**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 December 31, 2006**

**or**

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

 

**For the transition periodfrom                   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 telephone number, including area code)

 

**None**

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

** **

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

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

| Large accelerated  filer x |   | Accelerated  filer o |   | Non-accelerated  filer o |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

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

As of January 31, 2007, 453,336,561  shares of Common Stock,$.01 par value of Avaya 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 |       |   | 25 |   |   |
|   | 3.         |            |       | Quantitative and Qualitative Disclosures About Market  Risk                                 |       |   | 45 |   |   |
|   | 4.         |            |       | Controls and Procedures                                                                     |       |   | 45 |   |   |
|   | ** ** |            |       | **PART II—OTHER INFORMATION**                                                     |       |   |   |   |   |
|   | 1.         |            |       | Legal  Proceedings                                                                          |       |   | 46 |   |   |
|   | 1A.        |            | * *   | Risk  Factors                                                                               |       |   | 46 |   |   |
|   | 2.         |            | * *   | Unregistered Sales of Equity Securities and Use of  Proceeds                                |       |   | 55 |   |   |
|   | 3.         |            |       | Defaults Upon Senior Securities                                                             |       |   | 55 |   |   |
|   | 4.         |            |       | Submission of Matters to a Vote of Security Holders                                         |       |   | 55 |   |   |
|   | 5.         |            |       | Other  Information                                                                          |       |   | 55 |   |   |
|   | 6.         |            |       | Exhibits                                                                                    |       |   | 55 |   |   |
|   |       |            |       | Signatures                                                                                  |       |   | 56 |   |   |

 

This Quarterly Report on Form 10-Q contains trademarks,service marks and registered marks of Avaya Inc. and its subsidiaries and othercompanies, as indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q,trademarks identified by ® and TM areregistered trademarks or trademarks, respectively, of Avaya Inc. or itssubsidiaries. All other trademarks are the properties of their respectiveowners.

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**PART I  FINANCIALINFORMATION**

**Item1.**                        *Financial Statements.*

**AVAYA INC.CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**
|                                                                                 | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                      | ** ** | **December 31,**            | ** ** |
| **Dollars in millions, except per share amounts** | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| REVENUE                                                                         |       |                             |       |   |   |
| Sales of products                                                               |       | $                                | 619        |   | $ | 591 |   |
| Services                                                                        |       | 509                              |       | 504 |   |
| Rental and managed services                                                     |       | 152                              |       | 154 |   |
|                                                                            |       | 1,280                            |       | 1,249 |   |
| COSTS                                                                           |       |                             |       |   |   |
| Sales of products                                                               |       | 289                              |       | 277 |   |
| Services                                                                        |       | 324                              |       | 322 |   |
| Rental and managed services                                                     |       | 68                               |       | 61 |   |
|                                                                            |       | 681                              |       | 660 |   |
| GROSS MARGIN                                                                    |       | 599                              |       | 589 |   |
| OPERATING  EXPENSES                                                             |       |                             |       |   |   |
| Selling, general and administrative                                             |       | 389                              |       | 385 |   |
| Research and development                                                        |       | 114                              |       | 97 |   |
| Restructuring charges, net                                                      |       | 6                                |       | — |   |
| TOTAL OPERATING EXPENSES                                                        |       | 509                              |       | 482 |   |
| OPERATING INCOME                                                                |       | 90                               |       | 107 |   |
| Other income, net                                                               |       | 6                                |       | 5 |   |
| Interest expense                                                                |       | —                           |       | (1 | ) |
| INCOME BEFORE INCOME TAXES                                                      |       | 96                               |       | 111 |   |
| Provision for  income taxes                                                     |       | 25                               |       | 40 |   |
| **NET INCOME**                                                                  | ** ** | **$**                            | **71**     | ** ** | **$** | **71** | ** ** |
| **Earnings Per Common Share - Basic**                                           | ** ** | **$**                            | **0.16**   | ** ** | **$** | **0.15** | ** ** |
| **Earnings  Per Common Share - Diluted**                                        | ** ** | **$**                            | **0.15**   | ** ** | **$** | **0.15** | ** ** |

 

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

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**AVAYA INC.CONSOLIDATED BALANCE SHEETS (UNAUDITED)**
| Dollars in millions, except per share amounts                                                                                                                                                          | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                           | ** ** |                        | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                                                                      |       |                        |       |                         |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                            |       |                        | $          | 895                          |       |   |   | $ | 899 |   |   |
| Accounts receivable, less allowances of $55 million  and $57 million as of December 31, 2006 and September 30, 2006,  respectively                                                                                         |       |                        | 854        |                         |       |   | 871 |   |   |
| Inventory                                                                                                                                                                                                                            |       |                        | 293        |                         |       |   | 285 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                           |       |                        | 148        |                         |       |   | 153 |   |   |
| Other current assets                                                                                                                                                                                                                 |       |                        | 175        |                         |       |   | 151 |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                                                |       |                        | 2,365      |                         |       |   | 2,359 |   |   |
| Property, plant and equipment, net                                                                                                                                                                                                   |       |                        | 656        |                         |       |   | 668 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                           |       |                        | 776        |                         |       |   | 787 |   |   |
| Intangible assets                                                                                                                                                                                                                    |       |                        | 262        |                         |       |   | 263 |   |   |
| Goodwill                                                                                                                                                                                                                             |       |                        | 975        |                         |       |   | 941 |   |   |
| Other assets                                                                                                                                                                                                                         |       |                        | 192        |                         |       |   | 182 |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                                    | ** ** |                        | **$**      | **5,226**                    | ** ** |   |   | **$** | **5,200** | ** ** |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                       | ** ** |                        | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Current liabilities:                                                                                                                                                                                                                 |       |                        |       |                         |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                     |       |                        | $          | 371                          |       |   |   | $ | 418 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                                      |       |                        | 298        |                         |       |   | 377 |   |   |
| Deferred revenue                                                                                                                                                                                                                     |       |                        | 281        |                         |       |   | 286 |   |   |
| Business restructuring reserve                                                                                                                                                                                                       |       |                        | 98         |                         |       |   | 86 |   |   |
| Other current liabilities                                                                                                                                                                                                            |       |                        | 248        |                         |       |   | 249 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                           |       |                        | 1,296      |                         |       |   | 1,416 |   |   |
| Benefit obligations                                                                                                                                                                                                                  |       |                        | 1,351      |                         |       |   | 1,321 |   |   |
| Deferred income taxes, net                                                                                                                                                                                                           |       |                        | 75         |                         |       |   | 77 |   |   |
| Other liabilities                                                                                                                                                                                                                    |       |                        | 262        |                         |       |   | 300 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                                       |       |                        | 1,688      |                         |       |   | 1,698 |   |   |
| 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, 455,509,808 and 452,203,778 issued (including 562,341 and  461,429 treasury shares) as of December 31, 2006 and September 30,  2006, respectively |       |                        | 5          |                         |       |   | 5 |   |   |
| Additional paid-in-capital                                                                                                                                                                                                           |       |                        | 2,671      |                         |       |   | 2,637 |   |   |
| Retained earnings                                                                                                                                                                                                                    |       |                        | 219        |                         |       |   | 148 |   |   |
| Accumulated other comprehensive loss                                                                                                                                                                                                 |       |                        | (646       | )                            |       |   | (698 | ) |   |
| Less: Treasury stock at cost                                                                                                                                                                                                         |       |                        | (7         | )                            |       |   | (6 | ) |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                     |       |                        | 2,242      |                         |       |   | 2,086 |   |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                 | ** ** |                        | **$**      | **5,226**                    | ** ** |   |   | **$** | **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)**
|                                                                                      | ** ** | **Three months ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                           | ** ** | **December 31,**            | ** ** |
| **Dollars in millions**                                                    | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **OPERATING ACTIVITIES:**                                                            |       |                             |       |   |   |
| Net income                                                                           |       | $                                | 71         |   | $ | 71 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:   |       |                             |       |   |   |
| Depreciation and amortization                                                        |       | 68                               |       | 68 |   |
| Share-based compensation                                                             |       | 8                                |       | 8 |   |
| Deferred taxes                                                                       |       | 15                               |       | 24 |   |
| Gain resulting from sale of real estate                                              |       | (7                               | )          | (1 | ) |
| Restructuring charges, net                                                           |       | 6                                |       | — |   |
| Unrealized losses (gains) on foreign currency  exchange                              |       | 16                               |       | (9 | ) |
| Adjustments for other non-cash items, net                                            |       | 3                                |       | 4 |   |
| Changes in  operating assets and liabilities, net of effects of acquired businesses: |       |                             |       |   |   |
| Accounts receivable                                                                  |       | 20                               |       | 44 |   |
| Inventory                                                                            |       | (5                               | )          | 3 |   |
| Accounts payable                                                                     |       | (49                              | )          | (21 | ) |
| Payroll and benefits                                                                 |       | (70                              | )          | (31 | ) |
| Business restructuring reserve                                                       |       | (23                              | )          | (20 | ) |
| Deferred revenue                                                                     |       | (4                               | )          | (10 | ) |
| Other assets and liabilities                                                         |       | (32                              | )          | (24 | ) |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES                                           |       | 17                               |       | 106 |   |
| **INVESTING  ACTIVITIES:**                                                           |       |                             |       |   |   |
| Capital expenditures                                                                 |       | (20                              | )          | (26 | ) |
| Capitalized software development costs                                               |       | (19                              | )          | (18 | ) |
| Acquisition of business, net of cash acquired                                        |       | (15                              | )          | — |   |
| Proceeds from sale of real estate                                                    |       | 7                                |       | 1 |   |
| Other investing activities, net                                                      |       | (6                               | )          | 1 |   |
| NET CASH (USED  FOR) INVESTING ACTIVITIES                                            |       | (53                              | )          | (42 | ) |
| **FINANCING  ACTIVITIES:**                                                           | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Issuance of common stock                                                             |       | 20                               |       | 6 |   |
| Repurchase of common stock                                                           |       | —                           |       | (90 | ) |
| NET CASH PROVIDED  BY (USED FOR) FINANCING ACTIVITIES                                |       | 20                               |       | (84 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                        |       | 12                               |       | (4 | ) |
| NET (DECREASE) IN  CASH AND CASH EQUIVALENTS                                         |       | (4                               | )          | (24 | ) |
| Cash and cash  equivalents at beginning of fiscal year                               |       | 899                              |       | 750 |   |
| Cash and cash  equivalents at end of period                                          |       | $                                | 895        |   | $ | 726 |   |

T

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

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**AVAYA INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

**1.**                 Background andBasis 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 of Presentation***

The accompanying unaudited interim ConsolidatedFinancial Statements as of December 31, 2006 and for the three monthsended December 31, 2006 and 2005, havebeen prepared in accordance with accounting principles generally accepted inthe United States of America for interim financial statements and the rules andregulations of the U.S. Securities and Exchange Commission, or 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 filed with theSEC 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. The consolidated results of operations for theinterim periods reported are not necessarily indicative of the results to beexperienced for the entire fiscal year.

**2.**                 RecentAccounting Pronouncements

**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 and 132(R)” (“SFAS 158”). SFAS 158 improves reporting of obligationsfor pensions and other post-retirement benefits by recognizing the over-fundedor under-funded status of plans as an asset or liability. The pronouncementdoes not change how plan assets and benefit obligations are measured under FAS87 and FAS 106 nor does it change the approach for measuring annual benefitcost reported in earnings. Instead, it eliminates the provisions that permitplan assets and obligations to be measured as of a date not more than threemonths prior 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 othercomprehensive income (loss). The Company will adopt the provisions of SFAS 158by 

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the endof fiscal 2007 and estimates an increase in the liability for benefitobligations recognized on the Consolidated Balance Sheets of approximately $200 million(pre-tax) with an addition to accumulated other comprehensive loss. This amountis an estimate and is subject to change pending the funded status of the plansas of the measurement date. The Company is assessing the potential impact thatadoption of SFAS 158 may have on the Company’s postemployment liabilitiesestablished under SFAS No. 112, “Employers’ Accounting for PostemploymentBenefits.”

**SFAS 157**

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS157 defines fair value and establishes a framework for measuring fair valueunder U.S. GAAP. The pronouncement describes fair value as being based on ahypothetical transaction to sell an asset or transfer a liability at a specificmeasurement date, as considered from the perspective of a market participantwho holds the asset or owes the liability. In addition, fair value should beviewed as a market-based measurement, not an entity-specific measurement. Thereforefair value should be determined based on the assumptions that marketparticipants would use in pricing an asset or liability, including all risksassociated with that asset or liability. SFAS 157 will be effective for theCompany beginning in fiscal 2009. The adoption of SFAS 157 is not expected tohave a material impact on the Company’s Consolidated Financial 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 108 providesinterpretive guidance on how the effects of the carryover or reversal of prioryear 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 adopted the provisions of SAB 108 beginning in October 2006.The adoption of SAB 108 did not impact the Company’s Consolidated FinancialStatements.

**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 48 clarifiesthe accounting for uncertainty in tax positions and requires that companiesrecognize in their financial statements the impact of a tax position if it ismore likely than not that the position would be sustained on audit, based onthe technical merits of the position. The Company will be required to adopt theprovisions of FIN 48 beginning in fiscal 2008, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings as well as requiring additional disclosures. The Company iscurrently assessing the impact of the adoption of FIN 48 on its ConsolidatedFinancial Statements.

**3.**                 BusinessCombinations and Other Transactions

***Acquisition of Traverse***

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 $4million in other assets and recorded $8 million of goodwill as part of thepreliminary purchase price allocation. Management is responsible for estimatingthe fair value of the assets and liabilities acquired. Management has madeestimates and assumptions that could affect the reported 

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amountsof assets, liabilities and expenses resulting from this acquisition. Actualamounts could differ from these amounts. The purchase price for this acquisitionis not considered to be material to the Consolidated Financial Statements and,therefore, disclosure of pro forma financial information has not been presented.Results from Traverse are included in the Company’s Consolidated FinancialStatements beginning on November 9, 2006.

***Tender Offer to Acquire Ubiquity***

On January 12, 2007, theCompany announced that Avaya International Enterprises Limited, awholly-owned subsidiary of the Company, commenced a tender offer toacquire Ubiquity Software Corporation plc (“Ubiquity”). Ubiquity is publiclytraded on the Alternative Investment Market of the London Stock Exchange and isheadquartered in the United Kingdom with operations in Canada and the U.S. Ubiquitydevelops and markets SIP-based communications software. The tender offer price is37.3 pence in cash for each Ubiquity share. Based on the tender offer price pershare, the estimated aggregate purchase price is approximately $144 millionafter adjusting for theassumed proceeds from the exercise of options for Ubiquity shares (calculatedusing an assumed exchange rate).The purchase of Ubiquity is expected to be funded with existing cash resources.The tender offer is subject to a number of customary terms andconditions. The Company expects to close this transaction in the second quarterof fiscal 2007.

**4.**                 Goodwilland Intangible Assets

Thechanges in the carrying value of goodwill for the first quarter of fiscal 2007by operating segment are as follows:

| ** **                                 | ** ** | **Global**         | ** ** | **Avaya**     | ** ** | ** **   | ** ** |
|--------------------------------------------|------------|--------------------|------------|---------------|------------|--------------|------------|
| ** **                                 | ** ** | **Communications** | ** ** | **Global**    | ** ** | ** **   | ** ** |
| **Dollars in millions**          | ** ** | ** **         | ** ** | **Solutions** | ** ** | **Services** | ** ** | **Total** | ** ** |
| **Balance  as of September 30, 2006** | ** ** |               | **$**      | **658**       | ** ** |         |       | **$** | **283** | ** ** |   | **$** | **941** | ** ** |
| Acquisition of Traverse Networks           |       |               | 8          | ** **    |       |         | —     | ** ** |   | 8 |   |
| Impact of foreign currency fluctuations    |       |               | 19         | ** **    |       |         | 7          | ** ** |   | 26 |   |
| **Balance as of December 31,  2006**  | ** ** |               | **$**      | **685**       | ** ** |         |       | **$** | **290** | ** ** |   | **$** | **975** | ** ** |
|                                            |            |                    |            |               |            |              |            |  |  |  |  |  |  |  |  |  |

 

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

| ** **                                    | ** ** | **December 31, 2006** | ** ** | **September 30, 2006** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **Gross**                       | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**                    | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| **Dollars in millions**             | ** ** | ** **                      | ** ** | **Amount**                       | ** ** | **Amortization** | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| Existing  technology                          |       |                            | $          | 108                              |       |   |   | $ | 61 |   |   | $ | 47 |   |   | $ | 103 |   |   |   | $ | 57 |   |   | $ | 46 |   |
| Customer  relationships and other intangibles |       |                            | 306        |                             |       |   | 110 |   |   | 196 |   |   | 292 |   |   |   | 94 |   |   | 198 |   |
| **Total  amortizable intangible assets**      | ** ** | ** **                      | **$**      | **414**                          |       | ** ** | ** ** | **$** | **171** |   | ** ** | **$** | **243** | ** ** | ** ** | **$** | **395** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **244** | ** ** |
| Minimum pension  adjustment                   |       |                            | 19         |                             |       |   | — |   |   | 19 |   |   | 19 |   |   |   | — |   |   | 19 |   |
| **Total intangible assets**                   | ** ** | ** **                      | **$**      | **433**                          |       | ** ** | ** ** | **$** | **171** |   | ** ** | **$** | **262** | ** ** | ** ** | **$** | **414** |   | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **263** | ** ** |
|                                               |            |                                 |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the first quarter of fiscal 2007, amortization,partially offset by the impact of foreign currency fluctuations and theacquisition of Traverse, resulted in a net decrease of $1 million in thenet intangible assets balance. The weighted average useful lives of theexisting technology and customer relationships and other intangibles areapproximately five years and seven years, respectively.

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Amortizationexpense for the Company’s acquired intangible assets was $15 million and$16 million for the first quarters of fiscal 2007 and 2006, respectively. Estimatedfuture amortization expense is shown in the following table:

| ** **                        | ** ** | **Estimated future** | ** ** |
|-----------------------------------|------------|---------------------------|------------|
| **Dollars in millions** | ** ** | ** **                | ** ** | **amortization expense** | ** ** |
| Remainder of fiscal 2007          |       |                      | $          | 48 |   |   |
| 2008                              |       |                      | 63         |   |   |
| 2009                              |       |                      | 62         |   |   |
| 2010                              |       |                      | 48         |   |   |
| 2011                              |       |                      | 9          |   |   |
| 2012 and thereafter               |       |                      | 13         |   |   |
| **Total**                         | ** ** | ** **                | **$**      | **243** |   |   |
|                                   |            |                           |            |  |  |  |  |  |

 

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 minimum pensionliability is reassessed, which is conducted on an annual basis.

**5.**                 SupplementaryFinancial Information

***Statements ofIncome Information***

| ** **                                                              | ** ** | **Three months  ended  December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Dollars in millions**                                       | ** ** | ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **OTHER INCOME, NET:**                                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Interest income                                                         |       | $                                               | 11         |   | $ | 7 |   |
| Loss on foreign currency transactions                                   |       | (3                                              | )          | (1 | ) |
| Other, net                                                              |       | (2                                              | )          | (1 | ) |
| **Total  other income, net**                                            | ** ** | **$**                                           | **6**      | ** ** | **$** | **5** | ** ** |
| **COMPREHENSIVE  INCOME:**                                              | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Net income                                                              |       | $                                               | 71         |   | $ | 71 |   |
| Other  comprehensive income:                                            |       |                                            |       |   |   |
| Cumulative translation adjustment                                       |       | 51                                              |       | (23 | ) |
| Unrealized holding loss on securities classified as  available for sale |       | 1                                               |       | 1 |   |
| **Total comprehensive income**                                          | ** ** | **$**                                           | **123**    | ** ** | **$** | **49** | ** ** |
|                                                                         |            |                                                 |            |  |  |  |  |  |  |

 

9

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***Balance SheetInformation***

| **Dollars in millions**                | ** ** | ** ** | ** ** | **December 31, 2006** | ** ** | **September 30, 2006** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------------------|------------|----------------------------------|------------|
| **INVENTORY:**                                   | ** ** |       | ** ** | ** **                      |       |                             | ** ** | ** ** |   |
| Finished goods                                   |       |       | $          | 290                             |       |                             |       | $ | 281 |   |   |
| Raw materials                                    |       |       | 3          |                            |       |                             | 4          |   |   |
| **Total  inventory**                             | ** ** |       | **$**      | **293**                         | ** ** |                             |       | **$** | **285** | ** ** |   |
| **PROPERTY,  PLANT AND EQUIPMENT, NET:**         | ** ** |       | ** ** | ** **                      |       |                             | ** ** | ** ** |   |
| Land and improvements                            |       |       | $          | 58                              |       |                             |       | $ | 56 |   |   |
| Buildings and improvements                       |       |       | 469        |                            |       |                             | 460        |   |   |
| Machinery and equipment                          |       |       | 670        |                            |       |                             | 654        |   |   |
| Rental equipment                                 |       |       | 236        |                            |       |                             | 230        |   |   |
| Assets under construction                        |       |       | 4          |                            |       |                             | 8          |   |   |
| Internal use software                            |       |       | 232        |                            |       |                             | 226        |   |   |
| Total property,  plant and equipment             |       |       | 1,669      |                            |       |                             | 1,634      |   |   |
| Less: Accumulated  depreciation and amortization |       |       | (1,013     | )                               |       |                             | (966       | ) |   |
| **Property, plant and equipment,  net**          | ** ** |       | **$**      | **656**                         | ** ** |                             |       | **$** | **668** | ** ** |   |

 

**6.**                 RestructuringPrograms

The restructuring chargerecorded in the first quarter of fiscal 2007 is primarily composed of employeeseparation charges related to our Europe, Middle East and Africa (“EMEA”)operations, in addition to lease obligations. These charges were partiallyoffset by a net benefit due to changes in estimates for prior restructuringplans primarily related to leased facilities.

***Fiscal 2007 Restructuring Plan***

Thisreserve reflects the initiation of restructuring actions during the firstquarter of fiscal 2007. The following table summarizes the components of thisreserve during the first quarter of fiscal 2007:

| ** **                                | ** ** | **Employee**   | ** ** | ** ** | ** ** | ** **      | ** ** |
|-------------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|
| ** **                                | ** ** | **Separation** | ** ** | **Lease**  | ** ** | ** **      | ** ** |
| **Dollars in millions**         | ** ** | ** **     | ** ** | **Costs**  | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2006    |       |           | $          | —     |       |            |       | $ | — |   |   |   | $ | — |   |   |
| Charges                                   |       |           | 8          |       |       |            | 4          |   |   |   | 12 |   |   |
| **Balance as of December 31,  2006** | ** ** | ** **     | **$**      | **8**      |       | ** **      | ** ** | **$** | **4** |   | ** ** | ** ** | **$** | **12** |   |   |
|                                           |            |                |            |            |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

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 lease obligationsrelate to future rent payments, net of estimated sublease income, for unusedspace in connection with the closing or consolidation of office facilities.

10

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***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 first quarter of fiscal 2007:

| ** **                                | ** ** | **Employee**   | ** ** | ** ** | ** ** | ** **      | ** ** |
|-------------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|
| ** **                                | ** ** | **Separation** | ** ** | **Lease**  | ** ** | ** **      | ** ** |
| **Dollars in millions**         | ** ** | ** **     | ** ** | **Costs**  | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2006    |       |           | $          | 70         |       |            |       | $ | 17 |   |   | $ | 87 |   |
| Reversals                                 |       |           | —     |       |       |            | (7         | ) |   | (7 | ) |
| Cash payments                             |       |           | (16        | )          |       |            | (1         | ) |   | (17 | ) |
| Impact of foreign currency fluctuations   |       |           | 1          |       |       |            | —     |   |   | 1 |   |
| **Balance as of December 31,  2006** | ** ** | ** **     | **$**      | **55**     |       | ** **      | ** ** | **$** | **9** |   | ** ** | **$** | **64** | ** ** |
|                                           |            |                |            |            |            |                 |            |  |  |  |  |  |  |  |  |  |

 

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 lease obligationsrelate to future rent payments, net of estimated sublease income, for unusedspace in connection with the closing or consolidation of international office facilities,primarily located in the United Kingdom. During the three months ended December 31,2006, the Company concluded lease renegotiations, resulting in a change ofassumptions and a $7 million reversal of the initial liability.

***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 followingsummarizes the components of this restructuring reserve during the firstquarter of fiscal 2007:

| ** **                                | ** ** | **Employee**   | ** ** | ** ** | ** ** | ** **      | ** ** |
|-------------------------------------------|------------|----------------|------------|------------|------------|-----------------|------------|
| ** **                                | ** ** | **Separation** | ** ** | **Lease**  | ** ** | ** **      | ** ** |
| **Dollars in millions**         | ** ** | ** **     | ** ** | **Costs**  | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2006    |       |           | $          | 1          |       |            |       | $ | 22 |   |   |   | $ | 23 |   |   |
| Charges                                   |       |           | 1          |       |       |            | —     |   |   |   | 1 |   |   |
| Cash payments                             |       |           | (1         | )          |       |            | (1         | ) |   |   | (2 | ) |   |
| **Balance as of December 31,  2006** | ** ** | ** **     | **$**      | **1**      |       | ** **      | ** ** | **$** | **21** |   | ** ** | ** ** | **$** | **22** |   |   |
|                                           |            |                |            |            |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

***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 first quarter of fiscal 2007:

| ** **                                | ** ** | **Employee**   | ** ** |
|-------------------------------------------|------------|----------------|------------|
| ** **                                | ** ** | **Separation** | ** ** |
| **Dollars in millions**         | ** ** | ** **     | ** ** | **Costs** | ** ** |
| Balance as of  September 30, 2006    |       |           | $          | 30 |   |   |
| Cash payments                             |       |           | (4         | ) |   |
| Impact of foreign currency fluctuations   |       |           | 1          |   |   |
| **Balance as of December 31,  2006** | ** ** | ** **     | **$**      | **27** |   |   |
|                                           |            |                |            |  |  |  |  |  |

 

11

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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:

| **Dollars in millions**        | ** ** | ** ** | ** ** | **December 31, 2006** | ** ** | **September 30, 2006** | ** ** |
|------------------------------------------|------------|------------|------------|---------------------------------|------------|----------------------------------|------------|
| As reported in other current liabilities |       |       | $          | 4                               |       |                             |       | $ | 4 |   |   |
| As reported in other liabilities         |       |       | 8          |                            |       |                             | 9          |   |   |
| **Total capital lease obligations**      | ** ** | ** ** | **$**      | **12**                          |       | ** **                       | ** ** | **$** | **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 USA, Inc.,as agent for the lenders (the “credit facility”). The commitments pursuant tothe Company’s previous Amended and Restated Five Year Revolving Credit FacilityAgreement, dated as of April 30, 2003 (as amended), among the Company, thelenders party thereto and Citibank, N.A., as agent for the lenders, wereterminated and the security interests securing obligations under that facilitywere fully released.

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can beoutstanding at any time is $400 million, of which $150 million may be in theform 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 inreductions in 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, of 2.00 to 1.00,(c) maintaining a minimum ratio of adjusted EBITDA to interest expense of4.00 to 1.00, (d) limitations on the incurrence of subsidiaryindebtedness, (e) limitations on liens, (f) limitations oninvestments and (g) limitations on the creation or existence of agreementsthat prohibit liens on our properties. The credit facility also limits our ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquireshares of our common stock to an amount not to exceed 50% of consolidatednet income for the fiscal year immediately preceding the fiscal year in whichsuch dividend, 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, 2006 through September 30,2008 for such activities, over the amount provided for under the 50% ofconsolidated net income test each year. As of December 31, 2006,the Company was in compliance with all of the covenants included in the creditfacility.

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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. 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 $750million.

There are currently $29million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility and the remainingavailability is $371 million as of December 31, 2006. The Company believesthe credit facility provides it with an important source of backup liquidity.

**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, restricted stock units (“RSUs”) and warrants.

| ** **                                                                          | ** ** | **Three months  ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Dollars in millions, except per share amounts**     | ** ** | ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Earnings  Per Common Share—Basic:**                                          | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Net income                                                                          |       | $                                               | 71         |   | $ | 71 |   |
| Earnings per share—basic                                                       |       | $                                               | 0.16       |   | $ | 0.15 |   |
| Weighted average shares outstanding—basic                                      |       | 454                                             |       | 471 |   |
| **Earnings  Per Common Share—Diluted:**                                        | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Net income                                                                          |       | $                                               | 71         |   | $ | 71 |   |
| Earnings per share—diluted                                                     |       | $                                               | 0.15       |   | $ | 0.15 |   |
| **Diluted  Weighted Average Shares Outstanding:**                                   | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Weighted average  shares outstanding—basic                                     |       | 454                                             |       | 471 |   |
| Dilutive Potential  Common Shares:                                                  |       |                                            |       |   |   |
| Stock Options                                                                       |       | 4                                               |       | 5 |   |
| Restricted Stock Units                                                              |       | 1                                               |       | 1 |   |
| Warrants                                                                            |       | —                                          |       | 1 |   |
| Weighted average  shares outstanding—diluted                                   |       | 459                                             |       | 478 |   |
| **Securities  excluded from the computation of diluted earnings per common share:** | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Stock options (1)                                                                   |       | 37                                              |       | 37 |   |
|                                                                                     |            |                                                 |            |  |  |  |  |  |  |

----

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

On April 19, 2005,the Board of Directors authorized a share repurchase plan (the “plan”). Underthe provisions of the plan, Avaya may use up to $500 million of cash torepurchase shares of its outstanding common stock through April 2007. TheCompany did not repurchase any of its common stock during the first quarter offiscal 2007. From January 1, 2007 through February 6, 2007, theCompany repurchased and retired 2,791,600 shares of its common stock at anaverage price of $12.96 per share, for a total of $36 million. Approximately$29 million is available through April 2007 for further share repurchasesunder the plan. These repurchases are made at management’s discretion in theopen market or in privately 

13

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negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms of theCompany’s credit facility and other factors.

**9.**                 IncomeTaxes

Thefollowing table provides the provision for income taxes for the three-monthperiods ended December 31, 2006 and 2005:

| ** **                        | ** ** | **Three months ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| **Dollars in millions** | ** ** | ** **                                              | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| Provision for  income taxes       |       |                                                    | $          | 25 |   |   |   | $ | 40 |   |   | $ | (15 | ) | 38 | % |
|                                   |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provisionfor income taxes in the first quarter of fiscal 2007 is comprised ofU.S. Federal, state and non-U.S. taxes. The provision for the current quarterincludes 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 tax payablefor fiscal 2006 in Germany as a result of additional restructuring charges reportedfor statutory purposes.

**10.**          BenefitObligations

Thecomponents of net periodic benefit cost (credit) for the three months ended December 31,2006 and 2005 are provided in the table below:

| ** **                                      | ** ** | **Pension  Benefits-U.S.**                      | ** ** | **Pension  Benefits-  Non-U.S.**                | ** ** | **Postretirement  Benefits-U.S.**               | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **Three months  ended  December 31,** | ** ** | **Three months  ended  December 31,** | ** ** | **Three months  ended  December 31,** | ** ** |
| **Dollars in millions**               | ** ** | ** **                                      | ** ** | **2006**                                        | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Components of Net Periodic  Benefit Cost**    | ** ** | ** **                                      | ** ** | ** **                                      | ** ** |                                            | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                    |       | $                                               | 3          |                                            | $          | 4                                               |       |   | $ | 2 | ** ** |   |   | $ | 2 | ** ** |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                   |       | 42                                              |       | 41                                              |       |                                            | 5          | ** ** |   |   | 4 | ** ** |   |   | 10 |   |   |   | 8 |   |   |
| Expected return on plan assets                  |       | (51                                             | )          | (51                                             | )          |                                            | —     | ** ** |   |   | — | ** ** |   |   | (2 | ) |   |   | (2 | ) |   |
| Amortization of unrecognized prior service cost |       | 1                                               |       | 2                                               |       |                                            | —     | ** ** |   |   | — | ** ** |   |   | 8 |   |   |   | 4 |   |   |
| Recognized net actuarial loss                   |       | 11                                              |       | 14                                              |       |                                            | —     | ** ** |   |   | — | ** ** |   |   | — |   |   |   | 1 |   |   |
| **Net periodic benefit cost**                   | ** ** | **$**                                           | **6**      | ** **                                      | **$**      | **10**                                          | ** ** |   | **$** | **7** | ** ** |   |   | **$** | **6** | ** ** |   |   | **$** | **17** | ** ** |   |   | **$** | **12** | ** ** |   |
|                                                 |            |                                                 |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 three months ended December 31,2006, the Company made payments for these U.S. and non-U.S. pension benefitstotaling $2 million and $3 million, respectively. Estimated payments for theseU.S. and non-U.S. pension benefits for the remainder of fiscal 2007 are $4million and $9 million, respectively.

The Company also providescertain retiree medical benefits for U.S. employees, which are not pre-funded.Consequently, the Company makes payments as these benefits are disbursed. Forthe three months ended December 31, 2006, the Company made paymentstotaling $13 million for these retiree medical benefits. Estimated payments forthese retiree medical benefits for the remainder of fiscal 2007 are $50million.

**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 

14

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Avayacommon stock at 85% of market value. As of December 31, 2006, there were7.1 million shares authorized for future grants to purchase Avaya common stockunder the Company’s stock 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 ofgrant, have a term of 10 years or less and vest within four years from thedate of grant. Most of the stock options granted in fiscal 2004 or later have aterm of seven years and vest in three years. For the three months ended December 31,2006 and 2005, approximately $4.4 million and $3.6 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 intrinsic value of share-based awards based on the lattice-binomial model.The Company 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 theCompany’s historical experience.

Share-based compensation expense recognized in theConsolidated Statements of Income for the first quarter of fiscal 2007 and 2006is 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.

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

| ** **                          | ** ** | **Three months  ended**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **December 31, 2006** | ** ** |
| 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       |   |   |

 

15

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

| ** **                                        | ** ** | **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                                           |       | 4,773            |       |                      | 12.48      |   |   |
| Exercised                                         |       | (2,705           | )          |                      | 6.18       |   |   |
| Forfeited and Expired                             |       | (827             | )          |                      | 11.53      |   |   |
| OPTIONS OUTSTANDING AS  OF December 31, 2006 |       | 50,172           |       |                      | $          | 14.42 |   |   |

 

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

| ** **               | ** ** | **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           |       | 4,998                                   |       |                                    | 2.64       |   |   |   | $ | 4.28 |   |   |   | $ | 49,026 |   |   | 4,998 |   |   | $ | 4.28 |   |   |   | $ | 49,026 |   |   |
| $6.40 to $11.18          |       | 6,591                                   |       |                                    | 5.57       |   |   |   | 10.48 |   |   |   | 23,778 |   |   | 2,160 |   |   | 10.43 |   |   |   | 7,903 |   |   |
| $11.19 to $14.84         |       | 13,632                                  |       |                                    | 4.83       |   |   |   | 12.94 |   |   |   | 15,929 |   |   | 8,380 |   |   | 13.27 |   |   |   | 7,096 |   |   |
| $14.85 to $15.89         |       | 13,031                                  |       |                                    | 2.96       |   |   |   | 14.90 |   |   |   | — |   |   | 13,031 |   |   | 14.90 |   |   |   | — |   |   |
| $15.90 to $51.21         |       | 11,920                                  |       |                                    | 2.96       |   |   |   | 22.01 |   |   |   | — |   |   | 11,920 |   |   | 22.01 |   |   |   | — |   |   |
| Total                    |       | 50,172                                  |       |                                    |       |   |   |   | $ | 14.42 |   |   |   | $ | 88,733 |   |   | 40,489 |   |   | $ | 15.11 |   |   |   | $ | 64,025 |   |   |
|                          |            |                                         |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the preceding table represents the total pretax intrinsic value, basedon the Company’s average stock price on December 31, 2006, which wouldhave been received by the option holders had all option holders exercised theiroptions as of that date. The total number of in-the-money options exercisableon December 31, 2006 was approximately 14 million. The weighted averageremaining contractual life on December 31, 2006 for outstanding andexercisable options is 3.78 and 3.15 years, respectively.

***Restricted 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 afour-year period and are payable in shares of the Company’s common stock uponvesting.

Thefollowing table presents a summary of the status of the Company’s nonvestedRSUs as of September 30, 2006, and changes during the three months ended December 31,2006:

| ** **                                   | ** ** | ** ** | ** ** | **Weighted-Average**         | ** ** |
|----------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Grant-Date**               | ** ** |
| **Nonvested Shares**                    | ** ** | ** ** | ** ** | **Shares (000’s)** | ** ** | **Fair Value** | ** ** |
| Nonvested shares  at September 30, 2006 |       |       | 5,319      |                         |       |   | $ | 12.44 |   |   |
| Granted                                      |       |       | 2,034      |                         |       |   | 12.63 |   |   |
| Vested                                       |       |       | (289       | )                            |       |   | 9.61 |   |   |
| Forfeited                                    |       |       | (463       | )                            |       |   | 13.26 |   |   |
| Nonvested shares at  December 31, 2006  |       |       | 6,601      |                         |       |   | $ | 12.56 |   |   |
|                                              |            |            |            |                              |            |  |  |  |  |  |  |  |

 

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As of December 31,2006, there was approximately $51 million of total unrecognized compensationcost related to nonvested share-based compensation arrangements granted underthe plan. That cost is expected to be recognized over a weighted average periodof four years. Compensation expense related to RSUs was $4 million for each ofthe three-month periods ended December 31, 2006 and 2005.

**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 over a three-year 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 adjusted to reflect the impact of the market-vestingcondition including the estimated payout level based on that condition. Compensationcost is not adjusted for subsequent changes in the expected outcome of themarket-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, with a market-vesting condition comparing total shareholder return versusa 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 York Stock Exchange on the last trading dayof each month. For the three months ended December 31, 2006 and 2005, $0.7million and $0.6 million, respectively, of compensation expense related tothe employee stock purchase plan was recorded.

**12.**          OperatingSegments

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

The GCS segment includes the portion of the rental andmanaged services revenue attributed to the equipment 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 

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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** | ** ** | ** **    | ** ** | ** **          | ** ** |
|------------------------------------------------|------------|------------------------------|------------|---------------|------------|---------------------|------------|
| ** **                                     | ** ** | **Global**                   | ** ** | **Avaya**     | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Communications**           | ** ** | **Global**    | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| **Dollars in millions**              | ** ** | ** **                   | ** ** | **Solutions** | ** ** | **Services**        | ** ** | **Amounts** | ** ** | **Total** | ** ** |
| **Three  months ended December 31, 2006** | ** ** |                         | ** ** | ** **    |       |                | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Revenue                                        |       |                         | $          | 682           | ** ** |                |       | $ | 598 | ** ** |   |   | $ | — | ** ** |   | $ | 1,280 |   |
| Operating income                               |       |                         | 22         | ** **    |       |                | 53         | ** ** |   |   | 15 | ** ** |   | 90 |   |
| **Three  months ended December 31, 2005** | ** ** |                         | ** ** | ** **    |       |                | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Revenue                                        |       |                         | $          | 661           | ** ** |                |       | $ | 588 | ** ** |   |   | $ | — | ** ** |   | $ | 1,249 |   |
| Operating income                               |       |                         | 43         | ** **    |       |                | 60         | ** ** |   |   | 4 | ** ** |   | 107 |   |
|                                                |            |                              |            |               |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

| ** **                                                | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| **Dollars in  millions**                                  | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
| U.S.                                                      |       | $387                  |       | $442 |   |
| Outside the U.S.:                                         |       |                  |       |   |   |
| Germany                                                   |       | 202                   |       | 206 |   |
| EMEA - Europe / Middle East / Africa (excluding  Germany) |       | 44                    |       | 48 |   |
| APAC - Asia Pacific                                       |       | 17                    |       | 14 |   |
| Americas, non-U.S.                                        |       | 6                     |       | 5 |   |
| Total outside the U.S.                                    |       | 269                   |       | 273 |   |
| Total                                                     |       | $656                  |       | $715 |   |
|                                                           |            |                       |            |  |  |  |  |

 

**13.**          Commitmentsand Contingencies

**Legal Proceedings**

In the ordinary course of business the Company isinvolved in litigations, claims, government inquiries, investigations, chargesand proceedings, including, but not limited to, those identified below relatingto intellectual property, commercial, securities, employment, employeebenefits, environmental and regulatory matters. Other than as described below,the Company believes there is no litigation pending against the Company thatcould have, individually or in the aggregate, a material adverse effect on theCompany’s financial position, results of operations or cash flows.

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In accordance with SFASNo. 5, “Accounting for Contingencies,” the Company records an accrual fora contingency when it is both probable that a liability has been incurred andthe amount 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 in thesematters, it could in the future incur judgments or enter into settlements ofclaims that could have a material adverse effect on the results of operationsin any particular period.

***SecuritiesLitigation***

In April andMay of 2005, purported class action lawsuits were filed in the U.S.District Court for the District of New Jersey against us and certain of ourofficers, alleging violations of the federal securities laws. The actionspurport to be filed on behalf of purchasers of our common stock during the periodfrom October 5, 2004 (the date of our signing of the agreement to acquireTenovis 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 plaintiffs’ counsel. A consolidatedamended complaint was filed in October 2005. Pursuant to a schedulingorder issue by the District Court, defendants filed their motion to dismiss theconsolidated 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 seekcontribution from the defendants to the Company for alleged violations of thesecurities laws, restitution to the Company and disgorgement of profits earnedby defendants, 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 

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bepredicted and, as a result, we cannot be assured that these cases will not havea material adverse effect on our financial position, results of operations orcash 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 to the court and are awaiting a notice as to whether the court willentertain oral argument. Although the defendants believe that the DistrictCourt correctly decided the motion to dismiss, given the uncertainties of theappeal, at this time the Company cannot determine if this matter will have aneffect on its business or, if it does, whether its outcome will have a materialadverse effect on its financial position, results of operations or cash flows.Due to the uncertainty surrounding the issues involved in this matter and basedon the facts and circumstances known to date, the Company believes that anestimate or potential range of any loss that may be incurred cannot be made atthis time.

***ERISA Class Action—StockFunds***

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 to April 2003(“Alleged Class Period”). The complaint asserts, among other things, thatduring the Alleged Class Period defendants breached their fiduciary dutiesunder ERISA by violating ERISA’s provisions against prohibited transactions;offering the Lucent Fund and Avaya Fund imprudently as investment options;failing properly to monitor the funds; and, failing properly to monitor theactions of other plan fiduciaries, thus causing the Plans to suffer damages.The complaint seeks monetary relief on behalf of the Plans and itsparticipants, and also seeks injunctive relief and costs, including attorneys’fees. Defendants have filed a motion to dismiss this case in its entirety andwith prejudice, and that motion is currently pending with the District Court.

This matter is in theearly 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 

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operationsor cash flows. Due to the uncertainty surrounding the issues involved in thismatter and based on the facts and circumstances known to date, the Companybelieves that an estimate or potential range of any loss that may be incurredcannot be made at this time.

***Antitrust Lawsuit***

In July 2005, UnitedAsset Coverage, Inc. (“UAC”) filed a verified complaint against theCompany in the United States District Court, Northern District of Illinois,alleging, among other things, violations of federal and state antitrust laws,in the manner in which the Company seeks to protect its proprietaryinformation. The verified complaint sought a temporary restraining orderagainst the Company to enjoin immediately its practice of limiting the use ofits proprietary information in a manner which UAC believes is in violation ofits contracts and licensing agreements. The court denied UAC’s motion fortemporary restraints in August 2005 as well as its motion for preliminaryinjunction in January 2006. The plaintiff, however, has continued topursue this action, and, as a result, discovery is ongoing. Further, in January 2007,plaintiff filed a motion to amend the complaint to include additional claims ofantitrust violations against the Company.

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**

***GovernmentSubpoenas***

On April 29, 2005,the Company received a subpoena to produce documents before a grand jury of theUnited States District Court, District of South Carolina, relating to theUnited States’ investigation of potential antitrust and other violations inconnection with the federal E-Rate Program. The subpoena requests records fromthe period January 1, 1997 to the present. The Company complied with thesubpoena and has received no indication from the Department of Justice that ithas any further obligations or involvement in this matter. Nonetheless, at thistime, we cannot determine if this matter will have an effect on our businessor, if it does, whether its outcome will have a material adverse effect on ourfinancial position, results of operations or cash flows.

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

The Company is cooperatingwith the relevant government entities with respect to these subpoenas. 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 toa wide range of governmental requirements relating to employee safety andhealth and to the handling and emission into the environment of varioussubstances used in its operations. The Company is subject to certain provisionsof environmental laws, particularly in the United States and Germany, governingthe cleanup of soil and groundwater contamination. Such provisions imposeliability for the costs of investigating and remediating releases of hazardousmaterials at currently 

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orformerly owned or operated sites. In certain circumstances, this liability mayalso include the cost of cleaning up historical contamination, whether or notcaused by the Company. The Company is currently conducting investigation and/orcleanup of known contamination at nine of its current or former facilitieseither voluntarily or pursuant to government directives. Based on currentlyavailable information, none of the sites is reasonably likely to generateenvironmental costs that will be individually material nor will environmentalcosts for all sites in the aggregate be material in any fiscal year. There areno known third parties who may be responsible for investigation and/or cleanupat these sites and therefore, for purposes of assessing the adequacy ofaccruals for these liabilities, the Company has not assumed that it willrecover amounts from any third party, including under any insurance coverage orindemnification arrangement.

It is often difficult toestimate the future impact of environmental matters, including potentialliabilities. The Company has established financial reserves to coverenvironmental liabilities where they are probable and reasonably estimable.Reserves for estimated losses from environmental matters are undiscounted andconsist primarily of estimated remediation and monitoring costs and are,depending on the site, based primarily upon internal or third partyenvironmental studies and the extent of contamination and the type of requiredcleanup. The Company is not aware of, and has not included in reserves anyprovision for, unasserted environmental claims.

The reliability andprecision of estimates of the Company’s environmental costs may be affected bya variety of factors, including whether the remediation treatment will beeffective, contamination sources have been accurately identified andassumptions regarding the movement of contaminants are accurate. In addition,estimates of environmental costs may be affected by changes in law andregulation, including the willingness of regulatory authorities to concludethat remediation and/or monitoring performed by the Company is adequate.

The Company assesses theadequacy of environmental reserves on a quarterly basis. The Company does notexpect the outcome of these matters to have a material impact on its financialposition. Expenditures for environmental matters for the three-month periodsended December 31, 2006 and 2005 were not material to the Company’sfinancial position, results of operations or cash flows. Payment for theenvironmental 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 the 

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adequacy of its productwarranties and adjusts, if necessary, the warranty percentage and accruedwarranty reserve, which is included in other current liabilities in theConsolidated Balance Sheets, for actual experience.

| **Dollars in millions**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| Balance as of  September 30, 2006               |       | $          | 29         |       |
| Reductions for  payments and costs to satisfy claims |       | (11        | )          |
| Accruals for  warranties issued during the period    |       | 12         |       |
| Balance as of  December 31, 2006                |       | $          | 30         |       |

 

**Guarantees of Indebtedness and Other Off-Balance SheetArrangements**

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $131 million asof December 31, 2006, for the purpose of securing third party financialguarantees such as letters of credit that ensure the Company’s performance orpayment to third parties. Additionally, the Company has a $400 millioncommitted credit facility, which is discussed in Note 7, “FinancingArrangements.” As of December 31, 2006, the Company had outstanding anaggregate of $103 million in irrevocable letters of credit under the committedand uncommitted credit facilities (including $29 million under its $400 millioncommitted credit facility).

***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 $6million of our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$27 million as of December 31, 2006. Historically, no surety bondshave been drawn upon.

***Purchase Commitmentsand Termination Fees***

The Company purchasescomponents from a variety of suppliers and uses several contract manufacturersto provide manufacturing services for its products. During the normal course ofbusiness, in order to manage manufacturing lead times and to help assureadequate component supply, the Company enters into agreements with contractmanufacturers and suppliers that allow them to produce and procure inventorybased upon forecasted requirements provided by the Company. If the Company doesnot meet these specified purchase commitments, it could be required to purchasethe inventory, or in the case of certain agreements, pay an early terminationfee. As of December 31, 2006, themaximum potential payment under these commitments was approximately $166million. Historically, the Company has not been required to pay a charge fornot meeting its designated 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 FinancingArrangements***

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 guarantee repaymentto the lending institution. The repayment amount fluctuates with the level ofproduct financing activity. The guarantee repayment amount 

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reported to the Company from the lending institution wasapproximately $6 million as of December 31, 2006. 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 the founding of Avaya Inc. in October 2000.The Company has estimated the fair value of this guarantee as of December 31,2006, and has determined that it is not significant. There can be no assurancethat the Company will not be obligated to repurchase inventory under thisarrangement in the future.

***Performance 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 December 31, 2006, would beapproximately $15 million. The Company has assessed the probability of defaultby the assignees and has determined it to be remote.

***Credit FacilityIndemnification***

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.

***Transactionswith Lucent Technologies, Inc.***

Pursuant to theContribution and Distribution Agreement, Lucent Technologies Inc., predecessorto Alcatel-Lucent (“Lucent”), contributed to the Company substantially all ofthe assets, liabilities and operations associated with its enterprisenetworking businesses (“Company’s Businesses”). The Contribution andDistribution Agreement, among other things, provides that, in general, theCompany will indemnify Lucent for all liabilities including certainpre-distribution tax obligations of Lucent relating to the Company’s Businessesand all contingent liabilities primarily relating to the Company’s Businessesor otherwise assigned to the Company. In addition, the Contribution andDistribution Agreement provides that certain contingent liabilities notallocated to one of the parties will be shared by Lucent and the Company inprescribed percentages. The Contribution and Distribution Agreement alsoprovides that each party will share specified portions of contingentliabilities based upon agreed percentages related to the business of the otherparty that exceed $50 million. The Company is unable to determine themaximum potential amount of other future payments, if any, that it could berequired 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 Agreement governs Lucent’s and theCompany’s respective rights, responsibilities and obligations after thedistribution with respect to taxes for the periods ending on or before thedistribution. Generally, pre-distribution taxes or benefits that are clearlyattributable to the business of one party will be borne solely by that party,and other pre-distribution taxes or benefits will be shared by the parties basedon a formula set forth in the Tax Sharing Agreement. The Company may be subjectto additional taxes or benefits pursuant to the Tax Sharing Agreement relatedto future settlements of audits by state and local and foreign taxingauthorities for the periods prior to the Company’s separation from Lucent.

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**Item 2.   *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.***

| Forward-Looking  Statements                         |   | 25 |   |
|-----------------------------------------------------|--------|----|--------|
| Overview                                            |   | 26 |   |
| Key  Trends and Uncertainties Affecting Our Results |   | 28 |   |
| Operating Segments                                  |   | 30 |   |
| Results  from Continuing Operations                 |   | 31 |   |
| Segment  Results                                    |   | 33 |   |
| Liquidity and Capital Resources                     |   | 37 |   |

 

“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 unaudited interim ConsolidatedFinancial Statements as of December 31, 2006 and for the three monthsended December 31, 2006 and 2005, have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial statements and the rules and regulations of the U.S.Securities and Exchange Commission, or the SEC, for interim financialstatements, and should be read in conjunction with our Consolidated FinancialStatements and other financial information for the fiscal year ended September 30,2006, 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. The consolidated results of operations forthe interim periods reported are not necessarily indicative of the results tobe experienced for the entire fiscal year.

**Forward-LookingStatements**

Our disclosure and analysis in this Quarterly Reporton Form 10-Q contains some forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. Forward-looking statements give our current expectations orforecasts of future events. You can identify these statements by the fact thatthey do not relate strictly to historical or current facts. They use words suchas “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe”and other words and terms of similar meaning in connection with any discussionof future operating or financial performance. From time to time, we also mayprovide oral or written forward-looking statements in other materials werelease 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.

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**Overview**

***Products, Applications and Services***

We are a leading provider of communications solutions,comprised of equipment hardware, software and services that help enterprisestransform their businesses by redefining the way they work and interact withtheir customers, employees, business partners, suppliers and others. A keycomponent of our strategy is to leverage our substantial experience andexpertise in traditional voice communications systems to capitalize on thetransition of these traditional voice systems to Internet Protocol, or IP, andthe adoption of IP telephony solutions. Our product offerings include IPtelephony systems and traditional voice communications systems, multi-mediacontact center infrastructure and applications in support of customerrelationship management, unified communications applications and appliances,such as IP telephone sets.  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 anyway” 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 and Competitive Advantages***

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

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

We are focused on the transition of traditional voicecommunications to converged networks that provide for the integration of voice,data, video and other applications traffic on a single network. We offercustomers 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.”

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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;

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

·       alarge installed global customer base;

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

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

·       strategicalliances with world-class business partners, including our large network ofsoftware development partners who develop vertical and other softwareapplications that work with our telephony and contact center offerings to meetspecific customer needs.

***Financial Results Summary***

*Revenue—**Revenue* was $1,280million and $1,249 million for the first quarter of fiscal 2007 and 2006,respectively. Overall  revenue grew by2.5% as a result of increases in both of our operating segments. Revenues forthe first quarter of fiscal 2007 included a favorable currency impact of $31million that benefited both operating segments, almost entirely in Europe. Excludingthis benefit, overall revenue would have been flat compared to the firstquarter of fiscal 2006. Revenue in the quarter was impacted by disruptionsassociated with the warehousing and physical distribution issue discussed belowin “Manufacturing and Logistics.”

*GrossMargin—**Our* grossmargin increased by $10 million due to an increase in volume and a benefit fromforeign currency fluctuation, although the gross margin rate fell slightly to46.8%. Despite improvements in overall gross margin for sales of products andservices, the decrease in the overall gross margin rate was primarily theresult of the decline in margin rates on rental and managed service contracts,particularly due to a large managed services contract with a relatively lowermargin than historical contracts. The gross margin for the first quarter offiscal 2006 includes an $11 million benefit, or approximately one percentagepoint impact, from a change in our vacation policy.

*OperatingExpenses—**Our* selling, general andadministrative (SG&A) expenses increased by $4 million to $389 millionfor the first quarter of fiscal 2007 compared to the first quarter of fiscal2006. This net increase was primarily due to the inclusion of a $7 millionbenefit in the first quarter of fiscal 2006 related to the change in ourvacation policy, increased employee benefit costs and unfavorable foreigncurrency fluctuations, partially offset by several benefits in the currentquarter. These benefits included a gain on the sale of real estate and an $8million benefit from the favorable resolution of non-income tax audits inseveral jurisdictions. The increased employee benefit costs were primarily dueto the previously-disclosed increase in post-retirement health benefits forunion employees.

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During the first quarter of fiscal 2007, our researchand development (R&D) expenses increased $17 million to $114 million due toan increase in gross investment, in line with our initiative to invest ninepercent of revenue in R&D. The first quarter of fiscal 2006 included a $3million benefit related to the change in our vacation policy.

We also recorded $6 million in net charges forrestructuring actions during the first quarter of fiscal 2007. These represent$12 million of charges for employee separation costs and lease obligations,partially offset by a net benefit of $6 million for changes in estimatesfor prior restructuring plans primarily related to leased facilities.

*Profitability—**We* earned net incomeof $71 million for each of the first quarters of fiscal 2007 and 2006. Ouroperating income was $90 million, or 7.0% of revenue, for the first quarter offiscal 2007, compared to $107 million, or 8.6% of revenue, for the firstquarter of fiscal 2006. Operating income for the first quarter of fiscal 2007includes several benefits in costs and operating expenses as described above,partially offset by an increase in net restructuring charges and R&Dinvestment. Operating income for the first quarter of fiscal 2006 included a$21 million benefit from the change in our vacation policy.

**Key Trends andUncertainties Affecting Our Results**

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

The following arethe key factors we believe are currently affecting our revenue:

·       *Technologytransition*—Our growth strategy relies heavily on capturing asignificant share of the spending by enterprises on their transition oftechnology from traditional communications systems to IP telephony. We believethat IP telephony has gained widespread acceptance in the marketplace and overtime we expect 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 TDM. As a result of the technology transition,spending by enterprises on traditional voice communication systems has beendeclining. Increases in our product revenue attributable to sales of IPtelephony systems continue to be offset in part by declines in product revenueattributable 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 otheruncertainties related to the competitive environment in which we operate, see “RiskFactors—Risks Related To Our Revenue and Business Strategy—We face intense competition from our currentcompetitors and, as the enterprise communications and information technologymarkets evolve, may face increased competition from companies that do notcurrently compete directly against us.”

·       *Pressures on services business*—Due to advances intechnology, our customers continue to expect traditional services to be atlower prices to them. In addition, our customers routinely look foropportunities to reduce their information technology and related costs. A highcorrelation exists 

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with respect to customersin our direct channel who purchase products also electing to purchasemaintenance contracts at the time of the product purchase. However, at the timeof contract renewal, maintenance revenues have been affected by reductions inscope of contracted services (*i.e*. number ofports, number of sites, or hours and levels of coverage) at the time ofcontract renewal, cancellations and increased competition, as well as the priceerosion noted above. These factors have resulted in challenges to our AvayaGlobal Services segment. We have been able to partially offset these impacts byfocusing on new types of services such as professional and managed services. Thesenew types of services may have lower margins than our traditional services. Inaddition, we have also been able to reduce our costs to minimize the impact onour operating income.

·       *Disruption in logistics*—As we continue to seek to optimize ourend-to-end supply chain, we have been outsourcing various logistics functionsover the course of the past few years. As previously disclosed, in the fourthquarter of fiscal 2006 and the first quarter of fiscal 2007, we moved certainwarehousing and physical distribution operations to a different third partyprovider at a new facility. Following this move we have been experiencingdisruption, resulting in delays in delivery of products from this warehouse,which we estimate negatively impacted our revenue by approximately $20 millionduring the first quarter of fiscal 2007. We are working with this third partyprovider to resolve these issues. See “Manufacturing and Logistics” for moreinformation.

·       *Foreign currency—*Our revenues outside of the U.S. were43% of our consolidated revenues in the first quarter of fiscal 2007compared to 41% in the first quarter of fiscal 2006. Revenues for the firstquarter of fiscal 2007 include a favorable currency impact of $31 million ascompared to the first quarter of fiscal 2006. Any strengthening of the U.S.dollar against other currencies, particularly the euro, will have a negativeimpact on our reported revenues and, to a lesser degree, on our profitability.Conversely, any weakening of the U.S. dollar will have a positive impact.

·       *Economic conditions—*An important factoraffecting our ability to generate revenue is the effect of general economicconditions on our customers’ willingness to spend on information technologyand, particularly, enterprise communications technology. Variability inemployment, corporate profit growth, interest rates, energy prices and otherfactors in specific markets could impact corporate willingness to spend oncommunications technology in the near term. 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 and Logistics***

The Company’s products are supplied through contractmanufacturers and original equipment manufacturers. Our manufacturers produce amajority of our products in facilities located in Mexico, Malaysia, the CzechRepublic, China, Israel, Poland, Ireland, France, Germany and the UnitedStates. The contract manufacturing of the Company’s products is performed inaccordance with detailed specifications and product designs furnished by theCompany and is subject to rigorous quality control standards.

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 firstquarter of 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 have been disruptions and delays in deliveryof certain products from this facility 

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and we estimate the impacton revenue in the first quarter of fiscal 2007 was in the range of $20 millionand we incurred costs in the quarter related to these disruptions. While we andour logistics service provider have been making improvements as we progressthrough this transition, we cannot assure you that this issue will not continueto have an adverse effect on our revenue and increase our costs.

We also face increasing complexity in our productdesign, logistics and procurement operations as we adjust to new and upcomingrequirements relating to the materials composition of our products, such as theEuropean Union (“EU”) directives regarding Restriction of the Use of CertainHazardous Substances in Electrical and Electronic Equipment (“RoHS”) and theWaste Electrical and Electronic Equipment (“WEEE”) directive. Otherenvironmental regulations may require us to reengineer products to utilizecomponents compatible with these changing regulatory requirements and theresulting reengineering and component substitution may result in additionalcosts to us. Even if we are able and willing to reengineer products or payadditional costs, we still may be adversely affected if the materials andcomponents that we need are unavailable to us. In addition, if we were found tobe in violation of these regulations, we could be subject to government fines,noncompliant products may be banned from markets covered by the regulations andour customers 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 certain hardware components andlicense certain software components from third-party original equipmentmanufacturers and resell them under the Avaya brand.  In some cases certain components are onlyavailable from a single source or from a limited source of suppliers. Delays orshortages associated with these components could cause significant disruptionto 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.”

**Operating Segments**

We manageour business based on two operating segments—Global Communications Solutions,or GCS, and Avaya Global Services, or AGS. The following table sets forth theallocation of our revenue among our operating segments and expressed as apercentage of total revenue:

| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix**                           | ** ** | ** **                         | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $                    | 661        |       | $          | 661        |       | $          | 704        |                              | $          | 760                                |       | Global Communications Solutions |   | $ | 682 |   | $ | 661 |   |   | 53 | % |   |   | 53 | % |   | $ | 21 |   | 3.1 | % |
| 588                  |       | 577        |       | 593        |       | 604        |       | Avaya Global Services             |       | 598                                |       | 588 |   |   | 47 | % |   |   | 47 | % |   | 10 |   | 1.7 | % |
| $                    | 1,249      |       | $          | 1,238      |       | $          | 1,297      |                              | $          | 1,364                              |       | Total |   | $ | 1,280 |   | $ | 1,249 |   |   | 100 | % |   |   | 100 | % |   | $ | 31 |   | 2.5 | % |
|                      |            |            |            |            |            |            |            |                                   |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Overall revenue grew by2.5% and includes the benefit from foreign currency fluctuations. Excludingthis benefit, overall revenue would have been flat compared to the firstquarter of fiscal 2006. The 3.1% and 1.7% increases in GCS and AGS revenue, respectively,include benefits from foreign currency fluctuations. Excluding these foreigncurrency benefits, GCS and AGS revenue would have been relatively flat comparedto the first quarter of fiscal 2006. AGS revenues were affected by a decline inour rental base which was offset by the benefit of a large managed servicescontract.

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**Results fromContinuing Operations**

***Three Months Ended December 31, 2006 Comparedwith Three Months Ended December 31, 2005***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **           | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $                    | 591        |       | $          | 593                                |       | $ | 636 |   | $ | 690 |   | Sales of products |   | $ | 619 |   | $ | 591 |   |   | 48 | % |   |   | 47 | % |   | $ | 28 |   | 4.7 | % |
| 504                  |       | 492        |       | 507                                |       | 514 |   | Services |   | 509 |   | 504 |   |   | 40 | % |   |   | 40 | % |   | 5 |   | 1.0 | % |
| 154                  |       | 153        |       | 154                                |       | 160 |   | Rental and managed services |   | 152 |   | 154 |   |   | 12 | % |   |   | 13 | % |   | (2 | ) | -1.3 | % |
| $                    | 1,249      |       | $          | 1,238                              |       | $ | 1,297 |   | $ | 1,364 |   | Total revenue |   | $ | 1,280 |   | $ | 1,249 |   |   | 100 | % |   |   | 100 | % |   | $ | 31 |   | 2.5 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue from sales of products increased by 4.7% andincludes a benefit from foreign currency fluctuations and increases due todemand for our IP telephony solutions, partially offset by the decline in salesof TDM products. Services revenue increased by 1.0% and includes a benefit fromforeign currency fluctuations, partially offset by reductions in scope ofcontracted services, cancellations and pricing pressures. Rental and managedservices revenue decreased by 1.3% resulting from changes in scope ofcontracted services, cancellations and pricing pressures related to our rentalbusiness, partially offset by a benefit from foreign currency fluctuations andrevenue from a large managed services contract.

Thefollowing table sets forth a geographic comparison of revenue:

| ** **           | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **Q406** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
| $                    | 734        |       | $          | 719                                |       | $ | 753 |   | $ | 788 |   | U.S. |   | $ | 732 |   | $ | 734 |   |   | 57 | % |   |   | 59 | % |   | $ | (2 | ) | -0.3 | % |
|                 |       |       |       |                               |       |   |   | Outside  the U.S.: |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 186                  |       | 182        |       | 182                                |       | 183 |   | Germany |   | 186 |   | 186 |   |   | 14 | % |   |   | 15 | % |   | — |   | 0.0 | % |
| 178                  |       | 174        |       | 205                                |       | 208 |   | EMEA—Europe / Middle East / Africa (Excluding  Germany) |   | 203 |   | 178 |   |   | 16 | % |   |   | 14 | % |   | 25 |   | 14.0 | % |
| 364                  |       | 356        |       | 387                                |       | 391 |   | Total EMEA |   | 389 |   | 364 |   |   | 30 | % |   |   | 29 | % |   | 25 |   | 6.9 | % |
| 87                   |       | 99         |       | 87                                 |       | 110 |   | APAC—Asia Pacific |   | 88 |   | 87 |   |   | 7 | % |   |   | 7 | % |   | 1 |   | 1.1 | % |
| 64                   |       | 64         |       | 70                                 |       | 75 |   | Americas, non-U.S. |   | 71 |   | 64 |   |   | 6 | % |   |   | 5 | % |   | 7 |   | 10.9 | % |
| 515                  |       | 519        |       | 544                                |       | 576 |   | Total outside the U.S. |   | 548 |   | 515 |   |   | 43 | % |   |   | 41 | % |   | 33 |   | 6.4 | % |
| $                    | 1,249      |       | $          | 1,238                              |       | $ | 1,297 |   | $ | 1,364 |   | Total revenue |   | $ | 1,280 |   | $ | 1,249 |   |   | 100 | % |   |   | 100 | % |   | $ | 31 |   | 2.5 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues in the U.S. were flat compared with the firstquarter of fiscal 2006, as increases in product revenue were offset by declinesin managed services. Excluding the benefit of foreign currency fluctuations,Germany’s revenue would have declined. EMEA revenue, excluding Germany, grew by14%. Excluding the impact of foreign currency fluctuations, EMEA growth wasapproximately 7%, helped by strong demand in Russia and the United Kingdom. Althoughour APAC region was most adversely impacted by the disruption related to thewarehousing and physical distribution issue, APAC revenue was roughly flat,helped by  strong performance in India. Revenuein Americas, non-U.S. increased due to growth in contract maintenance andproduct revenues in the region’s major markets.

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

| ** **           | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                 | $          | 268        |       |                               |       | $ | 250 |   |   |   | $ | 277 |   |   |   | $ | 302 |   |   | Direct |   | $ | 259 |   | $ | 268 |   |   | 42 | % |   |   | 45 | % |   | $ | (9 | ) | -3.4 | % |
|                 | 323        |       |       |                               | 343        |   |   |   | 359 |   |   |   | 388 |   |   | Indirect |   | 360 |   | 323 |   |   | 58 | % |   |   | 55 | % |   | 37 |   | 11.5 | % |
|                 | $          | 591        |       |                               |       | $ | 593 |   |   |   | $ | 636 |   |   |   | $ | 690 |   |   | Total sales of  products |   | $ | 619 |   | $ | 591 |   |   | 100 | % |   |   | 100 | % |   | $ | 28 |   | 4.7 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Sales of products throughthe indirect channel accounted for 58% of the revenue from product sales ascompared to 55% for the same quarter last fiscal year. Increased demand for ourproducts through the indirect channel in the U.S., as well as in theinternational regions, contributed to the shift in mix.

***Gross Margin***

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

| ** **           | ** ** | ** ** | ** ** | **First Fiscal Quarter** |
|----------------------|------------|------------|------------|------------------------------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                 | 53.1       | %          |       |                               | 53.6 | % |   |   | 52.2 | % |   |   | 54.8 | % |   | On sales of  products |   | $ | 330 |   | $ | 314 |   |   | 53.3 | % |   |   | 53.1 | % |   | $ | 16 |   | 5.1 | % |
|                 | 36.1       | %          |       |                               | 35.2 | % |   |   | 33.9 | % |   |   | 32.1 | % |   | On services |   | 185 |   | 182 |   |   | 36.3 | % |   |   | 36.1 | % |   | 3 |   | 1.6 | % |
|                 | 60.4       | %          |       |                               | 56.9 | % |   |   | 54.5 | % |   |   | 57.5 | % |   | On rental and  managed services |   | 84 |   | 93 |   |   | 55.3 | % |   |   | 60.4 | % |   | (9 | ) | -9.7 | % |
|                 | 47.2       | %          |       |                               | 46.7 | % |   |   | 45.3 | % |   |   | 46.6 | % |   | Total gross margin |   | $ | 599 |   | $ | 589 |   |   | 46.8 | % |   |   | 47.2 | % |   | $ | 10 |   | 1.7 | % |
|                      |            |            |            |                                    |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $10 million increase in gross margin for the first quarter of fiscal2007 reflects an increase in the volume of sales of products and a benefit fromforeign currency fluctuation, although the gross margin rate fell slightly. Thefirst quarter of fiscal 2006 gross margin includes an $11 million benefit,or approximately one percentage point impact, from the change in our vacationpolicy. Despite improvements in overall gross margin on sales of products andservices, the decrease in the overall gross margin rate was primarily theresult of the decline in margin rates on rental and managed service contracts, particularlydue to a large, lower-margin managed services contract.

Gross margin on sales of products increased by $16 million primarily due tohigher sales volume. Factors affecting the gross margin rate includedbenefits from cost reductions, partially offset by the unfavorable impacts ofthe warehousing and physical distribution issue and mix of indirect channelsales.

Services gross margin and rate were essentially flat when compared to firstquarter of fiscal 2006. Cost reductions from employee restructuring actions inprior periods were partially offset by increased employee benefit costs.

Rental and managed services gross marginand rate both decreased due to reductions in scope of contracted services atthe time of contract renewal, cancellation of contracts with historicallyhigher margins as well as price erosion on new contracts, and a large managedservice contract with a relatively lower margin than historical contracts.

***Operating expenses***

| ** **           | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                 | $          | 385        |       |                               |       | $ | 399 |   |   |   | $ | 423 |   |   |   | $ | 388 |   |   | Selling, general and administrative |   | $ | 389 |   | $ | 385 |   |   | 30.4 | % |   |   | 30.8 | % |   | $ | 4 |   | 1.0 | % |
|                 | 97         |       |       |                               | 106        |   |   |   | 115 |   |   |   | 110 |   |   | Research and development |   | 114 |   | 97 |   |   | 8.9 | % |   |   | 7.8 | % |   | 17 |   | 17.5 | % |
|                 | —     |       |       |                               | 20         |   |   |   | 22 |   |   |   | 62 |   |   | Restructuring charges, net |   | 6 |   | — |   |   | 0.5 | % |   |   | 0.0 | % |   | 6 |   | — |   |
|                 | $          | 482        |       |                               |       | $ | 525 |   |   |   | $ | 560 |   |   |   | $ | 560 |   |   | Total operating  expenses |   | $ | 509 |   | $ | 482 |   |   | 39.8 | % |   |   | 38.6 | % |   | $ | 27 |   | 5.6 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The $4 million increase in SG&A expenses isprimarily due to increased employee benefit costs and unfavorable foreigncurrency fluctuations, partially offset by benefits resulting from thefavorable resolution of non-income tax audits and a gain on the sale of realestate.  The first quarter of fiscal 2006included a $7 million benefit related to the change in our vacation policy.

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R&D expenses increased by $17 million compared tothe same quarter last fiscal year due to increased gross investment, in linewith our current year initiative to invest nine percent of revenue in R&D. Thefirst quarter of fiscal 2006 included a $3 million benefit related to thechange in our vacation policy.

Restructuring charges, netfor the first quarter of fiscal 2007 represent $12 million of charges foremployee separation costs and lease obligations, partially offset by a netbenefit of $6 million for changes in estimates for prior restructuringplans primarily related to leased facilities.

***Other Income, Net***

| **Fiscal 2006** | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                 | $          | 5          |       |                               |       | $ | 6 |   |   |   | $ | 5 |   |   |   | $ | 8 |   |   | Other income, net |   |   | $ | 6 |   |   |   | $ | 5 |   |   | $ | 1 |   | 20 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

***Interest Expense***

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

 

Capital lease obligationsof $12 million represent our only financing arrangement as of December 31,2006, and therefore, we have incurred insignificant interest expense.

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

| **Fiscal 2006** | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**                           | ** ** | **4Q06** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                 | $          | 40         |       |                               |       | $ | 19 |   |   |   | $ | (11 | ) |   |   | $ | 35 |   |   | Provision for (benefit from) income taxes |   |   | $ | 25 |   |   |   | $ | 40 |   |   | $ | (15 | ) | 38 | % |
|                      |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes in the first quarter of fiscal 2007 iscomprised of U.S. Federal, state and non-U.S. taxes. It also includes a $6million benefit from the retroactive extension to January 1, 2006 of theresearch tax credit pursuant to the Tax Relief and Health Care Act of 2006 anda $7 million tax benefit due to a reduction in estimated tax payable for fiscal2006 in Germany as a result of additional restructuring charges reported forstatutory purposes. The provision for the first quarter of fiscal 2007 resultedin an effective tax rate of 26%, which we believe is not indicative of theestimated tax rate for the full fiscal year.

The provision for income taxes in thefirst quarter of fiscal 2006 was comprised of U.S. Federal, state and non-U.S.taxes. The provision for the first quarter of fiscal 2006 resulted in aneffective tax rate of 36.4%.

**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.

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Largecommunications systems are IP and traditional, or TDM, telephony systemsmarketed to large enterprises. These systems include:

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

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

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

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

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

·       AvayaExtension to Cellular, which transparently bridges any 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; and

·       messagingfor IP and traditional systems.

The followingtable sets forth revenue by similar class of products within the GCS segment:

| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix**                           | ** ** | ** **                         | ** ** | ** ** | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                      |            |            |            |            |            |            |            |                                   |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

|   | $   | 413    |   |   |   | $      | 414    |   |   |   | $      | 455    |   |   |   | $                              | 483    |   |   | Large Communications Systems |   | $      | 435 |   | $      | 413    |   |   | 64     | %      |   |   | 63  | % |   | $ | 22 |   | 5.3 | % |
|--------|-----|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------------------------------|--------|--------|--------|------------------------------|--------|--------|-----|--------|--------|--------|--------|--------|--------|--------|--------|--------|-----|---|--------|---|----|--------|-----|---|
|   | 88  |   |   |   | 94     |   |   |   | 92     |   |   |   | 96     |   |   | Small Communications Systems   |   | 85     |   | 88                           |   |   | 12  | %      |   |   | 13     | %      |   | (3     | )      | -3.4   | %   |
|   | 151 |   |   |   | 141    |   |   |   | 144    |   |   |   | 169    |   |   | Converged Voice   Applications |   | 151    |   | 151                          |   |   | 22  | %      |   |   | 23     | %      |   | — |   | 0.0    | %   |
|   | 9   |   |   |   | 12     |   |   |   | 13     |   |   |   | 12     |   |   | Other                          |   | 11     |   | 9                            |   |   | 2   | %      |   |   | 1      | %      |   | 2      |   | 22.2   | %   |
|   | $   | 661    |   |   |   | $      | 661    |   |   |   | $      | 704    |   |   |   | $                              | 760    |   |   | Total GCS revenue            |   | $      | 682 |   | $      | 661    |   |   | 100    | %      |   |   | 100 | % |   | $ | 21 |   | 3.2 | % |

 

Overall GCS revenue grew by $21 million, or 3.2%,primarily due to a benefit from foreign currency fluctuations that benefitedeach class of GCS revenue.

The $22 million increase in large communicationsystems revenue was the result of increased demand for enterprise gateways andequipment. These product increases were offset by lower sales of traditionalmessaging, appliances and other mature product lines. Small communicationssystems revenues fell slightly and converged voice applications revenues wereflat compared to the first quarter of fiscal 2006.

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Thefollowing table sets forth operating income of the GCS segment:

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

|   | $ | 43 |   |   |   | $ | 32 |   |   |   | $ | 36 |   |   |   | $ | 86 |   |   | Operating income |   |   | $ | 22 |   |   |   | $ | 43 |   |   |   | 3.2 | % |   |   | 6.5 | % |   | $ | (21 | ) | -48.7 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|-----|---|-------|---|

 

The $21 milliondecline in operating income was primarily due to increases in R&Dinvestment and the first quarter of fiscal 2006 benefit of $11 millionfrom a change in the Company’s vacation policy. In addition, operating income for the first quarter of 2007 was impactedby costs associated with higher inventory levels and increased sellingexpenses. 

***Avaya Global Services***

The AGS segment is focused on supporting our broadcustomer base with comprehensive end-to-end global service offerings thatenable our customers to plan, design, implement, monitor and manage theirconverged communications networks 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 levelsof service globally to these large, and often multi-national, customers whilecontrolling costs and expanding the required skill set of our servicesorganization.

The profitability of our services business is alsoaffected by the fixed costs associated with our represented workforces in theU.S. and EMEA and includes the impact of increases in employee benefit costs.In addition, 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.

35

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

| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **First Fiscal Quarter** | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|------------------------------------|------------|
| **Fiscal 2006** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Mix**                           | ** ** | ** **                         | ** ** |
| **1Q06**             | ** ** | **2Q06**   | ** ** | **3Q06**   | ** ** | **4Q06**   | ** ** | **Dollars in millions** | ** ** | ** **                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** | **Change** | ** ** |
|                      |            |            |            |            |            |            |            |                                   |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

|   | $      | 412    |   |   |   | $      | 401    |   |   |   | $      | 402    |   |   |   | $                                  | 404    |   |   | Product Support Services |   | $      | 411 |   | $      | 412    |   |   | 69     | %      |   |   | 70     | %      |   |   | $      | (1 | )      |   |   | -0.2 | % |   |
|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|------------------------------------|--------|--------|--------|--------------------------|--------|--------|-----|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|----|--------|--------|--------|------|---|--------|
|   | 95     |   |   |   | 89     |   |   |   | 106    |   |   |   | 111    |   |   | Consulting and Systems Integration |   | 98     |   | 95                       |   |   | 16  | %      |   |   | 16     | %      |   |   | 3      |   |   |   | 3.2    | %      |   |
|   | 81     |   |   |   | 86     |   |   |   | 84     |   |   |   | 89     |   |   | Global Managed Services            |   | 89     |   | 81                       |   |   | 15  | %      |   |   | 14     | %      |   |   | 8      |   |   |   | 9.9    | %      |   |
|   | — |   |   |   | 1      |   |   |   | 1      |   |   |   | — |   |   | Services—Other                |   | — |   | —                   |   |   | 0   | %      |   |   | 0      | %      |   |   | — |   |   |   | 0.0    | %      |   |
|   | $      | 588    |   |   |   | $      | 577    |   |   |   | $      | 593    |   |   |   | $                                  | 604    |   |   | Total AGS revenue        |   | $      | 598 |   | $      | 588    |   |   | 100    | %      |   |   | 100    | %      |   |   | $      | 10 |   |   |   | 1.7  | % |   |

 

Overall AGS revenue increased by $10 million, or 1.7%, due to foreign currency fluctuations thatbenefited each class of AGS revenue and increased global managed servicesrevenue. AGS revenues in the U.S. declined but were offset byincreases in all other geographic regions.

Product support services revenues were roughly flat compared to the firstquarter of fiscal 2006. Consulting and systems integration revenues grewslightly. Global managed services revenues increased due to a large managedservices contract which was partially offset by reductions in scope,cancellations of contracted services and price erosion on new contracts.

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

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

|   | $ | 60 |   |   |   | $ | 41 |   |   |   | $ | 34 |   |   |   | $ | 36 |   |   | Operating income |   |   | $ | 53 |   |   |   | $ | 60 |   |   |   | 8.9 | % |   |   | 10.2 | % |   |   | $ | (7 | ) |   | -11.0 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|------|---|--------|--------|---|----|---|--------|-------|---|

 

The decrease in operatingincome is primarily due to the benefit of $10 million during the first quarterof fiscal 2006 from the change in our vacation policy. In addition, the benefitof reduced costs from restructuring actions was offset by lower margins on alarge managed services contract and increased employee benefit costs.

**Corporate/Other Unallocated Amounts**

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

|   | $ | 4 |   |   |   | $ | (20 | ) |   |   | $ | (42 | ) |   |   | $ | (47 | ) |   | Operating income (loss) |   |   | $ | 15 |   |   |   | $ | 4 |   |   |   | 2.5 | % |   |   | 0.7 | % |   |   | $ | 11 |   |   | 272.1 | % |
|--------|---|---|--------|--------|--------|---|-----|---|--------|--------|---|-----|---|--------|--------|---|-----|---|--------|-------------------------|--------|--------|---|----|--------|--------|--------|---|---|--------|--------|--------|-----|---|--------|--------|-----|---|--------|--------|---|----|--------|--------|-------|---|

 

At the beginning of each fiscal year, the amount ofcorporate overhead and certain other expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year. Any adjustment of the annual incentive accrual, as well asany other over/under absorption of corporate overhead expenses against plan, isrecorded within Corporate/Other Unallocated Amounts. In addition, certaindiscrete items, such as charges relating to restructuring actions, are notallocated to the operating segments and remain in Corporate/Other UnallocatedAmounts.

For the first quarter offiscal 2007, operating income in Corporate/Other Unallocated Amounts isprimarily due to the $7 million gain on the sale of real estate, the $8 millionbenefit from non-income tax audit settlements in several jurisdictions and $6million of miscellaneous items, partially offset by $6 million of netrestructuring charges.

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**Liquidity andCapital Resources**

During the first quarterof fiscal 2007, we generated positive cash flow from operations of $17 million.In addition, we used $15 million of cash to acquire Traverse Networks and used$39 million of cash for capital expenditures and software development costs,which contributed to the decrease in cash and cash equivalents to $895 millionas of December 31, 2006 from $899 million as of September 30, 2006.

***Sources and Uses of Cash for the Three Months Ended December 31,2006***

Acondensed statement of cash flows for the first quarter of fiscal 2007 and 2006follows:

| ** **                                                    | ** ** | **First Fiscal Quarter** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------|------------|
| **Dollars in millions**                             | ** ** | ** **                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net cash provided by  (used for):                             |       |                               |       |   |   |
| Operating activities                                          |       | $                                  | 17         |   | $ | 106 |   |
| Investing activities                                          |       | (53                                | )          | (42 | ) |
| Financing activities                                          |       | 20                                 |       | (84 | ) |
| Effect of  exchange rate changes on cash and cash equivalents |       | 12                                 |       | (4 | ) |
| Net decrease in  cash and cash equivalents                    |       | (4                                 | )          | (24 | ) |
| Cash and cash  equivalents at beginning of the quarter        |       | 899                                |       | 750 |   |
| Cash and cash  equivalents at end of quarter                  |       | $                                  | 895        |   | $ | 726 |   |
|                                                               |            |                                    |            |  |  |  |  |  |  |

 

***Operating Activities***

Our net cash provided byoperating activities was $17 million for the first quarter of fiscal 2007,compared to $106 million in the first quarter of fiscal 2006. The decrease incash provided by operating activities was primarily driven by higher employeeincentive payments and an increase in working capital due primarily to thetiming of vendor payments and slower collections of non-U.S. receivables discussedbelow. The first quarter of fiscal 2007 included payment of employee incentivesbased on fiscal 2006 performance. The first quarter of fiscal 2006 includedpayments of lower discretionary awards based on fiscal 2005 performance.  This change in the level of incentive paymentsresulted in an approximately $70 million increase in cash usage.

*AccountsReceivable, Net—*The followingsummarizes our accounts receivable, net and related mertrics:

| **Dollars in millions**                                           | ** ** | ** ** | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** | **Change** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|------------------------------|------------|------------|------------|
| Accounts receivable,  gross                                                 |       |       | $          | 909                         |       |                         |       | $          | 928        |   |   |   | $ | (19 | ) |   |
| Allowance for  doubtful accounts                                            |       |       | (55        | )                           |       |                         | (57        | )          |       |   | 2 |   |   |
| Accounts  receivable, net                                                   |       |       | $          | 854                         |       |                         |       | $          | 871        |   |   |   | $ | (17 | ) |   |
| Allowance for doubtful accounts as a percent of  accounts receivable, gross |       |       | 6.1        | %                           |       |                         | 6.1        | %          |       |   | 0 | % |   |
| Past due  receivables as a percent of account receivable, gross             |       |       | 21.6       | %                           |       |                         | 17.8       | %          |       |   | 3.8 | % |   |

 

| ** **                    | ** ** | **For the three months ended** | ** **   | ** **                   | ** ** |
|-------------------------------|------------|----------------------------------------------------|--------------|------------------------------|------------|
| ** **                    | ** ** | **December 31,  2006**                        | ** **   | **September 30,  2006** | ** ** | **Change** | ** ** |
| Days sales  outstanding (DSO) |       |                                               | 60 days |                         |       |   | 57 days |   |   | +3 days |   |
|                               |            |                                                    |              |                              |            |  |  |  |  |  |  |

 

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The decrease in accounts receivable was primarily theresult of fluctuations in sales between the first quarter of fiscal 2007 andfourth quarter of fiscal 2006 and the timing of collections around calendaryear-end. The increase in DSO was primarily caused by slower collections ofnon-U.S. receivables.

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

| **Dollars in millions** | ** ** | ** ** | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** | **Change** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------|------------|------------------------------|------------|------------|------------|
| Finished goods                    |       |       | $          | 290                         |       |                         |       | $          | 281        |   |   | $ | 9 |   |
| Raw materials                     |       |       | 3          |                        |       |                         | 4          |       |       | (1 | ) |
| Total inventory                   |       |       | $          | 293                         |       |                         |       | $          | 285        |   |   | $ | 8 |   |
| Inventory  turnover               |       |       | 9.3 times  |                        |       |                         | 10.2 times |       |       | -0.9 times |   |

 

Inventory increasedslightly since the beginning of fiscal 2007, primarily as a result of thewarehousing and physical distribution issue described above in “Manufacturingand Logistics.”

*AccountsPayable*—The followingsummarizes our accounts payable:

| **Dollars in millions** | ** ** | ** ** | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** | **Change** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------|------------|------------------------------|------------|------------|------------|
| Accounts payable                  |       |       | $          | 371                         |       |                         |       | $          | 418        |   |   |   | $ | (47 | ) |   |
| Days payable outstanding          |       |       | 49         |                        |       |                         | 51         |       |       |   | -2 |   |   |

 

Accounts payable decreasedin the first quarter of fiscal 2007 from the prior quarter due to the timing ofpayments during the quarter.

***Investing Activities***

Net cash used for investing activities was $53 millionin the first quarter of fiscal 2007, compared with $42 million in the samequarter last year. Activities in the current quarter include $20 million forcapital expenditures, $19 million for capitalized software development costsand $15 million for the acquisition of Traverse Networks.

Cash used in the samequarter of fiscal 2006 included $26 million for capital expenditures and$18 million for capitalized software development costs.

***Financing Activities***

Net cash provided by financing activities was $20million in the first quarter of fiscal 2007, compared with net cash used forfinancing activities of $84 million in the same quarter last year. Activitiesin the current quarter included $20 million of cash received in connection withthe issuance of common stock under our employee stock purchase plan and stockoption plans.

Cash used in the samequarter of fiscal 2006 consisted primarily of $90 million to repurchase ourcommon stock pursuant to our stock repurchase plan, partially offset by $6million of cash received in connection with issuance of common stock under ouremployee stock purchase plan and stock option plans.

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

***Future Cash Requirements***

Our primary future cash requirements will be to fundcapital expenditures, restructuring payments, employee benefit obligations,share repurchases and future acquisitions.

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Specifically, weexpect our primary cash requirements for the remainder of fiscal 2007 to be asfollows:

·       *Capital expenditures*—We expect to spendapproximately $200 million for capital expenditures and capitalized softwaredevelopment costs during the remainder of fiscal 2007.

·       *Restructuring payments—*We expect to makepayments of approximately $70 million during the remainder of fiscal 2007 foremployee separation costs and lease termination obligations associated withrestructuring actions we have taken to date. We are evaluating a plan to takefurther actions during the remainder of fiscal 2007, primarily in EMEA and theU.S., to further reduce costs and expenses. We would expect to make additionalpayments during the remainder of fiscal 2007 associated with any furtherrestructuring activity in fiscal 2007.

·       *Employee benefit obligations*—We estimate we will pay $4million and $9 million for U.S. and non-U.S. pension benefits, respectively, forthe remainder of fiscal 2007. We also estimate that we will make payments of $50 million for retiree medicalbenefits that are not pre-funded during the remainder of fiscal 2007.

·       *Share repurchases—*In accordance with theshare repurchase plan authorized by the Board of Directors in April 2005,we may use up to $500 million of cash to repurchase shares of our outstandingcommon stock through April 2007. Since the start of the plan through February 6,2007, we paid $471 million to repurchase and retire our shares, leavingapproximately $29 million available for further share repurchases according tothe limitations of the plan. See Note 8, “Earnings Per Share of Common Stock,”to our Consolidated Financial Statements for further information.

·       *Acquisitions—*We expect to use cash of approximately $144million to complete our tender offer to acquire Ubiquity during the secondquarter of fiscal 2007, excluding transaction expenses. See Note 3, “BusinessCombinations and Other Transactions,” to our Consolidated Financial Statementsfor further information.

***Future Sources of Liquidity***

We expect our primary source of cash during theremainder of fiscal 2007 to be positive net cash provided by operatingactivities. We expect that growth in profitable revenues and continued focus onaccounts receivable, inventory management and cost containment will enable usto continue to generate positive net cash from operations.

We and a syndicate of lenders are currently party to a$400 million revolving credit facility (see Note 7, “FinancingArrangements” 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 $895 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.

***Uncertainties Regarding Our Liquidity***

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

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We believe thefollowing uncertainties exist regarding our liquidity:

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

·       *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 of Financial Instruments***

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

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We aretherefore subject to the risk associated with foreign currency exchange ratesand interest rates that could affect our results of operations, financialposition and cash flows. We manage our exposure to these market risks throughour regular operating and financing activities and, when deemed appropriate,through the use of derivative financial instruments. We use derivativefinancial instruments to reduce earnings and cash flow volatility associatedwith foreign exchange rate changes. Derivative financial instruments are usedas risk management tools and not for speculative or trading purposes. As of December 31,2006 and September 30, 2006, the estimated fair values of our foreigncurrency forward contracts were $1 million and $2 million,respectively, and were included in other current liabilities. The estimatedfair values of these forward contracts were based on market quotes obtainedthrough 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 December 31, 2006, we had a long-term corporate family rating of Ba3with a 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 facility contains affirmative andrestrictive covenants that we must comply with, as described in Note 7, “FinancingArrangements” to our Consolidated Financial Statements. As of December 31,2006, we were in compliance with all of the covenants included in the creditfacility.

Provided that we are in compliance with the terms ofthe credit facility, we may use up to $1 billion in cash (excluding transactionfees) and assumed debt for acquisitions completed after February 23, 2005.The acquisition amount will be permanently increased to $1.5 billion afterour consolidated adjusted EBITDA for any period of twelve consecutive monthsequals or exceeds $750 million.

There are currently $29million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility and the remainingavailability is $371 million as of December 31, 2006. We believe thecredit facility provides us with an important source of backup liquidity.

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**The Application ofCritical Accounting Policies**

Our Consolidated FinancialStatements are based on the selection and application of accounting principlesgenerally accepted in the United States of America, which require us to makeestimates and assumptions about future events that affect the amounts reportedin our financial statements and the accompanying notes. Future events and theireffects cannot be determined with absolute certainty. Therefore, thedetermination of estimates requires the exercise of judgment. Actual resultscould differ from those estimates, and any such differences may be material tothe financial statements. We believe that the following policies may involve ahigher degree of judgment and complexity in their application and represent thecritical accounting policies used in the preparation of our financialstatements. If different assumptions or conditions were to prevail, the resultscould be materially different from our reported results.

***Revenue Recognition***

We derive revenue primarily from the sale and serviceof communication systems and applications. In accordance with SEC StaffAccounting Bulletin No. 104, “Revenue Recognition,” revenue is recognizedwhen persuasive evidence of an arrangement exists, delivery has occurred, thefee is fixed and determinable, title and risk of loss have been transferred tothe customer, contractual obligations have been satisfied and.collectibility isreasonably assured. When we provide a combination of products and services tocustomers, the arrangement is evaluated under Emerging Issues Task Force Issue No. 00-21,“Revenue Arrangements with Multiple Deliverables,” or EITF 00-21, whichaddresses certain aspects of accounting by a vendor for arrangements underwhich the vendor will perform multiple revenue-generating activities. The applicationof the appropriate accounting guidance to our revenue requires judgment and isdependent upon the specific transaction and whether the sale includes systems,applications, services or a combination of these items. As our businessevolves, the mix of products and services sold may impact the timing of whenrevenue and related costs are recognized.

Our products are sold directly through our worldwidesales force and indirectly through our global network of distributors, dealers,value-added resellers and system integrators. The purchase price of oursystems and applications sold on a direct basis typically includes installationand a warranty for up to one year. Revenue from the direct sales of productsthat include installation services is recognized at the time the products areinstalled, after satisfaction of all the terms and conditions of the underlyingcustomer contract.

Our indirect sales of products to distributionpartners are generally recognized at the time of shipment if all contractual obligationshave been satisfied. We accrue a provision for estimated sales returns andother allowances and deferrals as a reduction of revenue at the time of revenuerecognition, as required. We calculate the provision for sales returns andallowances based on a quarterly analysis of actual historical returns andallowances in relation to current quarter sales, and determine the requiredallowance. This analysis requires a significant amount of judgment. If theaccrued provision is higher or lower than required based on our quarterlyanalysis, the provision is adjusted against revenue.

Revenue and the related costs from services performedunder managed services arrangements, professional services and servicesperformed under maintenance contracts are recognized ratably over the term ofthe underlying customer contract or at the end of the contract, whenobligations have been satisfied. For services performed on a time and materialsbasis, revenue is recognized upon performance.

Most of our sales require judgment principally in theareas of customer acceptance, returns assessment and collectibility. Theassessment of collectibility is particularly critical in determining whether ornot revenue should be recognized. We assess collectibility based primarily on thecreditworthiness of the customer as determined by credit checks and analysis,as well as the customer’s payment history. In addition, a significant amount ofour revenue is generated from sales of product to distributors. As such, 

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our provision for estimatedsales returns and other allowances and deferrals requires significant judgment.We provide for estimated sales returns and other allowances and deferrals as areduction of revenue at the time of revenue recognition, as required. If theseestimates, which are based on historical experience, are significantly belowthe actual amounts, our revenue could be adversely affected.

We also sell proprietaryvoice application software products. We recognize revenue related to thesesales in accordance with AICPA Statement of Position 97-2, “SoftwareRevenue Recognition.”  Inmultiple-element software arrangements, we allocate revenue to each elementbased on its relative fair value. The fair value of any undelivered element isdetermined using vendor-specific objective evidence (“VSOE”) or, in the absenceof VSOE for all elements, the residual method when VSOE exists for all of theundelivered elements. In the absence of fair value for a delivered element, wefirst allocate revenue based on VSOE of the undelivered elements and theresidual revenue to the delivered elements. Where VSOE of the undeliveredelement cannot be determined, we defer revenue for the delivered elements untilthe undelivered elements are delivered.

***Collectibility of Accounts Receivable***

Our accounts receivableare recorded net of an allowance for doubtful accounts. As discussed above, weaccrue for the allowance based on an analysis of historical trends. In order torecord our accounts receivable at their net realizable value, we also assesstheir collectibility. A considerable amount of judgment is required in order tomake this assessment including a detailed analysis of the aging of ourreceivables and the current creditworthiness of our customers and an analysisof historical bad debts and other adjustments. We have recorded allowances forreceivables which we believe are uncollectible, including amounts for theresolution of potential credit and other collection issues such as disputedinvoices, customer satisfaction claims and pricing discrepancies. However,depending on how such potential issues are resolved, or if the financialcondition of any of our customers were to deteriorate and their ability to makerequired payments became impaired, increases in these allowances may berequired. We actively manage our accounts receivable to minimize credit risk,and as of December 31, 2006, we have no individual customer thatconstitutes more than 10% of our accounts receivable.

***Inventories***

In order to record ourinventory at its lower of cost or market value, we regularly assess theultimate realizability of our inventory. We adjust our inventory balance basedon historical usage, inventory turnover and product life cycles through therecording of a provision which we include in cost of sales. In certaincircumstances such as the introduction of a new product, we may make judgmentsas to future demand and compare that with the current or committed inventorylevels. Where we have determined that the future demand is lower than ourcurrent inventory levels, we adjust our inventory balance accordingly. Inaddition, we have outsourced the manufacturing of substantially all of our GCSproducts. We may be obligated to purchase certain excess inventory levels fromour outsourced manufacturer that could result from our actual sales of productvarying from forecast, in which case we may need to record additional inventoryprovisions in the future.

***Deferred Tax Assets and Tax Liabilities***

Our deferred tax assets are primarily a result ofdeductible temporary differences related to pension and other accruals, as wellas tax credit carryforwards and net operating loss carryforwards which areavailable to reduce taxable income in future periods. A considerable amount ofjudgment is required in estimating the amount of deferred tax assets torecognize in the financial statements. In determining whether or not avaluation allowance is required, we must consider, among other things,historical results for both book and tax purposes and expectations of future bookand  taxable income.

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The Company is directlyresponsible for all U.S. federal, state, local or foreign tax audit issues forperiods subsequent to the distribution. Significant judgment is required indetermining the worldwide provision for income taxes. While it is oftendifficult to predict the final outcome or the timing of resolution of taxissues, the Company establishes tax reserves based on estimates of additionaltaxes and interest due with respect to certain positions that may not besustained on review by tax authorities. The Company adjusts these reserves inlight of changing facts and circumstances, including the results of tax auditsand changes in tax law. The Company believes that its tax reserves reflect theprobable outcome of known contingencies.

***Long-Lived Assets***

We have recorded property, plant and equipment,intangible assets, and capitalized software costs at cost less accumulateddepreciation or amortization. The determination of useful lives and whether ornot these assets are impaired involves significant judgment.

A considerable amount of judgment is also required incalculating any impairment charge for assets that are held and used,principally in determining discount rates, market premiums, financialforecasts, and allocation methodology. In calculating an impairment charge forassets held for sale, significant judgment is required in estimating fair valueand costs to sell. Our estimates are based on valuations obtained from thirdparties and on estimates of incremental costs such as commissions and fees thatare customary for sales of similar assets.

Any potential goodwillimpairment is determined using a two-step approach. The first step of thegoodwill impairment test is used to identify potential impairment by comparingthe fair value of a reporting unit, which is one level below our operatingsegments, with its carrying amount, including goodwill. If the fair value isless than the book value, a second step is then performed. The second step ofthe goodwill impairment test compares the implied fair value of the reportingunit’s goodwill with the carrying amount of that goodwill. If the carryingamount of the reporting unit’s goodwill exceeds the implied fair value of thatgoodwill, an impairment loss is recognized in an amount equal to that excess. Weconducted the required annual goodwill impairment review during the fourthquarter of fiscal 2006. We completed updated valuations for all reporting unitswith goodwill as of September 30, 2006 using a discounted cash flowapproach based on forward-looking information regarding market share,revenues and costs for each reporting unit as well as appropriate discountrates. As a result, we determined that goodwill was not impaired as of September 30,2006.

***Restructuring Programs***

We recorded restructuring charges during the fourthquarter of fiscal 2005, fiscal 2006 and the first quarter of fiscal 2007. Therestructuring charges include employee termination benefits as well as accrualsfor vacating leased premises and terminating operating leases. In connectionwith our acquisition of Tenovis in fiscal 2005, we recorded restructuringcharges in accordance with EITF 95-3 for termination benefits to be paidto former Tenovis employees. In prior years, we recorded restructuring chargesin accordance with EITF 94-3, the balance of which relates to leasedpremises that have been vacated.

A significant amount ofjudgment is required in estimating the amount of restructuring charges torecord. Estimates used to determine employee termination benefit payments maydiffer from the actual amounts paid. In addition, estimates used to establishreserves related to real estate lease obligations may be adjusted based on newinformation. Because certain of our real estate lease obligations extendthrough fiscal 2021, assumptions were made as to the timing, availability andamount of sublease income that we expect to receive. In making theseassumptions, we considered many variables such as the vacancy rates ofcommercial real estate in the local markets and the market rate for subleaserentals. The requirement to project sublease income for many years into thefuture, our estimates and assumptions regarding the 

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commercialreal estate market that we used to calculate future sublease income may bematerially different from actual sublease income. If our sublease incomeestimates were too high, we would incur additional real estate lease obligationcharges. Conversely, if our sublease income estimates were too low, we would berequired to reverse charges and recognize income.

***Pension and Postretirement Benefit Costs***

We sponsor non-contributory defined benefit pensionplans covering the majority of our U.S. employees and retirees, andpostretirement benefit plans for U.S. retirees that include healthcare benefitsand life insurance coverage. Certain non-U.S. operations have variousretirement benefit programs covering substantially all of their employees. Someof these programs are considered to be defined benefit pension plans foraccounting purposes.

Our pension and postretirement benefit costs aredeveloped from actuarial valuations. Inherent in these valuations are keyassumptions, including the discount rate and expected long-term rate of returnon plan assets. Material changes in our pension and postretirement benefitcosts may occur in the future due to changes in these assumptions, changes inthe number of plan participants, changes in the level of benefits provided, andchanges in asset levels and changes in legislation.

The discount rate is subject to change each year,consistent with changes in rates of return on high-quality fixed-incomeinvestments currently available and expected to be available during theexpected benefit payment period. We select the assumed discount rate for ourU.S. pension and postretirement plans by applying the published rates of anexisting yield curve, such as the Citigroup Above Median Pension DiscountCurve, to the expected benefit payment streams and develop a rate at which webelieve the benefit obligations could be effectively settled. Based on thepublished rates as of September 30, 2006, we used a discount rate of 5.90%for both the U.S. pension and postretirement plans, an increase of 40 basispoints from the 5.50% rate used as of September 30, 2005. For fiscal 2006,this had the effect of reducing our projected pension benefit obligation byapproximately $131 million, and our accumulated postretirement benefitobligation by approximately $29 million. For fiscal 2007, this has theeffect of reducing pension service cost by approximately $1 million andour postretirement service cost by less than $1 million.

The expected long-term rate of return on U.S. pensionand postretirement plan assets is selected by taking into account the expectedduration of the projected benefit obligation for the plans, the targeted assetmix of the plans, and whether the plan assets are actively managed. The forward-lookingassumptions underlying our expected long-term rate of return are developed byour investment adviser and reviewed by us for reasonableness. The return andrisk assumptions consider such factors as anticipated long-term performance ofindividual asset classes, risk premium for active management based onqualitative and quantitative analysis, and correlations of the asset classesthat comprise the asset portfolio. Based on the study completed in 2006, theexpected rate of return for fiscal 2007 will remain unchanged at 9.0% for thepension plan assets and 7.0% for the postretirement plan assets. A 25 basispoint change in the expected long-term rate of return would result inapproximately a $6 million change in our pension expense and less than $1million change in our postretirement expense.

The market-relatedvalue of our plan assets is developed using a five-year smoothing technique.The market-related value as of the measurement date is calculated asfollows: (1) A preliminary market-related value is calculated byadjusting the market-related value at the beginning of the year forpayments to and from plan assets and the expected return on assets during theyear. The expected return on assets represents the expected long-term rate ofreturn on plan assets adjusted up to plus or minus 2% based on the actual 10-yearaverage rate of return on plan assets. (2) The final market-relatedvalue is determined as the preliminary market-related value from (1) above,plus 20% of the difference between the actual return and expected return foreach of the past five years.

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***Commitments andContingencies***

We are subject to legalproceedings related to environmental, product, employment, intellectualproperty, licensing and other matters. In addition, we are subject toindemnification and liability sharing claims by Lucent under the terms of theContribution and Distribution Agreement. In order to determine the amount ofreserves required, we assess the likelihood of any adverse judgments oroutcomes to these matters as well as potential ranges of probable losses. Adetermination of the amount of reserves required for these contingencies ismade after analysis of each individual issue. The estimates of requiredreserves may change in the future due to new developments in each matter orchanges in approach such as a change in settlement strategy. Assessing theadequacy of any reserve for matters for which we may have to indemnify Lucentis especially difficult, as we do not control the defense of those matters andhave limited information. In addition, estimates are made for our repurchaseobligations related to products sold to various distributors who obtainfinancing from certain third party lending institutions, as described in Note13, “Commitments and Contingencies” to our Consolidated Financial Statements.

***Accounting forStock Options***

During fiscal 2005 andprior years, we accounted for stock options in accordance with AccountingPrinciples Board Opinion 25 and disclosed the pro forma effect of expensingstock options in accordance with SFAS 123. Effective October 2005, we haveadopted SFAS 123(R), which requires us to recognize compensation expense in ourfinancial statements for the fair value of stock options we issue. Both SFAS123 and SFAS 123(R) require management to make assumptions regarding theexpected life of the options, the expected liability of the options and otheritems in determining estimated fair value. Changes to the underlyingassumptions may have significant impact on the underlying value of the stockoptions, which could have a material impact on our financial statements. Wehave elected to adopt the alternative transition method provided in FASB StaffPosition No. SFAS 123(R)-3, “Transition Election Related to Accounting forTax Effects of Share-Based Payment Awards” for calculating the tax effects ofshare-based compensation pursuant to SFAS 123(R).

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

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

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

a)                *Evaluation of Disclosure Controls and Procedures.*

As ofthe end of the period covered by this report, our management, under thesupervision and with the participation of the principal executive officer andprincipal financial officer, evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as such term is defined inRules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)). Based on thisevaluation, our principal executive officer and principal financial officerhave concluded (1) that the disclosure controls and procedures wereeffective to provide reasonable assurance that information required to bedisclosed in reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in SEC rules andforms and (2) that the disclosure controls and procedures were effectiveto ensure that information required to be disclosed in the reports that we fileor submit under the Exchange Act is accumulated and communicated to ourmanagement, including the principal executive officer and principal financialofficer, as appropriate to allow timely decisions regarding requireddisclosure.

b)               *Changes in Internal Control Over Financial Reporting.*

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

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**PART II**   OTHERINFORMATION

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

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

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

**(Cautionary Statements Under the Private Securities Litigation ReformAct 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 risks and uncertainties referred to above include, butare not limited to:

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

·       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

·       theability to form and implement alliances.

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Below is a detaileddiscussion of certain of these risks and other risks affecting our business.The categorization of risks set forth below is meant to help you betterunderstand the risks facing our business and is not intended to limit yourconsideration of the possible effects of these risks to the listed categories.Any adverse effects related to the risks discussed below may, and likely will,adversely affect many aspects of our business.

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

**A key component of our strategy is our focus on thedevelopment and sale of advanced communications products and applications andrelated services, including IP telephony solutions, and this strategy may notbe 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.

Ourinvestments are targeted around achieving our strategic vision of intelligentcommunications. Our vision may fail to predict our customers’ business needs orchanges in technological trends, which may adversely affect our operatingresults. If we do not successfully execute our strategy, our operating resultsmay be adversely 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 ourproducts can change quickly and in ways that we may not anticipate because themarket is characterized by rapid, and sometimes disruptive, technologicaldevelopments, evolving industry standards, frequent new product introductionsand enhancements, 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 alsocreate competitors with broader and more geographic coverage, with the abilityto reach 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 in technologyand product development that has characterized our markets. In addition, inorder to effectively compete with any new market entrant, we may need to makeadditional investments in our business or use more capital resources than ourbusiness currently requires or reduce prices, which may adversely affect ourprofitability.

**Ourrevenues are dependent on general economic conditions and the willingness ofenterprises to make capital investments.**

One factor that significantlyaffects our operating results is the impact of economic conditions on thewillingness of enterprises to make capital investments, particularly inenterprise communications technology and related services. Although generaleconomic conditions have improved in recent years, we believe that enterprisescontinue to be concerned about sustained economic growth and they have tried tomaintain or improve profitability through cost control and constrained capitalspending. Because it is not certain whether enterprises will increase spendingon enterprise communications technology significantly in the near term, wecould experience continued pressure on our ability to increase our revenue. Ourability to grow revenue is also affected by other factors, such as competitivepricing pressures and price erosion, see Item 2. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Key Trends andUncertainties Affecting Our Results—Trends and Uncertainties Affecting Our Revenue—Technologytransition,” “—Competitive environment’’ and “—Pressures on 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 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.**

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 also been outsourcing various logistics functions overthe course 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 could delayor decrease our revenue or otherwise have an adverse effect on our revenue andour costs.  In the first quarter offiscal 2007 we moved certain warehousing and staging operations to a differentthird party logistics service provider at a new facility, which now services asignificant portion of our warehousing and physical distribution needs. We haveexperienced disruptions and delays in delivery of certain products from thisfacility and we estimate the impact on revenue in the first quarter of fiscal2007 was in the range of $20 million and we incurred costs in the quarterrelated to these disruptions. While we and our logistics service provider havebeen making improvements as we progress through this transition, we cannotassure you that this issue will not continue to have an adverse effect on ourrevenue and 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 source 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.Shortages could be a result of manufacturing or capacity issues at ouroutsourced manufacturers or suppliers or strong demand for certain products forwhich we have not made adequate forecasts. Our operating results could beadversely affected if shortages or delays persist or if the price of thenecessary components increases or the components become unavailable atreasonable prices or 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 businesses intoours effectively, our operating results may be adversely affected. Even if weare successful, the integration of these businesses has required, and willlikely continue to require, significant resources and management attention.**

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.

**Weare dependent on our intellectual property. If we are not able to protect ourproprietary rights or if those rights are invalidated or circumvented, ourbusiness 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 current intellectualproperty rights and the establishment of new intellectual property rights. Wegenerally protect our intellectual property through patents, trademarks, tradesecrets, copyrights, confidentiality and nondisclosure agreements and othermeasures. We cannot assure you that patents will be issued from pendingapplications that we have filed or that our patents will be sufficiently broadto protect our key technology. Although we have been granted many patents, haveobtained other intellectual property rights and continue to file new patentapplications and seek additional proprietary rights, there can be no assurancesmade that any of our patents, patent applications or our other proprietaryrights will not be challenged, invalidated, or circumvented. In addition, ourbusiness is global and the level of protection of our proprietary technologywill vary by country, particularly in countries that do not have well-developedjudicial systems or laws that adequately protect intellectual property rightsand any actions taken in these countries may have results that are differentthan if such actions were taken under the laws of the United States. Patentlitigation and other challenges to our patents and other proprietary rights arecostly and unpredictable and may result in preventing us from marketing andselling a product in a particular geographic area. Patent filings bythird parties, whether made before or after the date of our filings, couldrender our intellectual property less valuable. Competitors and others may alsomisappropriate 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 to maintain adequate security over ourinformation systems could adversely affect our 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.

**As our international business has grown significantlyin the last two fiscal years, changes in economic or political conditions in aspecific country or region could negatively affect our revenue, costs, expensesand financial condition.**

We conduct significant sales and customer supportoperations in countries outside of the United States and also depend onnon-U.S. operations of our contract manufacturers and our distributionpartners. For the first quarters of fiscal 2007 and 2006, we derived 43% and41% of our revenue, respectively, from sales outside the United States. Ourfuture international operating results, including our ability to import ourproducts to, export our products from, or sell our products in variouscountries, could be materially adversely affected by a variety ofuncontrollable and changing factors. These factors include politicalconditions, economic conditions, legal and regulatory constraints, currencyregulations, health or similar issues, natural disasters and other matters 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 may impact our internationaloperations include foreign trade, environmental, monetary and fiscal policies,laws, regulations and other activities of foreign governments, agencies andsimilar organizations, and risks associated with having facilities located incountries which have historically been less stable than the United States. Forexample, the EU has enacted the RoHS and WEEE directives, which are discussedin Item 2. “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Key Trends and Uncertainties Affecting Our Results—Manufacturingand 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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**Fluctuations inforeign currency exchange rates could negatively impact our operating results.**

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 to Contingent Liabilities***

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

Pursuant to the Contribution and DistributionAgreement, Lucent contributed to us substantially all of the assets,liabilities and operations associated with its enterprise networking businessesand distributed all of the outstanding shares of our common stock to itsstockholders. The Contribution and Distribution Agreement, among other things,provides that, in general, we will indemnify Lucent for all liabilitiesincluding certain pre-distribution tax obligations of Lucent relating to ourbusinesses and all contingent liabilities primarily relating to our businessesor otherwise assigned to us. In addition, the Contribution and DistributionAgreement provides that certain contingent liabilities not directlyidentifiable with one of the parties will be shared in the proportion of 90% byLucent and 10% by us. The Contribution and Distribution Agreement also providesthat contingent liabilities in excess of $50 million that are primarily relatedto Lucent’s businesses shall be borne 90% by Lucent and 10% by us andcontingent liabilities in excess of $50 million that are primarily related toour 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 that Lucent will not submit aclaim for indemnification or cost sharing to us in connection with any futurematter. In addition, our ability to assess the impact of matters for which wemay have to indemnify or share the cost with Lucent is made more difficult bythe fact that we do not control the defense of these matters.

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

From time to time, we receive notices from thirdparties asserting that our proprietary or licensed products, systems andsoftware infringe their intellectual property rights. We cannot assure you thatthe number of these notices will not increase in the future and that otherswill not claim that our proprietary or licensed products, systems and softwareare infringing their intellectual property rights or that we do not in factinfringe those intellectual property rights. We may be unaware of intellectualproperty rights of others that may cover some of our technology. Irrespectiveof the merits of these claims, if someone claimed that our proprietary orlicensed systems and software infringed their intellectual property rights, anyresulting litigation could be costly and time consuming and would divert theattention of management and key personnel from other business issues. Thecomplexity of the technology involved and the uncertainty of intellectualproperty litigation increase these risks. These matters may result in anynumber of outcomes for us, including entering into licensing agreements, redesigningour products to avoid infringement, being enjoined from selling products thatare found to infringe, paying damages if products are found to infringe, andindemnifying customers from claims as part of our contractual obligations.Royalty or license agreements may be very costly or we may be unable to obtainroyalty or license agreements on terms acceptable to us or at all. We also maybe subject to significant damages or an injunction against us or ourproprietary or licensed systems. A successful claim of patent or otherintellectual property infringement against us could materially adversely affectour operating results. We have made and will likely continue to makeinvestments to license and/or acquire the use of third party intellectualproperty rights and technology as part of our strategy to manage this risk, butwe cannot assure you that we will be successful. We may also be subject toadditional notice and other requirements to the extent we incorporate opensource software into our applications.

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

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

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

We could be liable for all or a portion of any taxesowed for the following reasons. First, as part of the distribution, we andLucent entered into the Tax Sharing Agreement, which generally allocatesbetween Lucent and us the taxes and liabilities relating to the failure of thedistribution to be tax-free. Under the Tax Sharing Agreement, if thedistribution fails to qualify as a tax-free distribution because of an issuanceor an acquisition of our stock or an acquisition of our assets, or some otheractions of ours, then we will be solely liable for any resulting taxes toLucent.

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.

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

***(c) IssuerPurchases of Equity Securities.***

On April 19, 2005, the Board of Directorsauthorized a share repurchase plan (the “plan”). Under the provisions of theplan, Avaya may use up to $500 million of cash to repurchase shares of itsoutstanding common stock through April 2007. The Company did notrepurchase any of its common stock during the first quarter of fiscal 2007. FromJanuary 1, 2007 through February 6, 2007, the Company repurchased andretired 2,791,600 shares of its common stock at an average price of $12.96 pershare, for a total of $36 million. Approximately $29 million is availablethrough April 2007 for further share repurchases under the plan. Theserepurchases are made at management’s discretion in the open market or inprivately negotiated transactions in compliance with applicable securities lawsand other legal requirements and are subject to market conditions, share price,the terms of Avaya’s credit facility and other factors.

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

None.

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

None.

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

We make available free of charge, through our investorrelations’ website, http://investors.Avaya.com, our Form 10-K, Form 10-Qand Form 8-K reports and all amendments to those reports as soon asreasonably practicable after such material is electronically filed with orfurnished to the Securities and Exchange Commission.

**Item 6.**                        *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    |       | Form of  Avaya Inc. 2004 Long Term Incentive Plan Performance Vesting Restricted Stock  Unit Award Agreement for awards made in fiscal 2007.(3)          |
| 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.

(3)          Incorporated byreference from Avaya’s Current Report on Form 8-K/A dated December 21,2006.

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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)* |
| February 6, 2007 |   |       |   |   |

 

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