**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, 2005**

**or**

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

**Forthe transition periodfrom                   to                   **

**CommissionFile Number 001-15951**

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**AVAYA INC.**

(Exact name of registrantas specified in its charter)

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

 

**(908) 953-6000**

(Registrant’s telephonenumber, including area code)

**None**

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

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

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

| Large accelerated filer | x | 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

Asof January 31, 2006, 468,580,039 shares of Common Stock, $.01 par value ofAvaya Inc. were outstanding.

 

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**TABLE OF CONTENTS**

| Item                                  | ** ** | **Description**                                                                             | ** ** |    | **Page** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|----|----------|------------|
| **PART I FINANCIAL INFORMATION** |       |
| 1.                                    |       | Financial  Statements                                                                       |       | 3  |     |
| 2.                                    |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       | 29 |     |
| 3.                                    |       | Quantitative  and Qualitative Disclosures About Market Risk                                 |       | 53 |     |
| 4.                                    |       | Controls  and Procedures                                                                    |       | 53 |     |
| **PART II OTHER  INFORMATION**   |       |                                                                                        |       |
| 1.                                    |       | Legal Proceedings                                                                           |       | 54 |     |
| 2.                                    |       | Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities           |       | 54 |     |
| 3.                                    |       | Defaults Upon Senior  Securities                                                            |       | 54 |     |
| 4.                                    |       | Submission of  Matters to a Vote of Security Holders                                        |       | 54 |     |
| 5.                                    |       | Other Information                                                                           |       | 54 |     |
| 6.                                    |       | Exhibits                                                                                    |       | 54 |     |
|                                  |       | Signatures                                                                                  |       | 55 |     |
|                                       |            |                                                                                             |            |    |          |            |  |  |

 

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

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**Item1.**                        *Financial Statements*

**AVAYAINC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME**

| ** **                                             | ** ** | **Three months ended  December 31,**                                       | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **    2005    **                                  | ** ** | **    2004    ** | ** ** |
| ** **                                             | ** ** | **Dollars in millions,   except per share  amounts (unaudited)** | ** ** |
| REVENUE                                                |       |                                                                                      |       |   |   |   |   |   |   |
| Sales of products                                      |       |                                                                                      | $          | 591 |   |   |   | $ | 554 |   |   |
| Services                                               |       |                                                                                      | 501        |   |   |   | 477 |   |   |
| Rental and managed services                            |       |                                                                                      | 157        |   |   |   | 117 |   |   |
|                                                   |       |                                                                                      | 1,249      |   |   |   | 1,148 |   |   |
| COSTS                                                  |       |                                                                                      |       |   |   |   |   |   |   |
| Sales of products                                      |       |                                                                                      | 277        |   |   |   | 245 |   |   |
| Services                                               |       |                                                                                      | 321        |   |   |   | 308 |   |   |
| Rental and managed services                            |       |                                                                                      | 62         |   |   |   | 52 |   |   |
|                                                   |       |                                                                                      | 660        |   |   |   | 605 |   |   |
| GROSS MARGIN                                           |       |                                                                                      | 589        |   |   |   | 543 |   |   |
| OPERATING  EXPENSES                                    |       |                                                                                      |       |   |   |   |   |   |   |
| Selling, general and administrative                    |       |                                                                                      | 385        |   |   |   | 357 |   |   |
| Research and development                               |       |                                                                                      | 97         |   |   |   | 98 |   |   |
| TOTAL OPERATING EXPENSES                               |       |                                                                                      | 482        |   |   |   | 455 |   |   |
| OPERATING INCOME                                       |       |                                                                                      | 107        |   |   |   | 88 |   |   |
| Other income (expense), net                            |       |                                                                                      | 5          |   |   |   | (38 | ) |   |
| Interest expense                                       |       |                                                                                      | (1         | ) |   |   | (10 | ) |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE INCOME  TAXES |       |                                                                                      | 111        |   |   |   | 40 |   |   |
| Provision for income taxes                             |       |                                                                                      | 40         |   |   |   | 7 |   |   |
| INCOME FROM CONTINUING OPERATIONS                      |       |                                                                                      | 71         |   |   |   | 33 |   |   |
| LOSS FROM DISCONTINUED OPERATIONS, NET OF INCOME TAXES |       |                                                                                      | —     |   |   |   | (2 | ) |   |
| **NET INCOME**                                         | ** ** | ** **                                                                                | **$**      | **71** |   | ** ** | ** ** | **$** | **31** |   |   |
| **Earnings  Per Common Share—Basic:**             |       |                                                                                      |       |   |   |   |   |   |   |
| Earnings per share from continuing operations          |       |                                                                                      | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| Loss per share from discontinued operations            |       |                                                                                      | —     |   |   |   | — |   |   |
| Earnings per share                                     |       |                                                                                      | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| **Earnings  Per Common Share—Diluted:**           |       |                                                                                      |       |   |   |   |   |   |   |
| Earnings per share from continuing operations          |       |                                                                                      | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| Loss per share from discontinued operations            |       |                                                                                      | —     |   |   |   | — |   |   |
| Earnings per share                                     |       |                                                                                      | $          | 0.15 |   |   |   | $ | 0.07 |   |   |

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                           | ** ** | **December 31,**                                                                        | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                           | ** ** | **2005**                                                                                     | ** ** | **2005**               | ** ** |
| ** **                                                                                                                                                                                                                           | ** ** | **Dollars in millions, except  per share amounts (unaudited)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                           |       |                                                                                         |       |                   |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                      |       |                                                                                         |       |                   |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                           |       |                                                                                         | $          | 726                    |       |   |   | $ | 750 |   |   |
| Accounts receivable,  less allowances of $56 million and $58 million as of December 31, 2005  and September 30, 2005, respectively                                                                                         |       |                                                                                         | 811        |                   |       |   | 862 |   |   |
| Inventory                                                                                                                                                                                                                            |       |                                                                                         | 282        |                   |       |   | 288 |   |   |
| Deferred tax asset, net                                                                                                                                                                                                              |       |                                                                                         | 136        |                   |       |   | 143 |   |   |
| Other current assets                                                                                                                                                                                                                 |       |                                                                                         | 137        |                   |       |   | 128 |   |   |
| TOTAL CURRENT ASSETS                                                                                                                                                                                                                 |       |                                                                                         | 2,092      |                   |       |   | 2,171 |   |   |
| Property, plant and  equipment, net                                                                                                                                                                                                  |       |                                                                                         | 715        |                   |       |   | 738 |   |   |
| Deferred tax asset, net                                                                                                                                                                                                              |       |                                                                                         | 888        |                   |       |   | 911 |   |   |
| Intangible assets                                                                                                                                                                                                                    |       |                                                                                         | 317        |                   |       |   | 337 |   |   |
| Goodwill                                                                                                                                                                                                                             |       |                                                                                         | 904        |                   |       |   | 914 |   |   |
| Other assets                                                                                                                                                                                                                         |       |                                                                                         | 162        |                   |       |   | 148 |   |   |
| **TOTAL ASSETS**                                                                                                                                                                                                                     | ** ** | ** **                                                                                   | **$**      | **5,078**              |       | ** ** | ** ** | **$** | **5,219** |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                        |       |                                                                                         |       |                   |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                 |       |                                                                                         |       |                   |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                     |       |                                                                                         | $          | 381                    |       |   |   | $ | 402 |   |   |
| Debt maturing within one  year                                                                                                                                                                                                       |       |                                                                                         | 5          |                   |       |   | 5 |   |   |
| Payroll and benefit  obligations                                                                                                                                                                                                     |       |                                                                                         | 245        |                   |       |   | 300 |   |   |
| Deferred revenue                                                                                                                                                                                                                     |       |                                                                                         | 236        |                   |       |   | 244 |   |   |
| Other current  liabilities                                                                                                                                                                                                           |       |                                                                                         | 318        |                   |       |   | 368 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                           |       |                                                                                         | 1,185      |                   |       |   | 1,319 |   |   |
| Long-term debt                                                                                                                                                                                                                       |       |                                                                                         | 25         |                   |       |   | 25 |   |   |
| Benefit obligations                                                                                                                                                                                                                  |       |                                                                                         | 1,577      |                   |       |   | 1,561 |   |   |
| Deferred tax liability,  net                                                                                                                                                                                                         |       |                                                                                         | 89         |                   |       |   | 96 |   |   |
| Other liabilities                                                                                                                                                                                                                    |       |                                                                                         | 267        |                   |       |   | 257 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                                       |       |                                                                                         | 1,958      |                   |       |   | 1,939 |   |   |
| Commitments and contingencies (Note)                                                                                                                                                                                                 |       |                                                                                         |       |                   |       |   |   |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                        |       |                                                                                         |       |                   |       |   |   |   |   |
| Series A junior  participating preferred stock, par value $1.00 per share, 7.5 million shares  authorized; none issued and outstanding                                                                                     |       |                                                                                         | —     |                   |       |   | — |   |   |
| Common stock, par value  $0.01 per share, 1.5 billion shares authorized, 469,845,994 and 471,328,963  issued (including 274,192 and 207,053 treasury shares) as of  December 31, 2005 and September 30, 2005, respectively |       |                                                                                         | 5          |                   |       |   | 5 |   |   |
| Additional paid-in-capital                                                                                                                                                                                                           |       |                                                                                         | 2,821      |                   |       |   | 2,895 |   |   |
| Retained earnings  (accumulated deficit)                                                                                                                                                                                             |       |                                                                                         | 18         |                   |       |   | (53 | ) |   |
| Accumulated other  comprehensive loss                                                                                                                                                                                                |       |                                                                                         | (905       | )                      |       |   | (883 | ) |   |
| Less: Treasury stock at  cost                                                                                                                                                                                                        |       |                                                                                         | (4         | )                      |       |   | (3 | ) |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                                                                                                                                                                     |       |                                                                                         | 1,935      |                   |       |   | 1,961 |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                 | ** ** | ** **                                                                                   | **$**      | **5,078**              |       | ** ** | ** ** | **$** | **5,219** |   |   |

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                    | ** ** | **Three months ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **   2005   **        | ** ** | **   2004   ** | ** ** |   |
| ** **                                                                                    | ** ** | **Dollars in millions  (unaudited)**      | ** ** |
| **OPERATING ACTIVITIES:**                                                                     |       |                                                |       |   |   |   |   |   |
| Net income                                                                                    |       |                                                | $          | 71 |   |   | $ | 31 |   |   |
| Less: Loss from discontinued operations, net                                                  |       |                                                | —     |   |   | (2 | ) |   |
| Income from continuing operations                                                             |       |                                                | 71         |   |   | 33 |   |   |
| Adjustments to  reconcile net income to net cash provided by (used for) operating activities: |       |                                                |       |   |   |   |   |   |
| Depreciation and amortization                                                                 |       |                                                | 68         |   |   | 54 |   |   |
| Share-based compensation                                                                      |       |                                                | 4          |   |   | — |   |   |
| Loss on extinguishment of debt, net                                                           |       |                                                | —     |   |   | 41 |   |   |
| Deferred income taxes                                                                         |       |                                                | 24         |   |   | 6 |   |   |
| Purchased in-process research and development                                                 |       |                                                | —     |   |   | 4 |   |   |
| Adjustments for other non-cash items, net                                                     |       |                                                | (2         | ) |   | 16 |   |   |
| Changes in  operating assets and liabilities, net of effects of acquired businesses:          |       |                                                |       |   |   |   |   |   |
| Accounts receivable                                                                           |       |                                                | 44         |   |   | 48 |   |
| Inventory                                                                                     |       |                                                | 3          |   |   | (12 | ) |
| Business restructuring reserve                                                                |       |                                                | (20        | ) |   | — |   |
| Accounts payable                                                                              |       |                                                | (21        | ) |   | 9 |   |
| Payroll and benefits                                                                          |       |                                                | (31        | ) |   | (150 | ) |
| Accrued interest payable on long-term debt                                                    |       |                                                | (1         | ) |   | (20 | ) |
| Deferred revenue                                                                              |       |                                                | (10        | ) |   | (52 | ) |
| Other assets and liabilities                                                                  |       |                                                | (23        | ) |   | (13 | ) |
| NET CASH PROVIDED  BY (USED FOR) OPERATING ACTIVITIES                                         |       |                                                | 106        |   |   | (36 | ) |
| **INVESTING ACTIVITIES:**                                                                     |       |                                                |       |   |   |   |   |
| Capital expenditures                                                                          |       |                                                | (26        | ) |   | (22 | ) |
| Capitalized software development costs                                                        |       |                                                | (18        | ) |   | (14 | ) |
| Acquisitions of businesses, net of cash acquired                                              |       |                                                | —     |   |   | (383 | ) |
| Other investing activities, net                                                               |       |                                                | 2          |   |   | 19 |   |
| NET CASH (USED  FOR) INVESTING ACTIVITIES                                                     |       |                                                | (42        | ) |   | (400 | ) |
| **FINANCING ACTIVITIES:**                                                                     |       |                                                |       |   |   |   |   |
| Issuance of common stock                                                                      |       |                                                | 6          |   |   | 29 |   |
| Repurchase of common stock                                                                    |       |                                                | (90        | ) |   | — |   |
| Repayment of long-term borrowings                                                             |       |                                                | —     |   |   | (314 | ) |
| Other financing activities, net                                                               |       |                                                | —     |   |   | (3 | ) |
| NET CASH (USED  FOR) FINANCING ACTIVITIES                                                     |       |                                                | (84        | ) |   | (288 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                                 |       |                                                | (4         | ) |   | 18 |   |
| Net (decrease) in  cash and cash equivalents                                                  |       |                                                | (24        | ) |   | (706 | ) |
| Cash and cash  equivalents at beginning of fiscal year                                        |       |                                                | 750        |   |   | 1,617 |   |
| Cash and cash  equivalents at end of period                                                   |       |                                                | $          | 726 |   |   | $ | 911 |   |
|                                                                                               |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See Notes to Consolidated Financial Statements.

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**AVAYAINC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.  **Backgroundand Basis of Presentation

***Background***

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

***Basis of Presentation***

The accompanying unauditedConsolidated Financial Statements as of December 31, 2005 and for thethree months ended December 31, 2005 and 2004, have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financial statements andthe rules and regulations of the United States Securities and ExchangeCommission (“SEC”) for interim financial statements, and should be read inconjunction with the Company’s Consolidated Financial Statements and otherfinancial information for the fiscal year ended September 30, 2005,included in its Annual Report on Form 10-K filed with the SEC on December 13,2005. In the Company’s opinion, the unaudited interim Consolidated FinancialStatements reflect all adjustments, consisting of normal and recurringadjustments, necessary for a fair presentation of the financial condition,results of operations and cash flows for the periods indicated. Certain prioryear amounts have been reclassified to conform to the current interim periodpresentation. The consolidated results of operations for the interim periodsreported are not necessarily indicative of the results to be experienced forthe entire fiscal year.

**2.   Summaryof Significant Accounting Policies**

***Share-based Compensation***

On October 1, 2005, the Company adopted Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment,” (“SFAS 123(R)”) which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to employees anddirectors including employee stock options and employee stock purchases relatedto the Employee Stock Purchase Plan (“employee stock purchases”) based onestimated fair values. SFAS 123(R) supersedes the Company’s previousaccounting under Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006.In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB107”) relating to SFAS 123(R). The Company has applied the provisions of SAB107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of the accountingstandard as of October 1, 2005, the first day of the Company’s fiscal year2006. The Company’s Consolidated Financial Statements as of and for the threemonths ended December 31, 2005 reflect the impact of SFAS 123(R). Inaccordance with the modified prospective 

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transition method, theCompany’s Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Share-basedcompensation expense recognized under SFAS 123(R) for the three monthsended December 31, 2005 was $4 million, which was related to stock optionsand the discount on employee stock purchases. There was no share-basedcompensation expense related to employee stock options and employee stockpurchases recognized during the three months ended December 31, 2004.

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

Share-based compensation expense recognized during thecurrent period is based on the value of the portion of share-based paymentawards that is ultimately expected to vest. SFAS 123(R) requiresforfeitures to be estimated at the time of grant in order to estimate theamount of share-based awards that will ultimately vest. The forfeiture rate isbased on historical rates. Share-based compensation expense recognized in theCompany’s Consolidated Statements of Income for the first quarter of fiscal2006 includes (i) compensation expense for share-based payment awardsgranted prior to, but not yet vested as of September 30, 2005, based onthe grant-date fair value estimated in accordance with the pro forma provisionsof SFAS 123 and (ii) compensation expense for the share-based paymentawards granted subsequent to September 30, 2005, based on the grant-datefair value estimated in accordance with the provisions of SFAS 123(R). Asshare-based compensation expense recognized in the Consolidated Statement ofIncome for the first quarter of fiscal 2006 is based on awards ultimatelyexpected to vest, it has been reduced for estimated forfeitures. In the Company’spro forma information required under SFAS 123 for the periods prior tofiscal 2006, the Company accounted for forfeitures as they occurred.

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

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

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

| ** **                                             | ** ** | **Three months ended**                                        | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **December 31, 2005**                                         | ** ** |
| ** **                                             | ** ** | **Dollars in millions,  except per share  amounts** | ** ** |
| Income from  continuing operations before income taxes |       |                                                                    | $          | 4 |   |   |
| Income from continuing operations                      |       |                                                                    | $          | 3 |   |   |
| Net income available to common stockholders            |       |                                                                    | $          | 3 |   |   |
| Earnings per Common Share—Basic:                  |       |                                                                    |       |   |   |
| Income from continuing operations                      |       |                                                                    | $          | 0.01 |   |   |
| Net income                                             |       |                                                                    | $          | 0.01 |   |   |
| Earnings per Common Share—Diluted:                |       |                                                                    |       |   |   |
| Income from continuing operations                      |       |                                                                    | $          | 0.01 |   |   |
| Net income                                             |       |                                                                    | $          | 0.01 |   |   |

 

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

| ** **                                                                                                                | ** ** | **Three months ended**                                        | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **December 31, 2004**                                         | ** ** |
| ** **                                                                                                                | ** ** | **Dollars in millions,  except per share  amounts** | ** ** |
| Net income  available to common stockholders, as reported                                                                 |       |                                                                    | $          | 31 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects              |       |                                                                    | 1          |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based method,  net of related tax effects |       |                                                                    | (8         | ) |   |
| Net income  available to common stockholders, pro forma                                                                   |       |                                                                    | $          | 24 |   |   |
| Earnings per Common Share—Basic:                                                                                     |       |                                                                    |       |   |   |
| As reported                                                                                                               |       |                                                                    | $          | 0.07 |   |   |
| Pro forma                                                                                                                 |       |                                                                    | $          | 0.05 |   |   |
| Earnings per Common Share—Diluted:                                                                                   |       |                                                                    |       |   |   |
| As reported                                                                                                               |       |                                                                    | $          | 0.07 |   |   |
| Pro forma                                                                                                                 |       |                                                                    | $          | 0.05 |   |   |

 

***Change in Vacation Policy***

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

8

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**3.   RecentAccounting Pronouncements**

**SFAS 154**

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

**4.   BusinessCombinations and Other Transactions**

***Acquisition of Tenovis***

On November 18, 2004, the Company completed itsacquisition of Tenovis Germany GmbH (“Tenovis”). Tenovis is the parent companyof Avaya-Tenovis GmbH & Co. KG (formerly Tenovis GmbH & Co.KG), a major European provider of enterprise communications systems andservices. The acquisition of Tenovis significantly expands the Company’sEuropean operations and increases the Company’s access to European customers,particularly in Germany. At the date of acquisition, the Company recordedTenovis’s accounts receivable, inventory, fixed assets, liabilities andidentified intangibles at estimated fair value. The remainder of the purchaseprice in excess of the net assets acquired was recorded as goodwill, which wasallocated $400 million to the Global Communications Solutions (“GCS”) segmentand $206 million to the Avaya Global Services (“AGS”) segment. None of the goodwill,intangibles or in-process research and development amounts is expected to bedeductible for tax purposes. The Company allocated $298 million to intangibleassets (including contractual customer relationships, existing technology andtrademarks) based on valuation studies performed with the assistance of thirdparty valuation consultants. These intangible assets are being amortized overtheir estimated useful lives. The weighted average useful lives of the existingtechnology, customer relationships and trademarks are 5 years, 6 years and 1.5years, respectively. In addition, the Company allocated $1 million toin-process research and development, which was charged to research anddevelopment expense in the Consolidated Statements of Income during the firstquarter of fiscal 2005.

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

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

 

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The Company recorded a restructuring liability of $106million in connection with the acquisition to reflect the estimate ofrestructuring-related costs in accordance with EITF 95-3, “Recognition ofLiabilities in Connection with a Purchase Business Combination.” This liabilityis for costs incurred to terminate Tenovis employees as part of the integrationof Tenovis operations. The plan, which was completed during fiscal 2005,provided for the termination of certain employees across various Tenovisfunctional groups and subsidiaries, including sales, operations, finance, humanresources, etc. Most of the positions identified in this plan have already beeneliminated. Terminations are planned to be completed by the end of fiscal 2006.During the first quarter of fiscal 2006, the Company paid cash of $12 millionfor termination benefits. The accrual of $57 million as of December 31,2005 reflects the remaining termination payments, adjusted for foreign currencyfluctuations since the acquisition date. The final termination payment amount peremployee is subject to applicable legislation and/or approval by the relevantWorks Councils or other employee representative organizations.

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

Thefollowing unaudited pro forma financial information presents the Company’sresults for the first quarter of fiscal 2005 as if the Tenovis acquisition hadoccurred at the beginning of the period, as compared with the as reportedresults for the first quarter of fiscal 2006:

| ** **                      | ** ** | **Three months ended**                                            | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **December 31,**                                                       | ** ** |
| ** **                      | ** ** | **2005**                                                                    | ** ** | **2004** | ** ** |
| ** **                      | ** ** | **(as reported)**                                                      | ** ** | **(pro forma)** | ** ** |
| ** **                      | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| Revenue                         |       |                                                                        | $          | 1,249 |   |   |   | $ | 1,251 |   |   |
| Net income                      |       |                                                                        | $          | 71 |   |   |   | $ | 5 |   |   |
| Earnings per  share—basic  |       |                                                                        | $          | 0.15 |   |   |   | $ | 0.01 |   |   |
| Earnings per share—diluted |       |                                                                        | $          | 0.15 |   |   |   | $ | 0.01 |   |   |

 

The pro forma results for the three months ended December 31,2004 have been prepared for comparative purposes only and include certainadjustments such as additional estimated depreciation and amortization expenseas a result of identifiable intangible assets arising from the acquisition. Thepro forma results are not necessarily indicative of the results of operationsthat actually would have resulted had the acquisition been in effect at thebeginning of the period or of future results.

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

The remainingnon-consolidated VIE is a non-U.S. telecommunications hardware productionmanufacturer and service provider. The Company has agreed to purchase from theVIE certain amounts of products and services, and the VIE has contracted forthe Company to provide certain IT services and purchasing services with respectto raw materials. These contracts expire in August 2007. During the firstquarter of fiscal 2006, the Company purchased products and services aggregating$8 million. Additionally, 

10

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theCompany is required to pay monthly rental subsidies on the VIE’s premises, andin the event the VIE is unable to pay its portion of the rental payments, theCompany is liable for their portion as well. During the first quarter of fiscal2006, the Company paid $225,000 in connection with rental subsidies. Themaximum exposure to loss as of December 31, 2005 for the remainder of theagreement is the minimum purchase order commitments and the minimum servicelevels for service contracts of $11 million and the guarantee for rents to bepaid by the VIE of $1 million.

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

***DiscontinuedOperations***

There was no revenue orincome before income taxes from discontinued operations for the first quarterof fiscal 2006. In the first quarter of fiscal 2005 the Company incurred a $2 million loss on the sale of the Company’sConnectivity Solutions business primarily as the result of the finalization ofthe working capital adjustment in accordance with the terms of the assetpurchase agreement.

**5.   Goodwilland Intangible Assets**

Thechanges in the carrying value of goodwill for the first quarter of fiscal 2006by operating segment are as follows:

| ** **                                             | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|------------|------------|
| ** **                                             | ** ** | **Communications**                | ** ** | **Global**   | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Total**  | ** ** |
| ** **                                             | ** ** | **Dollars in millions** | ** ** |
| **Balance as of  September 30, 2005**             | ** ** |                              | **$**      | **642**      | ** ** |       |       | **$** | **272** | ** ** |   | **$** | **914** | ** ** |
| Impact of foreign  currency exchange rate fluctuations |       |                              | (7         | )            |       |       | (3         | ) |   | (10 | ) |
| **Balance as of December 31, 2005**               | ** ** |                              | **$**      | **635**      | ** ** |       |       | **$** | **269** | ** ** |   | **$** | **904** | ** ** |

 

The following tablepresents the components of the Company’s acquired intangible assets.

| ** **                                    | ** ** | **December 31, 2005**   | ** ** | **September 30, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **Gross**                         | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**                      | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Amount**                        | ** ** | **Amortization**                 | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| ** **                                    | ** ** | **Dollars in millions** | ** ** |
| Existing technology                           |       |                              | $          | 101                              |       |   |   | $ | 45 |   |   | $ | 56 |   |   | $ | 101 |   |   |   | $ | 41 |   |   | $ | 60 |   |
| Customer relationships and  other intangibles |       |                              | 285        |                             |       |   | 57 |   |   | 228 |   |   | 288 |   |   |   | 45 |   |   | 243 |   |
| **Total amortizable intangible  assets**      | ** ** | ** **                        | **$**      | **386**                          |       | ** ** | ** ** | **$** | **102** |   | ** ** | **$** | **284** | ** ** | ** ** | **$** | **389** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **303** | ** ** |
| Minimum pension  adjustment, net of tax       |       |                              | 33         |                             |       |   | — |   |   | 33 |   |   | 34 |   |   |   | — |   |   | 34 |   |
| **Total intangible assets**                   | ** ** | ** **                        | **$**      | **419**                          |       | ** ** | ** ** | **$** | **102** |   | ** ** | **$** | **317** | ** ** | ** ** | **$** | **423** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **337** |   |

 

During the first quarter of fiscal 2006, amortizationand the impact of foreign currency fluctuations resulted in a decrease of $20million in the net intangible assets balance. The weighted average useful lifeof the technology, customer relationships, and trademarks are 5 years, 6 yearsand 5 years, respectively.

Amortization expense forthe Company’s acquired intangible assets was $16 million for the first quarterof fiscal 2006. The majority of future estimated amortization expense isassociated with intangible assets acquired in the Tenovis acquisition. Estimatedfuture amortization expense is shown in the following table.

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| ** **                      | ** ** | **Expected future**          | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **amortization expense**     | ** ** |
| ** **                      | ** ** | **Dollars in millions** | ** ** |
| Remainder of fiscal 2006        |       |                              | $          | 46 |   |   |
| 2007                            |       |                              | 58         |   |   |
| 2008                            |       |                              | 58         |   |   |
| 2009                            |       |                              | 56         |   |   |
| 2010                            |       |                              | 44         |   |   |
| 2011 and thereafter             |       |                              | 22         |   |   |
| **Future amortization expense** | ** ** | ** **                        | **$**      | **284** |   |   |

 

The minimum pensionadjustment, net of tax, represents unrecognized prior service costs associatedwith the recording of a minimum pension liability in fiscal 2004, 2003 and 2002.This intangible asset may be eliminated or adjusted as necessary when theamount of minimum pension liability is reassessed, which is conducted at leastannually.

**6.   SupplementaryFinancial Information**

***Statement of IncomeInformation***

| ** **                                 | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                 | ** ** | **   2005   **       | ** ** | **   2004   ** | ** ** |
| ** **                                 | ** ** | **Dollars in millions**                  | ** ** |
| **OTHER  INCOME (EXPENSE), NET**           |       |                                               |       |   |   |   |   |   |   |
| Interest income                            |       |                                               | $          | 7 |   |   |   | $ | 6 |   |   |
| Loss on long-term debt extinguishment, net |       |                                               | —     |   |   |   | (41 | ) |   |
| Other, net                                 |       |                                               | (2         | ) |   |   | (3 | ) |   |
| **Total other income (expense),  net**     | ** ** | ** **                                         | **$**      | **5** |   | ** ** | ** ** | **$** | **(38** | **)** | ** ** |

 

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***Balance SheetInformation***

| ** **                                                              | ** ** | **December 31, 2005**   | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY:**                                                          |       |                              |       |                             |       |   |   |   |   |
| Finished goods                                                          |       |                              | $          | 264                              |       |   |   | $ | 274 |   |   |
| Raw materials                                                           |       |                              | 18         |                             |       |   | 14 |   |   |
| **Total  inventory**                                                    | ** ** | ** **                        | **$**      | **282**                          | ** ** | ** ** | ** ** | **$** | **288** | ** ** | ** ** |
| **PROPERTY, PLANT AND EQUIPMENT, NET:**                                 |       |                              |       |                             |       |   |   |   |   |
| Land and improvements                                                   |       |                              | $          | 51                               |       |   |   | $ | 41 |   |   |
| Buildings and improvements                                              |       |                              | 443        |                             |       |   | 430 |   |   |
| Machinery and equipment                                                 |       |                              | 614        |                             |       |   | 640 |   |   |
| Rental equipment                                                        |       |                              | 211        |                             |       |   | 210 |   |   |
| Assets under construction                                               |       |                              | 9          |                             |       |   | 7 |   |   |
| Internal use software                                                   |       |                              | 240        |                             |       |   | 237 |   |   |
| Total property,  plant and equipment                                    |       |                              | 1,568      |                             |       |   | 1,565 |   |   |
| Less: Accumulated  depreciation and amortization                        |       |                              | (853       | )                                |       |   | (827 | ) |   |
| **Property,  plant and equipment, net**                                 | ** ** | ** **                        | **$**      | **715**                          | ** ** | ** ** | ** ** | **$** | **738** | ** ** | ** ** |
| **ACCUMULATED OTHER COMPREHENSIVE LOSS:**                               |       |                              |       |                             |       |   |   |   |   |
| Cumulative translation adjustment                                       |       |                              | $          | 25                               |       |   |   | $ | 48 |   |   |
| Minimum pension liability, net of tax                                   |       |                              | (928       | )                                |       |   | (928 | ) |   |
| Unrealized holding loss on securities classified as  available for sale |       |                              | (2         | )                                |       |   | (3 | ) |   |
| **Accumulated other comprehensive  loss**                               | ** ** | ** **                        | **$**      | **(905**                         | **)**      | ** ** | ** ** | **$** | **(883** | **)** | ** ** |

 

***Cash FlowInformation***

| ** **                                                 | ** ** | **Three months ended**  | ** ** |
|------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                 | ** ** | **December 31, 2004**   | ** ** |
| ** **                                                 | ** ** | **Dollars in millions** | ** ** |
| **CASH USED FOR ACQUISITIONS**                             |       |                              |       |   |   |
| Working capital, other than cash                           |       |                              | $          | (83 | ) |   |
| Property, plant and equipment                              |       |                              | 282        |   |   |
| Goodwill                                                   |       |                              | 677        |   |   |
| Intangible assets and in-process research and  development |       |                              | 349        |   |   |
| Long-term debt                                             |       |                              | (287       | ) |   |
| Other liabilities                                          |       |                              | (555       | ) |   |
| **Net cash used to acquire  businesses**                   | ** ** | ** **                        | **$**      | **383** |   |   |

 

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**7.**   RestructuringPrograms

***Fourth Quarter 2005 Restructuring Plan***

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

| ** **                                | ** ** | **Employee**                      | ** ** | **Lease**       | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                                | ** ** | **Separation**                    | ** ** | **Termination** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                                | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2005    |       |                              | $          | 7               |       |       |       | $ | 10 |   |   |   | $ | 17 |   |   |
| Cash payments                             |       |                              | (2         | )               |       |       | (2         | ) |   |   | (4 | ) |   |
| **Balance as of December 31,  2005** | ** ** | ** **                        | **$**      | **5**           |       | ** ** | ** ** | **$** | **8** |   | ** ** | ** ** | **$** | **13** |   |   |

 

The Company may takefurther restructuring actions in the future in its EMEA region. The potentialnumber of employee reductions and cost per employee cannot be reasonablyestimated at this time.

***EITF 95-3 Reserve***

Thisreserve reflects the remaining balance associated with employee separationcharges related to the acquisition of Tenovis. This balance is included inother liabilities in the Company’s Consolidated Balance Sheets. The followingtable summarizes the components of this reserve during the first quarter offiscal 2006:

| ** **                                | ** ** | **Employee**                  | ** ** |
|-------------------------------------------|------------|-------------------------------|------------|
| ** **                                | ** ** | **Separation**                | ** ** |
| ** **                                | ** ** | **Costs**                     | ** ** |
| ** **                                | ** ** | **Dollars  in millions** | ** ** |
| Balance as of September 30,  2005    |       |                          | $          | 70 |   |   |
| Foreign currency impacts                  |       |                          | (1         | ) |   |
| Cash payments                             |       |                          | (12        | ) |   |
| **Balance as of December 31,  2005** | ** ** | ** **                    | **$**      | **57** |   |   |

 

***EITF 94-3 Reserve***

This restructuring reservereflects the remaining balance associated with the business restructuring chargesrelated to lease terminations recorded in fiscal 2000 through 2002 inaccordance with EITF 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)” and is included in other liabilities in theCompany’s Consolidated Balance Sheets. The changes in estimates are included inselling, general and administrative expenses in the Company’s ConsolidatedStatements of Income. The following table summarizes the components of thisrestructuring reserve during the first quarter of fiscal 2006: 

14

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| ** **                               | ** ** | **Lease**                         | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **Termination**                   | ** ** |
| ** **                               | ** ** | **Obligations**                   | ** ** |
| ** **                               | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2005   |       |                              | $          | 24 |   |   |
| Changes in estimates                     |       |                              | 1          |   |   |
| Cash payments                            |       |                              | (3         | ) |   |
| **Balance as of December 31, 2005** | ** ** | ** **                        | **$**      | **22** |   |   |

 

**8.**   Long-Term Debt

Debtoutstanding consists of the following:

| ** **                                                                                      | ** ** | **December 31, 2005**   | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                      | ** ** | **Dollars in millions** | ** ** |
| Debt maturing  within one year:                                                                 |       |                              |       |                             |       |   |   |   |   |
| Capital lease obligations                                                                       |       |                              | $          | 5                                |       |   |   | $ | 5 |   |   |
| Long-term debt:                                                                                 |       |                              |       |                             |       |   |   |   |   |
| 111¤8% Senior  Notes, net of discount, premium and net deferred gain on interest rate swap |       |                              | 13         |                             |       |   | 14 |   |   |
| Capital lease obligations                                                                       |       |                              | 12         |                             |       |   | 11 |   |   |
| Total long-term debt                                                                            |       |                              | 25         |                             |       |   | 25 |   |   |
| **Total debt**                                                                                  | ** ** | ** **                        | **$**      | **30**                           |       | ** ** | ** ** | **$** | **30** |   |   |

 

Through a series oftransactions during fiscal 2005, the Company reduced the carrying value of the 111¤8%Senior Notes due April 2009(“Senior Notes”) from $294 million as of September 30, 2004 to $14 millionas of September 30, 2005. These notes can be redeemed at the Company’soption beginning in April 2006. In February 2006, the Companyprovided notice to the trustee under the note indenture that it will redeem alloutstanding notes in April 2006.

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

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

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

 

The carrying value as of September 30, 2005 of$14 million is comprised of the aggregate principal amount outstanding of $13million increased for $1 million of unamortized premium, net of discount andthe net unamortized deferred gain related to the termination of interest rateswap agreements. The reduction in carrying value as of December 31, 2005is due to the amortization of the net premium and deferred gain.

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

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***Credit Facility Amendments***

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

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can be outstandingat any time is $400 million, of which $150 million may be in the form ofletters of credit. The credit facility is a five-year revolving facility (withan expiration date of February 23, 2010) and is not secured by any assets.The credit facility contains 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 subsidiary indebtedness,(e) limitations on liens, (f) limitations on investments and (g) limitationson the creation or existence of agreements that prohibit liens on ourproperties. The credit facility also limits the Company’sability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock to an amount notto exceed 50% of consolidated net income of the Company for the fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. For fiscal 2006, thecredit facility allows the Company to repurchase, redeem or otherwise acquireshares of its common stock up to an amount not to exceed $461 million, or 50%of fiscal 2005 net income. As of December 31, 2005, the Company was incompliance with all of the covenants included in the credit facility.

The credit facility provides that the Company may useup to $1 billion in cash (excluding transaction fees) and assumed debt foracquisitions completed after February 23, 2005, provided that it is incompliance with the terms of the agreement. The acquisition amount will bepermanently increased to $1.5 billion after consolidated EBITDA of theCompany and its subsidiaries for any period of twelve consecutive months equalsor exceeds $750 million.

There are currently $57 million of letters ofcredit issued under the credit facility. There are no other outstandingborrowings under the facility. The Company believes the credit facilityprovides it with an important source of backup liquidity.

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

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**9.**   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, warrants and convertible debt.

| ** **                                                                            | ** ** | **Three months ended  December 31,**                              | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| ** **                                                                            | ** ** | **Dollars in millions,  except per share amounts**      | ** ** |
| ***Earnings  Per Common Share—Basic:***                                          |       |                                                                             |       |   |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                             | $          | 71 |   |   |   | $ | 33 |   |   |
| Loss from  discontinued operations                                                    |       |                                                                             | —     |   |   |   | (2 | ) |   |
| Net income                                                                            |       |                                                                             | $          | 71 |   |   |   | $ | 31 |   |   |
| Earnings per share from continuing operations                                         |       |                                                                             | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| Earnings per  share from discontinued operations                                      |       |                                                                             | —     |   |   |   | — |   |   |
| Earnings per  share**—**basic                                                    |       |                                                                             | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| Weighted average  shares outstanding**—**basic                                   |       |                                                                             | 471        |   |   |   | 460 |   |   |
| ***Earnings  Per Common Share—Diluted:***                                        |       |                                                                             |       |   |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                             | $          | 71 |   |   |   | $ | 33 |   |   |
| Interest charges  associated with LYONs convertible debt, net of tax effects          |       |                                                                             | —     |   |   |   | 2 |   |   |
| Income from  continuing operations after assumed conversion of LYONs debt             |       |                                                                             | 71         |   |   |   | 35 |   |   |
| Loss from  discontinued operations                                                    |       |                                                                             | —     |   |   |   | (2 | ) |   |
| Net income after  assumed conversion of LYONs debt                                    |       |                                                                             | $          | 71 |   |   |   | $ | 33 |   |   |
| Earnings per share from continuing operations                                         |       |                                                                             | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| Earnings per  share from discontinued operations                                      |       |                                                                             | —     |   |   |   | — |   |   |
| Earnings per  share—diluted                                                      |       |                                                                             | $          | 0.15 |   |   |   | $ | 0.07 |   |   |
| ***Diluted  Weighted Average Shares Outstanding:***                                   |       |                                                                             |       |   |   |   |   |   |   |
| Weighted average  shares outstanding**—**basic                                   |       |                                                                             | 471        |   |   |   | 460 |   |   |
| Dilutive Potential  Common Shares:                                                    |       |                                                                             |       |   |   |   |   |   |   |
| Stock Options                                                                         |       |                                                                             | 5          |   |   |   | 8 |   |   |
| Restricted Stock Units                                                                |       |                                                                             | 1          |   |   |   | — |   |   |
| Warrants                                                                              |       |                                                                             | 1          |   |   |   | 6 |   |   |
| LYONs Convertible Debt                                                                |       |                                                                             | —     |   |   |   | 18 |   |   |
| Weighted average  shares outstanding**—**diluted                                 |       |                                                                             | 478        |   |   |   | 492 |   |   |
| ***Securities  excluded from the computation of diluted earnings per common share:*** |       |                                                                             |       |   |   |   |   |   |   |
| Stock options(1)                                                                      |       |                                                                             | 37         |   |   |   | 12 |   |   |
| Warrants(1)                                                                           |       |                                                                             | —     |   |   |   | 6 |   |   |
|                                                                                  |       |                                                                             | 37         |   |   |   | 18 |   |   |

----

(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. Forfiscal 2006, the credit facility limits the Company’s ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquire sharesof Avaya 

17

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commonstock to $461 million (which represents 50% of net income for the Company forfiscal 2005). During the first quarter of fiscal 2006, the Company repurchasedand retired 7,947,600 shares at an average purchase price of $11.32 per share,for a total of $90 million. From January 1, 2006 through February 7, 2006,the Company repurchased and retired 4,867,600 shares at an average purchaseprice of $10.49 per share, for an additional $51 million. Approximately $252million 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 negotiated transactions in compliance withapplicable securities laws and other legal requirements and are subject tomarket conditions, share price, the terms of Avaya’s credit facility and otherfactors.

**10.**   Income Taxes

The provision for income taxes in the firstquarter of fiscal 2006 was****based on aneffective tax rate of 36.4%. The tax provision is comprised of U.S. federal,state and non-U.S. taxes.

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

**11.**   Benefit Obligations

Thecomponents of net periodic benefit cost (credit) for the three months ended December 31,2005 and 2004 are provided in the table below:

| ** **                                            | ** ** | **Pension Benefits**—   | ** ** | **Pension Benefits**—  | ** ** | **Postretirement**                           | ** ** |                                         |
|-------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|
| ** **                                            | ** ** | **U.S.**                          | ** ** | **Non-U.S.**                     | ** ** | **Benefits**—U.S.                       | ** ** |                                         |
| ** **                                            | ** ** | **Three months  ended**      | ** ** | **Three months  ended**     | ** ** | **Three months  ended**                 | ** ** |                                         |
| ** **                                            | ** ** | **December 31,**             | ** ** | **December 31,**            | ** ** | **December 31,**                        | ** ** |                                         |
| ** **                                            | ** ** | **  2005  **  | ** ** | **  2004  ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |   |
| ** **                                            | ** ** | **Dollars in millions** | ** ** |                             |
| **Components  of Net Periodic Benefit Cost (Credit)** |       |                              |       |                             |       |                                         |       |                                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                          |       |                              | $          | 4                                |       |                                         |       | $                                            | 4 |   |   |   | $ | 2 |   |   |   | $ | 2 |   |   |   | $ | 1 |   |   |   | $ | 1 |   |   |
| Interest cost                                         |       |                              | 41         |                             |       |                                         | 42         |                                         |   |   | 4 |   |   |   | 2 |   |   |   | 8 |   |   |   | 10 |   |   |
| Expected return on plan assets                        |       |                              | (51        | )                                |       |                                         | (54        | )                                            |   |   | — |   |   |   | — |   |   |   | (2 | ) |   |   | (3 | ) |   |
| Amortization of unrecognized prior service  cost      |       |                              | 2          |                             |       |                                         | 2          |                                         |   |   | — |   |   |   | — |   |   |   | 4 |   |   |   | 2 |   |   |
| Recognized net actuarial loss                         |       |                              | 14         |                             |       |                                         | 9          |                                         |   |   | — |   |   |   | — |   |   |   | 1 |   |   |   | 2 |   |   |
| **Net periodic benefit cost**                         | ** ** | ** **                        | **$**      | **10**                           |       | ** **                                   | ** ** | **$**                                        | **3** |   | ** ** | ** ** | **$** | **6** |   | ** ** | ** ** | **$** | **4** |   | ** ** | ** ** | **$** | **12** |   | ** ** | ** ** | **$** | **12** |   |   |

 

The Company provides certain pension benefits for U.S.and non-U.S. employees, which are not pre-funded. The Company makespayments as these benefits are disbursed. For the three months ended December 31,2005, the Company made payments for these U.S. and non-U.S. pension benefitstotaling $2 million and $2 million, respectively. Estimated payments for theseU.S. and non-U.S. pension benefits for the remainder of fiscal 2006 are $5million 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, 2005, the Company made paymentstotaling $12 million for these retiree medical benefits. Estimated payments forthese retiree medical benefits for the remainder of fiscal 2006 are $35million.

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**12.   StockCompensation Plans**

The Company has a stockcompensation plan, which provides for the issuance to eligible employees of nonqualifiedstock options and restricted stock units representing Avaya common stock. Inaddition, the Company has an employee stock purchase plan under which eligibleemployees have the ability to purchase shares of Avaya common stock at 85% of theaverage of the high and low per share trading price of Avaya’s common stock onthe New York Stock Exchange on the last trading day of each month.

**Stock Options**

Stock options are generally granted with an exerciseprice equal to or above the market value of a share of common stock on the dateof grant. Stock options granted prior to fiscal 2004 are for a contractual termof ten years or fewer and generally vest within four years from the grant-date.Options granted in fiscal 2004 or afterwards have a contractual term of sevenyears and vest in three years. For the three months ended December 31,2005, approximately $3.6 million of compensation expense related to stockoptions was recorded. At the 2004 Annual Meeting of Shareholders, the AvayaInc. 2004 Long Term Incentive Plan (the “Plan”) was approved. The Plan became thesuccessor plan and no further grants will be made from, the Company’s fourprevious existing plans: the 2000 Long Term Incentive Plan, the 2000 StockCompensation Plan for Non-employee Directors, the Broad Based Stock OptionPlan, and the Long Term Incentive Plan for Management Employees (the “ExistingPlans”). The consolidation of the Existing Plans into the Plan resulted in anaggregate reduction in the number of shares eligible for awards under theexisting plans. As of December 31, 2005, there were 14 million stockoptions authorized for grant to purchase Avaya common stock under the Company’sstock compensation plan.

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.

The company calculates expected volatility based onimplied and historical volatility of the company’s common stock, and otherfactors. The risk-free interest rate assumption is based upon observed interestrate appropriate for the term of the Company’s employee stock options. The dividendyield assumption is based on the Company’s intent not to issue a dividend underits dividend policy. The expected holding period assumption was estimated basedon historical experience.

As stock-based compensation expense recognized in theConsolidated Statement of Operations for the first fiscal quarter of 2006 isbased on awards ultimately expected to vest, it had been reduced for estimated forfeitures.SFAS 123(R) requires forfeitures to be estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ fromthose estimates. Forfeitures were estimated based on historical experience. Inthe Company’s pro forma information required under SFAS 123 for the periods priorto fiscal 2006, the Company accounted for forfeitures as they occurred.

The fair value of each option grant was estimated onthe grant-date using the lattice-binomial model with the following weightedaverage assumptions:

| ** **                          | ** ** | **Three months ended  December 31, 2005** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------------|------------|
| WEIGHTED AVERAGE  ASSUMPTIONS:      |       |                                                          |       |   |   |
| Expected volatility                 |       |                                                          | 58.62      | % |   |
| Dividend yield                      |       |                                                          | 0.00       | % |   |
| Risk-free  interest rate            |       |                                                          | 4.39       | % |   |
| Annual forfeiture  rate             |       |                                                          | 5.73       | % |   |
| Expected holding period  (in years) |       |                                                          | 3.49       |   |   |

 

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The following tablesummarizes information concerning options outstanding including the related transactionsunder the Plan for the three months ended December 31, 2005 and the yearended September 30, 2005:

| ** **                                    | ** ** | **Shares  (000’s)** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-----------------------------------------------|------------|--------------------------|------------|------------------------------------------------|------------|
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2004 |       | 48,540                   |       |                                           | $          | 13.35 |   |   |
| Granted                                       |       | 7,189                    |       |                                           | 14.90      |   |   |
| Exercised                                     |       | (4,421                   | )          |                                           | 7.84       |   |   |
| Forfeited and Expired                         |       | (2,783                   | )          |                                           | 15.72      |   |   |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2005 |       | 48,525                   |       |                                           | 13.95      |   |   |
| Granted                                       |       | 4,706                    |       |                                           | 11.17      |   |   |
| Exercised                                     |       | (600                     | )          |                                           | 4.95       |   |   |
| Forfeited and Expired                         |       | (437                     | )          |                                           | 17.73      |   |   |
| OPTIONS OUTSTANDING AS  OF DECEMBER 31, 2005  |       | 52,194                   |       |                                           | $          | 13.77 |   |   |

 

The following table summarizes the status of theCompany’s stock options as of December 31, 2005:

| ** **                              | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable**                | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Shares   (000’s)**          | ** ** | **Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value  (000’s)** | ** ** | **Shares  (000’s)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value  (000’s)** | ** ** |
| $0.01 to $9.70                |       | 10,493                                  |       |                                                   | 3.77       |   |   |   | $ | 4.40 |   |   |   | $ | 66,050 |   |   | 8,788 |   |   | $ | 4.47 |   |   |   | $ | 54,667 |   |   |
| $9.71 to $14.79               |       | 15,579                                  |       |                                                   | 5.44       |   |   |   | 12.41 |   |   |   | 440 |   |   | 9,952 |   |   | 13.16 |   |   |   | 132 |   |   |
| $14.80 to $15.19              |       | 12,317                                  |       |                                                   | 4.76       |   |   |   | 14.84 |   |   |   | — |   |   | 12,317 |   |   | 14.84 |   |   |   | — |   |   |
| $15.20 to $19.36              |       | 6,970                                   |       |                                                   | 5.56       |   |   |   | 16.17 |   |   |   | — |   |   | 6,913 |   |   | 16.17 |   |   |   | — |   |   |
| $19.36 to $51.21                        |       | 6,835                                   |       |                                                   | 3.16       |   |   |   | 26.87 |   |   |   | — |   |   | 6,834 |   |   | 26.87 |   |   |   | — |   |   |
| Total                                   |       | 52,194                                  |       |                                                   |       |   |   |   | $ | 13.77 |   |   |   | $ | 66,490 |   |   | 44,804 |   |   | $ | 14.47 |   |   |   | $ | 54,799 |   |   |

 

The aggregate intrinsicvalue in the preceding table represents the total pretax intrinsic value, basedon the Company’s average stock price on December 31, 2005, which would havebeen received by the option holders had all option holders exercised theiroptions as of that date. The total number of in-the-money options exercisableon December 31, 2005 was approximately 9 million. The weighted averageremaining contractual life on December 31, 2005 for outstanding and exercisableoptions is 4.66 and 4.60 years respectively.

***Restricted Stock Units***

The Company’s stock compensation plan permits thegranting of restricted stock units to eligible employees and non-employeeDirectors at fair market value at the date of grant and typically become fullyvested over a four-year period. Restricted stock units are payable in shares ofthe Company’s common stock upon vesting.

The following table presents a summary of the statusof the Company’s nonvested restricted stock units as of September 30, 2005, andchanges during the three months ended December 31, 2005:

| ** **                              | ** ** | ** **                   | ** ** | **Weighted-Average** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **                   | ** ** | **Grant-Date**       | ** ** |
| **Nonvested Shares**               | ** ** | **Shares (000’s)** | ** ** | **Fair Value**  | ** ** |
| Nonvested shares at  September 30, 2005 |       |                         | 3,708      |                 |       |   | $ | 12.08 |   |   |
| Granted                                 |       |                         | 2,051      |                 |       |   | 11.06 |   |   |
| Vested                                  |       |                         | (427       | )                    |       |   | 2.56 |   |   |
| Forfeited                               |       |                         | (64        | )                    |       |   | 13.50 |   |   |
| Nonvested shares at  December 31, 2005  |       |                         | 5,268      |                 |       |   | $ | 12.44 |   |   |

 

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As of December 31, 2005,there was approximately $45 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 4.0 years. Compensation expense related to restricted stock units was $4 millionand $2 million for the three months ended December 31, 2005 and 2004,respectively. At December 31, 2005 the Company had approximately6.6 million restricted stock units outstanding.

**Performance-BasedRestricted Stock Units**

Performance-basedrestricted stock units vest upon the achievement of certain targets, and are payablein shares of the Company’s common stock upon vesting typically over athree-year period. The fair value 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 performance-related conditions until the vesting date.

On December 15, 2005, the Compensation Committeeof the Board of Directors approved awards of 350,000 performance-vestingrestricted stock units to executive officers of the Company pursuant to the termsof the Avaya Inc. 2004 Long Term Incentive Plan.

**Employee StockPurchase Plan**

Under the terms of the employee stock purchase plan,eligible employees may have up to 10% of eligible compensation deducted fromtheir pay to purchase Avaya common stock. The per share purchase price is 85%of the average high and low per share trading price of Avaya’s common stock onthe New York Stock Exchange on the last trading day of each month. For the threemonths ended December 31, 2005, approximately $600,000 of compensationexpense related to the employee stock purchase plan was recorded.

**13.**   OperatingSegments

The Company reports its operations in two segments—GCSand AGS. The GCS segment develops, markets and sells communications systemsincluding IP telephony systems, multi-media contact center infrastructure andconverged applications in support of customer relationship management, unifiedcommunications applications, appliances such as IP telephone sets andtraditional voice communications systems. The AGS segment develops, markets andsells comprehensive end-to-end global service offerings that enable customersto plan, design, implement, monitor and manage their converged communicationsnetworks worldwide.

The GCS segment includes the portion of the rental andmanaged services revenue attributed to the equipment portion used in connectionwith the customer contracts. The portion of the customer rental and managedservices contracts attributed to maintenance and other services are included inthe AGS segment.

The segments are managed as two individual businessesand, as a result, include certain allocated costs and expenses of sharedservices, such as information technology, human resources, legal and finance(collectively, “corporate overhead expenses”). At the beginning of each fiscal year, the amount of certain corporateoverhead expenses, including targeted annual incentive awards, to be charged tooperating segments is determined and fixed for the entire year in the annualplan. The annual incentive award accrual is adjusted quarterly based on actualyear to date results and those estimated for the remainder of the year. Thisadjustment of the annual incentive award accrual, as well as any other over/underabsorption of corporate overhead expenses against plan is recorded and reportedwithin the Corporate/Other Unallocated Amounts caption. Restructuring chargesare also recorded and reported within the Corporate/Other Unallocated Amountscaption.

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The Company has outsourced all of its manufacturingoperations to a number of contract manufacturers. All manufacturing of theCompany’s products is performed in accordance with detailed specifications andproduct design furnished by the Company and is subject to quality controlstandards. See Part I, Item 2. “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Key Trends and UncertaintiesAffecting Our Results—Outsourcing of Certain Manufacturing Operations.”

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

| ** **                                    | ** ** | **Reportable Segments**      | ** ** | ** **   | ** ** | ** **          | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                    | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Communications**                | ** ** | **Global**   | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Amounts**         | ** ** | **Total** | ** ** |
| ** **                                    | ** ** | **Dollars in millions** | ** ** |
| **Three months ended December 31, 2005** |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                       |       |                              | $          | 661          |       |                |       | $ | 588 |   |   |   | $ | — |   |   | $ | 1,249 |   |
| Operating income                              |       |                              | 43         |         |       |                | 60         |   |   |   | 4 |   |   | 107 |   |
| **Three months ended December 31, 2004** |       |                              |       |         |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                       |       |                              | $          | 592          |       |                |       | $ | 556 |   |   |   | $ | — |   |   | $ | 1,148 |   |
| Operating income                              |       |                              | 25         |         |       |                | 56         |   |   |   | 7 |   |   | 88 |   |

 

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

| ** **                                                   | ** ** | **December 31,**             | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                   | ** ** | **  2005  **  | ** ** | **  2004  ** | ** ** |
| ** **                                                   | ** ** | **Dollars in millions** | ** ** |
| U.S.                                                         |       |                              | $          | 442 |   |   |   | $ | 453 |   |   |
| Outside the U.S.:                                            |       |                              |       |   |   |   |   |   |   |
| Germany                                                      |       |                              | 206        |   |   |   | 214 |   |   |
| EMEA—Europe / Middle East / Africa (excluding  Germany) |       |                              | 48         |   |   |   | 52 |   |   |
| APAC—Asia Pacific                                       |       |                              | 14         |   |   |   | 14 |   |   |
| Americas, non-U.S.                                           |       |                              | 5          |   |   |   | 5 |   |   |
| Total outside the U.S.                                       |       |                              | 273        |   |   |   | 285 |   |   |
| Total                                                        |       |                              | $          | 715 |   |   |   | $ | 738 |   |   |

 

**14.**   Commitments andContingencies

**Legal Proceedings**

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

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**Commissions Arbitration Demand**

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

**Securities Litigation**

In April and May of 2005, purported classaction lawsuits were filed in the Federal District Court for the District ofNew Jersey against us and certain of our officers, alleging violations of thefederal securities laws. The actions purport to be filed on behalf ofpurchasers of our common stock during the period from October 5, 2004 (thedate of our signing of the agreement to acquire Tenovis) through April 19,2005.

The complaints, which are substantially similar to oneanother, allege, among other things, that the plaintiffs were injured by reasonof certain allegedly false and misleading statements made by us relating to thecost of the Tenovis integration, the disruption caused by changes in thedelivery of our products to the market and reductions in the demand for ourproducts in the U.S., and that based on the foregoing we had no basis toproject our stated revenue goals for fiscal 2005. The Company has been servedwith a number of these complaints. No class has been certified in the actions.The complaints seek compensatory damages plus interest and attorneys’ fees. In August 2005,the court entered an order identifying a lead plaintiff and lead plaintiffs’counsel. A consolidated amended complaint was filed in October 2005. Pursuantto a scheduling order issue by the District Court, defendants filed theirmotion to dismiss the consolidated complaint in December 2005.

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

**Derivative Litigation**

In May and July of2005, three derivative complaints were filed against certain officers and theBoard of Directors (“Board”) of the Company. Two complaints were filed in theUnited States District Court, District of New Jersey, and one was filed in theSuperior Court of New Jersey, Somerset County. The allegations in each of thecomplaints are substantially similar and include the Company as a nominaldefendant. The complaints allege, among other things, that defendants violatedtheir fiduciary duties by failing to disclose material information and/or bymisleading the investing public about the Company’s business, asserting claimssubstantially similar to those asserted in the actions described above under “SecuritiesLitigation.” The complaints seek contribution from the defendants to theCompany for alleged violations of the securities laws, restitution to theCompany and disgorgement of profits earned by defendants, and fees and costs. Theseactions are in the early stages of litigation and an outcome cannot bepredicted and, as a result, we cannot determine if they will have an effect onour business or operations or, if they do, whether their outcomes will have amaterial adverse effect on our business or operations.

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**ERISA Class Action**

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

The complaint alleges, among other things, that thenamed defendants breached their fiduciary duties owed to participants andbeneficiaries of the Plans and failed to act in the interests of the Plans’participants and beneficiaries in offering Avaya common stock as an investmentoption, purchasing Avaya common stock for the Plans and communicatinginformation to the Plans’ participants and beneficiaries. No class has beencertified in the action. The complaint seeks a monetary payment to the plans tomake them whole for the alleged breaches, costs and attorneys’ fees. Pursuantto a scheduling order entered by the District Court, defendants filed their motionto dismiss the amended complaint in December 2005.

This matter is still inthe early stages of litigation and an outcome cannot be predicted and, as aresult, we cannot be assured that this case will not have a material adverseeffect on our financial position, results of operations or cash flows.

**Government Subpoenas**

On April 29, 2005, the Company received asubpoena to produce documents before a grand jury of the United States DistrictCourt, District of South Carolina, relating to the United States’ investigationof potential antitrust and other violations in connection with the federalE-Rate Program. The subpoena requests records from the period January 1,1997 to the present. At this time, we cannot determine if this matter will havean effect on our business or, if it does, whether its outcome will have amaterial adverse effect on our financial position, results of operations orcash flows.

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

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

**Antitrust Lawsuit**

In August 2005,United Asset Coverage, Inc. (“UAC”), filed a verified complaint againstthe Company 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 UAC seeks to protect its proprietary information. Theverified complaint sought a temporary restraining order against the Company toenjoin immediately its practice of limiting the use of its proprietaryinformation in a manner which UAC believes is in violation of its contracts andlicensing agreements. The court denied UAC’s motion for temporary restraints. Apreliminary injunction hearing began on October 25, 2005, and afterseveral adjournments of the hearing based on the District Court’s schedule,concluded on November 22, 2005. The parties 

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submittedpost-hearing briefs in support of their respective positions in mid December 2005.In early January 2006, the District Court issued its decision, denying inits entirety plaintiff’s motion for a preliminary injunction. The DistrictCourt also entered an order regarding scheduling in the matter. Even thoughAvaya prevailed in the preliminary injunction proceeding, an outcome in thismatter cannot be predicted at this time, and we cannot be assured that thiscase will not have a material adverse effect on our financial position, resultsof operations or cash flows.

**Environmental,Health and Safety Matters**

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

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

The reliability and precision of estimates of the Company’senvironmental costs may be affected by a variety of factors, including whetherthe remediation treatment will be effective, contamination sources have beenaccurately identified and assumptions regarding the movement of contaminantsare accurate. In addition, estimates of environmental costs may be affected bychanges in law and regulation, including the willingness of regulatoryauthorities to conclude that remediation and/or monitoring performed by theCompany 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 first quarters offiscal 2006 and 2005 were not material to the Company’s financial position,results of operations or cash flows. Payment for the environmental costscovered by the reserves may be made over a 30-year period.

**Product Warranties**

TheCompany recognizes a liability for the estimated costs that may be incurred toremedy certain deficiencies of quality or performance of the Company’s products.These product warranties extend over a specified period of time generallyranging up to two years from the date of sale depending upon the 

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product subject to the warranty. The Company accrues aprovision for estimated future warranty costs based upon the historicalrelationship of warranty claims to sales. The Company periodically reviews theadequacy of its product warranties and adjusts, if necessary, the warrantypercentage and accrued warranty reserve, which is included in other currentliabilities in the Consolidated Balance Sheets, for actual experience. 

| **Dollars in millions**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| Balance as of  September 30, 2005               |       | $          | 30         |       |
| Reductions for  payments and costs to satisfy claims |       | (9         | )          |
| Accruals for  warranties issued during the period    |       | 9          |       |
| Balance as of  December 31, 2005                |       | $          | 30         |       |

 

**Guaranteesof Indebtedness and Other Off-Balance Sheet Arrangements**

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $84 million as ofDecember 31, 2005, for the purpose of securing third party financialguarantees such as letters of credit which ensure the Company’s performance orpayment to third parties. Additionally, the Company has a $400 millioncommitted credit facility, which is discussed in Note 8 “Long-Term Debt.” As ofDecember 31, 2005, the Company had outstanding an aggregate of $141million in irrevocable letters of credit under the committed and uncommittedcredit facilities (including $57 million under its $400 million committedcredit 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. If the Company fails to performunder its obligations, the maximum potential payment under these surety bondsis $38 million as of December 31, 2005. Historically, no surety bondshave been drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchases components from a variety ofsuppliers and uses several contract manufacturers to provide manufacturingservices for its products. During the normal course of business, in order tomanage manufacturing lead times and to help assure adequate component supply,the Company enters into agreements with contract manufacturers and suppliersthat allows them to produce and procure inventory based upon forecastedrequirements provided by the Company. If the Company does not meet thesespecified purchase commitments, it could be required to purchase the inventory,or in the case of certain agreements, pay an early termination fee. As of December 31, 2005, the maximumpotential payment under these commitments was approximately $161 million. Historically,the Company has not been required to pay a charge for not meeting itsdesignated purchase commitments with these suppliers.

The Company’s outsourcingagreement with its most significant contract manufacturer expires in May 2006.The agreement will automatically renew for successive one-year termsunless either party elects to terminate the agreement by giving notice to theother party six months prior to the expiration of the renewal term. Pursuant tothe requirements of the agreement, the Company gave notice in November 2005of its intention not to renew this outsourcing agreement. The Company is indiscussions to negotiate a new outsourcing agreement. However, there can be noassurance that the Company will be able to negotiate a new agreement with thiscontract manufacturer or, alternatively, negotiate a replacement agreement witha new contract manufacturer on favorable terms. The Company relies on outsidesources for the supply of 

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thecomponents of its products and for the finished products. Delays or shortagesassociated with these components as well as a change in contract manufacturercould adversely affect our operating results. 

***Product Financing Arrangements***

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

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

For the Company’s productfinancing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guarantee repayment amount reported tothe Company from the lending institution was approximately $4 million asof December 31, 2005. The Company reviews and sets the maximum creditlimit for each reseller participating in this financing arrangement.Historically, there have not been any guarantee repayments by the Company sincethe founding of Avaya Inc. in October 2000. The Company has estimated thefair value of this guarantee as of December 31, 2005, and has determinedthat it is not significant. There can be no assurance that the Company will notbe obligated to repurchase inventory under this arrangement in the future.

***Performance Guarantee***

In connection with thesale of Connectivity Solutions and the sale of a portion of the Expanetsbusiness, the Company has assigned its rights and obligations under severalreal estate leases to the acquiring companies (the “assignees”). The remainingterms of these leases vary from one year to eight years. While the Company isno longer the primary obligor under these leases, the lessor has not completelyreleased the Company from its obligation, and holds it secondarily liable inthe event that the assignees default on these leases. The maximum potentialfuture payments the Company could be required to make, if all of the assigneeswere to default as of December 31, 2005, would be approximately $19 million.The Company has assessed the probability of default by the assignees and hasdetermined it to be remote.

***Credit Facility Indemnification***

In connection with itsobligations under the credit facility described in Note 8, “Long-TermDebt,” the Company has agreed to indemnify the third party lending institutionsfor costs incurred by the institutions related to changes in tax law or otherlegal requirements. While there have been no amounts paid to the lenderspursuant to this indemnity in the past, there can be no assurance that theCompany will not be obligated to indemnify the lenders under this arrangementin the future. 

***Transactions with Lucent***

In connection with the distribution in September 2000,the Company and Lucent executed and delivered the Contribution and DistributionAgreement and certain related agreements. 

Pursuant to the Contribution and DistributionAgreement, Lucent contributed to the Company substantially all of the assets,liabilities and operations associated with its enterprise networking businesses(“Company’s Businesses”). The Contribution and Distribution Agreement, amongother things, provides that, in general, the Company will indemnify Lucent forall liabilities including certain pre-distribution tax 

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obligations of Lucentrelating to the Company’s Businesses and all contingent liabilities primarilyrelating to the Company’s Businesses or otherwise assigned to the Company. Inaddition, the Contribution and Distribution Agreement provides that certaincontingent liabilities not allocated to one of the parties will be shared byLucent and the Company in prescribed percentages. The Contribution andDistribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to thebusiness of the other party that exceed $50 million. See “LegalProceedings” above for a discussion of the Company’s obligations under thesettlement of certain litigation constituting shared contingent liabilitiesunder the Contribution and Distribution Agreement. The Company is unable todetermine the maximum potential amount of other future payments, if any, thatit could be required to make under this agreement. 

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

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

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**Item2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

| Overview                                            |   | 29 |   |
|-----------------------------------------------------|--------|----|--------|
| Key Trends and Uncertainties  Affecting Our Results |   | 32 |   |
| Operating Segments                                  |   | 34 |   |
| Results from Continuing  Operations                 |   | 35 |   |
| Segment Results                                     |   | 37 |   |
| Results of Discontinued  Operations                 |   | 40 |   |
| Liquidity and Capital Resources                     |   | 40 |   |
| Forward Looking Statements                          |   | 45 |   |

 

“Management’s Discussion and Analysis of FinancialCondition and Results of Operations” should be read in conjunction with theConsolidated Financial Statements and the notes included elsewhere in thisquarterly report. The matters discussed in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contain certainforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. See “Forward Looking Statements” at the end ofthis discussion.

Our accompanying unauditedConsolidated Financial Statements as of December 31, 2005 and for thethree months ended December 31, 2005 and 2004, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the Securities and Exchange Commission, or the SEC, for interim financialstatements, and should be read in conjunction with our Consolidated FinancialStatements and other financial information for the fiscal year ended September 30,2005, which were included in our Annual Report on Form 10-K filed with theSEC on December 13, 2005. 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. Certainprior year amounts have been reclassified to conform to the current interimperiod presentation. The consolidated results of operations for the interimperiods reported are not necessarily indicative of the results to beexperienced for the entire fiscal year. 

**Overview**

***Products, Applications and Services***

We are a leading provider of communications solutions,comprised of equipment hardware, software and services that help enterprisestransform their businesses by redefining the way they work and interact withtheir customers, employees, business partners, suppliers and others. Our goalis to help our customers optimize their enterprise communications networks inorder to serve their customers better, enabling them to reduce costs and becomemore competitive while preserving the security and reliability of their networks.A key component 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 (“IP”), andthe adoption of IP telephony solutions. We believe our comprehensive suite ofIP telephony solutions, communications applications and appliances, assupported by our global services organization and extensive network of businesspartners, transforms the enterprise communications system into a strategicasset for businesses, by enabling them to communicate to “anyone, at any place,at any time and in any way” they choose.

Our productofferings include:

·       IPtelephony solutions;

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

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

·       appliances,such as telephone sets; and

·       traditionalvoice communication systems.

We support ourbroad customer base with comprehensive global services offerings that enableour customers to plan, design, implement, maintain and manage their communicationsnetworks. We believe our global services organization is an importantconsideration for customers purchasing our products and applications and is asource of significant revenue for us, primarily from maintenance contracts. Theskilled professionals of our services organization, together with our networkof business partners and our ability to diagnose customer network faultsremotely, can provide 24-hours-a-day, seven-days-a-week service to ourcustomers around the world. Our end-to-end portfolio of services offeringsprovides a single point of accountability and includes:

·       value-addedmaintenance services;

·       professionalservices, consulting, design and network integration;

·       productimplementation; and

·       rental and managedservices.

***Customers and Competitive Advantages***

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

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in nearly 100 other countries. As a result of ouracquisition of Tenovis in November 2004, we have significantly increasedour presence in Europe, particularly in Germany. In the first quarter of fiscal2006, approximately 41% of our revenues were generated outside the U.S.

We are focused on the migration of our customers’traditional voice communications to a converged network that provides for theintegration of voice, data, video and other applications traffic on a singlenetwork. We offer customers the flexibility to implement new IP telephonysolutions or “IP-enable” their existing voice communications systems, therebypreserving some of their existing communications technology investments andallowing them to implement IP telephony at their own pace. Converged networksoffer increased functionality and provide our enterprise customers with theability to reach the right person at the enterprise, at the right time, in theright place and in the right way, thereby optimizing business interactions andenhancing our customers’ ability to grow revenue and reduce costs. Ourproducts, applications and services are driving the integration ofcommunications and business processes, making communications an importantcomponent of our customers’ business strategies.

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

·       clearfocus on the enterprise;

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·       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

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

***First Quarter Fiscal 2006 Financial and OperatingResults***

*Revenue—**Revenue*was $1,249million and $1,148 million for the first quarters of fiscal 2006 and 2005, respectively.The 8.8% revenue growth was across both of our operating segments and in ourEMEA region, which benefited from a full quarter’s results of the Tenovisbusiness which we acquired in the first quarter of fiscal 2005, as well as ourAPAC region, which benefited from increased revenues associated with AvayaGlobalConnect, or AGC. Revenue was partially offset by unfavorable currencyimpacts in both segments, primarily related to the euro, which experienced a13% decrease in value against the U.S. dollar from December 31, 2004 to December 31,2005. 

*Profitability—**We*earned income fromcontinuing operations during the first quarter of fiscal 2006 of $71 million,compared to $33 million during the first quarter of fiscal 2005. We haveachieved net income for each of the last 11 consecutive quarters and each ofour operating segments has been profitable on an annual basis for the past twofiscal years. Our operating income was $107 million or 8.6% of revenue, for thefirst quarter of fiscal 2006, compared to $88 million, or 7.7% of revenue, forthe first quarter of fiscal 2005. Included in this fiscal 2006 increase is a$21 million one-time benefit arising from a change in company policy withrespect to carryover of vacation days applicable to substantially all of ourU.S. non-represented employees.

*Liquidity—**Our* debt balanceremained at $30 million as of December 31, 2005, which is comprised ofcapital lease obligations and the remaining senior notes balance of $13 million.We ended the first quarter of fiscal 2006 with a cash balance of $726 million.

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**KeyTrends and Uncertainties Affecting Our Results**

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

The following arethe key factors currently affecting our revenue:

·       *Acquisition of Tenovis—*Our acquisition of Tenovis resultedin a significant increase in our revenues. The large installed base of Europeancustomers that we acquired has enabled us to increase our presence in Europe. 

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

·       *Competitiveenvironment*—We have historically operated, and continue to operate,in an extremely competitive environment. One aspect of this environment is thatwe regularly face pricing pressures in the markets in which we operate. We havebeen able to mitigate the effects of pricing pressures on profitability throughour actions to improve gross margins, including cost reduction initiatives. Forother uncertainties related to the competitive environment in which we operate,see “Forward Looking Statements—Risks Related To Our Revenue and BusinessStrategy—We face intense competitionfrom our current competitors and, as the enterprise communications andinformation technology markets evolve, may face increased competition fromcompanies that do not currently compete directly against us.”

·       *Pressures on services business*—We expect to continue to facechallenges in our Avaya Global Services segment. A high correlation exists withrespect to customers who purchase products also electing to purchasemaintenance contracts at the time of the product purchase. The maintenancebusiness has been negatively affected by cancellations, subsequent contractrenegotiations and changes in scope (*i.e*. number ofports, number of sites, or hours and levels of coverage) at the time ofrenewal, and pricing pressures. Our managed services business generallyinvolves larger contracts with customers who outsource responsibility for theirvoice applications domain to us. We expect to face challenges in this arearelating to timing and closure of new business opportunities, as well aspricing pressures and scope changes similar to the maintenance business.

·       *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. As economic conditionshave gradually improved in most of our markets over the past few years, we haveseen indications that enterprises may be more willing to spend on enterprisecommunications technology than in the past several years. While the worldeconomy is expected to grow, variability in employment, corporate profit 

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growth, interest rates,energy prices and other factors in specific markets could impact corporatewillingness to spend on communications technology in the near term.Additionally, the country-to-country variability in worldwideeconomic growth could also impact our business as growth rates of developed andmore stable economies tend to be lower than that of emerging economies, wherethere could be more variables affecting the economic growth.Weaknessand uncertainty in European economies, coupled with the high concentration ofour business in Germany, have the potential to affect our results in Europe ashigh unemployment levels and low economic growth forecasts, particularly inGermany, remain a concern.

·       *Foreign currency—*With the full quarter benefit from theTenovis acquisition included in our results, our revenues outside of the U.S.were 41% of our consolidated revenues in the first quarter of fiscal 2006compared to 36% in the first quarter of fiscal 2005. Any weakening of the U.S.dollar against other currencies, particularly the euro, will have a positiveimpact on our reported revenues and profitability. Conversely, anystrengthening of the U.S. dollar will have a negative impact.

·       *Indirectdistribution channel—*During fiscal 2005, some of our indirectchannel partners began to reduce their levels of inventory. Although we notedno decreases in sales out to end customers, the timing of purchases by indirectchannel distributors affected our revenues. In addition, we implementedprograms with our largest distributors to move toward an inventoryreplenishment model, which may further affect the timing of purchases of ourproducts made by our channel partners. For the first quarter of fiscal 2006,inventory in the channel was consistent with the levels experienced during thelast few quarters. 

***Continued Focus on Cost Structure***

As a result of the growth of our revenue and ourcontinued focus on controlling costs, we returned to profitability in the thirdquarter of fiscal 2003 and have been profitable in each of the ten subsequentquarters. During fiscal 2005 and into fiscal 2006, we continued to focus oncontrolling our costs, particularly in relation to our revenue. As part of ourfocus on controlling costs, we have reduced primarily the management and backoffice headcount in our U.S. sales organization, and have also reduced theheadcount in our services business. During fiscal 2005, we reached agreementswith the Works Councils in Europe to reduce our workforce by approximately 530.Most of these positions have been eliminated, and we have begun to realize thefull benefits of these actions. 

As discussed in more detail below, our gross marginwas roughly flat at 47.3% for the first quarter of fiscal 2005, compared to47.2% for the first quarter of fiscal 2006. Cost savings associated withheadcount reductions and a $10 million benefit from the reduction of a portionof our vacation accrual in connection with the change in Company policy wereoffset by increased employee benefit costs.

As a percentage ofrevenue, our selling, general and administrative, or SG&A, expensesdecreased from 31.1% for the first quarter of fiscal 2005 to 30.8% for thefirst quarter of fiscal 2006. This decrease was primarily due to an $7 millionbenefit from the reduction of a portion of our vacation accrual in connectionwith the change in Company policy, as well as savings from fiscal 2005headcount reductions. These favorable items were partially offset by increasedemployee benefit costs.

***Strategic Uses of Cash and Cash Equivalents***

As further discussed in “Liquidityand Capital Resources,” our cash balance was reduced by $24 million duringthe quarter to $726 million as of December 31, 2005. During the firstquarter of fiscal 2006, we used $90 million to repurchase 7,947,600 shares ofour common stock in accordance with a share repurchase plan authorized by theBoard of Directors. See Part II, Item 2. “Changes in Securities, Use ofProceeds and Issuer Purchases of Equity Securities” for more information. Wealso continued to use cash for capital expenditures and software developmentcosts. 

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***Deferred Tax Assets***

As of December 31,2005, we had $935 million in net deferred tax assets resulting from tax creditcarry forwards, net operating losses and other deductible temporarydifferences, which are available to reduce taxable income predominately in theU.S. in future periods. The amount is net of a valuation allowance of $159million, which was calculated in accordance with the provisions of Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes.” Thevaluation allowance is comprised of $136 million of non-U.S. deferred taxassets and $23 million relating to certain U.S. federal and state deferred taxassets that continue to be fully valued. Included in the net deferred taxassets is an $89 million net deferred tax liability related to the acquisitionof intangible assets acquired in Germany and Canada.

***Outsourcing ofCertain Manufacturing Operations***

We have outsourcedsubstantially all of our product manufacturing operations.  Most of these operations have been outsourcedto Celestica Inc. (“Celestica”) and are currently manufactured in NorthAmerica, France, and Malaysia, although we also have other contractmanufacturers.  Our outsourcing agreementwith Celestica expires in May 2006.  Theagreement automatically renews for successive one-year terms unless eitherparty elects to terminate the agreement by giving notice to the other party sixmonths prior to the expiration.  Pursuantto the requirements of the agreement, we gave notice to Celestica on November2, 2005 of our intention not to renew our outsourcing agreement.  We are in discussions to negotiate a newoutsourcing agreement.  The remaining sourcesof our manufacturing capacity are outsourced to a number of other contractmanufacturers located in the United Kingdom, France and China.  All manufacturing of the Company’s productsis performed in accordance with detailed specifications and product designsfurnished by the Company and is subject to quality control standards.

At the end of the quarter,we experienced disruption and delays in delivery of certain products from ourcontract manufacturers in meeting required timelines for our customerrequirements.  We are continuing toexperience these delays early in our second fiscal quarter.  We are working closely with our contract manufacturersto resolve or minimize any impact this might have on revenue for the secondquarter.  However, due to the number ofvariables involved, it is difficult to quantify the impact, if any, at thistime.  For more information on risksrelated to the outsourcing of certain manufacturing operations, see “ForwardLooking Statements—Risks Related To Our Operations—We depend on contractmanufacturers to produce the majority of our products and if thesemanufacturers are unable to fill our orders on a timely and reliable basis, wewill likely be unable to deliver our products to meet customer orders orsatisfy their requirements.”

**Operating Segments**

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

| ** **                        | ** ** | ** ** | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|------------|------------|------------|------------------------------------|------------|
| **Fiscal 2005**              | ** ** | ** ** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **1Q05**                          | ** ** | **2Q05**   | ** ** | **3Q05**                           | ** ** | **4Q05** | ** ** | ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** |
| $                                 | 592        |       | $          | 625                                |       | $ | 648 |   | $ | 707 |   | Global Communications  Solutions |   | $ | 661 |   | $ | 592 |   |   | 53 | % |   |   | 52 | % |   |   | $ | 69 |   |   | 11.7 | % |
| 556                               |       | 597        |       | 588                                |       | 589 |   | Avaya Global Services |   | 588 |   | 556 |   |   | 47 | % |   |   | 48 | % |   |   | 32 |   |   | 5.8 | % |
| $                                 | 1,148      |       | $          | 1,222                              |       | $ | 1,236 |   | $ | 1,296 |   | Total |   | $ | 1,249 |   | $ | 1,148 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 101 |   |   | 8.8 | % |

 

The increase inrevenues contributed by the GCS segment for the first quarter of fiscal 2006compared to the first quarter of fiscal 2005 is primarily due to a full quarterof revenues associated with Tenovis, increases in North American sales of largecommunications systems to direct customers, growth in Russia 

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and revenues associatedwith AGC. The increase in AGS revenues is due primarily to a full quarter ofrevenues associated with Tenovis, offset by a decline in services revenues inthe U.S. Revenue increases for both segments were partially offset byunfavorable foreign currency impacts. 

**Resultsfrom Continuing Operations**

***Three Months Ended December 31,2005 Compared with Three Months Ended December 31, 2004***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **                        | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                   | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|------------|------------|------------|------------|------------|--------------|------------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | *** *** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | **Mix**                      | ** ** | ** **               | ** ** | ** ** | ** ** |
| **1Q05**                          | ** **   | **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | ** **                   | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** |
| $                                 | 554          |       | $          | 543        |       | $          | 566          |                         | $          | 631                      |       | Sales of products |   | $ | 591 |   | $ | 554 |   |   | 47 | % |   |   | 48 | % |   |   | $ | 37 |   |   | 6.7 | % |
| 477                               |         | 498        |       | 497        |       | 499        |         | Services                     |       | 501                      |       | 477 |   |   | 40 | % |   |   | 42 | % |   |   | 24 |   |   | 5.0 | % |
| 117                               |         | 181        |       | 173        |       | 166        |         | Rental and managed  services |       | 157                      |       | 117 |   |   | 13 | % |   |   | 10 | % |   |   | 40 |   |   | 34.2 | % |
| $                                 | 1,148        |       | $          | 1,222      |       | $          | 1,236        |                         | $          | 1,296                    |       | Total revenue |   | $ | 1,249 |   | $ | 1,148 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 101 |   |   | 8.8 | % |

 

All revenue types werefavorably impacted by a full quarter of revenues associated with Tenovis in thecurrent quarter. In addition, sales of products increased in the U.S., primarilydue to higher sales of large and small communications systems. Excluding theimpact of the full quarter of business associated with Tenovis, servicesrevenue would have been relatively flat. Excluding the impact of the fullquarter of business associated with Tenovis, rental and managed services revenueswere negatively affected due to customer changes in scope, pricing pressuresand cancellations.

Thefollowing table sets forth a geographic comparison of revenue:

|                                   | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                                         | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|--------------|------------|------------|------------|------------|--------------|------------------------------------------------------|------------|------------------------------------|------------|
| **Fiscal 2005**              | *** *** | *** *** | ** ** | ** ** | ** ** | ** ** | ** **   | **Mix**                                              | ** ** | ** **                         | ** ** |
| **1Q05**                          | ** **   | **2Q05**     | ** ** | **3Q05**   | ** ** | **Q405**   | *** *** | *** ***                                         | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                                 | 734          |         | $          | 689        |       | $          | 717          |                                                 | $          | 768                                |       | U.S. |   | $ | 734 |   | $ | 734 |   |   | 59 | % |   |   | 64 | % |   | $ | — |   | 0.0 | % |
|                              |         |         |       |       |       |       |         | Outside the U.S.:                                    |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 113                               |         | 211          |       | 206        |       | 194        |         | Germany                                              |       | 186                                |       | 113 |   |   | 15 | % |   |   | 10 | % |   | 73 |   | 64.6 | % |
|                              |         |         |       |       |       |       |         | EMEA—Europe / Middle  East /  Africa (Excluding |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 165                               |         | 176          |       | 171        |       | 184        |         | Germany)                                             |       | 178                                |       | 165 |   |   | 14 | % |   |   | 14 | % |   | 13 |   | 7.9 | % |
| 74                                |         | 89           |       | 83         |       | 90         |         | APAC—Asia Pacific                               |       | 87                                 |       | 74 |   |   | 7 | % |   |   | 6 | % |   | 13 |   | 17.6 | % |
| 62                                |         | 57           |       | 59         |       | 60         |         | Americas, non-U.S.                                   |       | 64                                 |       | 62 |   |   | 5 | % |   |   | 6 | % |   | 2 |   | 3.2 | % |
| 414                               |         | 533          |       | 519        |       | 528        |         | Total outside the U.S.                               |       | 515                                |       | 414 |   |   | 41 | % |   |   | 36 | % |   | 101 |   | 24.4 | % |
| $                                 | 1,148        |         | $          | 1,222      |       | $          | 1,236        |                                                 | $          | 1,296                              |       | Total revenue |   | $ | 1,249 |   | $ | 1,148 |   |   | 100 | % |   |   | 100 | % |   | $ | 101 |   | 8.8 | % |

 

Revenues in the U.S. wereunchanged compared with the first quarter of fiscal 2005, as increased sales ofproducts were offset by declines in services and rental and managed servicesrevenues. Outside the U.S., EMEA experienced the most significant growth inrevenue, primarily due to a full quarter of revenues associated with Tenovis inthe current fiscal quarter compared with the first quarter of fiscal 2005,which included only a partial quarter of Tenovis revenues. EMEA revenues alsoincreased because of higher volumes in Russia, partially offset by anunfavorable foreign currency impact, primarily related to the euro, and revenuedeclines in the United Kingdom. The increase in revenues in APAC relatesprimarily to an increase in revenues associated with AGC and increased productsales throughout the region. Revenue in Americas, non-U.S. increased slightlycompared to the first quarter of fiscal 2005 due to an increase in servicesrevenue and favorable foreign currency impact which offset a decline in salesof products in the region.

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

| ** **                        | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** | *** *** | *** *** | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|--------------|------------|------------|------------|------------|--------------|--------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | *** *** | *** *** | ** ** | ** ** | ** ** | ** ** | ** **   | **Mix**      | ** ** | ** **               | ** ** |
| **1Q05**                          | ** **   | **2Q05**     | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | *** *** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                                 | 261          |         | $          | 265        |       | $          | 279          |         | $          | 322                      |       | Direct |   | $ | 268 |   | $ | 261 |   |   | 45 | % |   |   | 47 | % |   | $ | 7 |   | 2.7 | % |
| 293                               |         | 278          |       | 287        |       | 309        |         | Indirect     |       | 323                      |       | 293 |   |   | 55 | % |   |   | 53 | % |   | 30 |   | 10.2 | % |
| $                                 | 554          |         | $          | 543        |       | $          | 566          |         | $          | 631                      |       | Total sales of products |   | $ | 591 |   | $ | 554 |   |   | 100 | % |   |   | 100 | % |   | $ | 37 |   | 6.7 | % |

 

Our mix of sales ofproducts shifted slightly toward indirect compared to the first quarter offiscal 2005. Increases in both large and small communications systems,especially in EMEA, contributed to an increase in indirect revenue through ourbusiness partners.

***Gross Margin***

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

| ** **                        | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                    | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|--------------|------------|------------|------------|------------|--------------|---------------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | *** *** | *** *** | ** ** | ** ** | ** ** | ** ** | ** **   | **Percent of Revenue**          | ** ** | ** **               | ** ** |
| **1Q05**                          | ** **   | **2Q05**     | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | *** ***                    | ** ** | **2006**                 | ** ** | **2005** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                                 | 309          |         | $          | 298        |       | $          | 301          |                            | $          | 337                      |       | On sales of  products |   | $ | 314 |   | $ | 309 |   |   | 53.1 | % |   |   | 55.8 | % |   | $ | 5 |   | 1.6 | % |
| 169                               |         | 159          |       | 172        |       | 174        |         | On services                     |       | 180                      |       | 169 |   |   | 35.9 | % |   |   | 35.4 | % |   | 11 |   | 6.5 | % |
| 65                                |         | 106          |       | 102        |       | 105        |         | On rental and  managed services |       | 95                       |       | 65 |   |   | 60.5 | % |   |   | 55.6 | % |   | 30 |   | 46.2 | % |
| $                                 | 543          |         | $          | 563        |       | $          | 575          |                            | $          | 616                      |       | Total gross margin |   | $ | 589 |   | $ | 543 |   |   | 47.2 | % |   |   | 47.3 | % |   | $ | 46 |   | 8.5 | % |

 

Gross margin dollarsincreased primarily due to the full quarter impact of Tenovis while the overallgross margin rate was flat as compared to the same quarter in fiscal 2005. Thelargest factor behind the decline in gross margin percentage on the sales ofproducts was the full quarter impact of Tenovis. Excluding the impact ofTenovis, gross margin on services revenue increased due to cost reductionsinitiated in prior periods. The increase in gross margin dollars and rate onrental and managed services was primarily due to the impact of a full quarterof Tenovis.

***Operating expenses***

| ** **                        | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***              | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|--------------|------------|------------|------------|------------|--------------|---------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | *** *** | *** *** | ** ** | ** ** | ** ** | ** ** | ** **   | **Percent of Revenue**    | ** ** | ** **               | ** ** |
| **1Q05**                          | ** **   | **2Q05**     | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | *** ***              | ** ** | **2006**                 | ** ** | **2005** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                                 | 357          |         | $          | 406        |       | $          | 406          |                      | $          | 414                      |       | Selling, general  and administrative |   | $ | 385 |   | $ | 357 |   |   | 30.8 | % |   |   | 31.1 | % |   | $ | 28 |   | 7.8 | % |
| 98                                |         | 105          |       | 93         |       | 98         |         | Research and  development |       | 97                       |       | 98 |   |   | 7.8 | % |   |   | 8.5 | % |   | (1 | ) | -1.0 | % |
| —                            |         | —       |       | —     |       | 22         |         | Restructuring  charges    |       | —                   |       | — |   |   | 0.0 | % |   |   | 0.0 | % |   | — |   | — |   |
| $                                 | 455          |         | $          | 511        |       | $          | 499          |                      | $          | 534                      |       | Total operating expenses  |   | $ | 482 |   | $ | 455 |   |   | 38.6 | % |   |   | 39.6 | % |   | $ | 27 |   | 5.9 | % |

 

The increase in SG&A expenses is primarily due tothe full quarter impact of the Tenovis operations, as well as the impact ofother acquisitions made during fiscal 2005. SG&A expense for the currentquarter also includes increased employee benefit costs. These items werepartially offset by a $7 million benefit related to the reduction of a portionof our vacation accrual as a result of a change in company policy eliminatingcarryover vacation days for U.S. non-represented employees.

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Research and development,or R&D, expenses were flat compared to the same quarter last fiscal year. Thecurrent quarter included a $3 million benefit related to the reduction of aportion of our vacation accrual as a result of a change in company policy. Thefirst quarter of fiscal 2005 also included $4 million of acquired in-processR&D expenses recorded upon the acquisitions of Spectel and Tenovis.

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

| **Fiscal 2005**                   |       | ** ** |       | **First Fiscal Quarter** |       |
|-----------------------------------|------------|------------|------------|--------------------------|------------|
| **1Q05**                          | ** ** | **2Q05**   | ** ** | **3Q05**                 | ** ** | **4Q05** |   | ** ** |   | **2006** |   | **2005** |   | **Change** |   |
| **Dollars in millions** |       |
| $                                 | (38        | )          |       | $                        | —     |   |   |   | $ | 4 |   |   |   | $ | 2 |   |   | Other income (expense), net |   |   | $ | 5 |   |   | $ | (38 | ) | $ | 43 |   | -113 | % |
|                                   |            |            |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income for the firstquarter of fiscal 2006 primarily represents interest income. Other expense forthe same quarter in fiscal 2005 is related primarily to a $41 million loss onthe repurchase of $271 million aggregate principal amount of our senior notesin the first quarter of fiscal 2005 and a loss on foreign currency translationof $3 million.

***Interest Expense***

| **Fiscal 2005** |       | ** ** |       | **First Fiscal Quarter** |       |
|-----------------|------------|------------|------------|--------------------------|------------|
| **1Q05**        | ** ** | **2Q05**   | ** ** | **3Q05**                 | ** ** | **4Q05** |   | ** ** |   | **2006** |   | **2005** |   | **Change** |   |
| ** **      | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** |   | **Dollars in millions** |   | ** ** |   | ** ** |   | ** ** |   |
|            | $10        |       |       |                     | $          | 5 |   |   |   | $ | 3 |   |   |   | $ | 1 |   |   | Interest expense |   |   | $ | 1 |   |   | $ | 10 |   | $ | (9 | ) | -90 | % |
|                 |            |            |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in interestexpense is due to lower year over year debt levels. Total debt decreased from$368 million as of December 31, 2004 to $30 million as of December 31,2005 due to the conversion into common stock of our LYONs, retirement ofTenovis’  secured floating rate notes andthe repurchase of a majority of our outstanding senior notes during fiscal2005.

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

| **Fiscal 2005** | ** ** | *** *** | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------|------------|--------------|------------|--------------------------|------------|
| **1Q05**        | ** ** | **2Q05**     | ** ** | **3Q05**                 | ** ** | **4Q05** | ** ** | ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **      | ** ** | ** **   | ** ** | ** **               | ** ** | ** ** | ** ** | **Dollars in millions** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|            | $          | 7            |       |                     |       | $ | 11 |   |   | $ | (117 | ) | $ | (577 | ) | Provision for  (benefit from) income taxes |   |   | $ | 40 |   |   |   | $ | 7 |   |   | $ | 33 |   | 471 | % |
|                 |            |              |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As a result of the reversal of a portionof our valuation allowance in the fourth quarter of fiscal 2005 on U.S.deferred tax assets, the provision for income taxes in the first quarter offiscal 2006 was****based on an effective tax rate of36.4%. The tax provision is comprised of U.S. federal, state and non-U.S. taxes.The provision for income taxes in the first quarter of fiscal 2005 wascomprised of state and non-U.S. income taxes.

**Segment Results**

***Global Communications Solutions***

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

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

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

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

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

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

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

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

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

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

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

·       associatedappliances, such as telephone handsets; and

·       mediaservers for voice applications used by smaller businesses.

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

·       applicationsin support of customer relationship management; and

·       messagingfor IP and traditional systems.

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

Thefollowing table sets forth revenue by similar class of products within theGlobal Communications Solutions segment:

| ** **                        | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                    | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|--------------|------------|------------|------------|------------|------------|--------------|-------------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | *** *** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | **Mix**                       | ** ** | ** **               | ** ** |
| **1Q05**                          | ** **   | **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | ** **                    | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                                 | 354          |       | $          | 393        |       | $          | 393          |                          | $          | 445                      |       | Large  Communications Systems |   | $ | 413 |   | $ | 354 |   |   | 63 | % |   |   | 60 | % |   | $ | 59 |   | 16.7 | % |
| 69                                |         | 78         |       | 93         |       | 91         |         | Small  Communications Systems |       | 88                       |       | 69 |   |   | 13 | % |   |   | 12 | % |   | 19 |   | 27.5 | % |
| 150                               |         | 145        |       | 151        |       | 164        |         | Converged Voice  Applications |       | 151                      |       | 150 |   |   | 23 | % |   |   | 25 | % |   | 1 |   | 0.7 | % |
| 19                                |         | 9          |       | 11         |       | 7          |         | Other                         |       | 9                        |       | 19 |   |   | 1 | % |   |   | 3 | % |   | (10 | ) | -52.6 | % |
| $                                 | 592          |       | $          | 625        |       | $          | 648          |                          | $          | 707                      |       | Total GCS revenue |   | $ | 661 |   | $ | 592 |   |   | 100 | % |   |   | 100 | % |   | $ | 69 |   | 11.7 | % |

 

The increase in total revenue for all GCS productclasses was primarily attributable toa full quarter of revenues associated with Tenovis. Large communicationsystems also benefited from increased sales of gateways and appliances. Inaddition to the increased revenue from Tenovis, small communications systemsrevenues benefited from increased sales of IP Office offset by lower sales oftraditional products such as the Merlin Magix® and Partner® brands. Convergedvoice applications sales were flat with an increase in EMEA offsetting adecline in the U.S. Contact center application sales rose, while messagingapplication sales declined, partly due to the anticipated rollout of a newmodular messaging release.

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The following table setsforth operating income (loss) of the GCS segment:

| ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **             | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|------------|------------|------------|------------|------------|------------|------------|------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** **               | ** ** |
| **1Q05**                          | ** ** | **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | ** **             | ** ** | **2006**                 | ** ** | **2005** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** ** |
|                              | $          | 25         |       |       | $          | (12        | )          |                   | $          | 1                        |       |   |   | $ | 43 |   |   | Operating income (loss) |   |   | $ | 43 |   |   |   | $ | 25 |   |   |   | 6.5 | % |   |   | 4.2 | % |   | $ | 18 |   | 72.0 | % |
|                                   |            |            |            |            |            |            |            |                        |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome was primarily due to a full quarter of revenues associated with Tenovis,as well as a benefit related to the reduction of a portion of our vacationaccrual as a result of a change in company policy eliminating carryovervacation days for substantially all of our U.S. non-represented employees.

***Avaya Global Services***

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

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

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

Managedservices—AGS supplements our customers’ in-house staff and manages complexmulti-vendor, multi-technology networks, optimizes network performance andconfigurations, backs up systems, detects and resolves faults, performs moves,adds and changes, and manages our customers’ trouble tickets and inventory. Thiscategory includes customers who have chosen a bundled solution with enhancedservices not provided in a basic maintenance contract. With the acquisition ofTenovis, Avaya acquired a business that includes both bundled services andproducts that are sold to customers on a monthly payment or rental paymentbasis.

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

| ** **              | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** | *** *** | *** ***                             | ** ** | **First Fiscal Quarter** | ** ** |
|-------------------------|--------------|--------------|------------|------------|------------|------------|--------------|------------------------------------------|------------|--------------------------|------------|
| **Fiscal 2005**         | *** *** | *** *** | ** ** | ** ** | ** ** | ** ** | ** **   | **Mix**                                  | ** ** | ** **               | ** ** |
| **1Q05**                | ** **   | **2Q05**     | ** ** | **3Q05**   | ** ** | **4Q05**   | *** *** | *** ***                             | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** **   |
| $                       | 371          |         | $          | 372        |       | $          | 378          |                                     | $          | 370                      |       | Maintenance |   | $ | 380 |   | $ | 371 |   |   | 65 | % |   |   | 67 | % |   |   | $ | 9 |   |   | 2.4 | % |
| 103                     |         | 122          |       | 117        |       | 125        |         | Implementation  and integration services |       | 123                      |       | 103 |   |   | 21 | % |   |   | 18 | % |   |   | 20 |   |   | 19.4 | % |
| 79                      |         | 96           |       | 88         |       | 87         |         | Managed services                         |       | 85                       |       | 79 |   |   | 14 | % |   |   | 14 | % |   |   | 6 |   |   | 7.6 | % |
| 3                       |         | 7            |       | 5          |       | 7          |         | Other                                    |       | —                   |       | 3 |   |   | 0 | % |   |   | 1 | % |   |   | (3 | ) |   | -100.0 | % |
| $                       | 556          |         | $          | 597        |       | $          | 588          |                                     | $          | 589                      |       | Total AGS revenue |   | $ | 588 |   | $ | 556 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 32 |   |   | 5.8 | % |

 

The increase in all AGS revenue classes wasattributable to a full quarter of revenues associated with Tenovis. Thisincrease was partially offset by a decline in maintenance and managed servicesrevenues in the U.S. Lower revenues in existing contract-related maintenancewere primarily due to cancellations and changes in contract scope.Implementation and integration services increased due to a full quarter of 

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Tenovis as well as a modestincrease in APAC and CALA. Managed services revenues in the U.S. wereunfavorably affected by customer changes in scope, pricing pressures andcancellations. Excluding the impact of the full quarter of business associatedwith Tenovis, total AGS revenue would have declined compared to the firstquarter of fiscal 2005.

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

| ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **              | ** ** | **First Fiscal Quarter** | ** ** |
|-----------------------------------|------------|------------|------------|------------|------------|------------|------------|-------------------------|------------|--------------------------|------------|
| **Fiscal 2005**                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** **               | ** ** |
| **1Q05**                          | ** ** | **2Q05**   | ** ** | **3Q05**   | ** ** | **4Q05**   | ** ** | ** **              | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| **Dollars in millions** | ** ** |
|                              | $          | 56         |       |       |       | $          | 27         |                    |       |                     | $          | 37 |   |   |   | $ | 46 |   |   | Operating income |   |   | $ | 60 |   |   |   | $ | 56 |   |   | 10.2 | % | 10.1 | % | $ | 4 |   |   | 7.1 | % |   |
|                                   |            |            |            |            |            |            |            |                         |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome is due to higher gross margins primarily in the U.S. Slightly highergross margins are primarily due to the impact of cost reductions in fiscal2005, as well as a benefit related to the reduction of a portion of ourvacation accrual as a result of a change in company policy eliminatingcarryover vacation days for substantially all U.S. non-represented employees. Excludingthe impact of the change in the Company’s vacation policy, operating incomewould have declined compared to the first quarter of fiscal 2005.

**Corporate/OtherUnallocated Amounts**

At the beginning of eachfiscal year, the amount of corporate overhead and certain other expenses,including targeted annual incentive awards, to be charged to operating segmentsis determined and fixed for the entire year in the annual plan. The annualincentive award accrual is adjusted quarterly based on actual year-to-dateresults and those estimated for the remainder of the year. The adjustment toemployee incentive awards, as well as any other over/under absorption ofcorporate overheads against plan, is recorded and reported within theCorporate/Other Unallocated Amounts caption. The $7 million operating incomefor the first quarter of fiscal 2005 also included acquisition integrationexpenses.

**Results of Discontinued Operations**

The $2 million loss fromdiscontinued operations in the first quarter of fiscal 2005 was primarily theresult of the finalization of the working capital adjustment related to thesale of our Connectivity Solutions business, in accordance with the assetpurchase agreement.

**Liquidity and Capital Resources**

During the first quarterof fiscal 2006, we continued the repurchase of our common stock pursuant to ourstock repurchase plan. These share repurchases aggregated $90 million duringthe quarter and contributed to the decrease in cash and cash equivalents to $726million as of December 31, 2005 from $750 million as of September 30,2005.

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***Sources and Uses of Cash for the Three Months Ended December 31,2005***

Acondensed statement of cash flows for the first quarter of fiscal 2006 and 2005follows:

| ** **                                                    | ** ** | **First Fiscal Quarter**           | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                    | ** ** | **   2006   ** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**            | ** ** |
| Net cash provided  by (used for):                             |       |                                         |       |   |   |   |   |
| Operating activities                                          |       |                                         | $          | 106 |   |   | $ | (36 | ) |
| Investing activities                                          |       |                                         | (42        | ) |   | (400 | ) |
| Financing activities                                          |       |                                         | (84        | ) |   | (288 | ) |
| Effect of  exchange rate changes on cash and cash equivalents |       |                                         | (4         | ) |   | 18 |   |
| Net decrease in  cash and cash equivalents                    |       |                                         | (24        | ) |   | (706 | ) |
| Cash and cash equivalents at beginning of year                |       |                                         | 750        |   |   | 1,617 |   |
| Cash and cash  equivalents at end of quarter                  |       |                                         | $          | 726 |   |   | $ | 911 |   |

 

***Operating Activities***

Our net cash providedby operating activities was $106 million for the first quarter of fiscal 2006,compared to $36 million of cash used for operating activities in the firstquarter of fiscal 2005. The increase in cash provided by operating activitieswas primarily driven by:

*Lowerincentive payments**—The*first quarter of fiscal 2006included payment of discretionary employee incentive awards. The first quarterof fiscal 2005 included payments of management incentives based on fiscal 2004performance.

*Improvementin Net Income**—We* generated net income of $71million for the first quarter of fiscal 2006 compared to $31 million in thesame quarter last year, a $40 million year-over-year improvement. Thisimprovement was due to a $101 million increase in revenue, with higher grossmargins generated from increased volumes, favorable product mix and continuedcost reductions.

*Accounts Receivable, Net**—The*followingsummarizes our accounts receivable, net and related metrics:

| ** **                                                                  | ** ** | **December 31,**             | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                  | ** ** | **2005**                          | ** ** | **2005**               | ** ** | **Change** | ** ** |
| ** **                                                                  | ** ** | **Dollars in millions** | ** ** |
| Accounts  receivable, gross                                                 |       |                              | $          | 867                    |       |       |       | $ | 920 |   |   | $ | (53 | ) |
| Allowance for  doubtful accounts                                            |       |                              | (56        | )                      |       |       | (58        | ) |   | 2 |   |
| Accounts  receivable, net                                                   |       |                              | $          | 811                    |       |       |       | $ | 862 |   |   | $ | (51 | ) |
| Allowance for doubtful accounts as a percent of accounts  receivable, gross |       |                              | 6.5        | %                      |       |       | 6.3        | % |   | + 0.2 pts |   |
| Days sales outstanding (DSO)                                                |       |                              | 58 days    |                   |       |       | 60 days    |   |   | -2  days |   |
| Past due  receivables as a percent of account receivable, gross             |       |                              | 24.4       | %                      |       |       | 21.7       | % |   | +2.7 pts |   |

 

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

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*Inventory**—*The followingsummarizes our inventory and inventory turnover:

| ** **         | ** ** | **December 31,**             | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|--------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **         | ** ** | **2005**                          | ** ** | **2005**               | ** ** | **Change** | ** ** |
| ** **         | ** ** | **Dollars in millions** | ** ** |
| Finished goods     |       |                              | $          | 264                    |       |       |       | $ | 274 |   |   | $ | (10 | ) |
| Raw materials      |       |                              | 18         |                   |       |       | 14         |   |   | 4 |   |
| Total inventory    |       |                              | $          | 282                    |       |       |       | $ | 288 |   |   | $ | (6 | ) |
| Inventory turnover |       |                              | 9.3 times  |                   |       |       | 9.4 times  |   |   | -  0.1 times |   |

 

Inventory remained roughly flat in the first quarterof fiscal 2006 compared to the prior quarter.

*Accounts Payable**—*The followingsummarizes our accounts payable:

| ** **               | ** ** | **December 31,**             | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|--------------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **               | ** ** | **2005**                          | ** ** | **2005**               | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions** | ** ** |
| Accounts payable         |       |                              | $          | 381                    |       |       |       | $ | 402 |   |   | $ | (21 | ) |
| Days payable outstanding |       |                              | 52 days    |                   |       |       | 53 days    |   |   | -  1 day |   |
|                          |            |                                   |            |                        |            |            |            |  |  |  |  |  |  |  |

 

Accounts payable decreasedin the first quarter of fiscal 2006 over the prior quarter due to lowerspending as part of our cost saving initiatives.

***Investing Activities***

Net cash used forinvesting activities was $42 million in the first quarter of fiscal 2006,compared with $400 million in the same quarter last year. Activities in thecurrent quarter include $26 million for capital expenditures and $18 millionfor capitalized software development costs. Cashused in the same quarter in fiscal 2005 included $383 million, net, used foracquisitions, consisting primarily of $265 million for Tenovis and $110 millionfor Spectel.

***Financing Activities***

Net cash used forfinancing activities was $84 million in the first quarter of fiscal 2006,compared with net cash used for financing activities of $288 million in thesame quarter last year. Cash used in the current quarter consists primarily of$90 million to repurchase our common stock pursuant to our stock repurchaseplan. This use of cash was partially offset by $6 million of cash received inconnection with the issuance of common stock under our employee stock purchaseplan and stock option plans.  Cash usedin the same quarter of fiscal 2005 consisted primarily of $314 million torepurchase substantially all of our Senior Notes in a public tender offerpartially offset by $29 million of cash received in connection with issuance ofcommon stock under our employee 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 fundworking capital requirements and capital expenditures, share repurchases, restructuringpayments, debt repayments and employee benefit obligations.

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

·  *Share repurchase plan*—Inaccordance with the share repurchase plan authorized by the Board of Directorsin April 2005, we may use up to $500 million of cash to repurchase sharesof our outstanding common stock through April 2007. For fiscal 2006, ourcredit facility described below 

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limits our ability to makedividend payments or distributions or to repurchase, redeem or otherwiseacquire shares of our common stock during fiscal 2006 to $461 million (whichrepresents 50% of net income for the Company for fiscal 2005). Since the startof the plan through December 31, 2005, we paid $197 million to repurchaseand retire our shares. From January 1, 2006 through February 7, 2006,we paid an additional $51 million to repurchase and retire our shares, leavingapproximately $252 million available for further share repurchases according tothe limitations of the plan. These repurchases are made at management’sdiscretion in the open market or in privately negotiated transactions incompliance with applicable securities laws and other legal requirements and aresubject to market conditions, share price and other factors. See Note 8 “Long-TermDebt,” to our Consolidated Financial Statements for further information.

·  *Capital expenditures*—We expect tospend approximately $109 million for capital expenditures and approximately $47million for capitalized software development costs during the remainder offiscal 2006.

·  *Restructuring payments—*We expect tomake termination payments to former Tenovis employees aggregating approximately$40 million during the remainder of fiscal 2006. We also plan to payapproximately $6 million for employee separation and lease termination costsrelated to our fourth quarter fiscal 2005 restructuring and approximately $6million for lease termination costs related to facilities accounted for underEITF 94-3. As we continue to identify additional areas to manage costs,including further possible opportunities in Europe, we may incur additionalrestructuring payments.

·  *Debt repayments—*We gave notice in February 2006to call for redemption the outstanding senior notes in April 2006 forapproximately $14 million.

·  *Benefit Obligations*—For theremainder of fiscal 2006, we estimate we will make payments totaling $5 millionfor certain U.S. pension benefits that are not pre-funded, and contributionstotaling $9 million for non-U.S. plans. Under current law, we will not berequired to make a contribution to our U.S. pension plans in fiscal 2006 tosatisfy minimum statutory funding requirements. For the remainder of fiscal2006 we also estimate we will makepayments totaling $35 million for retiree medical benefits that are notpre-funded.

In addition, we may usecash in the future to make strategic acquisitions.

***Future Sources of Liquidity***

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

We and a syndicate of lenders are currently party to a$400 million revolving credit facility (see Note 8 “Long-Term Debt” to ourConsolidated Financial Statements), which expires in February 2010. Ourexisting cash and cash equivalents and net cash provided by operatingactivities may be insufficient if we face unanticipated cash needs such as thefunding of a future acquisition or other capital investment. Furthermore, if weacquire a business in the future that has existing debt, our debt servicerequirements may increase, thereby increasing our cash needs.

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

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Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $726 million and our net cash provided by operating activitieswill be sufficient to meet our future cash requirements described above. Wealso believe we have sufficient cash and cash equivalents for futureacquisitions. Our ability to meet these requirements will depend on our abilityto generate cash in the future, which is subject to general economic,financial, competitive, legislative, regulatory and other factors that arebeyond our control.

***Uncertainties Regarding Our Liquidity***

We believe thefollowing uncertainties exist regarding our liquidity:

·  *Ability to IncreaseRevenue*—Our ability to generate net cash from operating activitieshas been a primary source of our liquidity. If our revenues were to decline,our ability to generate net cash from operating activities in a sufficientamount to meet our cash needs could be adversely affected.

·  *Debt Ratings—*Ourability to obtain external financing and the related cost of borrowing areaffected by our debt ratings. See “Debt Ratings.”

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

·  *Pension Reform*—There are various pension legislation reformproposals being considered by the U.S. Congress. The reform proposalscould cause a significant increase in our required pension contributionsbeginning in fiscal 2007.

***Fair Value of Financial Instruments***

The estimated aggregate fair value of the senior noteswas $15 million as of December 31, 2005 and September 30, 2005. Thefair  values are based upon quoted marketprices and yields obtained through independent pricing sources for the same orsimilar types of borrowing arrangements taking into consideration the underlyingterms of the debt.

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

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We aretherefore subject to the risk associated with foreign currency exchange ratesand interest rates that could affect our results of operations, financialposition and cash flows. We manage our exposure to these market risks throughour regular operating and financing activities and, when deemed appropriate,through the use of derivative financial instruments. We use derivativefinancial instruments to reduce earnings and cash flow volatility associatedwith foreign exchange rate changes. Derivative financial instruments are usedas risk management tools and not for speculative or trading purposes. As of December 31,2005 and September 30, 2005, the estimated fair values of our foreigncurrency forward contracts were $5 million and $6 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 obtain external financing and therelated cost of borrowing is affected by our debt ratings, which areperiodically reviewed by the major credit rating agencies. As of December 31,2005, we had a long-term corporate family rating of Ba3 with a positive outlookfrom Moody’s and a corporate credit rating of BB with a stable outlook fromStandard & Poor’s.

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These ratings are notrecommendations to buy, sell or hold securities. The ratings are subject tochange or withdrawal at any time by the respective credit rating agencies. Eachcredit rating should be evaluated independently of any other ratings.

***Credit Facility***

Our credit facility contains affirmative andrestrictive covenants that we must comply with, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio ofconsolidated debt to earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, of 2.00 to 1.00,(c) maintaining a minimum ratio of adjusted EBITDA to interest expense of4.00 to 1.00, (d) limitations on the incurrence of subsidiaryindebtedness, (e) limitations on liens, (f) limitations oninvestments and (g) limitations on the creation or existence of agreementsthat prohibit liens on our properties. The credit facility also limits theCompany’s ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock to an amount notto exceed 50% of consolidated net income of the Company for the fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. As of December 31,2005, we were in compliance with all of the covenants included in the creditfacility.

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

As of December 31,2005, there are $57 million of letters of credit issued under the creditfacility. There are no other outstanding borrowings under the facility and theremaining availability is $343 million. We believe the credit facility providesus with an important source of backup liquidity.

**Forward Looking Statements**

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

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

Any or all of our forward-looking statements inthis report, in the 2005 Annual Report to Shareholders and in any other publicstatements we make may turn out to bewrong. They can be affected by inaccurate assumptions we might make orby known or unknown risks and uncertainties. Many factors mentioned in thediscussion below will be important in determining future results. Consequently,no forward-looking statement can be guaranteed and you are cautioned notto place undue reliance on these forward-looking statements. Actual futureresults may vary materially.

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

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could also adverselyaffect us. This discussion is provided as permitted by the Private SecuritiesLitigation Reform Act of 1995.

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

·*** ***priceand product competition;

·  rapid or disruptive technological development,including the effects of the technology shift from traditional TDM to IPtelephony;

·  dependence on new product development;

·  the mix of our products and services;

·  customer demand for our products and services,including risks specifically associated with the services business and, inparticular, the maintenance and rental and managed services lines of business,primarily due to renegotiations of customer contracts and changes in scope,pricing pressures and cancellations;

·  general industry and market conditions andgrowth rates and general domestic and international economic conditionsincluding interest rate and currency exchange rate fluctuations;

·  risks related to inventory, including warrantycosts, obsolescence charges, excess capacity, material and labor costs, and ourdistributors’ decisions regarding their own inventory levels;

·  the economic, political and other risksassociated with international sales and operations, including increasedexposure to currency fluctuations and to European economies as a result of ouracquisition of Tenovis;

·  the ability to successfully integrate acquiredcompanies, including Tenovis, which has required significant management timeand attention;

·  the ability to attract and retain qualifiedemployees;

·  control of costs and expenses;

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

·  the ability to form and implement alliances.

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

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

**A key component of our strategy is our focus on the developmentand marketing of advanced communications products and applications and relatedservices, including IP telephony solutions, and this strategy may not besuccessful or may adversely affect our business.**

We are focused onthe development and sales of IP telephony solutions and other advancedcommunications products and applications and related services. In order toexecute this strategy successfully, we must continue to:

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

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·       researchand develop more IP telephony solutions and other products and applicationsthat use modes of communications other than voice, which has historically beenour core area of expertise;

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

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

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

·       enhanceour services organization’s ability to identify whether Avaya or non-Avayasources are causing network faults as converged networks move from closed,proprietary networks to standards-based networks;

·       developrelationships with new types of channel partners;

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

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

·       expandour geographic scope.

If we do notsuccessfully execute this strategy, our operating results may be adverselyaffected. Moreover, even if we successfully address these challenges, ouroperating results may still be adversely affected if the market opportunity foradvanced communications products, applications and services, including IPtelephony solutions, does not develop in the ways that we anticipate. The ratioof revenue attributable to IP telephony solutions versus traditional voicecommunication systems is expected to increase as more and more companiesconvert to IP telephony solutions. IP telephony lines constitute a smallpercentage of global installed enterprise telephony lines and if IP telephonydoes not gain widespread acceptance in the marketplace as an alternativereplacement option for enterprise telephony systems our overall revenue andoperating results may be adversely affected. Because this market opportunity isin its early stages, we cannot predict whether:

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

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

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

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

**Revenue generated by our traditional enterprise voicecommunications systems has been declining for the last several years and if wedo not successfully execute our strategy to substitute new technology or expandour sales in market segments with higher growth rates, our revenue andoperating results may continue to be adversely affected.**

We have been experiencing declines in revenue from ourtraditional enterprise voice communications business. We expect, based onvarious industry reports, that the demand for these traditional systems willdecline over time. We are executing a strategy to capitalize on products,advanced communications and 

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devices that providehigher growth opportunities, including IP telephony solutions. Many of theproducts and applications, including IP telephony solutions, have not yet beenwidely adopted by enterprises.

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

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

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

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

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

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traditionallyfocused on data network integration. We cannot predict with precision whichcompetitors may enter our markets in the future, what form such competition maytake or whether we will be able to respond effectively to the entry of newcompetitors into our markets or the rapid evolution in technology and productdevelopment that has characterized our markets. In addition, in order toeffectively compete with any new market entrant, we may need to make additionalinvestments in our business or use more capital resources than our businesscurrently requires or reduce prices, which may adversely affect ourprofitability.

**Although our revenue has continued to increase since2003, we have recently experienced difficulties in significantly growing ourrevenue other than through acquisitions, particularly in the U.S.**

Although our revenue increased from $3,796 million infiscal 2003 to $4,069 million in fiscal 2004 and to $4,902 million in fiscal2005, we have recently experienced difficulty in significantly growing ourrevenue, particularly in the U.S. In addition, our operating results for fiscal2005 include the operating results of Tenovis from November 18, 2004, aswell as other acquisitions. Revenues for the first quarters of fiscal 2006 and2005 were $1,249 million and $1,148 million, respectively.

One factor that significantly affects our operatingresults is the impact of economic conditions on the willingness of enterprisesto make capital investments, particularly in enterprise communicationstechnology and related services. Although general economic conditions haveimproved in recent years, we believe that enterprises continue to be concernedabout their ability to increase revenues and thereby increase their profitability.Accordingly, they have tried to maintain or improve profitability through costcontrol and constrained capital spending. Because it is not certain whetherenterprises will increase spending on enterprise communications technologysignificantly in the near term, we could experience continued pressure on ourability to increase our revenue.

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

***Risks Related To Our Operations***

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

We may not be able tosuccessfully integrate acquired businesses into ours, and therefore we may notbe able to realize the intended benefits from the acquisition. If we fail tosuccessfully integrate these acquisitions or if they fail to perform as weanticipated, our existing businesses and our revenue and operating resultscould be adversely affected. If the due diligence and audit of the operationsof these acquired businesses performed by us and by third parties on our behalfwas inadequate or flawed, we could later discover unforeseen financial orbusiness liabilities, or the acquired businesses may not perform as expected.Additionally, acquisitions could result in difficulties assimilating acquiredoperations and products, and the diversion of capital and management’sattention away from other business issues and opportunities. Acquisitions couldalso have a negative impact on our results of operations if it is subsequentlydetermined that goodwill or other acquired intangible assets are impaired, thusresulting in an impairment charge in a future period.

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

We have outsourced substantially all of ourmanufacturing operations. Our ability to realize the intended benefits of ourmanufacturing outsourcing initiative depends on the willingness and ability ofour 

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contract manufacturers toproduce our products. We may experience significant disruption to ouroperations by outsourcing too much of our manufacturing. If a contractmanufacturer terminates its relationship with us or is unable to fill ourorders on a timely basis, we may be unable to deliver the affected products tomeet our customers’ orders, which could delay or decrease our revenue orotherwise have an adverse effect on our operations. 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.

Additionally, our outsourcing agreement with our mostsignificant contract manufacturer, Celestica, expires in May 2006. Theagreement automatically renews for successive one-year terms unlesseither party elects to terminate the agreement by giving notice to the otherparty six months prior to the expiration. Pursuant to the requirements of theagreement, we gave notice to Celestica on November 2, 2005 of ourintention not to renew our outsourcing agreement. We are in discussions tonegotiate a new outsourcing agreement. There is no guarantee that we will beable to negotiate an agreement with Celestica or, alternatively, negotiate areplacement agreement with a new contract manufacturer on favorable terms. Werely on outside sources for the supply of the components of our products andfor the finished products that we purchase from third parties. Delays orshortages associated with these components could cause significant disruptionto our operations.

The success of our manufacturing initiative depends onthe willingness and ability of contract manufacturers to produce our products.We may experience significant disruption to our operations by outsourcing somuch of our manufacturing. If our contract manufacturers terminate theirrelationships with us or are unable to fill our orders on a timely basis, or ifwe do not accurately forecast our requirements, we may be unable to deliver ourproducts to meet our customers’ orders, which could delay or decrease ourrevenue.

For more information concerning the risks associated withour contract manufacturers operating internationally, please see “ForwardLooking Statements—Risks Related To Our Operations—As our internationalbusiness has grown significantly in the last fiscal year, changes in economicor political conditions in a specific country or region could negatively affectour revenue, costs, expenses and financial condition.”

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

Although we attempt to protect our intellectualproperty through patents, trademarks, trade secrets, copyrights,confidentiality and nondisclosure agreements and other measures, intellectualproperty is difficult to protect and these measures may not provide adequateprotection for our proprietary rights, particularly in countries that do nothave well-developed judicial systems or laws protecting intellectual propertyrights. Patent filings by third parties, whether made before or after the dateof our filings, could render our intellectual property less valuable.Competitors may misappropriate our intellectual property, disputes as to ownershipof intellectual property may arise and our intellectual property may otherwisebecome known or independently developed by competitors. We believe thatdeveloping new products and technology that are unique to Avaya is critical toour success and failure to adequately manage and protect our intellectualproperty could seriously harm our business and future prospects because webelieve that developing new products and technology that are unique to us iscritical to our success. If we do not obtain sufficient internationalprotection for our intellectual property, our competitiveness in internationalmarkets could be significantly impaired, which would limit our growth andfuture revenue.

In addition, we rely onthe security of our information systems, among other things, to protect ourproprietary information and information of our customers. If we do not maintainadequate security procedures over our information systems, we may besusceptible to computer hacking, cyberterrorism or 

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otherunauthorized attempts by third parties to access our proprietary information orthat of our customers. Even if we are able to maintain procedures that areadequate to address current security risks, hackers, cyberterrorists or otherunauthorized users may develop new techniques that will enable them tosuccessfully circumvent our current security procedures. The failure to protectour proprietary information could seriously harm our business and futureprospects or expose us to claims by our customers, employees or others that wedid not adequately protect their proprietary information.

**As our international business has grown significantlyin the last fiscal year, 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 2006 and 2005, we derived 41% and36% 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 resulting from the Tenovis acquisition.

Other factors which may impact our internationaloperations include foreign trade, environmental, monetary and fiscal policies,laws, regulations and other activities of foreign governments, agencies andsimilar organizations, and risks associated with having facilities located incountries which have historically been less stable than the United States. Oneenvironmental law that will impact our international operations in the EuropeanUnion (“EU”) is the EU’s Directive on Waste Electrical and Electronic Equipment(“the Directive”) that directs EU-member countries to adopt legislation toregulate the collection, treatment, recovery and environmentally sound disposalof electrical and electronic waste equipment, whereby commercial users will beobligated to retire, in an environmentally sound manner, specific assets thatqualify as historical waste.

Additional risks inherent in our internationaloperations generally include, among others, the costs and difficulties ofmanaging international operations, adverse tax consequences, includingimposition of withholding or other taxes on payments by subsidiaries, andgreater difficulty in enforcing intellectual property rights. The various risksinherent in doing business in the United States generally also exist when doingbusiness outside of the United States, and may be exaggerated by the difficultyof doing business in numerous sovereign jurisdictions due to differences inculture, laws and regulations.

In addition, foreigncurrency exchange rates and fluctuations may have an impact on our futurerevenue, costs or cash flows from our international operations, which couldadversely affect our financial performance. Because a significant portion ofour business is conducted outside the United States, we face exposure toadverse movements in foreign currency exchange rates. These exposures maychange over time as business practices evolve, and they could have a materialadverse impact on our financial results and cash flows. An increase in thevalue of the dollar could increase the real cost to our customers of ourproducts in those markets outside the United States, and a weakened dollarcould increase the cost of local operating expenses and procurement of rawmaterials.

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***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 primarilyrelated to Lucent’s businesses shall be borne 90% by Lucent and 10% by us andcontingent liabilities in excess of $50 million that are primarily relatedto our businesses shall be borne equally by the parties.

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

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

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

In addition, third partieshave, and may in the future, claimed that a customer’s use of our products,systems or software infringes the third party’s intellectual property rights.Under certain circumstances, we may be required to indemnify our customers forsome of the costs and damages related to such an infringement claim. Anyindemnification requirement could have a material adverse effect on ourbusiness and our operating results.

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

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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 the distributionto be tax-free. Under the Tax Sharing Agreement, if the distribution fails toqualify as a tax-free distribution because of an issuance or an acquisition ofour stock or an acquisition of our assets, or some other actions of ours, thenwe will be solely liable for any resulting taxes to Lucent.

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

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

See Avaya’s Annual Reporton Form 10-K for the fiscal year ended September 30, 2005 filedwith the SEC on December 13, 2005. As of December 31, 2005, there hasbeen no material change in this information.

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

*Evaluationof disclosure controls and procedures*.   Based on our management’sevaluation (with the participation of our principal executive officer andprincipal financial officer), as of the end of the period covered by thisreport, our principal executive officer and principal financial officer haveconcluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended,(the “Exchange Act”)) are effective to ensure that information required to bedisclosed by us in reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin Securities and Exchange Commission rules and forms.

*Changesin internal control over financial reporting*.   Therewas no change in our internal control over financial reporting during our firstquarter of fiscal 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

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**PART II**

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

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

**Item2.**                        *Changes in Securities, Use of Proceeds and Issuer Purchases of EquitySecurities.*

| ** **                    | ** ** | ** **         | ** ** | ** **         | ** ** | **Total**                     | ** ** | **Approximate**                        | ** ** |
|-------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | ** **         | ** ** | ** **         | ** ** | **number**                    | ** ** | **dollar value of**          | ** ** |
| ** **                    | ** ** | **Number**         | ** ** | **Average**        | ** ** | **of shares**            | ** ** | **shares that may**          | ** ** |
| ** **                    | ** ** | **of shares** | ** ** | **price per** | ** ** | **purchased as**         | ** ** | **yet be purchased as** | ** ** |
| ** **                    | ** ** | **purchased**      | ** ** | **share**          | ** ** | **part of program** | ** ** | **part of program**          | ** ** |
| October 1 -  31          |       | 1,000,000          |       |               | $          | 11.78                         |       |                                   |       | 1,000,000 |   |   |   | $ | 381,426,394 |   |   |
| November 1 -  30         |       | 5,603,000          |       |               | $          | 11.33                         |       |                                   |       | 5,603,000 |   |   |   | $ | 317,939,757 |   |   |
| December 1 -  31         |       | 1,344,600          |       |               | $          | 10.96                         |       |                                   |       | 1,344,600 |   |   |   | $ | 303,205,680 |   |   |
| First quarter of  fiscal 2006 |       | 7,947,600          |       |               | $          | 11.32                         |       |                                   |       | 7,947,600 |   |   |   |   |   |   |

 

From January 1, 2006through February 7, 2006, we repurchased and retired 4,867,600 shares atan average purchase price of $10.49 per share, for an additional $51 million,leaving approximately $252 million available under the limitations of the plan.

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

None.

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

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

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

**Item 6.**                        *Exhibits*

| 31.1 | Certification of Donald K. Peterson pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|------|------------------------------------------------------------------------------------------------------|
| 31.2 | Certification of Garry  K. McGuire pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.  |
| 32.1 | Certification of Donald  K. Peterson pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 | Certification of Garry  K. McGuire pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.  |

 

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**SIGNATURES**

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

|                       | AVAYA INC. |
|-----------------------|------------|
|                  | By:        | /s/  AMARNATH K. PAI |
|                  |       | Amarnath K. Pai |
|                  |       | *Vice-President  Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| February 9, 2006 |       |   |

 

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