizationexpense for the Company’s acquired intangible assets was $17 million and$32 million for the three and six months ended March 31, 2007,respectively, and was $17 million and $33 million for the three andsix months ended March 31, 2006, respectively. Estimated futureamortization expense is shown in the following table:
|                                 | ** ** | **Estimated future  amortization expense** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **Dollars in millions**                    | ** ** |
| Remainder of fiscal 2007        |       |                                                 | $          | 35 |   |   |
| 2008                            |       |                                                 | 69         |   |   |
| 2009                            |       |                                                 | 67         |   |   |
| 2010                            |       |                                                 | 54         |   |   |
| 2011                            |       |                                                 | 14         |   |   |
| 2012 and thereafter             |       |                                                 | 32         |   |   |
| **Future amortization expense** | ** ** | ** **                                           | **$**      | **271** |   |   |

 

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

9

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**5. SupplementaryFinancial Information**

***Statements ofIncome Information***
|                                                                                    | ** ** | **Three months  ended  March 31,** | ** ** | **Six months  ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                     | ** ** | **2006**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                         | ** ** | **Dollars in millions**            | ** ** |
| **OTHER  INCOME, NET**                                                             | ** ** |                                         | ** ** | ** **                                 |       |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                    |       |                                         | $          | 11                                         |       |   |   | $ | 8 |   |   | $ | 22 |   | $ | 15 |   |
| Loss on foreign currency transactions                                              |       |                                         | —     |                                       |       |   | (1 | ) |   | (3 | ) | (2 | ) |
| Other, net                                                                         |       |                                         | (4         | )                                          |       |   | (1 | ) |   | (6 | ) | (2 | ) |
| **Total  other income, net**                                                       | ** ** |                                         | **$**      | **7**                                      | ** ** |   |   | **$** | **6** | ** ** |   | **$** | **13** | ** ** | **$** | **11** | ** ** |
| **COMPREHENSIVE  INCOME:**                                                         | ** ** |                                         | ** ** | ** **                                 |       |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       |                                         | $          | 57                                         |       |   |   | $ | 38 |   |   | $ | 128 |   | $ | 109 |   |
| Other comprehensive income:                                                        |       |                                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Cumulative translation adjustment                                                  |       |                                         | 15         |                                       |       |   | 49 |   |   | 66 |   | 49 |   |
| Unrealized holding (loss) gain on available for sale  securities    |       |                                         | —     |                                       |       |   | (3 | ) |   | 1 |   | (3 | ) |
| **Total comprehensive income**                                                     | ** ** |                                         | **$**      | **72**                                     | ** ** |   |   | **$** | **84** | ** ** |   | **$** | **195** | ** ** | **$** | **155** | ** ** |

 

***Balance SheetInformation***
|                                                  | ** ** | **March 31, 2007**      | ** ** | **September 30, 2006** | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY:**                                   | ** ** |                              | ** ** | ** **                       |       |   | ** ** | ** ** |   |
| Finished goods                                   |       |                              | $          | 280                              |       |   |   | $ | 281 |   |   |
| Raw materials                                    |       |                              | 2          |                             |       |   | 4 |   |   |
| **Total  inventory**                             | ** ** |                              | **$**      | **282**                          | ** ** |   |   | **$** | **285** | ** ** |   |
| **PROPERTY,  PLANT AND EQUIPMENT, NET:**         | ** ** |                              | ** ** | ** **                       |       |   | ** ** | ** ** |   |
| Land and improvements                            |       |                              | $          | 60                               |       |   |   | $ | 56 |   |   |
| Buildings and improvements                       |       |                              | 474        |                             |       |   | 460 |   |   |
| Machinery and equipment                          |       |                              | 685        |                             |       |   | 654 |   |   |
| Rental equipment                                 |       |                              | 240        |                             |       |   | 230 |   |   |
| Assets under construction                        |       |                              | 3          |                             |       |   | 8 |   |   |
| Internal use software                            |       |                              | 236        |                             |       |   | 226 |   |   |
| Total property,  plant and equipment             |       |                              | 1,698      |                             |       |   | 1,634 |   |   |
| Less: Accumulated  depreciation and amortization |       |                              | (1,054     | )                                |       |   | (966 | ) |   |
| **Property, plant and equipment,  net**          | ** ** |                              | **$**      | **644**                          | ** ** |   |   | **$** | **668** | ** ** |   |

 

**6. RestructuringPrograms**

The restructuring charge recorded in the six monthsended March 31, 2007 is primarily comprised of employee separation chargesrelated to our Europe, Middle East and Africa (“EMEA”) operations, in additionto operating lease obligations. These charges were partially offset by a netbenefit due to changes in estimates for prior restructuring plans.

Restructuring charges, net, of $10 million forthe second quarter of fiscal 2007 represent $11 million of charges foremployee separation costs and operating lease obligations recorded in thefiscal 2007 restructuring plan, partially offset by a net benefit of $1 millionfor changes in estimates for prior restructuring plans.

10

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***Fiscal 2007 Restructuring Plan***

Thefollowing table summarizes the components of this reserve during the six monthsended March 31, 2007:
|                                        | ** ** | **Employee**   | ** ** | ** ** | ** ** | ** **      | ** ** |
|----------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|
| ** **                             | ** ** | **Separation** | ** ** | **Lease**  | ** ** | ** **      | ** ** |
| **Dollars in millions**      | ** ** | ** **     | ** ** | **Costs**  | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2006 |       |           | $          | —     |       |            |       | $ | — |   |   |   | $ | — |   |   |
| Charges                                |       |           | 17         |       |       |            | 6          |   |   |   | 23 |   |   |
| Cash payments                          |       |           | (4         | )          |       |            | (2         | ) |   |   | (6 | ) |   |
| **Balance as of March 31,  2007** | ** ** | ** **     | **$**      | **13**     |       | ** **      | ** ** | **$** | **4** |   | ** ** | ** ** | **$** | **17** |   |   |
|                                        |            |                |            |            |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

***Fiscal 2006 Restructuring Plan***

Thisreserve reflects the remaining balances associated with restructuring actionsinitiated during fiscal 2006. The following table summarizes the components ofthis reserve during the six months ended March 31, 2007:
|                                         | ** ** | **Employee**   | ** ** | ** ** | ** ** | ** **      | ** ** |
|-----------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|
| ** **                              | ** ** | **Separation** | ** ** | **Lease**  | ** ** | ** **      | ** ** |
| **Dollars in millions**       | ** ** | ** **     | ** ** | **Costs**  | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2006  |       |           | $          | 70         |       |            |       | $ | 17 |   |   | $ | 87 |   |
| Adjustments                             |       |           | (2         | )          |       |            | (7         | ) |   | (9 | ) |
| Cash payments                           |       |           | (34        | )          |       |            | (2         | ) |   | (36 | ) |
| Impact of foreign currency fluctuations |       |           | 1          |       |       |            | 1          |   |   | 2 |   |
| **Balance as of March 31,  2007**  | ** ** | ** **     | **$**      | **35**     |       | ** **      | ** ** | **$** | **9** |   | ** ** | **$** | **44** | ** ** |
|                                         |            |                |            |            |            |                 |            |  |  |  |  |  |  |  |  |  |

 

The employee separationcosts are related to workforce actions in the EMEA region, as well as areduction in the number of service technicians in the U.S. The headcountreductions identified in this action have been completed and the cash paymentsare expected to be made through the end of fiscal 2007. The operating leaseobligations relate to future rent payments, net of estimated sublease income,for unused space in connection with the closing or consolidation ofinternational office facilities, primarily located in the United Kingdom.During the six months ended March 31, 2007, the Company concluded leaserenegotiations, resulting in a change in the estimate and a $7 million reversalof the initial liability.

11

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

Thisreserve reflects the remaining balances associated with restructuring actionsinitiated prior to fiscal 2006. During the fourth quarter of fiscal 2005, theCompany recorded a restructuring charge to reorganize its North American salesand service organizations, consolidate facilities and reduce the workforce inorder to optimize the cost structure. The Company also previously recorded areserve in fiscal 2000 through 2002 for lease terminations. The following summarizesthe components of this restructuring reserve during the six months endedMarch 31, 2007:
|                                        | ** ** | **Employee**                      | ** ** | ** **      | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                             | ** ** | **Separation**                    | ** ** | **Lease**       | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006 |       |                              | $          | 1               |       |       |       | $ | 22 |   |   |   | $ | 23 |   |   |
| Adjustments                            |       |                              | 1          |            |       |       | 1          |   |   |   | 2 |   |   |
| Cash payments                          |       |                              | (1         | )               |       |       | (4         | ) |   |   | (5 | ) |   |
| **Balance as of March 31,  2007** | ** ** | ** **                        | **$**      | **1**           |       | ** ** | ** ** | **$** | **19** |   | ** ** | ** ** | **$** | **20** |   |   |

 

***EITF 95-3 Reserve***

Thisreserve reflects the remaining balance associated with employee separationcosts related to the acquisition of Tenovis. The following table summarizes thecomponents of this reserve during the six months ended March 31, 2007:
|                                         | ** ** | **Employee**                      | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|
| ** **                              | ** ** | **Separation**                    | ** ** |
| ** **                              | ** ** | **Costs**                         | ** ** |
| ** **                              | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2006  |       |                              | $          | 30 |   |   |
| Cash payments                           |       |                              | (12        | ) |   |
| Impact of foreign currency fluctuations |       |                              | 1          |   |   |
| **Balance as of March 31,  2007**  | ** ** | ** **                        | **$**      | **19** |   |   |

 

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

**7. FinancingArrangements**

***Capital Lease Obligations***

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

| ** **                               | ** ** | **March 31, 2007**      | ** ** | **September 30, 2006** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **Dollars in millions** | ** ** |
| As reported in other current liabilities |       |                              | $          | 3                                |       |   |   | $ | 4 |   |   |
| As reported in other liabilities         |       |                              | 8          |                             |       |   | 9 |   |   |
| **Total capital lease obligations**      | ** ** | ** **                        | **$**      | **11**                           |       | ** ** | ** ** | **$** | **13** |   |   |

 

***Credit Facility Amendments***

On February 23, 2005, the Company entered into aCredit Agreement among the Company, Avaya International Sales Limited, anindirect subsidiary of the Company, a syndicate of lenders and Citicorp 

12

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USA, Inc., as agentfor the lenders (the “credit facility”). The commitments pursuant to theCompany’s previous Amended and Restated Five Year Revolving Credit FacilityAgreement, dated as of April 30, 2003 (as amended), among the Company, thelenders party thereto and Citibank, N.A., as agent for the lenders, wereterminated and the security interests securing obligations under that facilitywere fully released.

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

The creditfacility also limits our ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares ofour common stock to an amount not to exceed 50% of consolidated net incomefor the fiscal year immediately preceding the fiscal year in which suchdividend, purchase, redemption, retirement or acquisition is paid or made. On September 8, 2006,the credit facility was amended to provide that the Company may use anadditional $500 million during the period from October 1, 2006through September 30, 2008 for such activities, over the amount providedfor under the 50% of consolidated net income test each year. Therefore,as of March 31, 2007, Avaya has remaining availability of $507 millionin fiscal 2007 for share repurchases under the credit facility.

Provided that the Company is in compliance with theterms of the credit facility, the Company may use up to $1 billion in cash(excluding transaction fees) and assumed debt for acquisitions completed afterFebruary 23, 2005, and the Company has used $199  million as ofMarch 31, 2007. The acquisition amount will be permanently increased to$1.5 billion after consolidated adjusted EBITDA of the Company and itssubsidiaries for any period of twelve consecutive months equals or exceeds $750 million.

As of March 31, 2007,the Company was in compliance with all of the covenants included in the creditfacility. There are currently $28 million of letters of credit issuedunder the credit facility. There are no other outstanding borrowings under thefacility and the remaining availability is $372 million as of March 31,2007.

13

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**8. EarningsPer Share of Common Stock**

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

| ** **                                                                          | ** ** | **Three months ended**                                                | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                          | ** ** | **March 31,**                                                              | ** ** | **March 31,**             | ** ** |
| ** **                                                                          | ** ** | **2007**                                                                        | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                          | ** ** | **Dollars in millions, except per share amounts** | ** ** |
| **Earnings  Per Common Share—Basic:**                                          |       |                                                                            |       |                           |       |   |   |   |   |
| Net income                                                                          |       | $                                                                               | 57         |                           | $          | 38 |   | $ | 128 |   | $ | 109 |   |
| Earnings per share—basic                                                       |       | $                                                                               | 0.13       |                           | $          | 0.08 |   | $ | 0.28 |   | $ | 0.23 |   |
| Weighted average  shares outstanding—basic                                     |       | 453                                                                             |       | 466                            |       | 453 |   | 469 |   |
| **Earnings  Per Common Share—Diluted:**                                        |       |                                                                            |       |                           |       |   |   |   |   |
| Net income                                                                          |       | $                                                                               | 57         |                           | $          | 38 |   | $ | 128 |   | $ | 109 |   |
| Earnings per  share—diluted                                                    |       | $                                                                               | 0.13       |                           | $          | 0.08 |   | $ | 0.28 |   | $ | 0.23 |   |
| **Diluted  Weighted Average Shares Outstanding:**                                   |       |                                                                            |       |                           |       |   |   |   |   |
| Weighted average  shares outstanding—basic                                     |       | 453                                                                             |       | 466                            |       | 453 |   | 469 |   |
| Dilutive Potential  Common Shares:                                                  |       |                                                                            |       |                           |       |   |   |   |   |
| Stock Options                                                                       |       | 3                                                                               |       | 5                              |       | 4 |   | 5 |   |
| Restricted Stock  Units                                                             |       | 1                                                                               |       | 1                              |       | 1 |   | 1 |   |
| Weighted average  shares outstanding—diluted                                   |       | 457                                                                             |       | 472                            |       | 458 |   | 475 |   |
| **Securities  excluded from the computation of diluted earnings per common share:** |       |                                                                            |       |                           |       |   |   |   |   |
| Stock options(1)                                                                    |       | 32                                                                              |       | 41                             |       | 36 |   | 41 |   |

----

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

On April 19, 2005, the Board of Directors authorized a sharerepurchase plan (the “2005 plan”). Under the provisions of the 2005 plan, Avayawas authorized to use up to $500 million of cash to repurchase shares ofits outstanding common stock through April 2007. During February 2007,Avaya completed the 2005 plan.

On February 15, 2007, the Board of Directors authorized another sharerepurchase plan (the “2007 plan”), under which Avaya may use up to $500 millionof cash for repurchases of its outstanding shares through February 2009. Avayarepurchased 7,304,779 shares of its common stock during the six months ended March 31,2007. This represented 5,008,479 shares of common stock pursuant to the 2005plan and 2,296,300 shares of common stock pursuant to the 2007 plan. Approximately$471 million is available through February 2009 for further sharerepurchases under the 2007 plan.

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

14

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**9. IncomeTaxes**

Thefollowing table provides the provision for income taxes for the three and sixmonths ended March 31, 2007 and 2006:

| ** **                  | ** ** | **Three months  ended**      | ** ** | **Six months  ended** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **March 31,**                | ** ** | **March 31**          | ** ** |
| ** **                  | ** ** | **2007**                          | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                  | ** ** | **Dollars in millions** | ** ** |
| Provision for  income taxes |       |                              | $          | 31                         |       |   |   | $ | 19 |   |   |   | $ | 56 |   |   |   | $ | 59 |   |   |
|                             |            |                                   |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provisionfor income taxes for the periods shown above are comprised ofU.S. Federal, state and non-U.S. taxes. The provision for the six months ended March 31,2007 includes a $6 million benefit from the retroactive extension to January 1,2006 of the research tax credit pursuant to the Tax Relief and Health Care Actof 2006, and a $7 million tax benefit due to a reduction in estimated taxpayable for fiscal 2006 in Germany as a result of additional restructuringcharges reported for statutory purposes.

**10. BenefitObligations**

Thecomponents of net periodic benefit cost (credit) for the three and six monthsended March 31, 2007 and 2006 are provided in the table below:

| ** **                                      | ** ** | **Pension  Benefits—U.S.**              | ** ** | **Pension  Benefits—  Non-U.S.**        | ** ** | **Postretirement  Benefits—U.S.**       | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **Three months  ended  March 31,** | ** ** | **Three months  ended  March 31,** | ** ** | **Three months  ended  March 31,** | ** ** |
| ** **                                      | ** ** | **2007**                                     | ** ** | **2006**                                     | ** ** | **2007**                                     | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **Dollars in millions**            | ** ** |
| **Components  of Net Periodic Benefit Cost**    | ** ** | ** **                                   | ** ** | ** **                                   | ** ** |                                         |       |   |   |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Service cost                                    |       | $                                            | 4          |                                         | $          | 5                                            |       |   | $ | 3 |   |   |   | $ | 3 | ** ** |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                   |       | 41                                           |       | 42                                           |       |                                         | 5          |   |   |   | 4 | ** ** |   |   | 10 |   |   |   | 9 |   |   |
| Expected return on plan assets                  |       | (51                                          | )          | (51                                          | )          |                                         | (1         | ) |   |   | — | ** ** |   |   | (2 | ) |   |   | (1 | ) |   |
| Amortization of unrecognized prior service cost |       | 1                                            |       | 1                                            |       |                                         | —     |   |   |   | — | ** ** |   |   | 8 |   |   |   | 4 |   |   |
| Recognized net actuarial loss                   |       | 12                                           |       | 14                                           |       |                                         | —     |   |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |
| **Net periodic benefit cost**                   | ** ** | **$**                                        | **7**      | ** **                                   | **$**      | **11**                                       | ** ** | ** ** | **$** | **7** |   |   |   | **$** | **7** | ** ** | ** ** | ** ** | **$** | **17** |   | ** ** | ** ** | **$** | **13** |   |   |

 
|                                                  | ** ** | **Pension  Benefits—U.S.**                | ** ** | **Pension  Benefits—  Non-U.S.**          | ** ** | **Postretirement  Benefits—U.S.**         | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                       | ** ** | **Six months  ended March 31,** | ** ** | **Six months  ended March 31,** | ** ** | **Six months  ended March 31,** | ** ** |
| ** **                                       | ** ** | **2007**                                       | ** ** | **2006**                                       | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **Dollars in millions**              | ** ** |
| **Components  of Net Periodic Benefit Cost**     | ** ** | ** **                                     | ** ** | ** **                                     | ** ** |                                           | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                     |       | $                                              | 7          |                                           | $          | 9                                              |       |   | $ | 5 |   |   |   | $ | 5 | ** ** |   |   | $ | 2 |   |   |   | $ | 2 |   |   |
| Interest cost                                    |       | 83                                             |       | 83                                             |       |                                           | 10         |   |   |   | 8 | ** ** |   |   | 20 |   |   |   | 17 |   |   |
| Expected return  on plan assets                  |       | (102                                           | )          | (102                                           | )          |                                           | (1         | ) |   |   | — | ** ** |   |   | (4 | ) |   |   | (3 | ) |   |
| Amortization of  unrecognized prior service cost |       | 2                                              |       | 3                                              |       |                                           | —     |   |   |   | — | ** ** |   |   | 16 |   |   |   | 8 |   |   |
| Recognized net  actuarial loss                   |       | 23                                             |       | 28                                             |       |                                           | —     |   |   |   | — | ** ** |   |   | — |   |   |   | 1 |   |   |
| **Net periodic benefit cost**                    | ** ** | **$**                                          | **13**     | ** **                                     | **$**      | **21**                                         | ** ** |   | **$** | **14** | ** ** |   |   | **$** | **13** | ** ** |   |   | **$** | **34** | ** ** |   |   | **$** | **25** | ** ** |   |

 

The Company provides certain pension benefits for U.S.and non-U.S. employees, which are not pre-funded. The Company makes payments asthese benefits are disbursed. For the six months ended March 31, 2007, theCompany made payments for these U.S. and non-U.S. pension benefits totaling 

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$3 million and $9 million,respectively. Estimated payments for these U.S. and non-U.S. pension benefitsfor the remainder of fiscal 2007 are $3 million and $3 million,respectively.

In compliance with theterms of the 2006 Agreement between the Company and the Communications Workersof America, the Company has contributed $12 million to the representedemployees’ post-retirement health trust for the six months ended March 31,2007, and expects to make additional contributions totaling $23 millionfor the remainder of fiscal 2007. The Company also provides certain retireemedical benefits for U.S. employees, which are not pre-funded. Consequently,the Company makes payments as these benefits are disbursed. For the six monthsended March 31, 2007, the Company made payments totaling $18 millionfor these retiree medical benefits. Estimated payments for these retireemedical benefits for the remainder of fiscal 2007 are $10 million.

**11. StockCompensation Plans**

The Company has a stockcompensation plan that provides for the issuance to eligible employees ofnonqualified stock options and restricted stock units representing Avaya commonstock. In addition, the Company has a stock purchase plan under which eligibleemployees have the ability to purchase shares of Avaya common stock at 85% ofmarket value. As of March 31, 2007, there were 36.7 million sharesauthorized for future grants to purchase Avaya common stock under the Company’sstock compensation plan.

**Stock Options**

Stock options are generally granted with an exerciseprice equal to the market value of a share of common stock on the date of grant,have a term of 10 years or less and vest within four years from the dateof grant. Most of the stock options granted in fiscal 2004 or later have a termof seven years and vest over three years. For the six months ended March 31,2007 and 2006, approximately $9 million and $7 million, respectively,of compensation expense related to stock options was recorded.

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

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

Share-based compensation expense recognized in theConsolidated Statements of Income for the six months ended March 31, 2007and 2006 is based on awards ultimately expected to vest, reduced for estimatedforfeitures. SFAS 123(R) requires forfeitures to be estimated at the timeof grant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates. Forfeitures were estimated based on the Company’shistorical experience.

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

| ** **                         | ** ** | **Six months ended** | ** ** |
|------------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **March 31, 2007**   | ** ** |
| WEIGHTED AVERAGE  ASSUMPTIONS:     |       |                           |       |   |   |
| Dividend yield                     |       |                           | 0.00       | % |   |
| Expected volatility                |       |                           | 56.72      | % |   |
| Risk-free interest rate            |       |                           | 4.66       | % |   |
| Annual forfeiture rate             |       |                           | 5.13       | % |   |
| Expected holding period (in years) |       |                           | 3.57       |   |   |

 

Thefollowing table summarizes information concerning options granted under theCompany’s stock compensation plan for the year ended September 30, 2006and the six months ended March 31, 2007, including information regardingoption exercises, forfeitures and expirations:
|                                               | ** ** | **Shares**  | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------------|------------|-------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **(000's)** | ** ** | **Exercise Price**   | ** ** |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2005 |       | 48,525      |       |                      | $          | 13.95 |   |   |
| Granted                                       |       | 6,503       |       |                      | 10.85      |   |   |
| Exercised                                     |       | (3,338      | )          |                      | 4.25       |   |   |
| Forfeited and  Expired                        |       | (2,759      | )          |                      | 15.57      |   |   |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2006 |       | 48,931      |       |                      | 14.10      |   |   |
| Granted                                       |       | 5,305       |       |                      | 12.49      |   |   |
| Exercised                                     |       | (3,576      | )          |                      | 6.22       |   |   |
| Forfeited and  Expired                        |       | (5,697      | )          |                      | 14.92      |   |   |
| OPTIONS OUTSTANDING AS  OF MARCH 31, 2007     |       | 44,963      |       |                      | $          | 14.44 |   |   |

 

The following table summarizes the status of theCompany’s outstanding stock options as of March 31, 2007:

| ** **               | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | ** **                              | ** ** | **Average**                             | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **Remaining**                           | ** ** | **Average** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |
| **Range of**        | ** ** | **Shares**                              | ** ** | **Contractual**                         | ** ** | **Exercise** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Exercise** | ** ** | **Value** | ** ** |
| **Exercise Prices** | ** ** | ** **                              | ** ** | **(000's)**                             | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **(000's)** | ** ** | **(000's)** | ** ** | **Price** | ** ** | **(000's)** | ** ** |
| $0.01 to $6.39           |       | 4,521                                   |       |                                    | 2.40       |   |   |   | $ | 4.34 |   |   |   | $ | 33,882 |   |   | 4,521 |   |   | $ | 4.34 |   |   |   | $ | 33,882 |   |   |
| $6.40 to $11.18          |       | 6,300                                   |       |                                    | 5.33       |   |   |   | 10.46 |   |   |   | 8,614 |   |   | 2,086 |   |   | 10.42 |   |   |   | 2,934 |   |   |
| $11.19 to $14.84         |       | 13,355                                  |       |                                    | 4.82       |   |   |   | 12.88 |   |   |   | 396 |   |   | 7,640 |   |   | 13.21 |   |   |   | 296 |   |   |
| $14.85 to $15.89         |       | 9,929                                   |       |                                    | 3.25       |   |   |   | 14.92 |   |   |   | — |   |   | 9,929 |   |   | 14.92 |   |   |   | — |   |   |
| $15.90 to $51.21         |       | 10,858                                  |       |                                    | 2.78       |   |   |   | 22.43 |   |   |   | — |   |   | 10,858 |   |   | 22.43 |   |   |   | — |   |   |
| Total                    |       | 44,963                                  |       |                                    |       |   |   |   | $ | 14.44 |   |   |   | $ | 42,892 |   |   | 35,034 |   |   | $ | 15.24 |   |   |   | $ | 37,112 |   |   |
|                          |            |                                         |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

The aggregate intrinsic value in the preceding tablerepresents the total pretax intrinsic value, based on the Company’s averagestock price on March 31, 2007, which would have been received by theoption holders had all option holders exercised their options as of that date.The total number of in-the-money options exercisable on March 31, 2007 wasapproximately 7 million. The weighted average remaining contractual lifeon March 31, 2007 for outstanding and exercisable options is 3.81 and 3.12 years,respectively.

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**Time-VestingRestricted Stock Units**

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

Thefollowing table summarizes information concerning unvested RSUs granted underthe Company’s stock compensation plan as of September 30, 2006, andincludes information regarding grants, vests and forfeitures during the sixmonths ended March 31, 2007:

| ** **                                                     | ** ** | ** ** | ** ** | **Weighted-Average**    | ** ** |
|----------------------------------------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | ** ** | ** ** | **Grant-Date**          | ** ** |
| **Unvested Shares**                                       | ** ** | ** ** | ** ** | **Shares (000's)** | ** ** | **Fair Value** | ** ** |
| Unvested shares at September 30, 2006 |       |       | 5,319      |                    |       |   | $ |  12.44 |   |   |
| Granted                                                        |       |       | 2,472      |                    |       |   | 12.64 |   |   |
| Vested                                                         |       |       | (375       | )                       |       |   | 10.86 |   |   |
| Forfeited                                                      |       |       | (827       | )                       |       |   | 12.83 |   |   |
| Unvested shares at March  31, 2007                             |       |       | 6,589      |                    |       |   | $ | 12.56 |   |   |
|                                                                |            |            |            |                         |            |  |  |  |  |  |  |  |

As of March 31, 2007, there was approximately $57 millionof total unrecognized compensation cost related to unvested share-based compensationarrangements granted under the plan. That cost is expected to be recognizedover a weighted average period of four years. Compensation expense related toRSUs was $4 million for each of the three month periods ended March 31,2007 and 2006,  and was $8 millionfor each of the six month periods ended March 31, 2007 and 2006.

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

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

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

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

Effective December 19,2006, the Compensation Committee of the Board of Directors approved awards of381,000 RSUs to executive officers of the Company pursuant to the terms of theplan, each with a market-vesting condition based on the Company’s totalshareholder return performance as a percentile against a peer group.

**Employee StockPurchase Plan**

Under the terms of theemployee stock purchase plan, eligible employees may have up to 10% of eligiblecompensation deducted from their pay to purchase Avaya common stock. The pershare purchase price is 85% of the average high and low per share trading priceof Avaya’s common stock on the New 

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YorkStock Exchange on the last trading day of each month. Compensation expenserelated to the employee stock purchase plan for the three and six months ended March 31,2007 was $0.5 million and $1.2 million, respectively, and for thethree and six months ended March 31, 2006 was $0.6 million and $1.2 million,respectively.

**12. OperatingSegments**

The Company reports its operations in two segments—GlobalCommunications Solutions (“GCS”) and Avaya Global Services (“AGS”). The GCS segmentdevelops, markets and sells communications systems including IP telephonysystems, multi-media contact center infrastructure and converged applicationsin support of customer relationship management, unified communicationsapplications, appliances such as IP telephone sets and traditional voicecommunications systems. The AGS segment develops, markets and sellscomprehensive end-to-end global service offerings that enable customers toplan, design, implement, monitor and manage their converged communicationsnetworks worldwide.

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

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

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

| ** **                             | ** ** | **Reportable Segments**      | ** ** | **Corporate/** | ** ** | ** **      | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|----------------|------------|-----------------|------------|
| ** **                             | ** ** | **Global**                        | ** ** | **Avaya**      | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Communications**                | ** ** | **Global**     | ** ** | **Unallocated** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Solutions**                     | ** ** | **Services**   | ** ** | **Amounts**     | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| **Three months ended March 31,  2007** |       |                              |       |           |       |            |       |   |   |   |   |   |   |   |   |
| Revenue                                |       |                              | $          | 698            |       |            |       | $ | 596 |   |   |   | $ | — |   |   | $ | 1,294 |   |
| Operating income  (loss)               |       |                              | 38         |           |       |            | 56         |   |   |   | (13 | ) |   | 81 |   |
| **Three  months ended March 31, 2006** |       |                              |       |           |       |            |       |   |   |   |   |   |   |   |   |
| Revenue                                |       |                              | $          | 661            |       |            |       | $ | 577 |   |   |   | $ | — |   |   | $ | 1,238 |   |
| Operating income  (loss)               |       |                              | 32         |           |       |            | 41         |   |   |   | (20 | ) |   | 53 |   |
| **Six  months ended March 31, 2007**   |       |                              |       |           |       |            |       |   |   |   |   |   |   |   |   |
| Revenue                                |       |                              | $          | 1,380          |       |            |       | $ | 1,194 |   |   |   | $ | — |   |   | $ | 2,574 |   |
| Operating income                       |       |                              | 60         |           |       |            | 109        |   |   |   | 2 |   |   | 171 |   |
| **Six  months ended March 31, 2006**   |       |                              |       |           |       |            |       |   |   |   |   |   |   |   |   |
| Revenue                                |       |                              | $          | 1,322          |       |            |       | $ | 1,165 |   |   |   | $ | — |   |   | $ | 2,487 |   |
| Operating income (loss)                |       |                              | 75         |           |       |            | 101        |   |   |   | (16 | ) |   | 160 |   |

 

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The following table setsforth the Company’s long-lived assets by geographic area:

| ** **                                                   | ** ** | **March 31, 2007**      | ** ** | **September 30, 2006** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                                   | ** ** | **Dollars in millions** |
| U.S.                                                         |       |                              | $          | 381                              |       |   |   | $ | 399 |   |   |
| Outside the U.S.:                                            |       |                              |       |                             |       |   |   |   |   |
| Germany                                                      |       |                              | 196        |                             |       |   | 200 |   |   |
| EMEA—Europe / Middle East / Africa (excluding  Germany) |       |                              | 43         |                             |       |   | 45 |   |   |
| APAC—Asia Pacific                                       |       |                              | 17         |                             |       |   | 18 |   |   |
| Americas, non-U.S.                                           |       |                              | 7          |                             |       |   | 6 |   |   |
| Total outside the U.S.                                       |       |                              | 263        |                             |       |   | 269 |   |   |
| Total                                                        |       |                              | $          | 644                              |       |   |   | $ | 668 |   |   |

**13. Commitments andContingencies**

**Legal Proceedings**

In the ordinary course ofbusiness the Company is involved in litigation, claims, government inquiries,investigations, charges and proceedings, including, but not limited to, thoseidentified below, relating to intellectual property, commercial, securities,employment, employee benefits, environmental and regulatory matters. Other thanas described below, the Company believes there is no litigation pending againstthe Company that could have, individually or in the aggregate, a materialadverse effect on the Company’s financial position, results of operations orcash flows.

In accordance with SFAS No. 5,“Accounting for Contingencies,” the Company records an accrual for acontingency when it is both probable that a liability has been incurred and theamount of the loss can be reasonably estimated. If a range of liability isprobable and estimable and some amount within the range appears to be a betterestimate than any other amount within the range, the Company accrues thatamount. If a range of liability is probable and estimable and no amount withinthe range appears to be a better estimate than any other amount within therange, the Company accrues the minimum of such probable range. Often theseissues are subject to substantial uncertainties and, therefore, the probabilityof loss and an estimation of damages are difficult to ascertain. Theseassessments can involve a series of complex judgments about future events andcan rely heavily on estimates and assumptions that have been deemed reasonableby management. Although the Company believes it has substantial defenses inthese matters, it could in the future incur judgments or enter into settlementsof claims that could have a material adverse effect on its financial position,results of operations or cash flows in any particular period.

***SecuritiesLitigation***

In April and May of2005, purported class action lawsuits were filed in the U.S. District Court forthe District of New Jersey against us and certain of our officers, allegingviolations of the federal securities laws. The actions purport to be filed onbehalf of purchasers of our common stock during the period from October 5,2004 (the date of our signing of the agreement to acquire Tenovis Germany GmbH(“Tenovis”)) through April 19, 2005.

The complaints, which aresubstantially similar to one another, allege, among other things, that theplaintiffs were injured by reason of certain allegedly false and misleadingstatements made by us relating to the cost of the Tenovis integration, thedisruption caused by changes in the delivery of our products to the market andreductions in the demand for our products in the U.S., and that based on theforegoing we had no basis to project our stated revenue goals for fiscal 2005.The Company has been served with a number of these complaints. No class hasbeen certified in the actions. The complaints seek compensatory damages plusinterest and attorneys’ fees. In August 2005, the court entered an orderidentifying a lead plaintiff and lead plaintiff’s counsel. A consolidatedamended complaint was filed in October 2005. Pursuant to a 

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schedulingorder issued by the District Court, defendants filed their motion to dismissthe consolidated complaint in December 2005. In September 2006, theDistrict Court granted defendants’ motion to dismiss the case in its entiretyand with prejudice, which was appealed by the plaintiffs. The appeal iscurrently pending with the United States Court of Appeals for the ThirdCircuit.

***DerivativeLitigation***

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

***ERISA Class Action—SecuritiesLitigation***

In July 2005, apurported class action lawsuit was filed in the United States District Courtfor the District of New Jersey against the Company and certain of its officers,employees and members of the Board of Directors (the “Directors”), allegingviolations of certain laws under the Employee Retirement Income Security Act of1974 (“ERISA”). On October 17, 2005, an amended purported class action wasfiled against us and certain of our officers, employees and Directors. Like theinitial complaint, the amended complaint purports to be filed on behalf of allparticipants and beneficiaries of the Avaya Inc. Savings Plan, the Avaya Inc.Savings Plan for Salaried Employees and the Avaya Inc. Savings Plan for theVariable Workforce (collectively, the “Plans”), during the period from October 5,2004 through July 20, 2005. It contains factual allegations substantiallysimilar to those asserted in the matters under the heading of “SecuritiesLitigation.”

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

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***ERISAClass Action—Stock Funds***

In April 2006, apurported class action was filed in the United States District Court for theDistrict of New Jersey, alleging that the Company, certain employees and thePension and Employee Benefits Investment Committee violated the EmployeeRetirement Income Security Act of 1974 (“ERISA”), by including in the AvayaInc. Savings Plan for Salaried Employees, the Avaya Inc. Savings Plan and theAvaya Inc. Savings Plan for the Variable Workforce (“Plans”), investmentoptions for the Lucent Technologies Inc. Stock Fund (“Lucent Fund”) and theAvaya Inc. Stock Fund (“Avaya Fund”) for the period of October 2000 toApril 2003 (“Alleged Class Period”). The complaint asserts, amongother things, that during the Alleged Class Period defendants breachedtheir fiduciary duties under ERISA by violating ERISA’s provisions againstprohibited transactions; offering the Lucent Fund and Avaya Fund imprudently asinvestment options; failing properly to monitor the funds; and, failingproperly to monitor the actions of other plan fiduciaries, thus causing thePlans to suffer damages. The complaint seeks monetary relief on behalf of thePlans and their participants, and also seeks injunctive relief and costs,including attorneys’ fees. Defendants have filed a motion to dismiss this casein its entirety and with prejudice. In April 2007, the District Courtissued an opinion dismissing all but one portion of one count of the complaint,reasoning that the circumstances surrounding the distribution of Avaya sharesof common stock prior to the spin-off of Avaya from Lucent in October 2000into the various Avaya Plans could not be addressed in the procedural postureof a motion to dismiss. Defendants intend to seek dismissal of the remainingcount of the complaint at the appropriate time.

Notwithstanding dismissalof the vast majority of the complaint, the remaining issues of this case are inthe early stages of litigation, and an outcome cannot be predicted and, as aresult, we cannot be assured that this case will not have a material adverseeffect on our financial position, results of operations or cash flows. Due tothe uncertainty surrounding the issues involved in this matter and based on thefacts and circumstances known to date, the Company believes that an estimate orpotential range of any loss that may be incurred cannot be made at this time.

***Antitrust Lawsuit***

In July 2005, United Asset Coverage, Inc. (“UAC”)filed a verified complaint against the Company in the United States DistrictCourt, Northern District of Illinois, alleging, among other things, violationsof federal and state antitrust laws, in the manner in which the Company seeksto protect its proprietary information. The verified complaint sought atemporary restraining order against the Company to enjoin immediately itspractice of limiting the use of its proprietary information in a manner whichUAC believes is in violation of its contracts and licensing agreements. Thecourt denied UAC’s motion for temporary restraints in August 2005 as wellas its motion for preliminary injunction in January 2006. The plaintiff,however, has continued to pursue this action, and, as a result, discovery isongoing. Further, in January 2007, plaintiff filed a motion to amend thecomplaint to include additional claims of antitrust violations against theCompany.

Even though Avayaprevailed in the preliminary injunction proceeding, an outcome in this mattercannot be predicted at this time, and we cannot be assured that this case willnot have a material adverse effect on our financial position, results ofoperations or cash flows. Due to the uncertainty surrounding the issuesinvolved in this matter and based on the facts and circumstances known to date,the Company believes that an estimate or potential range of any loss that maybe incurred cannot be made at this time.

**Other Matters**

***Government Subpoenas***

On April 29, 2005, the Company received asubpoena to produce documents before a grand jury of the United States DistrictCourt, District of South Carolina, relating to the United States’ investigationof 

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potential antitrust andother violations in connection with the federal E-Rate Program. The subpoenarequests records from the period January 1, 1997 to the present. TheCompany complied with the subpoena and has received no indication from theDepartment of Justice that it has any further obligations or involvement inthis matter. Nonetheless, at this time, we cannot determine if this matter willhave an effect on our business or, if it does, whether its outcome will have amaterial adverse effect on our financial position, results of operations orcash flows.

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

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

**Environmental,Health and Safety Matters**

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

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

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

The Company assesses the adequacy of environmentalreserves on a quarterly basis. The Company does not expect the outcome of thesematters to have a material impact on its financial position. Expenditures forenvironmental matters for the three and six months ended March 31, 2007and 2006 were 

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not material to theCompany’s financial position, results of operations or cash flows. Payment forthe environmental costs covered by the reserves may be made over a 30-yearperiod. Although the Company does not separately track recurring costs ofmanaging hazardous substances and pollutants in ongoing operations, it does notbelieve them to be material.

We also may from time totime be subject to various state, federal and international laws andregulations governing the environment, including those restricting the presenceof certain substances in electronic products and making producers of thoseproducts financially responsible for the collection, treatment, recycling anddisposal of certain products. For example, the EU has adopted the RoHS and WEEEdirectives. RoHS prohibits the use of certain substances, including mercury andlead, in certain products put on the market after July 1, 2006. The WEEEdirective obligates parties that place electrical and electronic equipment ontothe market in the EU to put a clearly identifiable mark on the equipment,register with and report to EU member countries regarding distribution of theequipment, and provide a mechanism to take back and properly dispose of theequipment. Each EU member country has enacted, or is expected soon to enact,legislation clarifying what is and what is not covered by the WEEE directive inthat country. We believe that we have met the requirements of the RoHS and WEEEdirectives. Similar laws and regulations have been or may be enacted in otherregions.

**Product Warranties**

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

| *** ***                                         | ** ** | **Dollars in millions** | ** ** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|------------|
| Balance as of  September 30, 2006                    |       |                              | $          | 29         |   |   |   |
| Reductions for  payments and costs to satisfy claims |       |                              | (25        | )          |   |   |
| Accruals for  warranties issued during the period    |       |                              | 27         |       |   |   |
| Balance as of  March 31, 2007                        |       |                              | $          | 31         |   |   |   |

 

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

***Letters of Credit***

In addition to its $400 millioncommitted credit facility, which is discussed in Note 7, “FinancingArrangements,” the Company has entered into uncommitted credit facilities thatvary in term totaling $131 million as of March 31, 2007. Theseuncommitted facilities are for the purpose of securing third party financialguarantees such as letters of credit that ensure the Company’s performance orpayment to third parties. As of March 31, 2007, the Company hasoutstanding an aggregate of $101 million in irrevocable letters of creditunder the committed and uncommitted credit facilities ($28 million underits committed credit facility and $73 million under uncommittedfacilities).

***Surety Bonds***

The Company arranges forthe issuance of various types of surety bonds, such as license, permit, bid andperformance bonds, which are agreements under which the surety companyguarantees that the Company will perform in accordance with contractual orlegal obligations. These bonds vary in duration although most are issued andoutstanding from six months to three years. These bonds are backed by 

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$5 millionof our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is $30 millionas of March 31, 2007. Historically, no surety bonds have been drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchases components from a variety ofsuppliers and uses several contract manufacturers to provide manufacturingservices for its products. During the normal course of business, in order tomanage manufacturing lead times and to help assure adequate component supply,the Company enters into agreements with contract manufacturers and suppliersthat allow them to produce and procure inventory based upon forecastedrequirements provided by the Company. If the Company does not meet thesespecified purchase commitments, it could be required to purchase the inventory,or in the case of certain agreements, pay an early termination fee. As of March 31, 2007, the maximum potentialpayment under these commitments was approximately $162 million. Historically,the Company has not been required to pay a charge for not meeting itsdesignated purchase commitments with these suppliers.

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

***Product Financing Arrangements***

The Company sells productsto various resellers that may obtain financing from certain unaffiliated thirdparty lending institutions. For the Company’sproduct financing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guarantee repayment amount wasapproximately $8 million as of March 31, 2007. The Company reviewsand sets the maximum credit limit for each reseller participating in thisfinancing arrangement. Historically, there have not been any guaranteerepayments by the Company since it became publicly traded in 2000. The Companyhas estimated the fair value of this guarantee as of March 31, 2007, andhas determined that it is not significant. There can be no assurance that theCompany will not be obligated to repurchase inventory under this arrangement inthe future.

***Performance Guarantee***

In connection with thesales of certain businesses, the Company has assigned its rights andobligations under several real estate leases to the acquiring companies (the “assignees”).The remaining terms of these leases vary from one year to eight years. Whilethe Company is no longer the primary obligor under these leases, the lessor hasnot completely released the Company from its obligation, and holds itsecondarily liable in the event that the assignees default on these leases. Themaximum potential future payments the Company could be required to make, if allof the assignees were to default as of March 31, 2007, would beapproximately $14 million. The Company has assessed the probability ofdefault by the assignees and has determined it to be remote.

***Credit Facility Indemnification***

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

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

Pursuant to the Contribution and DistributionAgreement, Lucent Technologies Inc., predecessor to Alcatel-Lucent (“Lucent”),contributed to the Company substantially all of the assets, liabilities andoperations associated with its enterprise networking businesses (“Company’sBusinesses”). The Contribution and Distribution Agreement, among other things,provides that, in general, the Company will indemnify Lucent for allliabilities including certain pre-distribution tax obligations of Lucentrelating to the Company’s Businesses and all contingent liabilities primarilyrelating to the Company’s Businesses or otherwise assigned to the Company. Inaddition, the Contribution and Distribution Agreement provides that certaincontingent liabilities not allocated to one of the parties will be shared byLucent and the Company in prescribed percentages. The Contribution andDistribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to thebusiness of the other party that exceed $50 million. The Company is unableto determine the maximum potential amount of other future payments, if any,that it could be required to make under this agreement.

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

The Tax Sharing Agreementgoverns Lucent’s and the Company’s respective rights, responsibilities andobligations after the distribution with respect to taxes for the periods endingon or before the distribution. Generally, pre-distribution taxes or benefitsthat are clearly attributable to the business of one party will be borne solelyby that party, and other pre-distribution taxes or benefits will be shared bythe parties based on a formula set forth in the Tax Sharing Agreement. TheCompany may be subject to additional taxes or benefits pursuant to the TaxSharing Agreement related to future settlements of audits by state and localand foreign taxing authorities for the periods prior to the Company’sseparation from Lucent.

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

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

Our accompanying unauditedinterim Consolidated Financial Statements as of March 31, 2007 and for thethree and six months ended March 31, 2007 and 2006, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the U.S. Securities and Exchange Commission, or the SEC, for interimfinancial statements, and should be read in conjunction with our ConsolidatedFinancial Statements and other financial information for the fiscal year ended September 30,2006, which were included in our Annual Report on Form 10-K filedwith the SEC on December 8, 2006. In our opinion, the unaudited interimConsolidated Financial Statements reflect all adjustments, consisting of normaland recurring adjustments, necessary for a fair presentation of the financialcondition, results of operations and cash flows for the periods indicated.

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

**Forward-Looking Statements**

Our disclosure andanalysis in this Quarterly Report on Form 10-Q contains some forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933 and Section 21E ofthe Securities Exchange Act of 1934. Forward-looking statements give ourcurrent expectations or forecasts of future events. You can identify thesestatements by the fact that they do not relate strictly to historical orcurrent facts. They use words such as “anticipate,” “estimate,” “expect,” “project,”“intend,” “plan,” “believe” and other words and terms of similar meaning inconnection with any discussion of future operating or financial performance.From time to time, we also may provide oral or written forward-lookingstatements in other materials we release to the public.

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

**Overview**

***Products,Applications and Services***

We are a leading providerof communications solutions, comprised of equipment hardware, software andservices that help enterprises transform their businesses by redefining the waythey work and interact with their customers, employees, business partners,suppliers and others. A key component of our strategy is to leverage oursubstantial experience and expertise in traditional voice communicationssystems to capitalize on the transition of these traditional voice systems toInternet Protocol, or IP, and the adoption of IP telephony solutions. Ourproduct offerings include IP telephony systems and traditional voicecommunications systems, multi-media contact center infrastructure andapplications in support of 

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customerrelationship management, unified communications applications and appliances,such as IP telephone sets.  Theseofferings are part of what we refer to as “Intelligent Communications,” whichis about embedding communications solutions into our customers’ businessprocesses to help them transform their businesses and innovate their businessmodels. We believe our comprehensive suite of IP telephony solutions,communications applications and appliances, as supported by our global servicesorganization and extensive network of business partners, transforms theenterprise communications system into a strategic asset for businesses, byenabling them to communicate to “anyone, at any place, at any time and in any way”they choose.

We support our broadcustomer base with comprehensive global services offerings that enable ourcustomers to plan, design, implement, integrate, monitor and manage theircommunications networks. We believe our global services organization is animportant consideration for customers purchasing our products and applicationsand is a source of significant revenue for us, primarily from maintenancecontracts. The skilled professionals of our services organization, togetherwith our network of business partners and our ability to diagnose customernetwork faults remotely, can provide 24-hour-a-day, seven-day-a-weekservice to our customers around the world. Our end-to-end portfolio of servicesofferings provides a single point of accountability.

***Customers andCompetitive Advantages***

Our customer base isdiverse, ranging in size from small businesses employing a few employees tolarge government agencies and multinational companies with over 100,000employees. Our customers include enterprises operating in a broad range ofindustries around the world, including financial services, manufacturing, mediaand communications, professional services, health care, education andgovernment.

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in nearly 100 other countries. In the first sixmonths of fiscal 2007, approximately 43% of our revenues were generated outsidethe U.S.

We are focused on the transition of traditional voice,or TDM, communications to converged networks that provide for the integrationof voice, data, video and other applications traffic on a single network. Weoffer customers the flexibility to implement new IP telephony solutions or “IP-enable”their existing voice communications systems, thereby preserving some of theirexisting communications technology investments and allowing them to implementIP telephony at their own pace. Converged networks offer increasedfunctionality and provide our enterprise customers with the ability to reachthe right person at the enterprise, at the right time, in the right place andin the right way, thereby optimizing business interactions and enhancing ourcustomers’ ability to grow revenue and reduce costs. Our products, applicationsand services are driving the integration of communications and businessprocesses, making communications an important component of our customers’business strategies. This is the focus of our strategic roadmap around “IntelligentCommunications.”

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

·       businessfocus on IP telephony and converged network technologies;

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

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

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

·       alarge installed global customer base;

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

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

·       strategic alliances withworld-class business partners, including our large network of software developmentpartners who develop vertical and other software applications that work withour telephony and contact center offerings to meet specific customer needs.

***Financial ResultsSummary***

*Revenue—*Revenue was $2,574 million and $2,487 million for the first sixmonths of fiscal 2007 and 2006, respectively. Overall revenue grew by 3.5% as aresult of increases in both of our operating segments. Revenues for the firstsix months of fiscal 2007 included a favorable currency impact of $63 millionthat benefited both operating segments, almost entirely in Europe. Excludingthis benefit, overall revenue increased $24 million compared to the firstsix months of fiscal 2006, primarily in the US.

*Gross Margin—*Our gross margin for the first six months of fiscal 2007 increased by$30 million to $1,197 million compared with the first six months offiscal 2006 due to an increase in sales volume and a benefit from foreigncurrency fluctuations, although the gross margin rate for fiscal 2007 wasslightly lower at 46.5%. The decrease in the overall rate was primarily theresult of the decline in margin rates on rental and managed service contracts,particularly in Germany. The gross margin for the first six months of fiscal2006 includes an $11 million benefit, or approximately a half-percentagepoint impact, from a change in our vacation policy eliminating carryovervacation days for U.S. non-represented employees.

*Operating Expenses—**Our*selling,general and administrative (SG&A) expenses decreased by $2 million to$782 million for the first six months of fiscal 2007 compared to the firstsix months of fiscal 2006. This net decrease was primarily due to lowerheadcount and lower discretionary spending in connection with our costmanagement initiatives, as well as several benefits in the first six months offiscal 2007, including a gain on the sale of real estate and an $8 millionbenefit from the favorable resolution of non-income tax audits in severaljurisdictions. These benefits were partially offset by expected increased employeebenefit costs and unfavorable foreign currency fluctuations. The increasedemployee benefit costs were primarily due to the previously-disclosed increasein post-retirement health benefits for union employees. The first six months offiscal 2006 included a $7 million benefit related to the change in ourvacation policy.

During the first sixmonths of fiscal 2007, our research and development (R&D) expensesincreased by $25 million to $228 million compared with the first sixmonths of fiscal 2006 due to an increase in gross investment and to a lesserextent, the acquisitions of Traverse and Ubiquity. The first six months offiscal 2006 included a $3 million benefit related to the change in ourvacation policy.

We also recorded $16 millionin net charges for restructuring actions during the first six months of fiscal2007. These represent $23 million of charges for employee separation costsand lease obligations, partially offset by a net benefit of $7 million forchanges in estimates for prior restructuring plans primarily related to leasedfacilities. During the first six months of fiscal 2006, we recorded netrestructuring charges of $20 million.

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*Profitability—**We* earned net incomeof $128 million and $109 million for the first six months of fiscal2007 and 2006, respectively. Our operating income was $171 million, or6.6% of revenue, for the first six months of fiscal 2007, compared to $160 million,or 6.4% of revenue, for the first six months of fiscal 2006. Operating incomefor the first six months of fiscal 2007 includes an increase in gross margindollars due to sales volume, as well as several benefits in costs and operatingexpenses as described above, partially offset by increased R&D investment. Operatingincome for the first six months of fiscal 2006 included a $21 millionbenefit from the change in our vacation policy.

**Key Trends and Uncertainties Affecting Our Results**

***Trends andUncertainties Affecting Our Revenue***

Thefollowing are the key factors we believe are currently affecting our revenue:

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

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

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

·       *Pressures on services business*—Due to advances in technology, ourcustomers continue to expect traditional services to be at lower prices to them.In addition, our customers routinely look for opportunities to reduce theirinformation technology and related costs. A high correlation exists withrespect to customers in our direct channel who purchase products also electingto purchase maintenance contracts at the time of the product purchase. However,at the time of contract renewal, maintenance and managed services revenues havebeen affected by reductions in scope of contracted services (*i.e*. number of ports, number of sites, or hours and levelsof coverage) at the time of contract renewal, cancellations and increasedcompetition, as well as the price erosion noted above. These factors haveresulted in challenges to our Avaya Global Services segment. We have been ableto partially offset these impacts by focusing on new types of services such as consultingand systems integration. These new types of services may have lower marginsthan our traditional 

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services. Inaddition, we have also been able to reduce our costs to minimize the impact onour operating income.

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

·       *Foreign currency*—Our revenues outside of the U.S. were43% of our consolidated revenues in the first six months of fiscal 2007compared to 42% in the first six months of fiscal 2006. Revenues for the firstsix months of fiscal 2007 include a favorable currency impact of $63 millionas compared to the first six months of fiscal 2006. Any strengthening of theU.S. dollar against other currencies, particularly the euro, will have anegative impact on our reported revenues. Conversely, any weakening of the U.S.dollar will have a positive impact.

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

***Manufacturing andLogistics***

The Company’s products aresupplied through contract manufacturers and original equipment manufacturers.Our manufacturers produce a majority of our products in facilities located inMexico, Malaysia, the Czech Republic, China, Israel, Poland, Ireland, France,Germany and the United States. The contract manufacturing of the Company’sproducts is performed in accordance with detailed specifications and productdesigns furnished by the Company and is subject to rigorous quality controlstandards.

As we continue to seek tooptimize our end-to-end supply chain, we have been outsourcing variouslogistics functions over the course of the past few years. We rely onthird-party logistics service providers to provide services for our business,including warehousing and physical distribution. If a logistics serviceprovider does not meet our service level and quality requirements for anyreason, we may be unable to fulfill our customers’ orders in a timely andaccurate manner, which could delay or decrease our revenue or otherwise have anadverse effect on our revenue and our costs. In the fourth quarter of fiscal2006 and first quarter of fiscal 2007, we moved certain warehousing and physicaldistribution operations to a different third party logistics service providerat a new facility, which now services a significant portion of our warehousingand physical distribution needs. There were disruptions and delays in deliveryof certain products from this facility in the first quarter of fiscal 2007. Additionally,there was an adverse impact on our costs throughout the first half of fiscal2007. We and our logistics service provider continue to work jointly in orderto promote stability in the warehousing operations and we have been makingimprovements as we progress through this transition, however, we cannot assureyou that this issue will not continue to have an adverse effect on our revenueand increase our costs.

We also face increasingcomplexity in our product design, logistics and procurement operations due toexisting and upcoming requirements relating to the materials composition of ourproducts, such as the European Union (“EU”) directives regarding Restriction ofthe Use of Certain Hazardous Substances in Electrical and Electronic Equipment(“RoHS”) and the Waste Electrical and Electronic Equipment 

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(“WEEE”)directive. We may be required to reengineer products to utilize componentscompatible with these changing environmental requirements and the resultingreengineering and component substitution may result in additional costs to us.Even if we are able and willing to reengineer products or pay additional costs,we still may be adversely affected if the materials and components that we needare unavailable to us. In addition, if we were found to be in violation ofthese regulations, we could be subject to government fines, noncompliantproducts may be banned from markets covered by the regulations and ourcustomers could incur liability. Although we do not anticipate any materialadverse effects based on the nature of our operations and the effect of suchregulations, there is no assurance that existing regulations or futureregulations will not have an adverse effect on us.

We also purchase certainhardware components and license certain software components from third-partyoriginal equipment manufacturers and resell them under the Avaya brand. In somecases certain components are only available from a single source or from alimited source of suppliers. Delays or shortages associated with thesecomponents could cause significant disruption to our operations.

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

**Results from Continuing Operations**

***Three Months Ended March 31, 2007 Comparedwith Three Months Ended March 31, 2006***

***Revenue***

The following table setsforth acomparison of revenue by type:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                      | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | 593        |       | $          | 636        |       | $          | 690          |                              | $          | 619                                 |       | Sales of products |   | $ | 639 |   | $ | 593 |   |   | 49 | % |   |   | 48 | % |   | $ | 46 |   | 7.8 | % |
| 492        |       | 507        |       | 514        |       | 509        |         | Services                          |       | 509                                 |       | 492 |   |   | 39 | % |   |   | 40 | % |   | 17 |   | 3.5 | % |
| 153        |       | 154        |       | 160        |       | 152        |         | Rental and managed services       |       | 146                                 |       | 153 |   |   | 12 | % |   |   | 12 | % |   | (7 | ) | -4.6 | % |
| $          | 1,238      |       | $          | 1,297      |       | $          | 1,364        |                              | $          | 1,280                               |       | Total revenue |   | $ | 1,294 |   | $ | 1,238 |   |   | 100 | % |   |   | 100 | % |   | $ | 56 |   | 4.5 | % |

 

Each type of revenuebenefited from favorable foreign currency fluctuations. Revenue from sales ofproducts increased by 7.8% due to demand for our converged voice applications,partially offset by the expected decline in sales of TDM products. Servicesrevenue increased by 3.5% and includes an increase in maintenance revenue andhigher demand for professional services. Rental and managed services revenuedecreased by 4.6% resulting from changes in scope of contracted services,cancellations and pricing pressures related to our rental base in Germany.

Thefollowing table sets forth a geographic comparison of revenue:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                                               | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|----------------------------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                                               | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions**                        | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | 719        |       | $          | 753        |       | $          | 788          |                                                     | $          | 732                                 |       | U.S. |   | $ | 746 |   | $ | 719 |   |   | 58 | % |   |   | 58 | % |   | $ | 27 |   | 3.8 | % |
|       |       |       |       |       |       |       |         | Outside the U.S.:                                        |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 182        |       | 182        |       | 183        |       | 186        |         | Germany                                                  |       | 178                                 |       | 182 |   |   | 14 | % |   |   | 15 | % |   | (4 | ) | -2.2 | % |
| 174        |       | 205        |       | 208        |       | 203        |         | EMEA - Europe / Middle East  / Africa(Excluding Germany) |       | 190                                 |       | 174 |   |   | 14 | % |   |   | 14 | % |   | 16 |   | 9.2 | % |
| 356        |       | 387        |       | 391        |       | 389        |         | Total EMEA                                               |       | 368                                 |       | 356 |   |   | 28 | % |   |   | 29 | % |   | 12 |   | 3.4 | % |
| 99         |       | 87         |       | 110        |       | 88         |         | APAC - Asia Pacific                                      |       | 111                                 |       | 99 |   |   | 9 | % |   |   | 8 | % |   | 12 |   | 12.1 | % |
| 64         |       | 70         |       | 75         |       | 71         |         | Americas, non-U.S.                                       |       | 69                                  |       | 64 |   |   | 5 | % |   |   | 5 | % |   | 5 |   | 7.8 | % |
| 519        |       | 544        |       | 576        |       | 548        |         | Total outside the U.S.                                   |       | 548                                 |       | 519 |   |   | 42 | % |   |   | 42 | % |   | 29 |   | 5.6 | % |
| $          | 1,238      |       | $          | 1,297      |       | $          | 1,364        |                                                     | $          | 1,280                               |       | Total  revenue |   | $ | 1,294 |   | $ | 1,238 |   |   | 100 | % |   |   | 100 | % |   | $ | 56 |   | 4.5 | % |

 

32

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Revenues in the U.S. increased 3.8% compared with thesecond quarter of fiscal 2006, primarily due to increases in sales of products,particularly converged voice applications. Germany revenue declined primarilydue to the continued decline in our rental base. EMEA revenue, excludingGermany, grew by 9.2%, helped by strong demand in high-growth markets, as wellas a benefit from foreign currency fluctuations. APAC revenue increased due tostrong demand and also benefited from shipments in the second quarter of fiscal2007 that were delayed due to the first quarter warehousing issues. Revenue inAmericas, non-U.S. increased primarily due to product demand through the directchannel.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | 250        |       | $          | 277        |       | $          | 302        |                              | $          | 259                                 |       | Direct |   | $ | 277 |   | $ | 250 |   |   | 43 | % |   |   | 42 | % |   | $ | 27 |   | 10.8 | % |
| 343        |       | 359        |       | 388        |       | 360        |       | Indirect                          |       | 362                                 |       | 343 |   |   | 57 | % |   |   | 58 | % |   | 19 |   | 5.5 | % |
| $          | 593        |       | $          | 636        |       | $          | 690        |                              | $          | 619                                 |       | Total sales of products |   | $ | 639 |   | $ | 593 |   |   | 100 | % |   |   | 100 | % |   | $ | 46 |   | 7.8 | % |

 

The mix of sales ofproducts in the second quarter of fiscal 2007 through the direct and indirectchannel was consistent with the same quarter last fiscal year.

***Gross Margin***

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| 53.6%      |       | 52.2%      |       | 54.8%      |       | 53.3%      |         | On sales of products              |       | $                                   | 338        |   | $ | 318 |   | 52.9% |   | 53.6% |   | $ | 20 |   | 6.3 | % |
| 35.2%      |       | 33.9%      |       | 32.1%      |       | 36.3%      |         | On services                       |       | 185                                 |       | 173 |   | 36.3% |   | 35.2% |   | 12 |   | 6.9 | % |
| 56.9%      |       | 54.5%      |       | 57.5%      |       | 55.3%      |         | On rental and managed services    |       | 75                                  |       | 87 |   | 51.4% |   | 56.9% |   | (12 | ) | -13.8 | % |
| 46.7%      |       | 45.3%      |       | 46.6%      |       | 46.8%      |         | Total gross margin                |       | $                                   | 598        |   | $ | 578 |   | 46.2% |   | 46.7% |   | $ | 20 |   | 3.5 | % |

 

The $20 million increase in gross margin for the second quarter offiscal 2007 reflects an increase in sales volume and a benefit from foreigncurrency fluctuations partially offset by a decrease in rental and managedservices.

Gross margin on sales of products increased by $20 million primarilydue to higher sales volume, although the gross margin rate was slightly lowerthan the second quarter of fiscal 2006 due to higher costs associated with ourwarehousing issues.

Services gross margin increased by $12 million compared to secondquarter of fiscal 2006, and the gross margin rate increased by over onepercentage point. The increase in gross margin was due to services sales volumeincreases and cost reductions from employee restructuring actions in priorperiods, which were partially offset by expected increased employee benefitcosts.

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

33

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***Operating expenses***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | 399        |       | $          | 423        |       | $          | 388          |                              | $          | 389                                 |       | Selling, general and administrative |   | $ | 393 |   | $ | 399 |   | 30.4% |   | 32.2% |   | $ | (6 | ) | -1.5% |   |
| 106        |       | 115        |       | 110        |       | 114        |         | Research and development          |       | 114                                 |       | 106 |   | 8.8% |   | 8.6% |   | 8 |   | 7.5% |   |
| 20         |       | 22         |       | 62         |       | 6          |         | Restructuring charges, net        |       | 10                                  |       | 20 |   | 0.8% |   | 1.6% |   | (10 | ) | -50.0% |   |
| $          | 525        |       | $          | 560        |       | $          | 560          |                              | $          | 509                                 |       | Total operating  expenses |   | $ | 517 |   | $ | 525 |   | 40.0% |   | 42.4% |   | $ | (8 | ) | -1.5% |   |

 

34

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The $6 million decrease in SG&A expenses isprimarily due to the impact of lower headcount and lower discretionary spendingin connection with our cost management initiatives, partially offset byexpected higher employee benefit costs.

R&D expenses increased by $8 million comparedto the same quarter last fiscal year due to increased gross investment and to alesser extent, the acquisitions of Traverse and Ubiquity.

Restructuring charges, netfor the second quarter of fiscal 2007 primarily represent $10 million ofnet charges for employee separation costs and lease obligations.

***Other Income, Net***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **Change** | ** ** |
|       | $          | 6          |       |       |       | $          | 5            |                              |       |                                | $          | 8 |   |   |   | $ | 6 |   |   | Other income, net |   |   | $ | 7 |   |   |   | $ | 6 |   |   | $ | 1 |   | 17 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

***Interest Expense***

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

 

Capital lease obligationsof $11 million represent our only financing arrangement as ofMarch 31, 2007, and therefore, we have incurred insignificant interestexpense.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **Change** | ** ** |
|       | $          | 19         |       |       |       | $          | (11          | )                                 |       |                                | $          | 35 |   |   |   | $ | 25 |   |   | Provision for  (benefit from) income taxes |   |   | $ | 31 |   |   |   | $ | 19 |   |   | $ | 12 |   | 63 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes in the second quarter of fiscal 2007 iscomprised of U.S. Federal, state and non-U.S. taxes. The provision for thesecond quarter of fiscal 2007 resulted in an effective tax rate of 34.7%.

The provision for income taxes in thesecond quarter of fiscal 2006 was comprised of U.S. Federal, state and non-U.S.taxes. The provision for the second quarter of fiscal 2006 resulted in aneffective tax rate of 33.3%.

**Segment Results**

***Global Communications Solutions***

The GCS segment is focused on the sale ofcommunications systems, equipment and applications to our enterprise customers.Our primary offerings in this segment include IP telephony solutions andtraditional voice communications solutions, multi-media contact centerinfrastructure and applications in support of customer relationship management,and unified communications applications and appliances.

Largecommunications systems are IP and traditional telephony systems marketed tolarge enterprises. These systems include:

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

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

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

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

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

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

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

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

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

·       associatedappliances, such as telephone handsets; and

·       mediaservers for voice applications used by smaller businesses.

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

·       applicationsin support of customer relationship management;

·       messagingfor IP and traditional systems;

·       applicationenablement services; and

·       unifiedcommunication client applications.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                      | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                      | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** | ** ** | ** ** |
| $          | 414        |       | $          | 455        |       | $          | 483          |                              | $          | 435                                 |       | Large  Communications Systems |   | $ | 440 |   | $ | 414 |   |   | 63 | % |   |   | 63 | % |   |   | $ | 26 |   |   | 6.3 | % |
| 94         |       | 92         |       | 96         |       | 85         |         | Small  Communications Systems     |       | 84                                  |       | 94 |   |   | 12 | % |   |   | 14 | % |   |   | (10 | ) |   | -10.6 | % |
| 141        |       | 144        |       | 169        |       | 151        |         | Converged Voice  Applications     |       | 162                                 |       | 141 |   |   | 23 | % |   |   | 21 | % |   |   | 21 |   |   | 14.9 | % |
| 12         |       | 13         |       | 12         |       | 11         |         | Other                             |       | 12                                  |       | 12 |   |   | 2 | % |   |   | 2 | % |   |   | — |   |   | 0.0 | % |
| $          | 661        |       | $          | 704        |       | $          | 760          |                              | $          | 682                                 |       | Total GCS revenue |   | $ | 698 |   | $ | 661 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 37 |   |   | 5.6 | % |

 

Overall GCS revenue grew by $37 million, or 5.6%.Product revenue increases, particularly related to converged voiceapplications,  and a benefit from foreigncurrency fluctuations, were offset by the expected reduced sales of traditionalproducts and a decline in our rental base in Germany. The $26 millionincrease in large communication systems revenue was primarily the result ofincreased demand for enterprise gateways and other equipment. Smallcommunications systems revenues decreased by $10 million due to continueddeclines of our sales of traditional products and in our rental base. Convergedvoice applications revenues increased due to increased demand for applications,especially IP messaging and contact center applications, offset by declines indemand for traditional messaging products.

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Thefollowing table sets forth operating income of the GCS segment:

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

|   | $ | 32 |   |   |   | $ | 36 |   |   |   | $ | 86 |   |   |   | $ | 22 |   |   | Operating income |   |   | $ | 38 |   |   |   | $ | 32 |   |   |   | 5.4 | % |   |   | 4.8 | % |   | $ | 6 |   | 18.8 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|---|--------|------|---|

 

The $6 millionincrease in operating income was primarily due to higher gross margin as aresult of higher sales volumes, partially offset by highercosts associated with our warehousing issues and increases in R&Dinvestment.

***Avaya GlobalServices***

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

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

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

Global Managed Services—AGS supplements our customers’in-house staff and manages complex multi-vendor, multi-technology networks,optimizes network performance and configurations, backs up systems, detects andresolves faults, performs moves, adds and changes, and manages our customers’trouble tickets and inventory. This category includes customers who have chosena bundled solution with enhanced services not provided in a basic maintenancecontract, and service of solutions sold under a rental payment basis. Themanaged services business generally involves larger contracts with customerswho outsource responsibility for their voice applications domain to us. We facechallenges in this area, including ensuring that we deliver consistent levels ofservice globally to these large, and often multi-national, customers whilecontrolling costs and expanding the required skill set of our AGS organization.

The profitability of our AGS segment is also affectedby the fixed costs associated with our represented workforces in the U.S. andEMEA and includes the impact of increases in employee benefit costs. Inaddition, our profitability is impacted by the complexities associated withmaintenance of global, multi-vendor IP networks as compared with local, closed,proprietary TDM networks, such as the need to assure a sufficient level ofservice technicians with IP skills.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | ** **                          | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | ** ** | **Dollars in millions**   | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | 401        |       | $          | 402        |       | $          | 404        |                                | $          | 411                                 |       | Product Support  Services |   | $ | 412 |   | $ | 401 |   |   | 69 | % |   |   | 70 | % |   | $ | 11 |   | 2.7 | % |
| 89         |       | 106        |       | 111        |       | 98         |       | Consulting and  Systems Integration |       | 97                                  |       | 89 |   |   | 16 | % |   |   | 15 | % |   | 8 |   | 9.0 | % |
| 86         |       | 84         |       | 89         |       | 89         |       | Global Managed  Services            |       | 87                                  |       | 86 |   |   | 15 | % |   |   | 15 | % |   | 1 |   | 1.2 | % |
| 1          |       | 1          |       | —     |       | —     |       | Services—Other                 |       | —                              |       | 1 |   |   | 0 | % |   |   | 0 | % |   | (1 | ) | 0.0 | % |
| $          | 577        |       | $          | 593        |       | $          | 604        |                                | $          | 598                                 |       | Total AGS revenue |   | $ | 596 |   | $ | 577 |   |   | 100 | % |   |   | 100 | % |   | $ | 19 |   | 3.3 | % |

 

Overall AGS revenue increased by $19 million, or 3.3%, due toincreases in product support services and consulting and systems integration,particularly related to professional services, as well as a benefit fromforeign currency fluctuations.

Product support services revenues increased by $11 million compared tothe second quarter of fiscal 2006, due to growth in maintenance revenues in allregions, particularly contract maintenance revenues in the U.S. Consulting andsystems integration revenues grew due to increases in professional services,particularly in the U.S. Global managedservices revenue was relatively flat. Factors negatively impacting revenuecompared to the prior year include reductions in scope related to our Germanyrental base, cancellations of contracted services, and price erosion on newcontracts. The second quarter of fiscal 2007 also includes revenue from atermination fee related to the cancellation of a large customer contract. Excludingthis termination fee, global managed services revenue would have declinedcompared to the prior year.

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

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

|   | $ | 41 |   |   |   | $ | 34 |   |   |   | $ | 36 |   |   |   | $ | 53 |   |   | Operating income |   |   | $ | 56 |   |   |   | $ | 41 |   |   |   | 9.4 | % |   |   | 7.1 | % |   | $ | 15 |   | 36.6 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|----|--------|------|---|

 

The $15 millionincrease in operating income is primarily due to higher gross margin as aresult of higher sales volumes. In addition, the net benefit of reduced costsfrom restructuring actions was partially offset by expected increased employeebenefit costs.

**Corporate/Other Unallocated Amounts**

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** **                        | ** ** | **Second Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|-------------------------------------|------------|
| **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **1Q07**   | *** *** | **Dollars in millions** | ** ** | **2007**                            | ** ** | **2006** | ** ** | **Change** | ** ** |
| $          | (20)       |       | $          | (42        | )          | $          | (47          | )                                 |       | $                                   | 15         |   |   | Operating (loss)  income |   | $ | (13 | ) | $ | (20 | ) | $ | 7 |   | 35 | % |
|            |            |            |            |            |            |            |              |                                   |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Corporate/OtherUnallocated amounts include a $10 million net restructuring charge in thesecond quarter of fiscal 2007, compared to a $20 million net charge forthe prior year. The remaining $3 million operating loss in the currentquarter is due to various overhead expenses. At the beginning of each fiscalyear, the amount of corporate overhead and certain other expenses, includingtargeted annual incentive awards, to be charged to operating segments isdetermined and fixed for the entire year. Any adjustment of the annualincentive accrual, as well as any other over/under absorption of corporateoverhead expenses against plan, is recorded within Corporate/Other UnallocatedAmounts. In addition, certain discrete items, such as charges relating torestructuring actions, are not allocated to the operating segments and remainin Corporate/Other Unallocated Amounts.

 

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***Six Months Ended March 31, 2007 Compared withSix Months Ended March 31, 2006***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **                   | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Sales of products            |       | $                                                  | 1,258      |   | $ | 1,184 |   |   | 48 | % |   |   | 48 | % |   | $ | 74 |   | 6.3 | % |
| Services                     |       | 1,018                                              |       | 996 |   |   | 40 | % |   |   | 40 | % |   | 22 |   | 2.2 | % |
| Rental and  managed services |       | 298                                                |       | 307 |   |   | 12 | % |   |   | 12 | % |   | (9 | ) | -2.9 | % |
| Total revenue                |       | $                                                  | 2,574      |   | $ | 2,487 |   |   | 100 | % |   |   | 100 | % |   | $ | 87 |   | 3.5 | % |

 

Each type of revenue benefited from favorable foreigncurrency fluctuations. Revenue from sales of products increased by 6.3% andincludes increases due to demand for our converged voice applications,partially offset by the expected decline in sales of traditional products.Services revenue increased by 2.2% and includes growth in professionalservices. Rental and managed services revenue decreased by 2.9% resulting fromchanges in scope of contracted services, cancellations and pricing pressuresrelated to our rental business.

Thefollowing table sets forth a geographic comparison of revenue:

| ** **                                                   | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                                                   | ** ** | **Dollars in millions**                  | ** ** |
| U.S.                                                         |       | $                                                  | 1,478      |   | $ | 1,453 |   |   | 57 | % |   |   | 58 | % |   | $ | 25 |   | 1.7 | % |
| Outside the U.S.:                                            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                      |       | 364                                                |       | 368 |   |   | 14 | % |   |   | 15 | % |   | (4 | ) | -1.1 | % |
| EMEA—Europe / Middle East / Africa (Excluding  Germany) |       | 393                                                |       | 352 |   |   | 15 | % |   |   | 14 | % |   | 41 |   | 11.6 | % |
| Total EMEA                                                   |       | 757                                                |       | 720 |   |   | 29 | % |   |   | 29 | % |   | 37 |   | 5.1 | % |
| APAC—Asia Pacific                                       |       | 199                                                |       | 186 |   |   | 8 | % |   |   | 8 | % |   | 13 |   | 7.0 | % |
| Americas, non-U.S.                                           |       | 140                                                |       | 128 |   |   | 6 | % |   |   | 5 | % |   | 12 |   | 9.4 | % |
| Total outside the U.S.                                       |       | 1,096                                              |       | 1,034 |   |   | 43 | % |   |   | 42 | % |   | 62 |   | 6.0 | % |
| Total revenue                                                |       | $                                                  | 2,574      |   | $ | 2,487 |   |   | 100 | % |   |   | 100 | % |   | $ | 87 |   | 3.5 | % |

 

Revenues in the U.S. increased 1.7% compared with thefirst six months of fiscal 2006, primarily due to increases in sales ofproducts, particularly converged voice applications. Germany’s revenuedecreased 1.1% due to the decline in our rental base. EMEA revenue, excludingGermany, grew by 11.6% due to a benefit from foreign currency fluctuations andstrong demand in high-growth markets. The increase in APAC revenue wasprimarily due to the increased demand for IP products through the directchannel. Revenue in Americas, non-U.S. increased due to product demand throughthe direct channel.

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

| ** **              | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**                  | ** ** |
| Direct                  |       | $                                                  | 536        |   | $ | 518 |   |   | 43 | % |   |   | 44 | % |   | $ | 18 |   | 3.5 | % |
| Indirect                |       | 722                                                |       | 666 |   |   | 57 | % |   |   | 56 | % |   | 56 |   | 8.4 | % |
| Total sales of products |       | $                                                  | 1,258      |   | $ | 1,184 |   |   | 100 | % |   |   | 100 | % |   | $ | 74 |   | 6.3 | % |

 

38

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The mix of sales ofproducts in the first six months of fiscal 2007 through the direct and indirectchannel was consistent with the same period last fiscal year.

***Gross Margin***

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

| ** **                      | ** ** | **Six Months Ended March 31,** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**                  | ** ** |
| On sales of  products           |       | $                                                  | 668        |   | $ | 632 |   | 53.1 | % | 53.4 | % | $ | 36 |   | 5.7 | % |
| On services                     |       | 370                                                |       | 355 |   | 36.3 | % | 35.6 | % | 15 |   | 4.2 | % |
| On rental and  managed services |       | 159                                                |       | 180 |   | 53.4 | % | 58.6 | % | (21 | ) | -11.7 | % |
| Total gross margin              |       | $                                                  | 1,197      |   | $ | 1,167 |   | 46.5 | % | 46.9 | % | $ | 30 |   | 2.6 | % |

 

The $30 million increase in gross margin for the first six months offiscal 2007 reflects an increase in the volume of sales of products and abenefit from foreign currency fluctuations, although the gross margin rate fellslightly. The decrease in the overall gross margin rate was due primarily tothe decline in margin rates on rental and managed service contracts,particularly in Germany. The first six months of fiscal 2006 gross marginincludes an $11 million benefit, or approximately a half percentage pointimpact, from the change in our vacation policy.

Gross margin on sales of products increased by $36 million primarilydue to higher sales volume. Factors affecting the gross margin rate includedhigher costs associated with our warehousing issues, partially offset bybenefits from cost reductions from employee restructuring actions.

Services gross margin increased by $15 million when compared to firstsix months of fiscal 2006. Cost reductions from employee restructuring actionsin prior periods and increased volume of professional services were partiallyoffset by expected increases in  employeebenefit costs.

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

***Operating expenses***

| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                           | ** ** | **Dollars in millions**                  | ** ** |
| Selling, general  and administrative |       | $                                                  | 782        |   | $ | 784 |   | 30.4 | % | 31.5 | % |   | $ | (2 | ) |   | -0.3 | % |
| Research and  development            |       | 228                                                |       | 203 |   | 8.9 | % | 8.2 | % |   | 25 |   |   | 12.3 | % |
| Restructuring  charges, net          |       | 16                                                 |       | 20 |   | 0.6 | % | 0.8 | % |   | (4 | ) |   | -20.0 | % |
| Total operating expenses             |       | $                                                  | 1,026      |   | $ | 1,007 |   | 39.9 | % | 40.5 | % |   | $ | 19 |   |   | 1.9 | % |

 

The $2 million decrease in SG&A expenses isprimarily due to lower headcount and lower discretionary spending, as well asbenefits resulting from the favorable resolution of non-income tax audits and again on the sale of real estate in fiscal 2007, partially offset by expectedincreases in employee benefit costs. The first six months of fiscal 2006included a $7 million benefit related to the change in our vacationpolicy.

R&D expenses increased by $25 millioncompared to the first six months of the last fiscal year due to increased grossinvestment and  to a lesser extent, theacquisitions of Traverse and Ubiquity. The first six months of fiscal 2006included a $3 million benefit related to the change in our vacationpolicy.

39

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Restructuring charges, netfor the first six months of fiscal 2007 represent $23 million of chargesfor employee separation costs and lease obligations, partially offset by a netbenefit of $7 million for changes in estimates for prior restructuringplans primarily related to facilities.

***Other Income, Net***

| ** **        | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------|------------|----------------------------------------------------|------------|
| ** **        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** |
| ** **        | ** ** | **Dollars in millions**                  |
| Other income, net |       |                                               | $          | 13 |   |   |   | $ | 11 |   |   | $ | 2 |   | 18 | % |
|                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

***Interest Expense***

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Interest expense |       |                                               | $          | — |   |   |   | $ | 3 |   |   | $ | (3 | ) | -100% |   |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Capital lease obligationsof $11 million represent our only financing arrangement as of March 31,2007, and therefore, we have incurred insignificant interest expense.

***Provision forIncome Taxes***

| ** **                  | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                  | ** ** | **Dollars in millions**                  | ** ** |
| Provision for  income taxes |       |                                               | $          | 56 |   |   |   | $ | 59 |   |   | $ | (3 | ) | -5 | % |
|                             |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes for the six month periods shown above arecomprised of U.S. Federal, state and non-U.S. taxes. The provision for the sixmonths ended March 31, 2007 also includes a $6 million benefit fromthe retroactive extension to January 1, 2006 of the research tax creditpursuant to the Tax Relief and Health Care Act of 2006 and a $7 milliontax benefit due to a reduction in estimated tax payable for fiscal 2006 inGermany as a result of additional restructuring charges reported for statutorypurposes. The provision for the first six months of fiscal 2007 resulted in aneffective tax rate of 30.2%, which we believe is not indicative of theestimated tax rate for the full fiscal year.

The provision for the first six months offiscal 2006 resulted in an effective tax rate of 35.1%.

40

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**Segment Results**

***Global Communications Solutions***

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

| ** **                    | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**                  | ** ** |
| Large  Communications Systems |       | $                                                  | 875        |   | $ | 827 |   |   | 63 | % |   |   | 62 | % |   | $ | 48 |   | 5.8 | % |
| Small  Communications Systems |       | 169                                                |       | 183 |   |   | 12 | % |   |   | 14 | % |   | (14 | ) | -7.4 | % |
| Converged Voice  Applications |       | 313                                                |       | 292 |   |   | 23 | % |   |   | 22 | % |   | 21 |   | 7.4 | % |
| Other                         |       | 23                                                 |       | 20 |   |   | 2 | % |   |   | 2 | % |   | 3 |   | 14.0 | % |
| Total GCS revenue             |       | $                                                  | 1,380      |   | $ | 1,322 |   |   | 100 | % |   |   | 100 | % |   | $ | 58 |   | 4.4 | % |

 

Overall GCS revenue grew by $58 million, or 4.4%.Product revenue increases, particularly related to converged voiceapplications  and a benefit from foreigncurrency fluctuations, were offset by the expected reduced sales of traditionalproducts and a decline in our rental base in Germany. The $48 millionincrease in large communication systems revenue was the result of increaseddemand for enterprise gateways and other equipment. Small communicationssystems revenues decreased by $14 million due to continued declines of oursales of traditional products and our rental base. Converged voice applicationsrevenues increased by $21 million due to increased demand forapplications, especially IP messaging and contact center applications, offsetby declines in demand for traditional messaging products.

Thefollowing table sets forth operating income of the GCS segment:

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **   2007   ** | ** ** | **   2006   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       |                                               | $          | 60 |   |   |   | $ | 75 |   |   |   | 4.3 | % |   |   | 5.7 | % |   |   | $ | (15 | ) |   | -20.0% |   |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $15 milliondecline in operating income was primarily due to highercosts associated with our warehousing issues, increases in R&Dinvestment and the benefit of $11 million from a change in the Company’svacation policy for the first six months of fiscal 2006, partially offset bythe impact of increases in sales volume.

***Avaya Global Services***

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

| ** **                          | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **                          | ** ** | **Dollars in millions**                  | ** ** |
| Product Support  Services           |       | $                                                  | 823        |   | $ | 813 |   |   | 69 | % |   |   | 70 | % |   |   | $ | 10 |   |   | 1.2 | % |
| Consulting and  Systems Integration |       | 195                                                |       | 184 |   |   | 16 | % |   |   | 16 | % |   |   | 11 |   |   | 5.8 | % |
| Global Managed  Services            |       | 176                                                |       | 167 |   |   | 15 | % |   |   | 14 | % |   |   | 9 |   |   | 5.1 | % |
| Services—Other                 |       | —                                             |       | 1 |   |   | 0 | % |   |   | 0 | % |   |   | (1 | ) |   | -100 | % |
| Total AGS revenue                   |       | $                                                  | 1,194      |   | $ | 1,165 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 29 |   |   | 2.5 | % |

 

Overall AGS revenue increased by $29 million, or 2.5%, due toincreases in product support services and consulting and systems integration,particularly related to professional services, as well as a benefit fromforeign currency fluctuations.

41

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Product support services revenues increased by $10 million compared tothe second quarter of fiscal 2006, particularly in the international regions. Consultingand systems integration revenues grew by $11 million due to increases inprofessional services, primarily in the U.S. Global managed services revenuesincreased due to higher customer termination fees, which were partially offsetby reductions in scope related to our Germany rental base, cancellations ofcontracted services and price erosion on new contracts.

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

| ** **       | ** ** | **Six Months Ended March 31,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       | $                                                  | 109        |   | $ | 101 |   |   | 9.1 | % |   |   | 8.7 | % |   | $ | 8 |   | 7.9 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $8 millionincrease in operating income is primarily due to an increase in sales volume.In addition, the benefit of reduced costs from restructuring actions waspartially offset by expected increases in employee benefit costs. Operatingincome for the first six months of fiscal 2006 included a benefit of $10 millionfrom the change in our vacation policy.

**Corporate/Other Unallocated Amounts**

| ** **               | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------|------------|----------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions**                       | ** ** |
| Operating income  (loss) |       |                                               | $          | 2 |   |   | $ | (16 | ) | $ | 18 |   | 113 | % |
|                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

For the first six monthsof fiscal 2007, operating income in Corporate/Other Unallocated Amounts isprimarily attributable to $8 million in gains on the sale of real estateand the $8 million benefit from non-income tax audit settlements inseveral jurisdictions, partially offset by $16 million of netrestructuring charges. The operating loss for the first six months of fiscal2006 was primarily due to $20 million of net restructuring charges.

**Liquidity andCapital Resources**

During the first sixmonths of fiscal 2007, we generated positive cash flow from operations of $222 million.We used $94 million during the first six months of fiscal 2007 torepurchase shares in connection with our 2005 and 2007 share repurchase plans. Inaddition, we used $15 million and $146 million of cash to acquireTraverse and Ubiquity, respectively, and used $87 million of cash forcapital expenditures and software development costs, which contributed to thedecrease in cash and cash equivalents to $829 million as of March 31,2007 from $899 million as of September 30, 2006.

42

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***Sources and Uses of Cash for the Six Months EndedMarch 31, 2007***

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

| ** **                                                    | ** ** | **Six months ended March 31,**                                           | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **       2007       ** | ** ** | **       2006       ** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**                                                            | ** ** |
| Net cash provided by  (used for):                             |       |                                                                                         |       |   |   |   |   |   |   |
| Operating activities                                          |       |                                                                                         | $          | 222 |   |   |   | $ | 275 |   |   |
| Investing activities                                          |       |                                                                                         | (245       | ) |   |   | (99 | ) |   |
| Financing activities                                          |       |                                                                                         | (66        | ) |   |   | (179 | ) |   |
| Effect of  exchange rate changes on cash and cash equivalents |       |                                                                                         | 19         |   |   |   | (2 | ) |   |
| Net decrease in  cash and cash equivalents                    |       |                                                                                         | (70        | ) |   |   | (5 | ) |   |
| Cash and cash equivalents at beginning of year                |       |                                                                                         | 899        |   |   |   | 750 |   |   |
| Cash and cash  equivalents at end of period                   |       |                                                                                         | $          | 829 |   |   |   | $ | 745 |   |   |

 

***Operating Activities***

Our net cash provided by operating activities was $222 millionfor the first six months of fiscal 2007, compared to $275 million in thefirst six months of fiscal 2006. The lower amount of cash provided by operatingactivities compared to the prior year was primarily driven by higher employeeincentive payments. The first six months of fiscal 2007 included payment ofemployee incentives based on fiscal 2006 performance. The first six months offiscal 2006 included payments of lower discretionary awards based on fiscal2005 performance.  This change in thelevel of incentive payments resulted in an approximately $70 millionincrease in cash usage in the first six months of fiscal 2007 compared with thesame period of fiscal 2006. In addition, changes in working capital,particularly accounts receivable, contributed to the decline in net cashprovided by operating activities for the first six months of fiscal 2007compared to the same period last fiscal year.

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

| ** **                                                                  | ** ** | **March 31,**                | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                  | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** ** |
| ** **                                                                  | ** ** | **Dollars in millions** | ** ** |
| Accounts  receivable, gross                                                 |       |                              | $          | 939                    |       |       |       | $ | 928 |   |   | $ | 11 |   |
| Allowance for  doubtful accounts                                            |       |                              | (52        | )                      |       |       | (57        | ) |   | 5 |   |
| Accounts  receivable, net                                                   |       |                              | $          | 887                    |       |       |       | $ | 871 |   |   | $ | 16 |   |
| Allowance for doubtful accounts as a percent of accounts  receivable, gross |       |                              | 5.5        | %                      |       |       | 6.1        | % |   | -0.6 pts |   |
| Past due  receivables as a percent of accounts receivable, gross            |       |                              | 19.7       | %                      |       |       | 17.8       | % |   | +1.9 pts |   |

 

| ** **                    | ** ** | **For the three months ended** | ** ** | ** **             | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **March 31,**                                 | ** ** | **September 30,** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2007**                                           | ** ** | **2006**               | ** ** | **Change** | ** ** |
| Days sales  outstanding (DSO) |       |                                               | 62 days    |                   |       |   | 57 days |   |   | +5 days |   |
|                               |            |                                                    |            |                        |            |  |  |  |  |  |  |

 

The increase in accounts receivable was primarily theresult of receivables acquired in connection with our purchase of Ubiquity, aswell as fluctuations in sales between the second quarter of fiscal 2007 andfourth quarter of fiscal 2006 and the timing of collections. The increase inDSO was primarily caused by slower collections of U.S. receivables.

43

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

| ** **          | ** ** | **March 31,**                | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|---------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **          | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** ** |
| ** **          | ** ** | **Dollars in millions** | ** ** |
| Finished goods      |       | $                                 | 280        |                   |       | $          | 281        |   |   | $ | (1 | ) |
| Raw materials       |       | 2                                 |       |                   | 4          |       |       | (2 | ) |
| Total inventory     |       | $                                 | 282        |                   |       | $          | 285        |   |   | $ | (3 | ) |
| Inventory  turnover |       | 9.8 times                         |       |                   | 10.2 times |       |       | - 0.4 times |   |

 

Inventory was roughly flat compared to the end offiscal 2006.

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

| ** **               | ** ** | **March 31,**                | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|--------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **               | ** ** | **2007**                          | ** ** | **2006**               | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions** | ** ** |
| Accounts payable         |       |                              | $          | 398                    |       |       |       | $ | 418 |   |   |   | $ | (20 | ) |   |
| Days payable outstanding |       |                              | 52         |                   |       |       | 52         |   |   |   | — |   |   |

 

Accounts payable decreasedin the first six months of fiscal 2007 from the prior year-end due to lowerspending levels and the timing of payments during the quarter.

***Investing Activities***

Net cash used for investing activities was $245million in the first six months of fiscal 2007, compared with $99 million inthe same period last year. Activities in the current period include $161million for the acquisitions of Ubiquity and Traverse, $46 million for capitalexpenditures and $41 million for capitalized software development costs.

Cash used in the sameperiod of fiscal 2006 included $54 million for capital expenditures and $37million for capitalized software development costs.

***FinancingActivities***

Net cash used forfinancing activities was $66 million in the first six months of fiscal 2007,compared with $179 million in the same period last year. Activities in thecurrent period primarily include $94 million of cash used to repurchase ourcommon stock pursuant to our stock repurchase plans, partially offset by $30million of cash received in connection with the issuance of common stock underour employee stock purchase plan and stock compensation plans.

Cash used in the sameperiod of fiscal 2006 consisted primarily of $193 million to repurchase ourcommon stock, partially offset by $14 million of cash received in connectionwith issuance of common stock under our employee stock purchase plan and stockcompensation plans.

***Future CashRequirements and Sources of Liquidity***

***Future CashRequirements***

Our primary future cashrequirements will be to fund capital expenditures, restructuring payments,employee benefit obligations, share repurchases and future acquisitions.

Specifically,we expect our primary cash requirements for the remainder of fiscal 2007 to beas follows:

·       *Capital expenditures*—We expect to spendapproximately $150 million for capital expenditures and capitalized softwaredevelopment costs during the remainder of fiscal 2007.

44

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·       *Restructuring payments—*We expect to makepayments of approximately $30 million during the remainder of fiscal 2007 foremployee separation costs and lease termination obligations associated withrestructuring actions we have taken to date. If we take any further actions toreduce costs and expenses, we would expect to make additional paymentsthroughout the remainder of fiscal 2007.

·       *Employee benefit obligations*—We estimate thatwe will pay $3 million each for U.S. and non-U.S. pension benefits for the remainderof fiscal 2007. We also estimate that we will make payments of $10 million for retiree medical benefits that are notpre-funded during the remainder of fiscal 2007.

·       *Share repurchases—*Since the start of the 2007 plan through May 8,2007, we paid $29 million to repurchase and retire our shares, leavingapproximately $471 million available for further share repurchases according tothe limitations of the 2007 plan. See Note 8, “Earnings Per Share of CommonStock,” to our Consolidated Financial Statements for further information.

***Future Sources ofLiquidity***

We expect our primarysource of cash during the remainder of fiscal 2007 to be positive net cashprovided by operating activities. We expect that growth in profitable revenuesand continued focus on accounts receivable, inventory management and costcontainment will enable us to continue to generate positive net cash fromoperations.

We and a syndicate oflenders are currently party to a $400 million revolving credit facility (seeNote 7, “Financing Arrangements” to our Consolidated Financial Statements),which expires in May 2011.

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $829 million and our net cash provided by operating activitieswill be sufficient to meet our future cash requirements described above. Ourability to meet these requirements will depend on our ability to generate cashin the future, which is subject to general economic, financial, competitive,legislative, regulatory and other factors that are beyond our control.

***UncertaintiesRegarding Our Liquidity***

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

Webelieve the following uncertainties exist regarding our liquidity:

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

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

***Fair Value ofFinancial Instruments***

The carrying amounts ofcash and cash equivalents, accounts receivable, accounts payable and accruedliabilities approximate fair value because of their short-term maturity andvariable rates of interest.

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We aretherefore subject to the risk associated with foreign currency exchange ratesand interest rates that could affect our results of operations, financialposition and cash flows. We manage our exposure to these market risks throughour regular operating and financing activities and, when deemed appropriate,through the use of derivative financial instruments. We use derivativefinancial instruments to reduce 

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earningsand cash flow volatility associated with foreign exchange rate changes. Derivativefinancial instruments are used as risk management tools and not for speculativeor trading purposes. As of March 31, 2007 and September 30, 2006, theestimated fair values of our foreign currency forward contracts were a gain of$3 million and a loss of $2 million, respectively. The gain wasincluded in other current assets, while the loss was included in other currentliabilities. The estimated fair values of these forward contracts were based onmarket quotes obtained through independent pricing sources.

***Debt Ratings***

Our ability to obtainexternal financing and the related cost of borrowing is affected by our debtratings, which are periodically reviewed by the major credit rating agencies. Asof March 31, 2007, we had a long-term corporate family rating of Ba3 witha positive outlook from Moody’s and a corporate credit rating of BB with astable outlook from Standard & Poor’s. These ratings are notrecommendations to buy, sell or hold securities. The ratings are subject tochange or withdrawal at any time by the respective credit rating agencies. Eachcredit rating should be evaluated independently of any other ratings.

***Credit Facility***

Our credit facilitycontains affirmative and restrictive covenants that we must comply with, asdescribed in Note 7, “Financing Arrangements” to our Consolidated FinancialStatements. Asof March 31, 2007, we were in compliance with all of the covenantsincluded in the credit facility.

There are currently $28million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility and the remainingavailability is $372 million as of March 31, 2007. We believe the creditfacility provides us with an important source of backup liquidity.

**Critical Accounting Policies and Estimates**

Thepreparation of the Consolidated Financial Statements and related disclosures inconformity with accounting principles generally accepted in the United Statesrequires us to establish accounting policies that contain estimates andassumptions that affect the amounts reported in the Consolidated FinancialStatements and accompanying notes. These policies include:

·       Revenue recognition;

·       Collectibility of accountsreceivable;

·       Inventories;

·       Deferred tax assets and taxliabilities;

·       The measurement oflong-lived assets, including goodwill, the impairment of which would impactoperating expenses;

·       Restructuring programs;

·       Pension and post-retirementbenefits costs;

·       Commitments andcontingencies; and

·       Accountingfor stock options

We have other importantaccounting policies and practices; however, once adopted, these other policieseither generally do not require us to make significant estimates or assumptionsor otherwise only require implementation of the adopted policy and not ajudgment as to the policy itself. We base our estimates on our historicalexperience and also on assumptions that we believe are standard and reasonable.Despite our intention to establish accurate estimates and assumptions, actualresults could differ from those estimates for various reasons including thosedescribed in “Forward Looking Statements.”

During the six monthsended March 31, 2007, management believes there have been no significantchanges to the items that we disclosed as our critical accounting polices andestimates in Management’s 

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Discussionand Analysis of Financial Condition and Results of Operations in our AnnualReport on Form 10-K for the fiscal year ended September 30,2006.

**Item3. *Quantitative and Qualitative Disclosures AboutMarket Risk.***

See Avaya’s Annual Reporton Form 10-K filed with the SEC on December 8, 2006. As of March 31,2007, there has been no material change in this information.

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

*a)*Evaluation of Disclosure Controls and Procedures.

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

b) *Changes inInternal Control Over Financial Reporting*.

There were no changes inour internal control over financial reporting during the second quarter offiscal 2007 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

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**PART IIOTHER INFORMATION**

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

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

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

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

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

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

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

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

·       dependenceon new product development;

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

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

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

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

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

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

·       theability to attract and retain qualified employees;

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

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

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·       theability to form and implement alliances.

Below is a detailed discussion of certain risksaffecting our business. The categorization of risks set forth below is meant tohelp you better understand the risks facing our business and is not intended tolimit your consideration of the possible effects of these risks to the listedcategories. Any adverse effects related to the risks discussed below may, andlikely will, adversely affect many aspects of our business.

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

**A key component of our strategy is our focus onthe development and sale of advanced communications products and applicationsand related services, including IP telephony solutions, and this strategy maynot be successful.**

A key component of our strategy is our focus on thedevelopment and sale of IP telephony solutions and other advancedcommunications products and applications and related services.  Our product offerings include IP telephonysystems and traditional voice communications systems, multi-media contactcenter infrastructure and applications in support of customer relationshipmanagement, unified communications applications and appliances, such as IPtelephone sets.  These offerings are partof what we refer to as “Intelligent Communications,” which is about embeddingcommunications solutions into our customers’ business processes to help themtransform their businesses and innovate their business models.

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

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

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

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

·       researchand develop IP telephony solutions and other advanced communications productsand applications;

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

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

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

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

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

·       establishpresence in key geographic markets.

Our investments aretargeted around achieving our strategic vision of Intelligent Communications. Ourvision may fail to predict our customers’ business needs or changes intechnological trends, which may adversely affect our operating results. If wedo not successfully execute our strategy, our operating results may beadversely affected.

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**The market opportunity for advanced communicationsproducts, applications and services, including IP telephony solutions, may notdevelop in the ways that we anticipate.**

The demand for our productscan change quickly and in ways that we may not anticipate because the market ischaracterized by rapid, and sometimes disruptive, technological developments,evolving industry standards, frequent new product introductions andenhancements, changes in customer requirements and a limited ability toaccurately forecast future customer orders. Our operating results may beadversely affected if the market opportunity for advanced communicationsproducts, applications and services, including IP telephony solutions, does notdevelop in the ways that we anticipate. The ratio of revenue attributable to IPtelephony solutions versus traditional voice communication systems is expectedto increase as more and more companies convert to IP telephony solutions. However,IP telephony lines currently constitute a small percentage of global installedenterprise telephony lines and if IP telephony does not gain widespreadacceptance in the marketplace as an alternative replacement option forenterprise telephony systems our overall revenue and operating results may beadversely affected. Even if we are successful in increasing our revenue fromsales of IP telephony solutions, if revenue from traditional enterprise voicecommunications systems and services declines faster than revenue from IPtelephony solutions increases, our overall revenue and operating results may beadversely affected. We cannot predict whether:

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

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

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

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

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

Historically, our GCS segment has competed againstother providers of enterprise voice communications solutions such as NortelNetworks Corporation, Siemens AG, Alcatel-Lucent and NEC Corporation. As wefocus on the development and marketing of advanced communications solutions,such as IP telephony solutions, we face intense competition from theseproviders of voice communications solutions as well as from data networkingcompanies such as Cisco Systems, Inc. and 3Com Corp. The GCS segmentalso faces competition in the small and medium business market from manycompetitors, including Cisco, Nortel, Alcatel-Lucent, NEC, Matsushita ElectricCorporation of America, Inter-Tel, Incorporated, 3Com, and Mitel NetworksCorp., although the market for these products is fragmented. Our AGS segmentcompetes with companies like those above offering services with respect totheir own product offerings, as well as many consulting and systems integrationfirms and network service providers.

In addition, because the market for our products issubject to rapid technological change, as the market evolves we may facecompetition in the future from companies that do not currently compete in theenterprise communications market, including companies that currently compete inother sectors of the information technology, communications and softwareindustries or communications companies that serve residential rather thanenterprise customers. In particular, as the convergence of enterprise voice anddata networks becomes more widely deployed by enterprises, the business,information technology and communication applications deployed on convergednetworks become more integrated. We may face increased competition from currentleaders in information technology infrastructure, information technology,personal and business applications and the software that connects the networkinfrastructure 

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to those applications,such as the alliance entered into between Microsoft Corp. and Nortel. We mayalso face competition from companies that seek to sell remotely hosted servicesor software as a service directly to the end customer. Competition from thesepotential market entrants may take many forms, including offering products andapplications similar to those we offer as part of another offering. Inaddition, these technologies continue to move from a proprietary environment toan open standards-based environment.

Several of these existing competitors have, and manyof our future competitors may have, greater financial, personnel, research andother resources, more well-established brands or reputations and broadercustomer bases than we and, as a result, these competitors may be in a strongerposition to respond quickly to potential acquisitions and other marketopportunities, new or emerging technologies and changes in customerrequirements. Some of these competitors may have customer bases that are moregeographically balanced than ours and, therefore, may be less affected by aneconomic downturn in a particular region. Competitors with greater resourcesalso may be able to offer lower prices, additional products or services orother incentives that we cannot match or do not offer. Industry consolidationssuch as the merger between Alcatel and Lucent Technologies Inc. may also createcompetitors with broader and more geographic coverage, with the ability toreach enterprises through service provider customers.

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

**Our revenues are dependent on general economicconditions and the willingness of enterprises to make capital investments.**

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

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

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***Risks Related To Our Operations***

**We rely onoutsourced product manufacturers, distributors and warehousing agents for ourproducts and various issues with respect to the delivery of our products couldarise which could adversely impact both our revenue and our costs.**

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

As we continue to seek to optimize our end-to-endsupply chain, we have been outsourcing various logistics functions over thecourse of the past few years. We rely on third-party logistics serviceproviders to provide services for our business, including warehousing andphysical distribution. If a logistics service provider does not meet ourservice level and quality requirements for any reason, we may be unable tofulfill our customers’ orders in a timely and accurate manner, which coulddelay or decrease our revenue or otherwise have an adverse effect on ourrevenue and our costs. In the fourth quarter of fiscal 2006 and first quarterof fiscal 2007, we moved certain warehousing and physical distributionoperations to a different third party logistics service provider at a newfacility, which now services a significant portion of our warehousing andphysical distribution needs. There were disruptions and delays in delivery ofcertain products from this facility in the first quarter of fiscal 2007. Additionally,there was an adverse impact on our costs throughout the first half of fiscal2007. We and our logistics service provider continue to work jointly in orderto promote stability in the warehousing operations and we have been makingimprovements as we progress through this transition, however, we cannot assureyou that this issue will not continue to have an adverse effect on our revenueand increase our costs.

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

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

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

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

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

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

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**The failure tomaintain adequate security over our information systems could adversely affectour operating results.**

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

**Asour international business has grown significantly in the last two fiscalyears, changes in economic or political conditions in a specific country orregion could negatively affect our revenue, costs, expenses and financialcondition.**

We conduct significantsales and customer support operations in countries outside of the United Statesand also depend on non-U.S. operations of our contract manufacturers and ourdistribution partners. For the first six months of fiscal 2007 and 2006, wederived 43% and 42% of our revenue, respectively, from sales outside the UnitedStates. Our future international operating results, including our ability toimport our products to, export our products from, or sell our products invarious countries, could be materially adversely affected by a variety ofuncontrollable and changing factors. These factors include politicalconditions, economic conditions, legal and regulatory constraints, currencyregulations, health or similar issues, natural disasters and other matters inany of the countries or regions in which we currently operate or intend tooperate in the future. Currently, we have concerns about weakness anduncertainty in European economies, including high unemployment levels and loweconomic growth forecasts, particularly in Germany where we have a highconcentration of our business.

Other factors which mayimpact our international operations include foreign trade, environmental,monetary and fiscal policies, laws, regulations and other activities of foreigngovernments, agencies and similar organizations, and risks associated withhaving facilities located in countries which have historically been less stablethan the United States. For example, the EU has enacted the RoHS and WEEEdirectives, which are discussed in Item 2. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Key Trends andUncertainties Affecting Our Results—Manufacturing and Logistics.”

Additional risks inherentin our international operations generally include, among others, the costs anddifficulties of managing international operations, adverse tax consequences,including imposition of withholding or other taxes on payments by subsidiaries,and greater difficulty in enforcing intellectual property rights. Our effectivetax rates in the future could be adversely affected if the geographicaldistribution of our earnings and losses is unfavorable, by changes in thevaluation of our deferred tax assets or liabilities, or by changes in tax laws,regulations, accounting principles, or interpretations thereof. The variousrisks inherent in doing business in the United States generally also exist whendoing business outside of the United States, and may be exaggerated by thedifficulty of doing business in numerous sovereign jurisdictions due todifferences in culture, laws and regulations.

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**Fluctuationsin foreign currency exchange rates could negatively impact our operatingresults.**

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

***Risks Related toContingent Liabilities***

**We mayincur liabilities as a result of our obligation to indemnify, and to sharecertain liabilities with, Lucent in connection with our spin-off from Lucent inSeptember 2000.**

Pursuant to theContribution and Distribution Agreement, Lucent contributed to us substantiallyall of the assets, liabilities and operations associated with its enterprisenetworking businesses and distributed all of the outstanding shares of ourcommon stock to its stockholders. The Contribution and Distribution Agreement,among other things, provides that, in general, we will indemnify Lucent for allliabilities including certain pre-distribution tax obligations of Lucentrelating to our businesses and all contingent liabilities primarily relating toour businesses or otherwise assigned to us. In addition, the Contribution andDistribution Agreement provides that certain contingent liabilities notdirectly identifiable with one of the parties will be shared in the proportionof 90% by Lucent and 10% by us. The Contribution and Distribution Agreementalso provides that contingent liabilities in excess of $50 million thatare primarily related to Lucent’s businesses shall be borne 90% by Lucent and10% by us and contingent liabilities in excess of $50 million that areprimarily related to our businesses shall be borne equally by the parties.

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

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

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

From time to time, wereceive notices from third parties asserting that our proprietary or licensedproducts, systems and software infringe their intellectual property rights. Wecannot assure you that the number of these notices will not increase in thefuture and that others will not claim that our proprietary or licensedproducts, systems and software are infringing their intellectual propertyrights 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 someof our technology. Irrespective of the merits of these claims, if someoneclaimed that our proprietary or licensed systems and software infringed theirintellectual property rights, any resulting litigation could be costly and timeconsuming and would divert the attention of management and key 

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personnelfrom other business issues. The complexity of the technology involved and theuncertainty of intellectual property litigation increase these risks. Thesematters may result in any number of outcomes for us, including entering intolicensing agreements, redesigning our products to avoid infringement, beingenjoined from selling products that are found to infringe, paying damages ifproducts are found to infringe, and indemnifying customers from claims as partof our contractual obligations. Royalty or license agreements may be verycostly or we may be unable to obtain royalty or license agreements on termsacceptable to us or at all. We also may be subject to significant damages or aninjunction against us or our proprietary or licensed systems. A successfulclaim of patent or other intellectual property infringement against us couldmaterially adversely affect our operating results. We have made and will likelycontinue to make investments to license and/or acquire the use of third partyintellectual property rights and technology as part of our strategy to managethis risk, but we cannot assure you that we will be successful. We may also besubject to additional notice and other requirements to the extent weincorporate open source software into our applications.

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

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

Lucent has received aprivate letter ruling from the Internal Revenue Service stating, based oncertain assumptions and representations, that the distribution would not betaxable to Lucent. Nevertheless, Lucent could incur a significant tax liabilityif the distribution did not qualify for tax-free treatment because any of thoseassumptions or representations were not correct.

We could be liable for allor a portion of any taxes owed for the following reasons. First, as part of thedistribution, we and Lucent entered into the Tax Sharing Agreement, whichgenerally allocates between Lucent and us the taxes and liabilities relating tothe failure of the distribution to be tax-free. Under the Tax SharingAgreement, if the distribution fails to qualify as a tax-free distributionbecause of an issuance or an acquisition of our stock or an acquisition of ourassets, or some other actions of ours, then we will be solely liable for anyresulting taxes to Lucent.

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

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

***(c) Issuer Purchasesof Equity Securities.***
|                               | ** ** | ** **            | ** ** | ** **          | ** ** | ** **                    | ** ** | **Approximate**                        | ** ** |
|-------------------------------|------------|-----------------------|------------|---------------------|------------|-------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | ** **            | ** ** | ** **          | ** ** | **Total number**         | ** ** | **dollar value of**          | ** ** |
| ** **                    | ** ** | **Total number** | ** ** | **Average**         | ** ** | **of shares**            | ** ** | **shares that may**          | ** ** |
| ** **                    | ** ** | **of shares**    | ** ** | **price paid** | ** ** | **purchased as**         | ** ** | **yet be purchased as** | ** ** |
| **Period**                    | ** ** | **purchased**         | ** ** | **per share**  | ** ** | **part of program** | ** ** | **part of program**          | ** ** |
| January 1–31             |       |                  | 2,791,600  |                |       |                          | $          | 12.96                                  |       |   |   | 44,226,000 |   |   |   | $ | 28,754,616 |   |   |
| February 1–28            |       |                  | 2,325,779  |                |       |                          | $          | 12.97                                  |       |   |   | 46,551,779 |   |   |   | $ | 498,594,905 |   |   |
| March 1–31               |       |                  | 2,187,400  |                |       |                          | $          | 12.46                                  |       |   |   | 48,739,179 |   |   |   | $ | 471,339,650 |   |   |
| Second quarter of fiscal 2007 |       |                  | 7,304,779  |                |       |                          |       |                                   |       |   |   |   |   |   |   |   |   |

 

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On April 19, 2005, the Board ofDirectors authorized a share repurchase plan (the “2005 plan”). Under theprovisions of the 2005 plan, Avaya was authorized to use up to $500 millionof cash to repurchase shares of its outstanding common stock through April 2007.During February 2007, Avaya completed the 2005 plan.

On February 15, 2007, the Board ofDirectors authorized another share repurchase plan (the “2007 plan”), underwhich Avaya may use up to $500 million of cash for repurchases of itsoutstanding shares through February 2009. Approximately $471 millionis available through February 2009 for further share repurchases under the2007 plan.

All repurchases are made at management’sdiscretion in the open market or in privately negotiated transactions in compliancewith applicable securities laws and other legal requirements and are subject tomarket conditions, share price, the terms of Avaya’s credit facility and otherfactors.

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

None.

**Item4. *Submission of Matters to a Vote of Security Holders*.**

Avayaheld its Annual Meeting of Shareholders on February 15, 2007. At thatmeeting, shareholders elected/re-elected each of Mr. Landy, Mr. Leslie,Dr. Stanzione and Mr. Terracciano as Class 3 Directors of theCompany for a term to expire at the 2010 Annual Meeting. The results of thevoting are as follows:
|                        | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|------------------------|------------|--------------------|------------|-------------------------|------------|
| Joseph P. Landy        |       | 375,496,716        |       |                    | 26,199,411 |   |   |
| Mark Leslie            |       | 376,641,332        |       |                    | 25,054,795 |   |   |
| Daniel C. Stanzione    |       | 372,498,019        |       |                    | 29,198,108 |   |   |
| Anthony P. Terracciano |       | 392,326,973        |       |                    | 9,369,154  |   |   |

 

The following Directorsalso have terms in office that continue after the 2007 Annual Meeting: PhilipA. Odeen (Non-Executive Chairman), Bruce R. Bond, Louis J. D’Ambrosio(President and Chief Executive Officer), Frank J. Fanzilli, Hellene S. Runtagh,Paula Stern, Michael C. Thurk (Chief Operating Officer), Richard F. Wallman andRonald L. Zarrella.

Inaddition, at the 2007 Annual Meeting, (i) a proposal to ratify theselection of PricewaterhouseCoopers LLP as Avaya’s independent auditor forfiscal 2007 was approved, (ii) a proposal to amend the Avaya Inc. 2004Long Term Incentive Plan was approved and (iii) a shareholder proposalrelating to executive compensation was defeated. The results of the voting are as follows:
|                                                                                                                                                                        | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstained** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|---------------|------------|
| Directors’ Proposal—Ratification  of the Selection of  PricewaterhouseCoopers LLP as Independent Auditors for fiscal 2007      |       | 394,987,573        |       | 3,017,223              |       | 3,691,325     |       |

 
|                                                                                                           | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstained** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|---------------|------------|
| Directors’ Proposal—Approval  of Amendment to the Avaya Inc. 2004 Long Term Incentive Plan |       | 265,721,388        |       | 78,349,777             |       | 4,172,240     |       |

 
|                                                   | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstained** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|------------------------|------------|---------------|------------|
| Shareholder Proposal—Executive  Compensation |       | 109,669,959        |       | 232,574,573            |       | 5,998,876     |       |

 

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

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

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**Item6. *Exhibits*.**
| Exhibit | ** ** | **Number**                                                                                                                                               | ** ** | ** ** |
|---------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| 3.1     |       | Restated Certificate of Incorporation of Avaya Inc.(1)                                                                                              |
| 3.2     |       | Amended and Restated By-laws of Avaya Inc., as  amended on July 18, 2002.(2)                                                                        |
| 10.1    |       | Avaya Inc. 2004 Long Term Incentive Plan, as  amended on May 3, 2007.*                                                                         |
| 10.2    |       | Summary of the Avaya Inc. Non-Employee Director  Compensation Program (as of February 2007).*                                                  |
| 31.1    |       | Certification of Principal Executive Officer  Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended.* |
| 31.1    |       | Certification of Principal Financial Officer  Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of  the Securities Exchange Act, as amended.* |
| 32.1    |       | Certification of Principal Executive Officer  pursuant to18 U.S.C. Section 1350.*                                                              |
| 32.2    |       | Certification of Principal Financial Officer  pursuant to 18 U.S.C. Section 1350.*                                                             |

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*                    Filedherewith.

(1)          Incorporated byreference from Exhibit 3.1 to Amendment No. 1 to Avaya’s RegistrationStatement on Form 10 (Reg. No. 1-15951).

(2)          Incorporated byreference from Exhibit 3.1 to Avaya’s Quarterly Report on Form 10-Qfor the quarter ended June 30, 2002.

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**SIGNATURES**

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

|                  | **AVAYA INC.** |
|------------------|----------------|
|             | By:            | /s/ AMARNATH K. PAI** |
|             |           | Amarnath K. Pai |
|             |           | *Vice President Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| May 8, 2007 |           |   |   |   |
|                  |                |  |  |  |

 

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