**UNITED STATES**

**SECURITIES 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 June 30, 2005**

**OR**

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

**CommissionFile Number 001-15951**

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AVAYA INC.

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

 

**211 Mount Airy Road,Basking Ridge, New Jersey 07920**

**TelephoneNumber 908-953-6000**

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

Asof July 31, 2005, 476,533,310 common shares were outstanding.

 

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**TABLE OF CONTENTS**
| Item                                   | ** **                                                                                  | ** ** | **Description** | ** ** |  | **Page** | ** ** |
|----------------------------------------|---------------------------------------------------------------------------------------------|------------|-----------------|------------|--|----------|------------|
| **PART I  FINANCIAL INFORMATION** |
| 1.                                     | Financial Statements                                                                        |       | 3               |       |
| 2.                                     | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       | 30              |       |
| 3.                                     | Quantitative and Qualitative  Disclosures About Market Risk                                 |       | 60              |       |
| 4.                                     | Controls and Procedures                                                                     |       | 60              |       |
| **PART II OTHER INFORMATION**     |
| 1.                                     | Legal Proceedings                                                                           |       | 62              |       |
| 2.                                     | Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities           |       | 62              |       |
| 3.                                     | Defaults Upon Senior Securities                                                             |       | 62              |       |
| 4.                                     | Submission of Matters to a  Vote of Security Holders                                        |       | 62              |       |
| 5.                                     | Other Information                                                                           |       | 62              |       |
| 6.                                     | Exhibits                                                                                    |       | 62              |       |
|                                   | Signatures                                                                                  |       | 63              |       |
|                                        |                                                                                             |            |                 |            |  |          |            |  |  |

 

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*

**AVAYA INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME**
| ** **                                              | ** ** | **Three months ended  June 30,**                                              | ** ** | **Nine months ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                              | ** ** | **      2005    **                         | ** ** | **   2004   **   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **Dollars in millions, except per share amounts  (unaudited)** | ** ** |
| REVENUE                                                 |       |                                                                                         |       |                                           |       |   |   |   |   |
| Sales of products                                       |       |                                                                                         | $          | 566                                            |       |   | $ | 506 |   | $ | 1,663 |   | $ | 1,483 |   |
| Services                                                |       |                                                                                         | 497        |                                           |       | 446 |   | 1,472 |   | 1,307 |   |
| Rental and managed services                             |       |                                                                                         | 173        |                                           |       | 64 |   | 471 |   | 203 |   |
|                                                    |       |                                                                                         | 1,236      |                                           |       | 1,016 |   | 3,606 |   | 2,993 |   |
| COSTS                                                   |       |                                                                                         |       |                                           |       |   |   |   |   |   |   |
| Sales of products                                       |       |                                                                                         | 265        |                                           |       | 233 |   | 755 |   | 691 |   |
| Services                                                |       |                                                                                         | 325        |                                           |       | 263 |   | 972 |   | 793 |   |
| Rental and managed services                             |       |                                                                                         | 71         |                                           |       | 32 |   | 198 |   | 102 |   |
|                                                    |       |                                                                                         | 661        |                                           |       | 528 |   | 1,925 |   | 1,586 |   |
| GROSS MARGIN                                            |       |                                                                                         | 575        |                                           |       | 488 |   | 1,681 |   | 1,407 |   |
| OPERATING  EXPENSES                                     |       |                                                                                         |       |                                           |       |   |   |   |   |   |   |
| Selling, general and administrative                     |       |                                                                                         | 406        |                                           |       | 307 |   | 1,169 |   | 948 |   |
| Research and development                                |       |                                                                                         | 93         |                                           |       | 89 |   | 296 |   | 255 |   |
| TOTAL OPERATING EXPENSES                                |       |                                                                                         | 499        |                                           |       | 396 |   | 1,465 |   | 1,203 |   |
| OPERATING INCOME                                        |       |                                                                                         | 76         |                                           |       | 92 |   | 216 |   | 204 |   |
| Other income (expense), net                             |       |                                                                                         | 4          |                                           |       | (11 | ) | (34 | ) | (24 | ) |
| Interest expense                                        |       |                                                                                         | (3         | )                                              |       | (14 | ) | (18 | ) | (54 | ) |
| INCOME FROM CONTINUING OPERATIONS BEFORE INCOME  TAXES  |       |                                                                                         | 77         |                                           |       | 67 |   | 164 |   | 126 |   |
| (Benefit from) provision for income taxes               |       |                                                                                         | (117       | )                                              |       | 9 |   | (99 | ) | (65 | ) |
| INCOME FROM CONTINUING OPERATIONS                       |       |                                                                                         | 194        |                                           |       | 58 |   | 263 |   | 191 |   |
| Income (loss) from discontinued operations, net of  tax |       |                                                                                         | —     |                                           |       | 3 |   | (2 | ) | 5 |   |
| **NET INCOME**                                          | ** ** |                                                                                         | **$**      | **194**                                        |       | ** ** | **$** | **61** | ** ** | **$** | **261** | ** ** | **$** | **196** | ** ** |
| **Earnings  Per Common Share**—**Basic:**          |       |                                                                                         |       |                                           |       |   |   |   |   |   |   |
| Earnings per share from continuing operations           |       |                                                                                         | $          | 0.41                                           |       |   | $ | 0.13 |   | $ | 0.56 |   | $ | 0.44 |   |
| Earnings (loss) per share from discontinued  operations |       |                                                                                         | —     |                                           |       | 0.01 |   | (0.01 | ) | 0.01 |   |
| Earnings per share                                      |       |                                                                                         | $          | 0.41                                           |       |   | $ | 0.14 |   | $ | 0.55 |   | $ | 0.45 |   |
| **Earnings  Per Common Share**—**Diluted:**        |       |                                                                                         |       |                                           |       |   |   |   |   |   |   |
| Earnings per share from continuing operations           |       |                                                                                         | $          | 0.40                                           |       |   | $ | 0.12 |   | $ | 0.54 |   | $ | 0.42 |   |
| Earnings per share from discontinued operations         |       |                                                                                         | —     |                                           |       | 0.01 |   | — |   | 0.01 |   |
| Earnings per share                                      |       |                                                                                         | $          | 0.40                                           |       |   | $ | 0.13 |   | $ | 0.54 |   | $ | 0.43 |   |

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                 | ** ** | **June 30,  2005**                                                                  | ** ** | **September 30,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                 | ** ** | **Dollars in millions,  except per share amounts  (unaudited)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                 |       |                                                                                     |       |                         |       |   |   |
| Current assets:                                                                                                                                                                                                            |       |                                                                                     |       |                         |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                 |       | $                                                                                        | 735        |                         |       | $ | 1,617 |   |   |
| Receivables, less  allowances of $48 million as of June 30, 2005 and September 30,  2004                                                                                                                         |       | 813                                                                                      |       |                         | 696        |   |   |
| Inventory                                                                                                                                                                                                                  |       | 328                                                                                      |       |                         | 239        |   |   |
| Deferred income taxes,  net                                                                                                                                                                                                |       | 58                                                                                       |       |                         | 27         |   |   |
| Other current assets                                                                                                                                                                                                       |       | 131                                                                                      |       |                         | 145        |   |   |
| TOTAL CURRENT ASSETS                                                                                                                                                                                                       |       | 2,065                                                                                    |       |                         | 2,724      |   |   |
| Property, plant and  equipment, net                                                                                                                                                                                        |       | 731                                                                                      |       |                         | 509        |   |   |
| Deferred income taxes,  net                                                                                                                                                                                                |       | 372                                                                                      |       |                         | 400        |   |   |
| Goodwill                                                                                                                                                                                                                   |       | 894                                                                                      |       |                         | 257        |   |   |
| Other intangible assets,  net                                                                                                                                                                                              |       | 355                                                                                      |       |                         | 75         |   |   |
| Other assets                                                                                                                                                                                                               |       | 162                                                                                      |       |                         | 194        |   |   |
| **TOTAL ASSETS**                                                                                                                                                                                                           | ** ** | **$**                                                                                    | **4,579**  |                         | ** ** | **$** | **4,159** |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                              |       |                                                                                     |       |                         |       |   |   |
| Current liabilities:                                                                                                                                                                                                       |       |                                                                                     |       |                         |       |   |   |
| Accounts payable                                                                                                                                                                                                           |       | $                                                                                        | 390        |                         |       | $ | 345 |   |   |
| Debt maturing within one  year                                                                                                                                                                                             |       | 5                                                                                        |       |                         | 299        |   |   |
| Payroll and benefit  obligations                                                                                                                                                                                           |       | 282                                                                                      |       |                         | 328        |   |   |
| Deferred revenue                                                                                                                                                                                                           |       | 237                                                                                      |       |                         | 178        |   |   |
| Other current  liabilities                                                                                                                                                                                                 |       | 397                                                                                      |       |                         | 273        |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                 |       | 1,311                                                                                    |       |                         | 1,423      |   |   |
| Long-term debt                                                                                                                                                                                                             |       | 26                                                                                       |       |                         | 294        |   |   |
| Benefit obligations                                                                                                                                                                                                        |       | 1,572                                                                                    |       |                         | 1,263      |   |   |
| Deferred income taxes,  net                                                                                                                                                                                                |       | 99                                                                                       |       |                         | —     |   |   |
| Other liabilities                                                                                                                                                                                                          |       | 248                                                                                      |       |                         | 385        |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                             |       | 1,945                                                                                    |       |                         | 1,942      |   |   |
| Commitments and  contingencies                                                                                                                                                                                             |       |                                                                                     |       |                         |       |   |   |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                                                                             |       |                                                                                     |       |                         |       |   |   |
| Series A junior  participating preferred stock, par value $1.00 per share, 7.5 million shares  authorized; none issued and outstanding                                                                                |       | —                                                                                   |       |                         | —     |   |   |
| Common stock, par value  $0.01 per share, 1.5 billion shares authorized, 476,256,305 and 455,827,524  issued (including 136,476 and 0 treasury shares) as of June 30, 2005 and  September 30, 2004, respectively |       | 5                                                                                        |       |                         | 5          |   |   |
| Additional  paid-in-capital                                                                                                                                                                                                |       | 2,897                                                                                    |       |                         | 2,592      |   |   |
| Accumulated deficit                                                                                                                                                                                                        |       | (713                                                                                     | )          |                         | (974       | ) |   |
| Accumulated other  comprehensive loss                                                                                                                                                                                      |       | (864                                                                                     | )          |                         | (829       | ) |   |
| Less: Treasury stock at  cost                                                                                                                                                                                              |       | (2                                                                                       | )          |                         | —     |   |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                                                                                                                                                           |       | 1,323                                                                                    |       |                         | 794        |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                       | ** ** | **$**                                                                                    | **4,579**  |                         | ** ** | **$** | **4,159** |   |   |

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                                           | ** ** | **Nine months ended**                          | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                                                           | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                                                                                           | ** ** | **Dollars in millions  (unaudited)**           | ** ** |
| **OPERATING ACTIVITIES:**                                                                                            |       |                                                     |       |   |   |   |   |   |   |
| Net income                                                                                                           |       |                                                     | $          | 261 |   |   |   | $ | 196 |   |   |
| Less: (Loss) income from  discontinued operations, net                                                               |       |                                                     | (2         | ) |   |   | 5 |   |   |
| Income from continuing  operations                                                                                   |       |                                                     | 263        |   |   |   | 191 |   |   |
| Adjustments to reconcile income from continuing  operations to net cash provided by operating activities:            |       |                                                     |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                                                       |       |                                                     | 202        |   |   |   | 113 |   |   |
| Loss on extinguishment of  debt, net                                                                                 |       |                                                     | 44         |   |   |   | 42 |   |   |
| Purchased in-process  research and development                                                                       |       |                                                     | 4          |   |   |   | — |   |   |
| Deferred taxes                                                                                                       |       |                                                     | (7         | ) |   |   | 4 |   |   |
| Reversal of liabilities  related to tax settlement                                                                   |       |                                                     | (116       | ) |   |   | (47 | ) |   |
| Provision for  uncollectible receivables                                                                             |       |                                                     | 11         |   |   |   | 9 |   |   |
| Amortization of  restricted stock units                                                                              |       |                                                     | 7          |   |   |   | 13 |   |   |
| Unrealized losses on  foreign currency exchange                                                                      |       |                                                     | 14         |   |   |   | 35 |   |   |
| Adjustments for other  non-cash items, net                                                                           |       |                                                     | (8         | ) |   |   | 5 |   |   |
| Changes in operating assets and liabilities, net of  effects of acquired businesses:                                 |       |                                                     |       |   |   |   |   |   |   |
| Receivables                                                                                                          |       |                                                     | (19        | ) |   |   | 60 |   |   |
| Inventory                                                                                                            |       |                                                     | 2          |   |   |   | 37 |   |   |
| Restricted cash                                                                                                      |       |                                                     | 9          |   |   |   | 28 |   |   |
| Accounts payable                                                                                                     |       |                                                     | (29        | ) |   |   | 7 |   |   |
| Payroll and benefits                                                                                                 |       |                                                     | (134       | ) |   |   | 35 |   |   |
| Accrued interest payable  on long-term debt                                                                          |       |                                                     | (28        | ) |   |   | (70 | ) |   |
| Deferred revenue                                                                                                     |       |                                                     | (3         | ) |   |   | (12 | ) |   |
| Other assets and  liabilities                                                                                        |       |                                                     | (26        | ) |   |   | (95 | ) |   |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES FOR CONTINUING OPERATIONS                                                 |       |                                                     | 186        |   |   |   | 355 |   |   |
| **INVESTING ACTIVITIES:**                                                                                            |       |                                                     |       |   |   |   |   |   |   |
| Capital expenditures                                                                                                 |       |                                                     | (97        | ) |   |   | (60 | ) |   |
| Capitalized software  development costs                                                                              |       |                                                     | (44        | ) |   |   | (28 | ) |   |
| Acquisitions of  businesses, net of cash acquired                                                                    |       |                                                     | (383       | ) |   |   | (121 | ) |   |
| (Payments) proceeds from  sales of discontinued operations                                                           |       |                                                     | (3         | ) |   |   | 260 |   |   |
| Proceeds from sale of  CommScope common stock                                                                        |       |                                                     | —     |   |   |   | 28 |   |   |
| Proceeds from sales of  property, plant and equipment                                                                |       |                                                     | 30         |   |   |   | — |   |   |
| Investment in marketable  securities                                                                                 |       |                                                     | —     |   |   |   | (18 | ) |   |
| Other investing  activities, net                                                                                     |       |                                                     | 19         |   |   |   | 2 |   |   |
| NET CASH (USED  FOR) PROVIDED BY INVESTING ACTIVITIES FROM CONTINUING OPERATIONS       |       |                                                     | (478       | ) |   |   | 63 |   |   |
| **FINANCING ACTIVITIES:**                                                                                            |       |                                                     |       |   |   |   |   |   |   |
| Issuance of common stock                                                                                             |       |                                                     | 45         |   |   |   | 336 |   |   |
| Repurchase of common  stock                                                                                          |       |                                                     | (47        | ) |   |   | — |   |   |
| Repayment of long-term  debt                                                                                         |       |                                                     | (576       | ) |   |   | (404 | ) |   |
| Other financing  activities, net                                                                                     |       |                                                     | (4         | ) |   |   | (2 | ) |   |
| NET CASH USED FOR  FINANCING ACTIVITIES FROM CONTINUING OPERATIONS                                                   |       |                                                     | (582       | ) |   |   | (70 | ) |   |
| Effect of exchange  rate changes on cash and cash equivalents                                                        |       |                                                     | (8         | ) |   |   | 4 |   |   |
| Net (decrease)  increase in cash and cash equivalents from continuing operations                                     |       |                                                     | (882       | ) |   |   | 352 |   |   |
| Net decrease in  cash and cash equivalents from discontinued operations                                              |       |                                                     | —     |   |   |   | (21 | ) |   |
| Cash and cash  equivalents at beginning of fiscal year                                                               |       |                                                     | 1,617      |   |   |   | 1,192 |   |   |
| Cash and cash  equivalents at end of period                                                                          |       |                                                     | $          | 735 |   |   |   | $ | 1,523 |   |   |

 

See Notes to Consolidated Financial Statements.

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**AVAYA INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**   Backgroundand Basis of Presentation

***Background***

Avaya Inc. (the “Company” or “Avaya”) providescommunication systems, applications and services for enterprises, includingbusinesses, government agencies and other organizations. The Company’s productofferings include Internet Protocol (“IP”) telephony systems and traditionalvoice communications systems, multi-media contact center infrastructure andapplications in support of customer relationship management, unifiedcommunications applications and appliances, such as IP telephone sets. TheCompany supports its broad customer base with comprehensive global serviceofferings that enable our customers to plan, design, implement, monitor andmanage their communications networks.

We were incorporated under the laws of theState of Delaware under the name “Lucent EN Corp.” on February 16, 2000,as a wholly owned subsidiary of Lucent Technologies Inc. (“Lucent”). As of June 27,2000, our name was changed to “Avaya Inc.” On September 30, 2000, Lucentcontributed its enterprise networking business to us and distributed all of theoutstanding shares of our capital stock to its shareowners. We refer to thesetransactions in this Quarterly Report on Form 10-Q as the “distribution.”Prior to the distribution, we had no material assets or activities as aseparate corporate entity. Following the distribution, we became an independentpublic company, and Lucent has no continuing stock ownership interest in us.

***Basis of Presentation***

The accompanying unaudited consolidated financialstatements as of June 30, 2005 and for the three and nine months ended June 30,2005 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 for interim financial statements, andshould be read in conjunction with the Company’s consolidated financialstatements and other financial information for the fiscal year ended September 30,2004, which were included in its Annual Report on Form 10-K filed with theSecurities and Exchange Commission on December 13, 2004. In the Company’sopinion, the unaudited interim consolidated financial statements reflect alladjustments, consisting of normal and recurring adjustments, necessary for afair presentation of the financial condition, results of operations and cashflows for the periods indicated. Certain prior year amounts have beenreclassified to conform to the current interim period presentation. Theconsolidated results of operations for the interim periods reported are notnecessarily indicative of the results to be experienced for the entire fiscalyear.

In order to better reflectthe way the Company manages the business, beginning in October 2004, theCompany began reporting its results in two operating segments—GlobalCommunications Solutions (“GCS”) and Avaya Global Services (“AGS”).

**2.   Summaryof Significant Accounting Policies**

***Stock Compensation***

Certain of the Company’s employees participate instock option plans and stock purchase plans. The Company applies therecognition and measurement principles of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB 25”) and relatedinterpretations in accounting for such stock compensation. Accordingly, nostock-based employee compensation cost related to stock options isreflected in the Company’s Consolidated Statements of Income, as all optionsgranted under the 

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plan had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant. The Company records compensation expense for the amortization ofrestricted stock units issued to employees based on the fair market value ofthe restricted stock units at the date of grant over the vesting period, whichis typically three years.

Thefollowing table illustrates the effect on net income and earnings per share asif the Company had applied the fair value recognition provisions of Statementof Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”) as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure “ (“SFAS 148.”)
| ** **                                                                                                                | ** ** | **Three months ended**                                                | ** ** | **Nine months ended**                          | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **June 30,**                                                               | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                                                                | ** ** | **    2005    **                        | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                                                                                                | ** ** | **Dollars in millions, except per share amounts** | ** ** |
| Net income, as  reported                                                                                                  |       |                                                                            | $          | 194                                                      |       |   |   | $ | 61 |   |   |   | $ | 261 |   |   |   | $ | 196 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects              |       |                                                                            | 1          |                                                     |       |   | 2 |   |   |   | 4 |   |   |   | 8 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based  method, net of related tax effects |       |                                                                            | (9         | )                                                        |       |   | (7 | ) |   |   | (28 | ) |   |   | (24 | ) |   |
| Net income, pro  forma                                                                                                    |       |                                                                            | $          | 186                                                      |       |   |   | $ | 56 |   |   |   | $ | 237 |   |   |   | $ | 180 |   |   |
| Earnings per Common Share—Basic:                                                                                     |       |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                                                                            | $          | 0.41                                                     |       |   |   | $ | 0.14 |   |   |   | $ | 0.55 |   |   |   | $ | 0.45 |   |   |
| Pro forma                                                                                                                 |       |                                                                            | $          | 0.39                                                     |       |   |   | $ | 0.12 |   |   |   | $ | 0.50 |   |   |   | $ | 0.42 |   |   |
| Earnings per Common Share—Diluted:                                                                                   |       |                                                                            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                                                                            | $          | 0.40                                                     |       |   |   | $ | 0.13 |   |   |   | $ | 0.54 |   |   |   | $ | 0.43 |   |   |
| Pro forma                                                                                                                 |       |                                                                            | $          | 0.38                                                     |       |   |   | $ | 0.12 |   |   |   | $ | 0.49 |   |   |   | $ | 0.40 |   |   |

 

In July 2005, theCompany announced that its Board of Directors approved a plan to accelerate thevesting of certain outstanding stock options exercisable for Avaya common stock.Based on this action, all stock options outstanding as of July 26, 2005having an exercise price greater than or equal to $13 per share vested andbecame fully exercisable as of that date. Aside from the acceleration of thevesting date, the terms and the conditions of the stock option award agreementsgoverning the underlying stock options grants remained unchanged. As a resultof this plan, options to purchase approximately 10.2 million shares becameexercisable. This action will result in stock option expense to be recorded inthe statements of income over the next three fiscal years in accordance withSFAS  123 (revised 2004) “Share-Based Payment” (“SFAS 123(R )”) to beapproximately $62 million lower on a pre-tax basis than the expense would havebeen if the vesting had not been accelerated. As a result of the acceleratedvesting, the pro forma stock-based employee compensation expense for the fourthquarter of fiscal 2005 will increase by about $62 million.

**3.   RecentAccounting Pronouncements**

***FSP FAS 143-1***

On June 8, 2005, the FinancialAccounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS No. 143-1,“Accounting for Electronic Equipment Waste Obligations,” to address theaccounting for obligations associated with Directive on Waste Electrical andElectronic Equipment (“the Directive”) issued by the European Union (“EU”). TheDirective was enacted on February 13, 2003 and directs EU-member countriesto adopt legislation to regulate the collection, treatment, recovery andenvironmentally sound disposal of electrical and electronic waste equipment. TheDirective concludes that commercial users are obligated to retire, in anenvironmentally sound manner, specific assets that qualify 

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as historicalwaste. FSP FAS 143-1 is effective for reporting periods ending after June 8,2005. The Company is currently evaluating the impact of FSP FAS 143-1 tooperations in EU countries that have adopted legislation. The Company will continueto evaluate the impact as other EU-member countries enact legislation.

***SFAS 154***

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections—areplacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS154 changes the requirements for the accounting for, and reporting of, a changein accounting principle. SFAS 154 requires that a voluntary change inaccounting principle be applied retrospectively with all prior period financialstatements presented using the new accounting principle. SFAS 154 is effectivefor accounting changes and corrections of errors in fiscal years beginningafter December 15, 2005. The implementation of SFAS 154 is not expected tohave a material impact on the Company’s consolidated financial statements.

***SFAS 123(R)***

In December 2004, theFASB issued SFAS 123(R), which requires the Company to recognize compensationexpense for stock options and discounts under employee stock purchase plansgranted to employees based on the estimated fair value of the equity instrumentat the time of grant. Currently, the Company discloses the pro forma net incomeand earnings per share as if the Company applied the fair value recognitionprovisions of SFAS 123 as amended by SFAS 148. The requirements of SFAS 123(R) areeffective for the Company beginning in the first quarter of fiscal 2006. Weexpect to record expense of approximately $5 million in fiscal 2006 related topreviously-issued, unvested stock options for which vesting has not beenaccelerated. The Company is currently evaluating how it will apply theprovisions of SFAS 123(R) to stock options to be issued after September30, 2005.

**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 and services.The acquisition of Tenovis significantly expands the Company’s Europeanoperations and increases the Company’s access to European customers,particularly in Germany. In connection with the share purchase agreement, theCompany paid $381 million in cash (which includes $10 million of transactionfees that were not paid to the sellers) and assumed $287 million in debt,including $17 million of capital lease obligations. Additionally, the Companyacquired cash and cash equivalents of $116 million, resulting in a net cashoutlay related to the acquisition of $265 million. Results of operations forTenovis are included in the Company’s consolidated results as of November 18,2004.

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. TheCompany allocated $298 million to intangible assets (including contractualcustomer relationships, existing technology and trademarks) based on valuationstudies performed by third party valuation consultants. These intangible assetsare being amortized over their estimated useful lives. In addition, the Companyallocated $1 million to in-process research and development, which was writtenoff to research and development expense in the Consolidated Statement of Incomeduring the first quarter of fiscal 2005.

During the secondand third quarters of fiscal 2005, the preliminary purchase price allocationwas adjusted upon review of additional information and final third partyvaluation reports. The following 

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adjustmentsincreased goodwill arising from the acquisition of Tenovis by $161 million to$609 million as of June 30, 2005.

·       TheCompany adjusted its valuation of the acquired intangible assets and long-livedtangible assets. These valuations were based, in part, on valuation reportswhich were completed by third-party valuation consultants during the secondquarter of fiscal 2005. As a result, the Company recorded a purchase priceallocation adjustment during the second quarter of fiscal 2005 to reduceacquired intangible assets by $103 million. This represents decreases of $50million for existing technology, $31 million for customer contracts andrelationships and $22 million for trademarks. Long-lived tangible assets werealso reduced by $128 million, including the $88 million decrease discussedbelow related to a property subject to a sale-leaseback arrangement.

·       TheCompany increased the restructuring liability from $73 million to $84 millionto reflect the revised estimate of restructuring-related costs in accordancewith EITF 95-3, “Recognition of Liabilities in Connection with a PurchaseBusiness Combination.” This liability is for costs to be incurred to terminateTenovis employees as part of the integration of Tenovis operations. During thesecond quarter, the Company completed its plan for involuntary employeeterminations related to the acquisition. The plan provides for the terminationof certain employees across various Tenovis functional groups, including sales,operations, finance, human resources, etc. The Company has reached agreementswith the Works Councils in Europe to reduce the workforce by over 500, and iscontinuing discussions with the Works Councils. Most of these positions havealready been eliminated. The terminations are planned to be completed by theend of the third quarter of fiscal 2006. The amount to be ultimately paid issubject to regulatory approval. The accrual as of June 30, 2005 is $63million, which reflects changes in estimates, termination payments and foreigncurrency fluctuations since the acquisition date.

·       InFebruary 2004, Tenovis entered into an arrangement to sell one of itsproperties to a third party and lease it back. As a result of certain terms,Tenovis was considered to have continuing involvement in the property, whichprecluded accounting for the arrangement as a sale under SFAS 98, “Accountingfor Leases,” regarding sale-leaseback transactions. The arrangement wasinitially recorded as a secured borrowing in the purchase price allocation. Subsequently,the Company determined that the arrangement should be accounted for as anoperating lease. As a result, the preliminary purchase price allocation wasadjusted, resulting in an $88 million reduction of fixed assets, $68 millionreduction in debt and a $20 million increase in goodwill.

·       InJune 2005, the Company received information indicating that certain leasesmet the criteria to be accounted for as capital leases as of the acquisitiondate. As a result, the Company recorded fixed assets of $10 million andassociated debt of $9 million, resulting in a $1 million reduction to goodwillin the third quarter of fiscal 2005.

·       Otheradjustments reflecting various changes to working capital accounts wererecorded based upon additional information received during the second and thirdquarters of fiscal 2005.

·       Asa result of the above changes to the initial purchase price allocation, thedeferred tax liability included in the purchase price allocation was reduced by$41 million.

These adjustments to the initial purchase priceallocation resulted from a comprehensive review by management of the thirdparty valuation reports and analysis of information received subsequent torecording the initial purchase price allocation to ensure that the fair valuesassigned to the acquired assets and liabilities are appropriately estimated. Asof June 30, 2005, the purchase price allocation is still subject to finaladjustment for amounts relating to the restructuring liability and to certainworking capital accounts, including accounts receivable and inventory. TheCompany expects to finalize the allocation of the purchase price for the assetsacquired and the liabilities assumed by the end of fiscal 2005.

9

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Thefollowing table summarizes the estimated fair values of the acquired assets andassumed liabilities as of the acquisition date, adjusted for items during thesecond and third quarters of fiscal 2005:
| ** **                                                        | ** ** | **Preliminary**                   | ** ** | **Adjusted**            | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|-------------------------|------------|
| ** **                                                        | ** ** | **Purchase Price**           | ** ** | **Purchase Price** | ** ** |
| ** **                                                        | ** ** | **Allocation**                    | ** ** | **Allocation**          | ** ** |
| ** **                                                        | ** ** | **Dollars in millions** | ** ** |
| Cash                                                              |       |                              | $          | 116                     |       |   |   | $ | 116 |   |   |
| Rental equipment                                                  |       |                              | 132        |                    |       |   | 132 |   |   |
| Fixed assets                                                      |       |                              | 272        |                    |       |   | 144 |   |   |
| Intangible assets and  in-process research & development |       |                              | 402        |                    |       |   | 299 |   |   |
| Long-term debt                                                    |       |                              | (347       | )                       |       |   | (287 | ) |   |
| Deferred tax liability                                            |       |                              | (160       | )                       |       |   | (119 | ) |   |
| Restructuring                                                     |       |                              | (73        | )                       |       |   | (84 | ) |   |
| Pension liability                                                 |       |                              | (313       | )                       |       |   | (313 | ) |   |
| Working capital and  other assets and liabilities                 |       |                              | (96        | )                       |       |   | (116 | ) |   |
| **Net  assets acquired**                                          |       |                              | (67        | )                       |       |   | (228 | ) |   |
| Goodwill                                                          |       |                              | 448        |                    |       |   | 609 |   |   |
| **Purchase price**                                                | ** ** | ** **                        | **$**      | **381**                 |       | ** ** | ** ** | **$** | **381** |   |   |

 

Thefollowing unaudited pro forma financial information presents the Company’sresults as if the Tenovis acquisition had occurred at the beginning of therespective periods:
| ** **                      | ** ** | **Three months ended**                                                | ** ** | **Nine months ended**                                      | ** ** |
|---------------------------------|------------|---------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                      | ** ** | **June 30,**                                                               | ** ** | **June 30,**                                                    | ** ** |
| ** **                      | ** ** | **2004**                                                                        | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| ** **                      | ** ** | **Dollars in millions, except per share amounts** | ** ** |
| Revenue                         |       |                                                                            | $          | 1,271                                                                |       |   |   | $ | 3,709 |   |   |   | $ | 3,771 |   |   |
| Net income                      |       |                                                                            | $          | 49                                                                   |       |   |   | $ | 235 |   |   |   | $ | 123 |   |   |
| Earnings per share—basic   |       |                                                                            | $          | 0.11                                                                 |       |   |   | $ | 0.50 |   |   |   | $ | 0.28 |   |   |
| Earnings per share—diluted |       |                                                                            | $          | 0.10                                                                 |       |   |   | $ | 0.48 |   |   |   | $ | 0.26 |   |   |

 

These pro forma results have been prepared forcomparative purposes only and include certain adjustments such as additionalestimated amortization expense as a result of identifiable intangible assetsarising from the acquisition. The pro forma results are not necessarilyindicative of the results of operations that actually would have resulted hadthe acquisition been in effect at the beginning of the respective periods or offuture results.

In connection with the acquisition, the Companyperformed an evaluation to identify the existence of any variable interestentities (“VIEs”) related to Tenovis. As a result of this evaluation, theCompany identified three VIEs and further determined the Company, through itsownership of Tenovis, was the primary beneficiary of all three VIEs. However,in accordance with FIN 46(R), “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51” (“FIN 46(R)”), the Company is not requiredto apply the provisions of FIN 46(R) to two of the VIEs because it isunable to obtain the information necessary to perform the accounting requiredto consolidate these VIEs. Although the Company has made an effort to gatherthe required information, management of these two VIEs has declined in writingto transfer any of the necessary financial data to the Company. For informationconcerning the Company’s one consolidated VIE, see Note 8 to the consolidatedfinancial statements. Information concerning the Company’s two non-consolidatedVIEs follows below.

The first non-consolidated VIE is a non-U.S.telecommunications hardware manufacturer and service provider. Prior to itsacquisition by the Company, Tenovis agreed to purchase from the VIE certainamounts of products and services, and the VIE contracted with Tenovis toprovide certain IT services and purchasing services with respect to rawmaterials. During the nine months ended June 30, 2005, Tenovis purchasedproducts and services aggregating $27 million. These contracts expire in August 2007.

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Additionally, Tenovis isrequired to pay monthly rental subsidies on the VIE’s premises, and in theevent the VIE is unable to pay its portion of the rental payments, Tenovis isliable for the VIE’s portion as well. During the nine months ended June 30,2005, Tenovis paid approximately $500,000 in connection with rental subsidies. Themaximum exposure to loss as of June 30, 2005 for the remainder of theagreement is the minimum purchase order commitments and the minimum servicelevels for service contracts of $16 million and the guarantee for rents to bepaid by the VIE of $1 million.

The secondnon-consolidated VIE provides development, testing and quality control servicesto Tenovis and other companies in the telecommunications industry. Prior to theacquisition, Tenovis guaranteed the VIE minimum revenue over a period of threeyears through guaranteed annual purchase orders. During the six months ended March 31,2005, Tenovis purchased services aggregating $4 million from this VIE. Thisservice contract expired on March 31, 2005 and consequently the entity isno longer considered to be a VIE of the Company.

***Other Acquisitions***

On October 4, 2004, the Company completed thepurchase of Spectel plc (“Spectel”), a world leader in audio and webconferencing solutions, for $110 million in cash (including $6 million oftransaction fees that were not paid to the sellers), net of $3 million of cashacquired. The acquisition enabled the Company to continue to expand itscapabilities in conferencing, which is a core business communicationstechnology. In connection with the acquisition, the Company allocated $3million to in-process research and development, which was written off toresearch and development expense in the Consolidated Statement of Income duringthe first quarter of fiscal 2005.

On October 15, 2004, the Company acquired a 23%share of Agile Software NZ Limited (“Agile Software”), a software subsidiary ofAgile (NZ) Limited, which primarily produces contact center software, as wellas other software products. Under terms of the subscription and shareholdingagreement, the Company has the option to acquire the remaining equity in AgileSoftware; this option vests in October 2005 and has no expiration date. Thefair value of this purchase option is not material to the Company’sconsolidated results of operations, financial position or cash flows. TheCompany accounts for its investment in Agile Software using the equity method.

On December 15, 2004, the Company acquiredsubstantially all of the assets of RouteScience Technologies, Inc. (“RouteScience”),a software company based in California focused on products that monitor, assessand optimize network applications.

The respective purchase prices for the above threeacquisitions were not material, either individually or in the aggregate, to theconsolidated financial statements of the Company. Therefore, disclosures of proforma financial information have not been presented.

Through a series of transactions during fiscal 2004,the Company increased its ownership of the issued share capital of Tata TelecomLtd. (“Tata”), a leading voice communications solutions provider in India, from25.1% to 59.1% for a total purchase price of $24 million. After the closing,Tata’s name was changed to Avaya GlobalConnect Ltd. (“AGC”), and the Companybegan consolidating its results on August 4, 2004. This acquisition wasnot material to the consolidated financial statements of the Company. Therefore,disclosures of pro forma financial information have not been presented.

The Company acquired substantially all of the assetsand certain liabilities of Expanets Inc. on November 25, 2003. If theacquisition had occurred at the beginning of fiscal 2004, Avaya’s revenues forthe first nine months of fiscal 2004 would have been $3,041 million and netincome would have been $179 million, resulting in earnings of $0.41 perbasic share and $0.40 per diluted share. Avaya’s actual results for the firstnine months of fiscal 2004 were revenues of $2,993 million, net income of $196million, and earnings of $0.45 per basic share and $0.43 per diluted share.

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***DiscontinuedOperations***

Thefollowing table displays revenue and income (loss) before income taxes fromdiscontinued operations for the three months ended June 30, 2004 and ninemonths ended June 30, 2005 and 2004:
| ** **                                                            | ** ** | **Three months ended**  | ** ** | **Nine months ended**                                      | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **June 30,**                 | ** ** | **June 30,**                                                    | ** ** |
| ** **                                                            | ** ** | **2004**                          | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| ** **                                                            | ** ** | **Dollars in millions** | ** ** |
| Revenue from  discontinued operations:                                |       |                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Connectivity Solutions                                                |       |                              | $          | 1                                                                    |       |   |   | $ | — |   |   |   | $ | 168 |   |   |
| Expanets                                                              |       |                              | —     |                                                                 |       |   | — |   |   |   | 8 |   |   |
| Total revenue from  discontinued operations                           |       |                              | $          | 1                                                                    |       |   |   | $ | — |   |   |   | $ | 176 |   |   |
| Income (loss) before  income taxes from discontinued operations:      |       |                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Connectivity Solutions:                                               |       |                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Results of operations                                                 |       |                              | $          | —                                                               |       |   |   | $ | — |   |   |   | $ | (72 | ) |   |
| Gain (loss) on sale                                                   |       |                              | 3          |                                                                 |       |   | (2 | ) |   |   | 84 |   |   |
| Total income (loss) before  income taxes for Connectivity Solutions   |       |                              | 3          |                                                                 |       |   | (2 | ) |   |   | 12 |   |   |
| Expanets:                                                             |       |                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Results of operations                                                 |       |                              | —     |                                                                 |       |   | — |   |   |   | (6 | ) |   |
| Total income (loss) before income taxes from  discontinued operations |       |                              | $          | 3                                                                    |       |   |   | $ | (2 | ) |   |   | $ | 6 |   |   |

 

For the nine months ended June 30,2005, the $2 million loss associated with the sale of the Company’sConnectivity Solutions business was primarily the result of the finalization ofthe working capital adjustment in accordance with the asset purchase agreement.

**5.   Goodwilland Intangible Assets**

The changes in the carrying value of goodwill byoperating segment for the nine months ended June 30, 2005 are as follows:
| ** **                             | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|--------------|------------|------------|------------|
| ** **                             | ** ** | **Communications**                | ** ** | **Global**   | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Total**  | ** ** |
| ** **                             | ** ** | **Dollars in millions** | ** ** |
| Balance as of September 30,  2004 |       |                              | $          | 187          |       |       |       | $ | 70 |   |   | $ | 257 |   |
| Goodwill acquired:                     |       |                              |       |         |       |       |       |   |   |   |   |
| Tenovis                                |       |                              | 347        |         |       |       | 262        |   |   | 609 |   |
| Other acquisitions                     |       |                              | 58         |         |       |       | 13         |   |   | 71 |   |
| Impact of foreign currency translation |       |                              | (24        | )            |       |       | (19        | ) |   | (43 | ) |
| **Balance as of June 30,  2005**  | ** ** | ** **                        | **$**      | **568**      |       | ** ** | ** ** | **$** | **326** |   | ** ** | **$** | **894** | ** ** |

 

Thefollowing table presents the components of the Company’s acquired intangibleassets with finite lives:
| ** **                                     | ** ** | **June 30, 2005**       | ** ** | **September 30, 2004** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **Gross**                         | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Carrying**                      | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Amount**                        | ** ** | **Amortization**                 | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| ** **                                     | ** ** | **Dollars in millions** | ** ** |
| Existing  technology                           |       |                              | $          | 93                               |       |   |   | $ | 38 |   |   | $ | 55 |   |   | $ | 28 |   |   |   | $ | 26 |   |   | $ | 2 |   |
| Customer  relationships and other  intangibles |       |                              | 291        |                             |       |   | 34 |   |   | 257 |   |   | 32 |   |   |   | 2 |   |   | 30 |   |
| Total amortizable  intangible assets           |       |                              | $          | 384                              |       |   |   | $ | 72 |   |   | $ | 312 |   |   | $ | 60 |   |   |   | $ | 28 |   |   | $ | 32 |   |

 

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During the first quarterof fiscal 2005, the Company acquired $298 million of intangible assets inconnection with the acquisition of Tenovis consisting of existing technology of$36 million, customer relationships of $254 million and trademarks of $8million. Other acquisitions during the first quarter of fiscal 2005 resulted inadditional existing technology and customer relationships of $31 million and$14 million, respectively. These acquisitions, as well as the impact of foreigncurrency translation, resulted in an increase in the gross balance ofintangible assets of $324 million compared to the balance as of September 30,2004. The weighted average useful life of the existing technology, customerrelationships, and trademarks are 5 years, 6 years and 1.5 years, respectively.For further information concerning these intangible assets, see Note 4, “BusinessCombinations and Other Transactions.”

Amortization expense forthe Company’s acquired intangible assets with finite lives was $16 million and$42 million for the three and nine months ended June 30, 2005,respectively. Estimated future amortization expense is (i) $16 million inthe remainder of fiscal 2005; (ii) $61 million in fiscal 2006; (iii) $57million in fiscal 2007; (iv) $57 million in fiscal 2008; (v) $56million in fiscal 2009; and (vi) $65 million thereafter. The majority ofthe future estimated amortization expense is associated with intangible assetsacquired in the Tenovis acquisition. As these assets are recorded in euros, thefuture estimated amortization expense is subject to the impact of foreigncurrency translation.

In addition, included inother intangible assets in the Consolidated Balance Sheets as of June 30,2005 and September 30, 2004 is an intangible asset of $43 millionrepresenting unrecognized prior service costs associated with the recording ofa minimum pension liability in fiscal 2004, 2003 and 2002. This intangibleasset may be eliminated or adjusted as necessary when the amount of minimumpension liability is reassessed, which is conducted at least annually.

**6.   ComprehensiveIncome**

Other comprehensive incomeis recorded directly to a separate component of stockholders’ equity inaccumulated other comprehensive loss and includes unrealized gains and lossesexcluded from the Consolidated Statements of Income. These unrealized gains andlosses for the three and nine months ended June 30, 2005 and 2004consisted primarily of foreign currency translation, which is not adjusted forincome taxes since it primarily relates to indefinite investments in non-U.S.subsidiaries, unrealized holding gains and losses on securities classified asavailable for sale and adjustments to the minimum pension liability, net ofincome taxes and valuation allowance.
| ** **                                                                                                                                                                                                                          | ** ** | **Three months ended**                         | ** ** | **Nine months ended**                          | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                          | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                                                                                                                                                                          | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                                                                                                                                                                                                          | ** ** | **Dollars in millions**                        | ** ** |
| Net income                                                                                                                                                                                                                          |       |                                                     | $          | 194                                                      |       |   |   | $ | 61 |   |   |   | $ | 261 |   |   |   | $ | 196 |   |   |
| Other  comprehensive income:                                                                                                                                                                                                        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustments                                                                                                                                                                                            |       |                                                     | (68        | )                                                        |       |   | (13 | ) |   |   | (34 | ) |   |   | 40 |   |   |
| Unrealized holding loss on available-for-sale  securities                                                                                                                                                                           |       |                                                     | (3         | )                                                        |       |   | (3 | ) |   |   | (1 | ) |   |   | (3 | ) |   |
| Minimum pension liability adjustment, net of a  reversal of deferred income taxes of $14  million offset by a reversal of the corresponding $14 million valuation  allowance for the three and nine months ended June 30, 2004 |       |                                                     | —     |                                                     |       |   | — |   |   |   | — |   |   |   | 36 |   |   |
| Total comprehensive  income                                                                                                                                                                                                         |       |                                                     | $          | 123                                                      |       |   |   | $ | 45 |   |   |   | $ | 226 |   |   |   | $ | 269 |   |   |

 

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**7.   Supplementary Financial Information**

***Statements of Income Information***
| ** **                                                                                             | ** ** | **Three months ended**                         | ** ** | **Nine months ended**                          | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                                             | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                                                                             | ** ** | **Dollars in millions**                        | ** ** |
| **OTHER  INCOME (EXPENSE), NET**                                                                       |       |                                                     |       |                                                     |       |   |   | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |
| Interest income                                                                                        |       |                                                     | $          | 6                                                        |       |   |   | $ | 6 | ** ** |   |   | $ | 18 | ** ** |   |   | $ | 13 | ** ** |   |
| Gain on foreign currency translation                                                                   |       |                                                     | 2          |                                                     |       |   | 2 | ** ** |   |   | — | ** ** |   |   | 4 | ** ** |   |
| Loss on long-term debt extinguishment, net                                                             |       |                                                     | (1         | )                                                        |       |   | (21 | **)** |   |   | (44 | **)** |   |   | (42 | **)** |   |
| Loss on sale of CommScope common stock received in connection  with the sale of Connectivity Solutions |       |                                                     | —     |                                                     |       |   | — | ** ** |   |   | — | ** ** |   |   | (5 | **)** |   |
| Other, net                                                                                             |       |                                                     | (3         | )                                                        |       |   | 2 | ** ** |   |   | (8 | **)** |   |   | 6 | ** ** |   |
| **Total other income (expense),  net**                                                                 | ** ** | ** **                                               | **$**      | **4**                                                    |       | ** ** | ** ** | **$** | **(11** | **)** | ** ** | ** ** | **$** | **(34** | **)** | ** ** | ** ** | **$** | **(24** | **)** |   |

 

***Balance SheetInformation***
| ** **                                          | ** ** | **June 30,  2005**           | ** ** | **September 30,  2004** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                          | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY**                                       |       |                              |       |                         |       |   |   |
| Finished goods                                      |       | $                                 | 312        |                         |       | $ | 221 |   |   |
| Work in process and raw materials                   |       | 16                                |       |                         | 18         |   |   |
| **Total  inventory**                                | ** ** | **$**                             | **328**    |                         | ** ** | **$** | **239** |   |   |
| **PROPERTY, PLANT AND EQUIPMENT, NET**              |       |                              |       |                         |       |   |   |
| Land and improvements                               |       | $                                 | 49         |                         |       | $ | 27 |   |   |
| Buildings and improvements                          |       | 434                               |       |                         | 394        |   |   |
| Machinery and equipment, including rental equipment |       | 802                               |       |                         | 581        |   |   |
| Assets under construction                           |       | 7                                 |       |                         | 1          |   |   |
| Internal use software                               |       | 224                               |       |                         | 175        |   |   |
| Total property,  plant and equipment                |       | 1,516                             |       |                         | 1,178      |   |   |
| Less: Accumulated  depreciation and amortization    |       | (785                              | )          |                         | (669       | ) |   |
| **Property, plant and equipment,  net**             | ** ** | **$**                             | **731**    |                         | ** ** | **$** | **509** |   |   |

 

***Cash FlowInformation***
| ** **                               | ** ** | **Nine months ended June 30,**                                           | ** ** |
|------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **       2005       ** | ** ** | **       2004       ** | ** ** |
| ** **                               | ** ** | **Dollars in millions**                                                            | ** ** |
| **CASH USED FOR ACQUISITIONS**           |       |                                                                                         |       |   |   |   |   |   |   |
| Working capital, other than cash         |       |                                                                                         | $          | 170 |   |   |   | $ | 33 |   |   |
| Property, plant and equipment            |       |                                                                                         | 282        |   |   |   | 4 |   |   |
| Goodwill                                 |       |                                                                                         | 681        |   |   |   | 97 |   |   |
| Intangibles and other assets             |       |                                                                                         | 349        |   |   |   | 40 |   |   |
| Long-term debt                           |       |                                                                                         | (287       | ) |   |   | — |   |   |
| Other liabilities                        |       |                                                                                         | (812       | ) |   |   | (63 | ) |   |
| Net assets from discontinued operations  |       |                                                                                         | —     |   |   |   | 10 |   |   |
| **Net cash used to acquire  businesses** | ** ** | ** **                                                                                   | **$**      | **383** |   | ** ** | ** ** | **$** | **121** |   |   |

 

14

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**8.   Long-Term Debt**

Debtoutstanding consists of the following:
| ** **                                                                                      | ** ** | **June 30, 2005**       | ** ** | **September 30, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                      | ** ** | **Dollars in millions** | ** ** |
| Debt maturing within one  year:                                                                 |       |                              |       |                             |       |   |   |   |   |
| LYONs convertible debt, net of discount                                                         |       |                              | $          | —                           |       |   |   | $ | 297 | (3) |   |
| Other current debt                                                                              |       |                              | 5          | (1)                              |       |   | 2 |   |   |
| Total current portion of long-term debt                                                         |       |                              | $          | 5                                |       |   |   | $ | 299 |   |   |
| Long-term debt:                                                                                 |       |                              |       |                             |       |   |   |   |   |
| 111¤8% Senior  Notes, net of discount, premium and net deferred gain on interest rate swap |       |                              | 14         | (2)                              |       |   | 294 | (2) |   |
| Other long-term debt                                                                            |       |                              | 12         | (1)                              |       |   | — |   |   |
| Total long-term debt                                                                            |       |                              | $          | 26                               |       |   |   | $ | 294 |   |   |
| **Total debt**                                                                                  | ** ** | ** **                        | **$**      | **31**                           |       | ** ** | ** ** | **$** | **593** |   |   |

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(1)          Primarilyrepresents the current and long-term portions of capital lease obligationsassociated with Tenovis.

(2)          Thecarrying value of the 111¤8%Senior Notes due April 2009 (“Senior Notes”) as of September 30,2004 of $294 million is comprised of the aggregate principal amount outstandingof $284 million increased for $5 million of unamortized premium, net ofdiscount and the net unamortized deferred gain of $5 million related to thetermination of interest rate swap agreements. All of these notes except forapproximately $13 million aggregate principal amount were repurchased for cashthrough a public tender offer during the first quarter of fiscal 2005. These notesare no longer secured.

(3)          Thecarrying value of the Liquid Yield OptionTM Notes (“LYONs”)represented the value of 549,022 notes outstanding. These notes were redeemedfor cash or converted into shares of Avaya common stock during the firstquarter of fiscal 2005.

The following tablesummarizes the Company’s long-term debt obligations by period as of June 30,2005:
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | ** **                                | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| ** **                       | ** ** | **Total**                                 | ** ** | **1 year(a)** | ** ** | **1-3 years(a)** | ** ** | **3-5 years(b)** | ** ** | **5 years** | ** ** |
| ** **                       | ** ** | **Dollars in millions**         | ** ** |
| Total long-term debt obligations |       | $                                         | 31         |   |   | $ | 5 |   |   |   | $ | 6 |   |   |   | $ | 20 |   |   |   | $ | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)    Includes capital lease obligations.

(b)   Includes Senior Notes and capital lease obligations.

See below for a detaileddiscussion of actions the Company has taken during the first nine months offiscal 2005 related to its long-term debt.

***Secured FloatingRate Notes***

In November 2001,Tenovis entered into an asset securitization transaction whereby Tenovis FinanceLimited, a variable interest entity for which Tenovis is the primarybeneficiary, issued Secured Floating Rate Notes due 2013 (“secured floatingrate notes”) that were secured by a pool of Tenovis’s current and futurereceivables associated with rental contracts. In accordance with FIN 46(R), theCompany consolidated Tenovis Finance Limited upon the acquisition of Tenovis. TenovisFinance Limited is a special purpose company established to issue the securedfloating rate notes and enter into all related financial arrangements.

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The secured floating ratenotes are denominated in euros and were originally issued in an aggregateprincipal amount of Euro 300 million, representing 3,000 notes each having aprincipal amount of Euro 100,000. As of the date of the Company’s acquisitionof Tenovis, each note translated to principal of $130,300 or $268 million intotal for the 2,060 notes outstanding.

In November 2001, Tenovis Finance Limitedentered into two interest rate swap agreements, each with an original notionalamount of Euro 150 million, which matched the notional amount of the securedfloating rate notes outstanding. Mirroring the secured floating rate notes, theinterest rate swaps have a final maturity date of November 2007. Theseinterest rate swap agreements were executed in order to convert the securednotes floating rate debt into fixed rate debt. Under these agreements, Tenovisreceived a floating interest rate based on the three-month EURIBOR and paid afixed interest rate of 4.72%. Because there was a 1.50% spread on theunderlying floating rate notes, the total fixed rate interest payment on thenotes was 6.22% per annum. The swaps were marked to market at each reportingdate.

During the second quarterof fiscal 2005, the Company repaid principal of $103 million, and recognized apre-tax loss of $2 million, primarily representing the reduction in the netunamortized discount recorded at the time of original debt issuance. Concurrently,the Company partially reduced the two related interest rate swaps by $41million, for a total reduction of $82 million. The Company paid $7 millionin interest and related costs, and reduced the fair market value of the swapsto $5 million during the second quarter.

On May 17, 2005, theCompany repaid the remaining principal amount of $159 million and terminatedthe two related interest rate swaps described above. Additionally, the Companypaid $8 million in interest and related costs during the third quarter offiscal 2005, for a total cash payment of $167 million. As a result of therepayment, the Company recognized a pre-tax loss of $1 million, which isincluded in other income (expense), net for the third quarter of fiscal 2005. Thisloss primarily consists of a $3 million reduction in the net unamortizeddiscount recorded at the time of the original debt issuance, partially offsetby a $2 million gain on the change in the fair market value of the interestrate swaps.

***Senior Notes***

On November 1, 2004,the Company commenced a cash tender offer for any and all of its Senior Notesand a consent solicitation to amend the related indenture as described below. Theoffer included an early consent date of November 15, 2004, and expired on December 1,2004. The consideration for each $1,000 principal amount of Senior Notes validlytendered by the early consent date and not validly withdrawn and accepted forpayment was $1,158.95, which included a consent payment of $30 per $1,000principal amount.

As of the early consentdate, holders tendered $271 million aggregate principal amount of Senior Notes,and were paid $314 million in cash. An additional $100,000 aggregate principalamount was tendered prior to December 1, 2004, and cash of $113,000 waspaid. Upon repurchase of the notes, the Company paid interest of $4 million,which had accrued from October 1, 2004 through November 15, 2004. Followingthese transactions, there were $13 million aggregate principal amount of theSenior Notes outstanding.

As a result of the cashtender offer, the Company recognized a pre-tax loss of $41 million, which isincluded in other income (expense), net for the first quarter of fiscal 2005. Thisloss consists of (i) $43 million of premiums on the repurchase, (ii) thewrite-off of $5 million of deferred financing costs and (iii) $1 millionof fees, partially offset by the recognition of (iv) $4 million ofunamortized net premium recorded at the time of the original debt issuances,and (v) $4 million of deferred gain related to the interest rate swaps.

During the first quarterof fiscal 2005, the Company received the requisite consents with respect to theconsent solicitation for the adoption of certain proposed amendments to theindenture relating to the 

16

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SeniorNotes. On November 16, 2004, the Company and the trustee for the SeniorNotes executed a supplemental indenture, which eliminated substantially all ofthe restrictive covenants, the reporting requirements and certain events ofdefault from the indenture. Additionally, the supplemental indenture eliminatedthe requirement under the indenture to provide security for the Senior Notesand accordingly, the Company’s obligations under the Senior Notes that remainoutstanding are unsecured.

The Senior Notes areredeemable in April 2006.

***LYONs ConvertibleDebt***

On October 31, 2004,$238,000 principal amount of LYONs were put to the Company pursuant to theterms of the indenture governing the LYONs for an aggregate redemption price of$129,000. On November 18, 2004, the Company announced that it would redeemfor cash all of the outstanding LYONs on December 20, 2004. As providedpursuant to the indenture governing the LYONs, the redemption price was $545.67per $1,000 principal amount at maturity of LYONs. Prior to December 20,2004, holders of $549 million principal amount at maturity of LYONs convertedtheir outstanding LYONs into 20,546,199 shares of Avaya common stock pursuantto the terms of the indenture. Pursuant to the indenture, each $1,000 principalamount was exchangeable for 37.4437 shares of Avaya common stock. On December 20,2004, $61,000 aggregate principal amount at maturity of LYONs, whichrepresented all remaining outstanding LYONs, were redeemed for cash at anaggregate redemption price of $33,000.

***Fair Value ofLong-Term Debt***

Thefollowing table summarizes the components of the Company’s long-term debt,their aggregate carrying values and related fair market values as of June 30,2005 and September 30, 2004:
| ** **   | ** ** | **June 30, 2005**       | ** ** | **September 30, 2004** | ** ** |
|--------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **   | ** ** | **Number**                        | ** ** | ** **                       | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **   | ** ** | **of Notes**                 | ** ** | **Carrying**                     | ** ** | **Fair** | ** ** | **of Notes** | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **   | ** ** | **Outstanding**                   | ** ** | **Value**                        | ** ** | **Value** | ** ** | **Outstanding** | ** ** | **Value** | ** ** | **Value** | ** ** |
| ** **   | ** ** | **Dollars in millions** | ** ** |
| LYONs        |       |                              | —     |                             |       |   | $ | — |   |   |   | $ | — |   |   |   | 549,022 |   |   |   | $ | 297 |   |   | $ | 307 |   |
| Senior Notes |       |                              | 13,205     |                             |       |   | $ | 14 |   |   |   | $ | 15 |   |   |   | 284,395 |   |   |   | $ | 289 |   |   | $ | 330 |   |

 

In addition to the itemsin the table above, long-term debt as of June 30, 2005 includes $17million of other debt, of which $16 million represents capital leaseobligations associated with Tenovis. Long-term debt as of September 30, 2004includes $5 million of net unamortized deferred gain related to the terminationof the interest rate swap agreements related to the Senior Notes and $2 millionother debt, primarily related to commercial paper of AGC, the Company’smajority-owned subsidiary in India.

The carrying value of thedebt instruments listed above reflects the aggregate principal amountoutstanding adjusted for the unamortized discount and premium related to eachdebt instrument, as well as the related interest rate swap values.

The fair market values ofthe debt instruments listed above are based upon quoted market prices andyields obtained through independent pricing sources for the same or similartypes of borrowing arrangements taking into consideration the underlying termsof the debt.

***Credit Facility***

On February 23, 2005,the Company entered into a Credit Agreement (the “credit facility”), among theCompany, Avaya International Sales Limited, an indirect subsidiary of thecompany (“AISL”), with lenders party thereto and with Citicorp USA, Inc.,as agent for the lenders. The commitments pursuant to the Company’s previousAmended and Restated Five Year Revolving Credit Facility Agreement, dated as ofApril 30, 2003 (as amended), among the Company, the lenders party theretoand Citibank, N.A., as 

17

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agentfor the lenders, were terminated and the security interests securingobligations under that facility were fully released.

Under the credit facility,borrowings are available in U.S. dollars or euros to the Company and AISL, andthe maximum amount of borrowings that can be outstanding is $400 million, ofwhich $150 million may be in the form of letters of credit. The credit facilityis a five-year revolving facility (with an expiration date of February 23,2010) and is not secured by any assets. The credit facility containsaffirmative and restrictive covenants that the Company must comply with,including: (a) periodic financial reporting requirements, (b) maintaininga maximum ratio of consolidated debt to earnings before interest, taxes,depreciation and amortization, adjusted for certain business restructuringcharges and related expenses and non-cash charges, referred to as adjustedEBITDA, of 2.00 to 1.00, (c) maintaining a minimum ratio of adjustedEBITDA to interest expense of 4.00 to 1.00, (d) limitations on theincurrence of subsidiary indebtedness, (e) limitations on liens, (f) limitationson investments and (g) limitations on the creation or existence ofagreements that prohibit liens on our properties. The creditfacility also limits the Company’s ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares ofits common stock to an amount not to exceed 50% of consolidated net incomeof the Company for the fiscal year immediately preceding the fiscal year inwhich such dividend, purchase, redemption, retirement or acquisition is paid ormade. The credit facility was amended in May 2005 to provide the Companywith the ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of its common stock in fiscal 2005 up to anamount not to exceed $250 million. As of June 30, 2005, the Company was incompliance with all of the covenants included in the credit facility.

The credit facility providesthat the Company may use up to $1 billion in cash (excluding transaction fees)and assumed debt for acquisitions completed after the date of the agreement,provided that it is in compliance with the terms of the agreement. Theacquisition amount will be permanently increased to $1.5 billion afterconsolidated EBITDA of the Company and its subsidiaries for any period oftwelve consecutive months equals or exceeds $750 million.

There are currently $55million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility, and the remainingavailability is $345 million. The Company believes the credit facility providesit 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**                                                                 | ** ** | **Nine months ended**                          | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **June 30,**                                                                                | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                          | ** ** | **    2005    **                                         | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                                                          | ** ** | **Dollars and shares in millions,  except per share amounts** | ** ** |
| **Earnings Per Common Share—Basic:**                                           |       |                                                                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income from continuing  operations                                                  |       |                                                                                             | $          | 194                                                      |       |   |   | $ | 58 |   |   |   | $ | 263 |   |   |   | $ | 191 |   |   |
| Income (loss) from discontinued  operations                                         |       |                                                                                             | —     |                                                     |       |   | 3 |   |   |   | (2 | ) |   |   | 5 |   |   |
| Net income                                                                          |       |                                                                                             | $          | 194                                                      |       |   |   | $ | 61 |   |   |   | $ | 261 |   |   |   | $ | 196 |   |   |
| Weighted average shares—basic                                                  |       |                                                                                             | 478        |                                                     |       |   | 446 |   |   |   | 473 |   |   |   | 434 |   |   |
| Earnings per share from  continuing operations                                      |       |                                                                                             | $          | 0.41                                                     |       |   |   | $ | 0.13 |   |   |   | $ | 0.56 |   |   |   | $ | 0.44 |   |   |
| Earnings (loss) per  share from discontinued operations                             |       |                                                                                             | —     |                                                     |       |   | 0.01 |   |   |   | (0.01 | ) |   |   | 0.01 |   |   |
| Earnings per share—basic                                                       |       |                                                                                             | $          | 0.41                                                     |       |   |   | $ | 0.14 |   |   |   | $ | 0.55 |   |   |   | $ | 0.45 |   |   |
| **Earnings Per Common Share—Diluted:**                                         |       |                                                                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income from continuing  operations                                                  |       |                                                                                             | $          | 194                                                      |       |   |   | $ | 58 |   |   |   | $ | 263 |   |   |   | $ | 191 |   |   |
| Interest charges  associated with convertible debt                                  |       |                                                                                             | —     |                                                     |       |   | 2 |   |   |   | 2 |   |   |   | 7 |   |   |
| Income from continuing  operations used for diluted EPS                             |       |                                                                                             | 194        |                                                     |       |   | 60 |   |   |   | 265 |   |   |   | 198 |   |   |
| Income (loss) from  discontinued operations                                         |       |                                                                                             | —     |                                                     |       |   | 3 |   |   |   | (2 | ) |   |   | 5 |   |   |
| Net income used for  diluted EPS                                                    |       |                                                                                             | $          | 194                                                      |       |   |   | $ | 63 |   |   |   | $ | 263 |   |   |   | $ | 203 |   |   |
| Weighted average shares—basic                                                  |       |                                                                                             | 478        |                                                     |       |   | 446 |   |   |   | 473 |   |   |   | 434 |   |   |
| Potential dilutive securities:                                                      |       |                                                                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Assumed exercise of  stock options                                                  |       |                                                                                             | 5          |                                                     |       |   | 9 |   |   |   | 6 |   |   |   | 9 |   |   |
| Assumed vesting of  restricted stock units                                          |       |                                                                                             | —     |                                                     |       |   | 1 |   |   |   | 1 |   |   |   | 2 |   |   |
| Assumed exercise of  warrants                                                       |       |                                                                                             | 4          |                                                     |       |   | 6 |   |   |   | 5 |   |   |   | 6 |   |   |
| Assumed conversion of  LYONs                                                        |       |                                                                                             | —     |                                                     |       |   | 21 |   |   |   | 6 |   |   |   | 21 |   |   |
| Weighted average shares—diluted                                                |       |                                                                                             | 487        |                                                     |       |   | 483 |   |   |   | 491 |   |   |   | 472 |   |   |
| Earnings per share from  continuing operations                                      |       |                                                                                             | $          | 0.40                                                     |       |   |   | $ | 0.12 |   |   |   | $ | 0.54 |   |   |   | $ | 0.42 |   |   |
| Earnings per share from  discontinued operations                                    |       |                                                                                             | —     |                                                     |       |   | 0.01 |   |   |   | — |   |   |   | 0.01 |   |   |
| Earnings per share—diluted                                                     |       |                                                                                             | $          | 0.40                                                     |       |   |   | $ | 0.13 |   |   |   | $ | 0.54 |   |   |   | $ | 0.43 |   |   |
| **Securities  excluded from the computation of diluted earnings  per common share** |       |                                                                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Options(1)                                                                          |       |                                                                                             | 38         |                                                     |       |   | 10 |   |   |   | 36 |   |   |   | 25 |   |   |
| Warrants(1)                                                                         |       |                                                                                             | 5          |                                                     |       |   | 6 |   |   |   | 5 |   |   |   | 6 |   |   |
| Total                                                                               |       |                                                                                             | 43         |                                                     |       |   | 16 |   |   |   | 41 |   |   |   | 31 |   |   |

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(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. Under the provisionsof this plan, Avaya is authorized to repurchase up to $500 million of itsoutstanding common stock over the next two years. The Company’s credit facilitycurrently provides it with the ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquireshares of its common stock in fiscal 2005 up to an amount not to exceed $250million. See Note 8, “Long-Term Debt,” for further information concerning thelimitations under the credit facility. Repurchases under the plan will be made 

19

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at management’sdiscretion in the open market or in privately negotiated transactions incompliance with applicable securities laws and other legal requirements and aresubject to market conditions, share price, the terms of Avaya’s credit facilityand other factors. As of June 30, 2005, the Company had repurchased5,575,000 shares of its common stock pursuant to the share repurchase plan atan average price of $8.38 per share, for a total of $47 million.

**10.   Benefit Obligations**

Thecomponents of net periodic benefit cost (credit) for the Company’s pension andpostretirement benefit plans for the three and nine months ended June 30,2005 and 2004 are provided in the table below:
| ** **                                            | ** ** | **Pension Benefits-**                               | ** ** | **Pension Benefits-**                               | ** ** | **Postretirement**                                       | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                            | ** ** | **U.S.**                                                 | ** ** | **Non-U.S.**                                             | ** ** | **Benefits**                                             | ** ** |
| ** **                                            | ** ** | **Three months ended**                         | ** ** | **Three months ended**                         | ** ** | **Three months ended**                         | ** ** |
| ** **                                            | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                            | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                            | ** ** | **Dollars in millions**                        | ** ** |
| **Components  of Net Periodic Benefit Cost (Credit)** |       |                                                     |       |                                                     |       |                                                     |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                          |       |                                                     | $          | 5                                                        |       |                                                     |       | $ | 4 | ** ** |   |   | $ | 2 |   |   |   | $ | 1 |   |   |   | $ | 2 |   |   |   | $ | 1 |   |   |
| Interest cost                                         |       |                                                     | 43         |                                                     |       |                                                     | 43         | ** ** |   |   | 3 |   |   |   | — |   |   |   | 9 |   |   |   | 10 |   |   |
| Expected return on plan assets                        |       |                                                     | (55        | )                                                        |       |                                                     | (54        | ) |   |   | (1 | ) |   |   | — |   |   |   | (3 | ) |   |   | (4 | ) |   |
| Amortization of unrecognized prior service  cost      |       |                                                     | 2          |                                                     |       |                                                     | 2          | ** ** |   |   | — |   |   |   | — |   |   |   | 2 |   |   |   | 3 |   |   |
| Recognized net actuarial loss                         |       |                                                     | 8          |                                                     |       |                                                     | 3          | ** ** |   |   | — |   |   |   | — |   |   |   | 1 |   |   |   | 1 |   |   |
| Settlement loss                                       |       |                                                     | —     |                                                     |       |                                                     | —     | ** ** |   |   | 1 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| **Net periodic benefit cost  (credit)**               | ** ** | ** **                                               | **$**      | **3**                                                    |       | ** **                                               | ** ** | **$** | **(2** | **)** | ** ** | ** ** | **$** | **5** |   | ** ** | ** ** | **$** | **1** |   | ** ** | ** ** | **$** | **11** |   | ** ** | ** ** | **$** | **11** |   |   |

 
| ** **                                            | ** ** | **Pension Benefits-**                               | ** ** | **Pension Benefits-**                               | ** ** | **Postretirement**                                       | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                            | ** ** | **U.S.**                                                 | ** ** | **Non-U.S.**                                             | ** ** | **Benefits**                                             | ** ** |
| ** **                                            | ** ** | **Nine months ended**                          | ** ** | **Nine months ended**                          | ** ** | **Nine months ended**                          | ** ** |
| ** **                                            | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                            | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| ** **                                            | ** ** | **Dollars in millions**                        | ** ** |
| **Components of Net Periodic  Benefit Cost (Credit)** |       |                                                     |       |                                                     |       |                                                     |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                          |       |                                                     | $          | 13                                                       |       |                                                     |       | $ | 12 | ** ** |   |   | $ | 7 |   |   |   | $ | 3 |   |   |   | $ | 4 |   |   |   | $ | 3 |   |   |
| Interest cost                                         |       |                                                     | 127        |                                                     |       |                                                     | 127        | ** ** |   |   | 9 |   |   |   | 1 |   |   |   | 29 |   |   |   | 30 |   |   |
| Expected return on plan assets                        |       |                                                     | (163       | )                                                        |       |                                                     | (160       | **)** |   |   | (1 | ) |   |   | (1 | ) |   |   | (8 | ) |   |   | (12 | ) |   |
| Amortization of unrecognized prior service  cost      |       |                                                     | 5          |                                                     |       |                                                     | 5          | ** ** |   |   | — |   |   |   | — |   |   |   | 7 |   |   |   | 8 |   |   |
| Recognized net actuarial loss                         |       |                                                     | 26         |                                                     |       |                                                     | 11         | ** ** |   |   | — |   |   |   | — |   |   |   | 4 |   |   |   | 4 |   |   |
| Settlement loss                                       |       |                                                     | —     |                                                     |       |                                                     | —     | ** ** |   |   | 1 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| **Net periodic benefit cost  (credit)**               | ** ** | ** **                                               | **$**      | **8**                                                    |       | ** **                                               | ** ** | **$** | **(5** | **)** | ** ** | ** ** | **$** | **16** |   | ** ** | ** ** | **$** | **3** |   | ** ** | ** ** | **$** | **36** |   | ** ** | ** ** | **$** | **33** |   |   |

 

The results of the non-U.S. pension plans for fiscal2005 include the unfunded pension plans assumed with the acquisition ofTenovis.

During the quarter ended June 30, 2005, thedefined benefit pension plan associated with one of our Irish subsidiaries wasterminated in favor of a defined contribution plan, and the benefit obligationwas settled at a net loss of $1 million.

The Company provides certain pension benefits for U.S.and non-U.S. employees which are not pre-funded. Consequently, the Companymakes payments as these benefits are disbursed. For the nine months ended June 30,2005, the Company made payments for these U.S. and non-U.S. pension benefitstotaling $5 million and $7 million, respectively. Estimated payments for theseU.S. and non-U.S. pension benefits for the remainder of fiscal 2005 are $2million and $2 million, respectively.

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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 nine months ended June 30, 2005, the Company made payments totaling$15 million for these retiree medical benefits. Estimated payments for theseretiree medical benefits for the remainder of fiscal 2005 are $11 million.

**11.   Stock Compensation Plans**

The Company has a stock compensation plan whichprovides for the issuance to eligible employees of nonqualified stock optionsand restricted stock units representing Avaya common stock. In addition, theCompany has a stock purchase plan under which eligible employees have theability to purchase shares of Avaya common stock at 85% of market value.

On December 16, 2004, the Compensation Committeeof the Board of Directors approved awards of 0.4 million performance vestingrestricted stock units to executive officers of the Company pursuant to theterms of the Avaya Inc. 2004 Long Term Incentive Plan. The performance vestingrestricted stock units vest upon the achievement of certain targets.

Additionally, during thenine months ended June 30, 2005, the Company granted to eligible employeesapproximately six million stock options at a weighted average exercise price of$15.55 per option and approximately two million restricted stock units at aweighted average market value of $15.59 per unit.

**12.   Operating Segments**

The Company reports its operations in two segments—GlobalCommunications Solutions (“GCS”) and Avaya Global Services (“AGS”). Thisstructure represents a change from the Company’s three-segment structureutilized in fiscal 2004, and better reflects how the businesses are beingmanaged consistent with the Company’s operating structure and go-to-marketstrategies. Accordingly, prior period amounts have been restated to reflectthis change. The GCS segment, which includes our prior reportable segments ofEnterprise Communications Group (“ECG”) and Small and Medium Business Solutions(“SMBS”), develops, markets and sells communications systems including IPtelephony systems, multi-media contact center infrastructure and convergedapplications in support of customer relationship management, unifiedcommunications applications, appliances such as IP telephone sets, andtraditional voice communications systems.TheAGS segment develops, markets and sells comprehensive end-to-end global serviceofferings that enable customers to plan, design, implement, monitor and managetheir converged communications networks worldwide.

The GCS segment includes the portion of the Tenovisrental and managed services revenue attributable to the equipment used in connectionwith the customer contracts. The portion of the customer contracts attributableto maintenance and other services is included in the 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 otherover/under absorption of corporate overhead expenses against plan is recordedand reported within the Corporate/Other Unallocated Amounts caption.

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The Company has outsourced the majority of itsmanufacturing operations related to its GCS segment to a number of contractmanufacturers. All manufacturing of the Company’s products is performed inaccordance with detailed specifications and product designs furnished by theCompany and is subject to quality control standards.

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  June 30, 2005** |       |                              |       |                     |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                              | $          | 648                      |       |                |       | $ | 588 |   |   |   | $ | — |   |   | $ | 1,236 |   |
| Operating income                           |       |                              | 1          |                     |       |                | 37         |   |   |   | 38 |   |   | 76 |   |
| **Three  months ended June 30, 2004** |       |                              |       |                     |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                              | $          | 506                      |       |                |       | $ | 510 |   |   |   | $ | — |   |   | $ | 1,016 |   |
| Operating income                           |       |                              | 17         |                     |       |                | 68         |   |   |   | 7 |   |   | 92 |   |
| **Nine  months ended June 30, 2005**  |       |                              |       |                     |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                              | $          | 1,865                    |       |                |       | $ | 1,741 |   |   |   | $ | — |   |   | $ | 3,606 |   |
| Operating income                           |       |                              | 14         |                     |       |                | 120        |   |   |   | 82 |   |   | 216 |   |
| **Nine  months ended June 30, 2004**  |       |                              |       |                     |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                              | $          | 1,479                    |       |                |       | $ | 1,510 |   |   |   | $ | 4 |   |   | $ | 2,993 |   |
| Operating income                           |       |                              | 16         |                     |       |                | 184        |   |   |   | 4 |   |   | 204 |   |

 

Thefollowing table sets forth the Company’s long-lived assets by geographic area:
| ** **                               | ** ** | **June 30,  2005**           | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Dollars in millions** | ** ** |
| U.S.                                     |       |                              | $          | 440                          |       |   |   | $ | 460 |   |   |
| International:                           |       |                              |       |                         |       |   |   |   |   |
| EMEA—Europe / Middle  East / Africa |       |                              | 272        |                         |       |   | 31 |   |   |
| APAC—Asia Pacific                   |       |                              | 14         |                         |       |   | 13 |   |   |
| Americas, non-U.S.                       |       |                              | 5          |                         |       |   | 5 |   |   |
| Total international                      |       |                              | 291        |                         |       |   | 49 |   |   |
| Total                                    |       |                              | $          | 731                          |       |   |   | $ | 509 |   |   |

 

Long-lived assetsrepresent property, plant and equipment, net of accumulated depreciation. Theincrease in international long-lived assets was primarily due to theacquisition of Tenovis.

**13.   Commitments and Contingencies**

**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. Consequently,it is difficult to reasonably estimate the maximum potential exposure or therange of possible loss. These assessments can involve a series of complexjudgments about future events and can rely heavily on estimates and 

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assumptions.Our assessments are based on estimates and assumptions that have been deemedreasonable by management. In accordance with SFAS No. 5, “Accountingfor Contingencies,” the Company makes a provision for a liability when it isboth probable that a liability has been incurred and the amount of the loss canbe reasonably estimated. Other than as described below, the Company believesthere is no litigation pending against the Company that could have,individually or in the aggregate, a material adverse effect on the Company’sfinancial position, results of operations or cash flows.

***Year 2000 Actions***

On September 30, 2000, Lucentcontributed its enterprise networking business to us and distributed all of theoutstanding shares of our capital stock to its shareowners. We refer to thesetransactions in this Quarterly Report on Form 10-Q as the “distribution.”

Three separate purportedclass action lawsuits are pending against Lucent, Avaya’s former parent, one instate court in West Virginia, one in federal court in the Southern District ofNew York and another in federal court in the Southern District of California.The case in New York was filed in January 1999 and, after being dismissed,was refiled in September 2000. The case in West Virginia was filed in April 1999and the case in California was filed in June 1999, and amended in 2000 toinclude Avaya as a defendant. The Company has assumed Lucent’s obligations forall of these cases under the Contribution and Distribution Agreement between usand Lucent, which sets forth the agreements between us and Lucent with respectto the principal corporate transactions required to effect the distribution(the “Contribution and Distribution Agreement”). All three actions are basedupon claims that Lucent sold products that were not Year 2000 compliant,meaning that the products were designed and developed without considering thepossible impact of the change in the calendar from December 31, 1999 to January 1,2000. The complaints allege that the sale of these products violated statutoryconsumer protection laws and constituted breaches of implied warranties.

A class was certified inthe West Virginia state court matter. The certified class in the West Virginiamatter includes those persons or entities that purchased, leased or financedthe products in question. In addition, the court also certified as a subclassall class members who had service protection plans or other service or extendedwarranty contracts with Lucent in effect as of April 1, 1998, as to whichLucent failed to offer a free Year 2000-compliant solution. The federalcourt in the New York action has issued a decision and order denying classcertification, dismissing all but certain fraud claims by one representativeplaintiff. No class claims remain in this case at this time. The federal courtin the California action also issued an opinion and order granting classcertification. The class includes any entities that purchased or leased certainproducts on or after January 1, 1990, excluding those entities that didnot have a New Jersey choice of law provision in their contracts and those whodid not purchase equipment directly from defendants. The federal court in theCalifornia action issued an order staying the action pending the outcome of theWest Virginia matter.

In May 2004, the Companyentered into a settlement agreement with the plaintiffs in all of theabove-described actions. Under the general terms of the agreement, eligibleclass members who acquired certain products between 1990 and 1999 may receivecredits up to $110 million or a cash alternative. The credits are valid for athree-year period and can be applied toward a 45 percent discount on purchasesof new Avaya products and/or a 30 percent discount on Avaya maintenanceservices. Alternatively, eligible class members may receive a one-time cashpayment equal to 25 percent of the credits to which they may be entitled. Thestate court in West Virginia approved the settlement in July 2004 and issued anorder of final approval of the settlement. The claims process commenced inAugust 2004 and the time period for filing claims expired in October 2004. TheCompany has notified eligible class members of the amounts that they areeligible to receive under the settlement.

Pursuant to the terms ofthe Contribution and Distribution Agreement, Lucent is responsible for 50% ofthe costs related to these matters in excess of $50 million, includingattorneys’ fees. The Company has 

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notifiedLucent that costs incurred in these matters, including costs expended sincethese matters commenced in 1999, have exceeded the $50 million threshold.Accordingly, Lucent will be responsible for a portion of the cost of thesettlement. Based on existing reserves for these matters, the Company does notbelieve the settlement will have a material adverse effect on its financialposition, results of operations or cash flows.

***CommissionsArbitration 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 productsfrom Avaya’s businesses that were formerly owned by Lucent involving theMinistry of Russian Railways. In April 2003, CDC initiated the arbitrationbefore the American Arbitration Association. The plaintiff alleges that as aresult of agreements entered into between the plaintiff and the Company, it isowed commissions on sales by the Company to the Ministry of Russian Railways ona continuing basis. The Company believes that the agreements relating to the plaintiff’sclaim have expired or do not apply to the products in question. As the sales ofproducts continue, CDC may likely increase its commission demand. The partieshave selected arbitrators in this matter. A hearing date has not yet been set.

***Securities Litigation***

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

The complaints, which aresubstantially similar to one another, allege, among other things, that theplaintiffs were injured by reason of certain allegedly false and misleadingstatements made by us relating to the cost of the Tenovis integration, thedisruption caused by changes in the delivery of our products to the market andreductions in the demand for our products in the U.S., and that based on theforegoing we had no basis to project our stated revenue goals for fiscal 2005. TheCompany has been served with a number of these complaints. No class has beencertified in the actions. The complaints seek compensatory damages plusinterest and attorneys’ fees.

These matters are still inthe early stages of litigation and an outcome cannot be predicted and, as aresult, we cannot be assured that these cases will not have a material adverseeffect on our financial position, results of operations or cash flows.

***DerivativeLitigation***

In May and July of2005, a number of derivative complaints were filed against certain officers andthe Board of Directors (“Board”) of the Company. Two complaints were filed inthe United States District Court, District of New Jersey, and two were filed inthe Superior Court of New Jersey, Somerset County. The allegations in each ofthe complaints 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 seekcontribution from the defendants to the Company for alleged violations of thesecurities laws, restitution to the Company and disgorgement of profits earnedby defendants, and fees and costs.

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These actions are in the early stages oflitigation and an outcome cannot be predicted and, as a result, we cannotdetermine if they will have an effect on our business or operations or, if theydo, whether their outcomes will have a material adverse effect on our businessor operations.

***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”). The actionpurports to be filed on behalf of all participants and beneficiaries of theAvaya Inc. Savings Plan, the Avaya Inc. Savings Plan for Salaried Employees andthe Avaya Inc. Savings Plan for the Variable Workforce (collectively, the “Plans”),during the period from October 5, 2004 through July 20, 2005. Itcontains factual allegations substantially similar to those asserted in thematters under the heading of “Securities Litigation.”

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. As of this time,defendants have not been served with this complaint. 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.

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.

**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 in 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 

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cleaning up historicalcontamination, whether or not caused by the Company. The Company is currentlyconducting investigation and/or cleanup of known contamination at 10 of itscurrent or former facilities either voluntarily or pursuant to governmentdirectives. None of the sites is reasonably likely to generate environmentalcosts that will be individually material nor will environmental costs for allsites in the aggregate be material in any fiscal year. There are no known thirdparties who may be responsible for investigation and/or cleanup at these sitesand therefore, for purposes of assessing the adequacy of financial reserves forthese liabilities, the Company has not assumed that it will recover amountsfrom any third 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 theextent of contamination and the type of required cleanup. The Company is notaware of, and has not included in reserves any provision for, any unassertedenvironmental claims.

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

The Company assesses theadequacy of environmental reserves on a quarterly basis. The Company does notexpect the outcome of these matters to have a material impact on its financialposition. Expenditures for environmental matters for the nine months ended June 30,2005 and 2004 were not material to the Company’s financial position, results ofoperations or cash flows. Payment for the environmental costs covered by thereserves may be made over a 30-year period.

**Product Warranties**

The Company recognizes a liability for the estimatedcosts that may be incurred to meet obligations arising from product warranties.These product warranties extend over a specified period of time generallyranging up to one year from the date of sale depending upon the product subjectto the warranty. The Company accrues for warranty costs as part of its cost ofsales based on associated material costs, technical support and help desk laborcosts, and associated overhead. The Company accrues this provision forestimated future warranty costs based upon the historical relationship ofwarranty claims to sales. The Company periodically reviews the adequacy of itsproduct warranties and adjusts, if necessary, the accrued warranty reserve,which is included in other current liabilities in the Consolidated BalanceSheets, for actual experience.

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The following tablesummarizes the activity related to the product warranty liability during thenine months ended June 30, 2005:
| ** **                                             | ** ** | **Dollars in millions** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|
| Balance as of September  30, 2004                      |       |                              | $          | 23 |   |   |
| Reductions for payments  and costs to satisfy claims   |       |                              | (34        | ) |   |
| Accruals for warranties  issued during the period*     |       |                              | 40         |   |   |
| Changes to accrual  relating to preexisting warranties |       |                              | 1          |   |   |
| Balance as of June 30,  2005                           |       |                              | $          | 30 |   |   |

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*                    Includes theopening balances of accruals related to acquisitions that occurred during thefirst nine months of fiscal 2005.

The increase in theproduct warranty liability for the nine months ended June 30, 2005 is dueto the additional accruals for product warranty associated with acquisitionsmade subsequent to September 30, 2004.

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

***Letters of Credit***

As of June 30, 2005, the Company hadentered into uncommitted credit facilities that vary in term totaling $183million for the purpose of securing third party financial guarantees such asletters of credit which ensure the Company’s performance or payment to thirdparties. Additionally, the Company had $400 million of committed creditfacilities, which is discussed in Note 8, “Long-Term Debt.” The Company hadoutstanding an aggregate of $158 million in irrevocable letters of credit underthe committed and uncommitted credit facilities (including an aggregate of $55million under its $400 million committed credit facility) and $1 million ofrestricted cash.

***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 one to three years. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$17 million as of June 30, 2005. Historically, no surety bonds havebeen drawn upon and there is no future expectation that any surety bonds willbe drawn upon.

***Purchase Commitments and Termination Fees***

The Company purchasescomponents from a variety of suppliers and uses several contract manufacturersto provide manufacturing services for its products. During the normal course ofbusiness, in order to manage manufacturing lead times and to help assureadequate component supply, the Company enters into purchase agreements withcontract manufacturers and suppliers that allow them to produce and procureinventory based upon forecasted requirements provided by the Company. If theCompany does not meet these specified purchase commitments, it could be requiredto purchase the inventory, or in the case of certain agreements, pay an earlytermination fee. As of June 30, 2005,the maximum potential payment under these commitments was approximately $126million. Historically, the Company has not been required to pay a charge fornot meeting its designated purchase commitments with these suppliers.

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***Product Financing Arrangements***

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

The Company has a product financing arrangement withone U.S. reseller. The Company is obligated under certain circumstances torepurchase inventory previously sold to this reseller, in the event the lendinginstitution which financed the transaction repossesses the reseller’s inventoryof the Company’s products. The Company’s obligation to repurchase inventoryfrom the lending institution terminates 180 days from the date ofinvoicing by the Company to the reseller. The repurchase amount is equal to theprice originally paid to the Company by the reseller for the inventory. Thisreseller has financed $54 million of inventory purchases under thisarrangement as of June 30, 2005, which is the maximum exposure to theCompany under this arrangement. There have not been any repurchases made by theCompany since the Company entered into this agreement in March 2001. TheCompany has estimated the fair value of this guarantee as of June 30,2005, and has determined that it is not significant. There can be no assurancethat the Company will not be obligated to repay a lending institution underthis arrangement in the future.

For the Company’s productfinancing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guarantee repayment amount reported tothe Company from the lending institution was $6 million as of June 30,2005. The Company reviews and sets the maximum credit limit for each resellerparticipating in this financing arrangement. There have not been any guaranteerepayments by the Company since the Company entered in this arrangement in October 2000.The Company has estimated the fair value of this guarantee as of June 30,2005, and has determined that it is not significant. There can be no assurancethat the Company will not be obligated to repurchase inventory under thisarrangement in the future.

***Performance Guarantees***

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 less than one year to eight years. While theCompany is no longer the primary obligor under these leases, the lessor has notcompletely released the Company from its obligation, and holds it secondarilyliable in the event that the assignees default on these leases. The maximumpotential future payments the Company could be required to make, if all of theassignees were to default as of June 30, 2005, would be $21 million. TheCompany 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 Company’s spin-off from Lucentin September 2000, the Company and Lucent executed and delivered theContribution and Distribution Agreement and certain related agreements.

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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(“the Company’s Businesses”). The Contribution and Distribution Agreement,among other things, provides that, in general, the Company will indemnifyLucent for all liabilities including certain pre-distribution tax obligationsof Lucent relating to the Company’s Businesses and all contingent liabilitiesprimarily relating to the Company’s Businesses or otherwise assigned to theCompany. In addition, the Contribution and Distribution Agreement provides thatcertain contingent liabilities not allocated to one of the parties will beshared by Lucent and the Company in prescribed percentages. The Contributionand Distribution Agreement also provides that each party will share specifiedportions of contingent liabilities based upon agreed percentages related to thebusiness of the other party that exceed $50 million. The Company is unableto determine the maximum potential amount of other future payments, if any,that it could be required to make under this agreement.

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

***Tax Settlement with Lucent***

In the third quarter of fiscal 2005, federal incometax audit matters for the years 1999 and 2000 and certain state tax mattersthat arose prior to the Company’s separation from Lucent were resolved. Uponthe settlement with Lucent, the Company recognized income of $116 millionassociated with the reversal of certain tax liabilities that were establishedat the time of distribution. This benefit is reflected in the ConsolidatedStatement of Income for the three-month period ended June 30, 2005 as abenefit from income taxes and is the most significant part of the Company’sbenefit from income taxes for the three and nine month periods ended June 30,2005. The Tax Sharing Agreement governs Lucent’s and the Company’s respectiverights, responsibilities and obligations after the distribution with respect totaxes for the periods ending on or before the distribution. Generally,pre-distribution taxes or benefits that are clearly attributable to thebusiness of one party will be borne solely by that party, and other pre-distributiontaxes or benefits will be shared by the parties based on a formula set forth inthe Tax Sharing Agreement. The Company may be subject to additional taxes orbenefits pursuant to the Tax Sharing Agreement related to future settlements ofaudits by taxing authorities for the periods prior to the Company’sdistribution.

In accordance with the terms of the Tax Sharing Agreement that the Companyand Lucent entered into in connection with the distribution, the Company isobligated to pay Lucent $39 million resulting from the resolution of federalincome tax audit matters for the years 1999 and 2000 and certain state taxmatters which were prior to our separation from Lucent. In addition, theCompany is entitled to receive an $8 million tax refund from Lucent whichbecame payable to the Company subsequent to June 30, 2005.

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**Item2.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*

“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 and Analysisof Financial Condition and Results of Operations contain certain forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995. See “Forward Looking Statements” at the end of this discussion.

Our accompanying unauditedconsolidated financial statements as of June 30, 2005 and for the threeand nine months ended June 30, 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 30,2004, which were included in our Annual Report on Form 10-K filed with theSEC on December 13, 2004. 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 be expectedfor the entire fiscal year.

**Overview**

***Products, Applications and Services***

We are a leading provider of communications systems,applications and services that help enterprises transform their businesses byredefining the way they work and interact with their customers, employees,business partners, suppliers and others. Our goal is to help our customersoptimize their enterprise communications networks in order to serve theircustomers better, enabling them to reduce costs and grow revenue whilepreserving the security and reliability of their networks. A key component ofour strategy is to leverage our substantial experience and expertise intraditional voice communications systems to capitalize on the transition ofthese traditional voice systems to Internet Protocol (IP), and the adoption ofIP telephony systems. We believe our comprehensive suite of IP telephonysystems, communications applications and appliances, as supported by our globalservices organization and extensive network of business partners, transformsthe enterprise communications system into a strategic asset for businesses, byenabling them to communicate to “anyone, at any place, at any time and in anyway” they choose.

Our productofferings include:

·       IPtelephony systems;

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

·       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 theircommunications networks. We believe our global services organization is animportant consideration for customers purchasing our products and applicationsand is a source of significant revenue for us, primarily from maintenancecontracts. The skilled 

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professionalsof our services organization, together with our networks of business partnersand our ability to diagnose customer network faults remotely, can provide24-hour-a-day, seven-day-a-week service to our customers around the world. Ourend-to-end portfolio of services offerings provides a single point ofaccountability and includes:

·       value-addedmaintenance services;

·       professionalservices, consulting, design and network integration;

·       productimplementation; and

·       rentaland managed services.

***Customers and Competitive Advantages***

Our customer base is diverse, ranging in size fromsmall businesses employing ten 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, manufacturing, media and communications, professionalservices, health care, education and governmental. As a result of ouracquisition of Tenovis in November 2004, we have significantly increasedour presence in Europe, particularly in Germany.

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 telephonysystems or “IP-enable” their existing voice communications systems, therebypreserving their existing communications technology investments and allowingthem to implement IP telephony at their own pace. The flexibility of convergednetworks offers increased functionality and provides our enterprise customerswith the ability to reach the right person at the enterprise, at the righttime, in the right place and in the right way, thereby optimizing businessinteractions and enhancing our customers’ ability to grow revenue and reducecosts. Our products, 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;

·       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 professional offerings such as speech access, remote agents andsoftphones, which allow our customers to improve worker productivity and reducenetwork and real estate costs by providing secure business communications to adispersed workforce;

·       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” theirexisting voice communications system);

·       alarge installed global customer base, further enhanced in Europe with theacquisition of Tenovis;

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

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

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

**Key Trends andUncertainties 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 which we acquired has enabled us to increase our presence in Europe. Theintegration of the Tenovis business into ours was and remains a substantialeffort requiring significant managerial resources and attention.

·       *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 profitgrowth, interest rates, energy prices and other factors in specific marketscould impact corporate willingness to spend on communications technology in thenear term. Additionally, the country-to-country variability inworldwide economic growth could also impact our business as growth rates ofdeveloped and more stable economies tend to be lower than that of emergingeconomies, where there could be more variables affecting the economic growth. Theeconomic regions comprising the highest concentrations of our revenues are furtherexpanded below:

·        U.S.—Economicgrowth is expected to slow through the remainder of 2005, causing expectedslowdowns in job growth as companies seek to maintain profitability. However,information technology spending is forecast to increase and could have apositive impact if there are signs of economic stability and companies cansubstantiate communication technology spending through increased productivity.

·        Europe,Middle East and Africa (EMEA)—Weakness and uncertainty in European economies,coupled with the high concentration of our business in Germany, could affectour results in Europe as high unemployment levels and low economic growthforecasts, particularly in Germany, remain a concern.

*Technologytransition*—There are several factors that indicatethat enterprises may be poised to transition their traditional communicationssystems to next-generation communications technology. First, although manylarge companies have already begun to transition to IP telephony, IP telephonylines still constitute a very small percentage of global installed enterprisetelephony lines. 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 such investments,may consider IP telephony. Additionally, we believe that IP telephony hasgained widespread acceptance in the marketplace as an alternative replacementoption, and expect to see increased demand as the industry goes through themainstream adoption phase in the product lifecycle. Other factors enterprisesmay consider as 

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they decide whether todeploy IP telephony include whether IP telephony will provide the level ofsecurity and reliability provided by traditional telephony systems.

As a result of thetechnology transition, however, spending by enterprises on traditional voicecommunication systems has been declining. Increases in our revenue attributableto sales of IP telephony systems continue to be offset in part by declines inrevenue attributable to traditional voice communications systems. Revenueattributable to traditional voice communications systems currently comprises amuch smaller portion of our product revenues than in the past. Additionally,the ratio of revenue attributable to IP telephony systems versus traditionalvoice communication systems is expected to increase as more and more companiesconvert to IP telephony systems.

·       *Competitive environment*—We have historically operated, andcontinue to operate, in an extremely competitive environment. One aspect ofthis environment is that we regularly face pricing pressures in the markets inwhich we operate. We have been able to mitigate the effects of pricingpressures on profitability through our actions to improve gross margins,including cost reduction initiatives. For other uncertainties related to thecompetitive environment in which we operate, see “Forward Looking Statements—**We face intense competition from our currentcompetitors and, as the enterprise communications and information technologymarkets evolve, may face increased competition from companies that do notcurrently compete directly against us.”**

·       *Pressures on services business*—We expect to continue to facechallenges in our Avaya Global Services segment. Although the proportion ofcustomers who elect to purchase maintenance contracts at the time equipment ispurchased has remained at relatively constant levels over recent quarters, themaintenance business has been negatively affected by contract renegotiations atthe time of renewal, changes in scope (i.e. number of ports, number of sites,or hours and levels of coverage) and pricing pressures. Our managed servicesbusiness generally involves larger contracts with customers who outsourceresponsibility for their telephony systems to us. We expect to face challengesin this area relating to timing and closure of the new business opportunities,as well as pricing pressures and scope changes similar to the maintenancebusiness that are discussed above.

·       *Foreign currency—*With our acquisition of Tenovis, ourinternational revenues have exceeded 40% of our total consolidatedrevenues for the first nine months 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.

***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 eight subsequentquarters. During fiscal 2005, we are continuing to focus on controlling ourcosts, particularly in relation to our revenue. As part of our focus oncontrolling costs, we have taken actions to reduce the headcount in our U.S.services business, and have reached agreements with the Works Councils inEurope to reduce our workforce by over 500. Most of these positions havealready been eliminated.

As discussed in more detail below, our gross margindecreased from 48.0% for the three months ended June 30, 2004 to 46.5% forthe three months ended June 30, 2005 and from 47.0% to 46.6 % for thecomparable nine-month period. The decreases for the three and nine monthperiods are primarily due to the lower margins achieved by the Tenovis servicesbusiness, which historically has achieved lower margins than the rest of theCompany.

As a percentage ofrevenue, selling, general and administrative, or SG&A, expenses increasedfrom 30.2% to 32.8% for the three months ended June 30, 2005, and from31.7% to 32.4% for the nine months 

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ended June 30,2005. The increase in dollar terms for both periods was due to the inclusion ofTenovis SG&A expenses following the acquisition, as well as our otherrecent acquisitions.

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

As further discussed in “Liquidity and CapitalResources,” we have been focused on using cash for strategic acquisitions anddebt reduction, as well as generating cash from our operating activities. Weused net cash of $265 million and $110 million to acquire Tenovis and Spectel,respectively, in the first quarter of fiscal 2005. During the nine months endedJune 30, 2005, we used $318 million, including $4 million of interest and fees,to reduce substantially the amount of our senior notes outstanding and $277 million, including $15 million ofinterest and fees, to repurchase Tenovis’s outstanding secured floating ratenotes. In addition, we used $47 million to repurchase shares of ourcommon stock as discussed below.

As of September 30, 2004, our cash and cashequivalents exceeded our debt by $1,024 million and as of June 30, 2005,our cash and cash equivalents exceeded our debt by $704 million. We expect tohave positive operating cash flow for the remainder of fiscal 2005.

On April 19, 2005,the Board of Directors authorized a share repurchase plan. On April 20, 2005, the Company commencedpurchasing shares under this plan, and as of June 30, 2005, we hadrepurchased 5,575,000 shares of our common stock at an average price of $8.38per share. See Part II, Item 2, Changes in Securities, Use of Proceeds andIssuer Purchases of Equity Securities, for more information regarding our sharerepurchases.

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

As of June 30, 2005, we had $430 million in netdeferred tax assets resulting from tax credit carryforwards, net operatinglosses and other deductible temporary differences, which are available toreduce taxable income predominantly in the U.S. in future periods. This amountis net of a valuation allowance of $893 million, which was calculated inaccordance with the provisions of Statement of Financial Accounting Standards No. 109,“Accounting for Income Taxes.”

We continue to analyze ourprofitability and the probability of the realization of our deferred tax assetsin future periods as a result of profitable operations. We have determined thata partial valuation allowance is required until sufficient positive evidenceexists to support its reversal.

**Operating Segments**

Beginning in the first quarter of fiscal 2005, we aremanaging our business based on two operating segments: Global CommunicationsSolutions, or GCS, which includes our prior reportable segments of EnterpriseCommunications Group and Small and Medium Business Solutions, and Avaya GlobalServices, or AGS. This realignment of operating segments enables management toassess results of operations in a manner consistent with our operatingstructure and go-to-market strategies. Our comparative results for the quarterspresented have been reclassified to reflect our new segment structure.

Thefollowing table sets forth the allocation of our revenue among our operatingsegments and expressed as a percentage of total revenue:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 506        |       | $          | 565        |       | $          | 592        |                              | $          | 625                      |       | Global Communications  Solutions |   | $ | 648 |   | $ | 506 |   | 52 | % | 50 | % | $ | 142 |   | 28.1 | % |
| 510        |       | 511        |       | 556        |       | 597        |       | Avaya Global Services             |       | 588                      |       | 510 |   | 48 | % | 50 | % | 78 |   | 15.3 | % |
| $          | 1,016      |       | $          | 1,076      |       | $          | 1,148      |                              | $          | 1,222                    |       | Total |   | $ | 1,236 |   | $ | 1,016 |   | 100 | % | 100 | % | $ | 220 |   | 21.7 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The increase in revenuescontributed by the GCS segment and the AGS segment for the third quarter offiscal 2005 compared to the third quarter of fiscal 2004 is due to acquisitionsand increased sales from all international regions. These positive effects werepartially offset by weaker sales in the U.S. of both products and services.

**Acquisitions andDivestitures**

***Acquisition of Tenovis***

On November 18, 2004, we acquired all of theissued share capital of Tenovis Germany GmbH, or Tenovis. Tenovis is a majorEuropean provider of enterprise communications systems and services. Under theterms of the share purchase agreement we paid $381 million in cash (whichincludes $10 million of transaction fees that were not paid to the sellers) andassumed $287 million in debt, including $17 million of capital leaseobligations. Additionally, we acquired cash and cash equivalents of $116million, resulting in a net cash outlay related to the acquisition of $265million. We also recorded $313 million of pension liabilities in connectionwith this acquisition. Tenovis results are included in our consolidatedfinancial statements as of November 18, 2004.

The planned integration ofTenovis has resulted in significant cross-deployment of resources and theintegration of various legal entities and operations. As previously disclosed,we will therefore not be providing Tenovis financial information on astand-alone basis herein or in the future.

***Other Acquisitions***

On October 4, 2004, we acquired all of the issuedshare capital of Spectel plc, or Spectel, pursuant to the terms of a SharePurchase Agreement dated August 2, 2004, for $110 million in cash (whichincludes $6 million of transaction fees that were not paid to the sellers), netof cash acquired of $3 million. Spectel is a company incorporated in Irelandand a leading provider of audio conferencing solutions. Results from Spectelare included in our consolidated financial statements beginning on October 4,2004.

On October 15, 2004, we acquired a 23% share ofAgile Software NZ Limited, a software subsidiary of Agile NZ Limited, whichprimarily produces contact center software, as well as other software products.We account for this investment using the equity method.

On December 15, 2004, we acquired substantiallyall of the assets of RouteScience Technologies, Inc., a software companybased in California focused on products that monitor, assess and optimizenetwork applications.

Through a series oftransactions during fiscal 2004, we increased our ownership of the issued sharecapital of Tata Telecom Ltd., or Tata, a leading voice communications solutionsprovider in India, from 25.1% to 59.1% for a total of $24 million. After theclosing, Tata’s name was changed to Avaya GlobalConnect, or AGC, and we beganconsolidating its results on August 4, 2004.

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**Results fromContinuing Operations**

***Three Months Ended June 30, 2005 Compared withThree Months Ended June 30, 2004***

***Revenue***

The primary driver of the increase in ourrevenues for the third quarter of fiscal 2005 compared to the third quarter offiscal 2004 was our acquisition of Tenovis. Revenues were also positivelyimpacted by the acquisition of the majority interest in AGC in the fourthquarter of fiscal 2004, as well as foreign currency fluctuations. This impactwas partially offset by declines in U.S. sales of both products and services. Thedecline in U.S. revenues was primarily attributable to the following:

·       Wepreviously announced changes in our go-to-market strategy to realign our salesand marketing efforts. Although we expect this realignment to provide benefitsas we focus our direct sales efforts on our larger enterprise customers, thebenefits have taken longer than expected to materialize, resulting in adisruption to our sales efforts. This disruption primarily affected ourU.S. business. We continue to take actions to minimize the effects of thisdisruption while continuing to implement the realignment.

·       We continueto see declines in revenues from our U.S. services business, particularly inthe maintenance and rental and managed services lines of business, primarilydue to renegotiations by customers of their contracts to change the scope ofexisting contracts, pricing pressures and cancellations.

·       We havedevoted significant management attention and resources to the Tenovisintegration. These integration efforts have diverted management’s time andattention away from other business issues.

A detailed analysis of the impact of these factors is included in thediscussion below.

Thefollowing table sets forth a comparison of revenue by type:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 506        |       | $          | 565        |       | $          | 554        |                              | $          | 543                      |       | Sales of products |   | $ | 566 |   | $ | 506 |   | 46 | % | 50 | % | $ | 60 |   | 11.9 | % |
| 446        |       | 454        |       | 477        |       | 498        |       | Services                          |       | 497                      |       | 446 |   | 40 | % | 44 | % | 51 |   | 11.4 | % |
| 64         |       | 57         |       | 117        |       | 181        |       | Rental and  managed services      |       | 173                      |       | 64 |   | 14 | % | 6 | % | 109 |   | 170.3 | % |
| $          | 1,016      |       | $          | 1,076      |       | $          | 1,148      |                              | $          | 1,222                    |       | Total revenue |   | $ | 1,236 |   | $ | 1,016 |   | 100 | % | 100 | % | $ | 220 |   | 21.7 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Higher revenues in all categories were primarily dueto the acquisition of Tenovis, and to a lesser extent, our acquisition of amajority interest in AGC. The increase in revenues from sales of productsrelated to acquisitions was partially offset by lower volumes in the U.S.,partially as a result of the sales force realignment and decreases in sales ofsmall communications systems to our indirect channel business partners, as wellas the distraction caused by the Tenovis integration. The increase in revenues fromservices and rental and managed services related to acquisitions was partiallyoffset by lower volumes due primarily to renegotiations affecting the scope ofexisting maintenance and managed service contracts, as well as pricingpressures and cancellations.

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Thefollowing table sets forth a geographic comparison of revenue:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions**   | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 769        |       | $          | 822        |       | $          | 734        |                                | $          | 689                      |       | U.S. International: |   | $ | 717 |   | $ | 769 |   | 58 | % | 76 | % | $ | (52 | ) | -6.8 | % |
| 135        |       | 142        |       | 278        |       | 387        |       | EMEA—Europe/Middle East/Africa |       | 377                      |       | 135 |   | 30 | % | 13 | % | 242 |   | 179.3 | % |
| 58         |       | 59         |       | 74         |       | 89         |       | APAC—Asia Pacific              |       | 83                       |       | 58 |   | 7 | % | 6 | % | 25 |   | 43.1 | % |
| 54         |       | 53         |       | 62         |       | 57         |       | Americas, non-U.S.                  |       | 59                       |       | 54 |   | 5 | % | 5 | % | 5 |   | 9.3 | % |
| 247        |       | 254        |       | 414        |       | 533        |       | Total international                 |       | 519                      |       | 247 |   | 42 | % | 24 | % | 272 |   | 110.1 | % |
| $          | 1,016      |       | $          | 1,076      |       | $          | 1,148      |                                | $          | 1,222                    |       | Total revenue |   | $ | 1,236 |   | $ | 1,016 |   | 100 | % | 100 | % | $ | 220 |   | 21.7 | % |
|            |            |            |            |            |            |            |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

U.S. revenues were down considerably against thecomparable prior year quarter due to the continued disruption from therealignment of our sales and marketing structure, the distraction caused by theTenovis integration and decreases in sales of small communications systems toour indirect channel business partners as well as decreases in the scope ofexisting maintenance contracts and pricing pressures, as described above.

Higher revenues in EMEA were largely attributable tothe acquisition of Tenovis. Revenues in EMEA also benefited slightly from theincreased acceptance of IP telephony, which increased customers’ willingness tospend on converged communications technology. Revenues in APAC benefited fromthe acquisition of a majority ownership interest in AGC in the fourth quarterof fiscal 2004, which added approximately $14 million in incremental revenue,as well as higher volumes in China, Japan and Australia, particularly inconnection with sales to our customers in the financial services andtelecommunications industries. Revenues in the Americas, non-U.S. regionbenefited from increased sales primarily in Brazil and Mexico, partially offsetby declines in Canada.

Thefollowing table sets forth a comparison of revenue from sales of products by channel:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** **              |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|-------------------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** **              | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**                | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $219       |       | $          | 280        |       | $          | 261        |       | $                                 | 265        |                     | Direct                  |   | $ | 279 |   | $ | 219 |   | 49 | % | 43 | % | $ | 60 |   | 27.4 | % |
| 287        |       | 285        |       | 293        |       | 278        |       | Indirect                          |       | 287                      |                    | 287 |   | 51 | % | 57 | % | — |   | 0.0 | % |
| $506       |       | $          | 565        |       | $          | 554        |       | $                                 | 543        |                     | Total sales of products |   | $ | 566 |   | $ | 506 |   | 100 | % | 100 | % | $ | 60 |   | 11.9 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |                         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue from the sales ofproducts through the direct channel increased due to the acquisition ofTenovis, which sells primarily through the direct channel.

***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | *** *** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 273        |       | $          | 328        |       | $          | 309          |                              | $          | 298                      |       | On sales of products |   | $ | 301 |   | $ | 273 |   | 53.2 | % | 54.0 | % | $ | 28 |   | 10.3 | % |
| 183        |       | 183        |       | 169        |       | 159        |         | On services                       |       | 172                      |       | 183 |   | 34.6 | % | 41.0 | % | (11 | ) | -6.0 | % |
| 32         |       | 27         |       | 65         |       | 106        |         | On rental and managed services    |       | 102                      |       | 32 |   | 59.0 | % | 50.0 | % | 70 |   | 218.8 | % |
| $          | 488        |       | $          | 538        |       | $          | 543          |                              | $          | 563                      |       | Total gross margin |   | $ | 575 |   | $ | 488 |   | 46.5 | % | 48.0 | % | $ | 87 |   | 17.8 | % |
|            |            |            |            |            |            |            |              |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Gross margin on the sales of products increased $28million compared to the third quarter of fiscal 2004 due primarily toadditional sales volumes gained from the acquisition of Tenovis, the increasedproportion of software to hardware in our product mix and the benefitsassociated with our ongoing cost reduction initiatives. However, while theacquisition of Tenovis added additional gross margin in dollars, as a percentof revenue, our overall gross margin gains were partially offset by the lowermargin rates achieved by Tenovis.

Gross margin on services decreased $11 million duemainly to decreased U.S. revenues, and gross margin as a percent of revenuedeclined primarily due to the impact of the significantly lower-margin Tenovisservices business. In addition, gross margins were negatively impacted bychanges in revenue mix, primarily due to a shift from annual maintenance-relatedservices, which generate higher margins, to implementation services, whichgenerate lower margins. These declines in gross margin were partially offset bycost savings as a result of headcount reductions taken during this fiscal year.

Gross margin on rental andmanaged services increased $70 million due entirely to the acquisition ofTenovis. This increase was partially offset by lower revenues associated withU.S. managed services.

***Operating Expenses***

Thefollowing table sets forth a comparison of operating expenses:
|            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $          | 307        |       | $          | 326        |       | $          | 357        |                              | $          | 406                      |       | Selling, general and  administrative |   | $ | 406 |   | $ | 307 |   | 32.8 | % | 30.2 | % | $ | 99 |   | 32.2 | % |
| 89         |       | 93         |       | 98         |       | 105        |       | Research and development          |       | 93                       |       | 89 |   | 7.5 | % | 8.8 | % | 4 |   | 4.5 | % |
| $          | 396        |       | $          | 419        |       | $          | 455        |                              | $          | 511                      |       | Total operating expenses |   | $ | 499 |   | $ | 396 |   | 40.4 | % | 39.0 | % | $ | 103 |   | 26.0 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in SG&A expenses is primarily due tothe acquisition of Tenovis, which resulted in higher SG&A expenses indollar terms as well as a negative impact on SG&A expenses as a percent ofrevenue. Included with Tenovis’s SG&A expenses is approximately $14 millionof amortization of intangible assets.

Research and development(R&D) expenses increased due to the acquisition of Tenovis.

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

Thefollowing table sets forth a comparison of other income (expense), net:
|          | ** ** | ** ** | ** ** | ** ** | ** ** | ** **           | ** ** | ** **                        | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|----------|------------|------------|------------|------------|------------|----------------------|------------|-----------------------------------|------------|------------|------------------------------------|------------|
| **3Q04** | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | ** 2Q05 ** | ** ** | **Dollars in millions** | ** ** | ** ** | **2005**                           | ** ** | **2004** | ** ** | **Change** | ** ** |
| $        | (11        | )          |       | $          | 9          |                 |       | $                                 | (38        | )          |                               | $          | — |   |   | Other income (expense),  net |   |   | $ | 4 |   |   | $ | (11 | ) | $ | 15 |   | -136 | % |
|          |            |            |            |            |            |                      |            |                                   |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income (expense),net for the third quarter of fiscal 2005 is primarily related to $6 million ofinterest income, partially offset by a $1 million loss on the repayment of $159million principal amount of secured floating rate notes and other miscellaneousitems. Other income (expense), net for the same period last year was primarilyrelated to the $21 million loss on the repurchase of $132 million aggregateprincipal amount of senior notes, partially offset by $6 million of interestincome and other miscellaneous items.

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***Interest Expense***

Thefollowing table sets forth a comparison of interest expense:
| ** ** | ** ** | ** **           | ** ** | ** **           | ** ** | ** ** | *** *** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|----------------------|------------|----------------------|------------|------------|--------------|-----------------------------------|------------|------------------------------------|------------|
| **3Q04**   | ** ** | ** 4Q04 ** | ** ** | ** 1Q05 ** | ** ** | **2Q05**   | *** *** | **Dollars in millions** | ** ** | ** **                         | **2005**   | ** ** | **2004** | ** ** | **Change** | ** ** |
|       | $14        |                 |       |                 | $          | 12         |         |                              |       | $                                  | 10         |   |   |   | $ | 5 |   |   | Interest expense |   |   | $ | 3 |   |   | $ | 14 |   | $ | (11 | ) | -79 | % |
|            |            |                      |            |                      |            |            |              |                                   |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in interestexpense is due to lower year over year debt levels. Overall debt decreasedprimarily due to the repurchases of our senior notes in fiscal 2004 and thefirst quarter of fiscal 2005, as well as the redemption for cash and conversioninto common stock of our LYONs in the first quarter of fiscal 2005. Thisdecrease was partially offset by interest expense associated with the debtassumed in the Tenovis acquisition, which was then repaid during the second andthird quarters of fiscal 2005.

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

Thefollowing table sets forth a comparison of the provision for (benefit from)income taxes:
| ** ** | ** ** | ** **           | ** ** | ** ** | ** ** | ** **           | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|----------------------|------------|------------|------------|----------------------|------------|-----------------------------------|------------|--------------------------|------------|
| **3Q04**   | ** ** | ** 4Q04 ** | ** ** | **1Q05**   | ** ** | ** 2Q05 ** | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **Change** | ** ** |
|       | $9         |                 |       |       | $          | 16                   |       |                              |       | $                        | 7          |   |   |   | $ | 11 |   |   | Provision for  (benefit from) income taxes |   | $ | (117 | ) |   | $ | 9 |   |   | $ | (126 | ) | -1400 | % |
|            |            |                      |            |            |            |                      |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The benefit from income taxes for the third quarter offiscal 2005 is primarily related to a $116 million benefit from the settlementof certain U.S. federal and state income tax matters from years prior to thedistribution in accordance with the Tax Sharing Agreement between us and Lucent.The provision for income taxes in the third quarter of fiscal 2004 was composedof state and foreign income taxes.

**Segment Results**

As discussed above, wechanged our operating segment structure effective October 2004. Theresults for the quarters presented have been reclassified to reflect our newsegment structure.

***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 systems, 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;

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

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

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

·       AvayaCommunications ManagerTM, 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 CellularTM, which transparently bridges any cell phone to any Avayacommunications server.

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

·       AvayaIP OfficeTM, an IP telephony system for small and medium-sizedenterprises;

·       TraditionalKey Systems, PartnerTM, MagixTM, 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.

Thefollowing table sets forth revenue by similar class of products within the GCSsegment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | **Third Fiscal Quarter** | ** **                    |
|------------|------------|------------|------------|------------|------------|------------|--------------|-----------------------------------|------------|--------------------------|-------------------------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** *** | ** **                        | ** ** | ** **               | ** **                    | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | *** *** | **Dollars in millions** | ** ** | ** **               | **2005**                      | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $299       |       | $          | 336        |       | $          | 354        |         | $                                 | 393        |                     | Large Communications  Systems |   | $ | 393 |   | $ | 299 |   | 61 | % | 59 | % | $ | 94 |   | 31.4 | % |
| 57         |       | 59         |       | 69         |       | 78         |         | Small Communications  Systems     |       | 93                       |                          | 57 |   | 14 | % | 11 | % | 36 |   | 63.2 | % |
| 133        |       | 159        |       | 150        |       | 145        |         | Converged Voice Applications      |       | 151                      |                          | 133 |   | 23 | % | 27 | % | 18 |   | 13.5 | % |
| 17         |       | 11         |       | 19         |       | 9          |         | Other                             |       | 11                       |                          | 17 |   | 2 | % | 3 | % | (6 | ) | -35.3 | % |
| $506       |       | $          | 565        |       | $          | 592        |         | $                                 | 625        |                     | Total revenue                 |   | $ | 648 |   | $ | 506 |   | 100 | % | 100 | % | $ | 142 |   | 28.1 | % |
|            |            |            |            |            |            |            |              |                                   |            |                          |                               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The revenue increase forall GCS product classes is primarily attributable to the acquisition of Tenovis.Large Communications Systems also benefited from increased sales of IP productswhich exceeded the decrease in TDM sales. The acquisition of a majorityinterest in AGC also contributed to the increased revenues. The increase inSmall Communications Systems revenues attributable to Tenovis was partiallyoffset by lower sales volumes in the U.S., mainly in the indirect channel. Inaddition to the increase in revenues from Tenovis, Converged Voice Applicationsrevenues also benefited from increased sales of third-party or originalequipment manufacturer, or OEM, software products.

Thefollowing table sets forth operating income (loss) of the GCS segment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
|       | $17        |       |       | $          | 55         |       | $          | 25                                |       | $                        | (12        | ) | Operating income  (loss) |   |   | $ | 1 |   |   | $ | 17 |   |   | 0.2 | % |   |   | 3.4 | % |   | $ | (16 | ) | -94.1 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operatingincome was primarily due to the effects of unfavorable product mix,particularly a higher mix of lower- margin product such as OEM software, andpricing pressures. The decrease is also a result of higher SG&A costs and increasedR&D spending over the prior year due to the acquisition of Tenovis.

***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.

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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.

Rental and managed services—AGS supplements ourcustomers’ in-house staff and manages complex multi-vendor, multi-technologynetworks, optimizes network performance and configurations, backs up systems,detects and resolves faults, performs moves, adds, and changes and manages ourcustomers’ trouble tickets and inventory. This category includes customers whohave chosen a bundled solution with enhanced services not provided in a basicmaintenance contract.

Thefollowing table sets forth revenue by similar class of services within the AGSsegment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                               | ** ** | **Third Fiscal Quarter** | ** **    |
|------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------------|------------|--------------------------|---------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                               | ** ** | ** **               | ** **    | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions**        | ** ** | ** **               | **2005**      | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| $359       |       | $          | 358        |       | $          | 371        |       | $                                        | 372        |                     | Maintenance   |   | $ | 378 |   | $ | 359 |   | 64 | % | 70 | % | $ | 19 |   | 5.3 | % |
| 87         |       | 95         |       | 103        |       | 122        |       | Implementation and  integration services |       | 117                      |          | 87 |   | 20 | % | 17 | % | 30 |   | 34.5 | % |
| 64         |       | 57         |       | 79         |       | 96         |       | Rental and  managed services             |       | 88                       |          | 64 |   | 15 | % | 13 | % | 24 |   | 37.5 | % |
| —     |       | 1          |       | 3          |       | 7          |       | Other                                    |       | 5                        |          | — |   | 1 | % | 0 | % | 5 |   | n/a |   |
| $510       |       | $          | 511        |       | $          | 556        |       | $                                        | 597        |                     | Total revenue |   | $ | 588 |   | $ | 510 |   | 100 | % | 100 | % | $ | 78 |   | 15.3 | % |
|            |            |            |            |            |            |            |            |                                          |            |                          |               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue for AGS was primarilyattributable to the acquisition of Tenovis, partially offset by lower volumesin the maintenance and rental and managed services businesses in the U.S.

The acquisition of Tenovis favorably impacted revenuefor each of the service lines. However, these sales increases were partiallyoffset by lower volumes, especially in the U.S. Our maintenance revenues wereunfavorably impacted by renegotiations by customers of their contracts tochange the scope of existing maintenance and managed services contracts,pricing pressures and cancellations, which exceeded new service businessgenerated by off-warranty maintenance. Implementation and integration servicesrevenues increased marginally due to a product mix which requires complex (andtherefore more expensive) services. Rental and managed services revenues in theU.S. were unfavorably affected by customer changes in scope, pricing pressuresand cancellations, as well as lower sales of telephony equipment to the U.S.managed services customers.

The followingtable sets forth operating income of the AGS segment:
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| **3Q04**   | ** ** | **4Q04**   | ** ** | **1Q05**   | ** ** | **2Q05**   | ** ** | **Dollars in millions** | ** ** | ** **               | **2005**   | ** ** | **2004** | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** | **Change** | ** ** |
|       | $68        |       |       | $          | 65         |       | $          | 56                                |       | $                        | 27         |   | Operating income |   | $ | 37 |   | $ | 68 |   |   | 6.3 | % |   |   | 13.3 | % |   | $ | (31 | ) | -45.6 | % |
|            |            |            |            |            |            |            |            |                                   |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operatingincome was primarily attributable to lower gross margins in the U.S. as well asSG&A expenses contributed by Tenovis. The Tenovis services business hassignificantly lower margins than those historically generated by the rest ofthe Company. In addition, the U.S. business experienced a lower proportion of maintenanceand managed services annual contracts as compared to the same period last year,and a higher proportion of implementation and integration services, whichtraditionally have lower margins. These declines in gross margin were partiallyoffset by cost savings as a result of headcount reductions taken during thisfiscal year.

**Corporate/OtherUnallocated Amounts**

Operating income of $38million in the third quarter of fiscal 2005 is primarily due to lower corporateoverhead expenses mainly driven by a reduction of the estimated annualincentive award expenses. At the 

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beginningof each fiscal year, the amount of certain corporate overhead expenses, includingtargeted annual incentive awards, to be charged to operating segments isdetermined 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. This adjustment ofthe annual incentive award accrual, as well as any other over/under absorptionof corporate overheads against plan, is recorded and reported within theCorporate/Other Unallocated Amounts caption.

***Nine Months Ended June 30, 2005 Compared withNine Months Ended June 30, 2004***

***Revenue***

The increase in revenue compared to the first ninemonths of fiscal 2004 was driven primarily by the acquisition of Tenovis. Revenueswere also positively impacted by the acquisition of a majority interest in AGCin the fourth quarter of fiscal 2004. Additionally, revenues for the nine-monthperiod increased approximately $27 million due to foreign currency translationdue to the weakening of the U.S. dollar, particularly against the euro.

Thefollowing table sets forth a comparison of revenue by type:
| ** **                   | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Sales of products            |       | $                                                  | 1,663      |   | $ | 1,483 |   | 46 | % | 49 | % | $ | 180 |   | 12.1 | % |
| Services                     |       | 1,472                                              |       | 1,307 |   | 41 | % | 44 | % | 165 |   | 12.6 | % |
| Rental and  managed services |       | 471                                                |       | 203 |   | 13 | % | 7 | % | 268 |   | 132.0 | % |
| Total revenue                |       | $                                                  | 3,606      |   | $ | 2,993 |   | 100 | % | 100 | % | $ | 613 |   | 20.5 | % |

 

Higher revenues in all categories were primarily dueto the acquisition of Tenovis. Revenues from sales of products also benefitedfrom the acquisition of a majority interest in AGC in the fourth quarter offiscal 2004. The increases in revenues from sales of product were partiallyoffset by lower volumes in the U.S. due to the disruption from the realignmentof our sales and marketing efforts and the distraction caused by the Tenovisintegration.The increase in revenues from services and rental and managed services,primarily attributable to Tenovis, was partially offset by lower volumes duemainly to renegotiations affecting the scope of existing managed servicescontracts, as well as pricing pressures and cancellations.

Thefollowing table sets forth a geographic comparison of revenue:
| ** **                          | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                          | ** ** | **Dollars in millions**                  | ** ** |
| U.S.                                |       | $                                                  | 2,140      |   | $ | 2,267 |   | 59 | % | 76 | % | $ | (127 | ) | -5.6 | % |
| International:                      |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| EMEA—Europe/Middle East/Africa |       | 1,042                                              |       | 396 |   | 29 | % | 13 | % | 646 |   | 163.1 | % |
| APAC—Asia Pacific              |       | 246                                                |       | 167 |   | 7 | % | 6 | % | 79 |   | 47.3 | % |
| Americas, non-U.S.                  |       | 178                                                |       | 163 |   | 5 | % | 5 | % | 15 |   | 9.2 | % |
| Total international                 |       | 1,466                                              |       | 726 |   | 41 | % | 24 | % | 740 |   | 101.9 | % |
| Total revenue                       |       | $                                                  | 3,606      |   | $ | 2,993 |   | 100 | % | 100 | % | $ | 613 |   | 20.5 | % |

 

U.S. revenues were down against the comparable priornine-month period due to the disruption from the sales and marketingrealignment and the distraction caused by the Tenovis integration, as well as 

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decreases in the scope ofexisting maintenance contracts and pricing pressures in our services businessas described above.

Higher revenues in EMEA were primarily attributable tothe acquisition of Tenovis. Revenues in EMEA continue to benefit from theincreased acceptance of IP telephony, which increased customers’ willingness tospend on converged communications technology. Excluding Tenovis, revenues inEMEA increased, primarily due to sales of large communications systems. Inaddition, currency translation had a positive impact as the euro strengthenedagainst the U.S. dollar for most of the period. Revenues in APAC benefited fromthe acquisition of a majority ownership interest in AGC as well as highervolumes in China and Japan, particularly in connection with sales to ourcustomers in the financial services industry. Revenues in the Americas,non-U.S. region benefited from higher volumes associated with the call centerbusiness due to the expansion and upgrade of the installed base in LatinAmerica.

Thefollowing table sets forth a comparison of revenue from sales of products by channel:
| ** **              | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**                  | ** ** |
| Direct                  |       | $                                                  | 805        |   | $ | 643 |   | 48 | % | 43 | % | $ | 162 |   | 25.2 | % |
| Indirect                |       | 858                                                |       | 840 |   | 52 | % | 57 | % | 18 |   | 2.1 | % |
| Total sales of products |       | $                                                  | 1,663      |   | $ | 1,483 |   | 100 | % | 100 | % | $ | 180 |   | 12.1 | % |

 

Revenue from the sales ofproducts through the direct channel increased due to the acquisition ofTenovis, which sells primarily through the direct channel.

***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
| ** **                      | ** ** | **Nine Months Ended June 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**                  | ** ** |
| On sales of  products           |       | $                                                  | 908        |   | $ | 792 |   |   | 54.6 | % |   |   | 53.4 | % |   | $ | 116 |   | 14.6 | % |
| On services                     |       | 500                                                |       | 514 |   |   | 34.0 | % |   |   | 39.3 | % |   | (14 | ) | -2.7 | % |
| On rental and  managed services |       | 273                                                |       | 101 |   |   | 58.0 | % |   |   | 49.8 | % |   | 172 |   | 170.3 | % |
| Total gross margin              |       | $                                                  | 1,681      |   | $ | 1,407 |   |   | 46.6 | % |   |   | 47.0 | % |   | $ | 274 |   | 19.5 | % |

 

Gross margin on the sales of products increased dueprimarily to additional sales volumes gained from the acquisition of Tenovis,the increased proportion of software to hardware in our product mix and thebenefits associated with our ongoing cost reduction initiatives. However, whilethe acquisition of Tenovis added additional gross margin in dollars, as apercent of revenue, our overall gross margin gains were partially offset by thelower margin rates achieved by Tenovis.

Gross margin on services decreased due mainly to theimpact of lower revenues in the U.S., as well as the impact of thesignificantly lower margin Tenovis services business. In addition, grossmargins were negatively impacted by changes in revenue mix primarily due to ahigher proportion of government contracts and wire installations, as well as ahigher proportion of implementation services revenues, which generate lowermargins than those achieved by annual maintenance-related services. Thesedeclines in gross margin were partially offset by cost savings as a result ofheadcount reductions taken during this fiscal year.

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Gross margin on rental andmanaged services increased due primarily to the acquisition of Tenovis, whichwas partially offset by lower revenues associated with U.S. managed services.

***Operating Expenses***

Thefollowing table sets forth a comparison of operating expenses:
| ** **                           | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| ** **                           | ** ** | **Dollars in millions**                  | ** ** |
| Selling, general and  administrative |       | $                                                  | 1,169      |   | $ | 948 |   |   | 32.4 | % |   |   | 31.7 | % |   | $ | 221 |   | 23.3 | % |
| Research and development             |       | 296                                                |       | 255 |   |   | 8.2 | % |   |   | 8.5 | % |   | 41 |   | 16.1 | % |
| Total operating expenses             |       | $                                                  | 1,465      |   | $ | 1,203 |   |   | 40.6 | % |   |   | 40.2 | % |   | $ | 262 |   | 21.8 | % |

 

The increase in SG&A expenses is primarily due tothe acquisition of Tenovis, and to a lesser extent our other acquisitions,which resulted in higher SG&A expenses in dollar terms as well as anegative impact as a percent of revenue. Included with Tenovis’s SG&Aexpenses is approximately $34 million of amortization of intangible assets. Thesenegative impacts associated with our acquisitions were partially offset byimproved operational efficiencies.

Research and developmentexpenses increased due to the acquisition of Tenovis.

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

Thefollowing table sets forth a comparison of other income (expense), net:
| ** **                   | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**                  | ** ** |
| Other income  (expense), net |       | $                                                  | (34        | ) | $ | (24 | ) | $ | (10 | ) | 41.7 | % |
|                              |            |                                                    |            |  |  |  |  |  |  |  |  |  |

 

Other income (expense),net for the nine months ended June 30, 2005 is due primarily to a $41million loss on the repurchase of $271 million aggregate principal amount ofsenior notes and a $3 million loss on the repayment of $262 million principalamount of secured floating rate notes, partially offset by $18 million ofinterest income. Other income (expense), net for the same period last fiscalyear was mainly due to the $42 million loss on the extinguishment andrepurchase of a portion of our senior notes and a $5 million loss on the saleof Commscope common stock (which we acquired with the disposal of ourConnectivity Solutions business), partially offset by $13 million of interestincome and other miscellaneous items.

***Interest Expense***

Thefollowing table sets forth a comparison of interest expense:
| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** 2005 **                               | ** ** | ** 2004 ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Interest expense |       |                                               | $          | 18 |   |   |   | $ | 54 |   |   | $ | (36 | ) | -66.7 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in interestexpense is due to lower year over year debt levels. Overall debt decreasedprimarily due to the repurchases of our senior notes in fiscal 2004 and thefirst quarter of fiscal 2005, as well as the redemption for cash and conversioninto common stock of our LYONs in the first quarter of fiscal 2005. Thisdecrease was partially offset by interest expense associated with the debtassumed in the Tenovis acquisition, which was substantially repaid during thesecond and third quarters of fiscal 2005.

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***Benefit from Income Taxes***

Thefollowing table sets forth a comparison of the benefit from income taxes:
| ** **                 | ** ** | **Nine Months Ended June 30,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                 | ** ** | **Dollars in millions**                  | ** ** |
| Benefit from  income taxes |       | $                                                  | (99        | ) | $ | (65 | ) | $ | (34 | ) | 52.3 | % |
|                            |            |                                                    |            |  |  |  |  |  |  |  |  |  |

 

The benefit from incometaxes for the nine months ended June 30, 2005 is primarily due to a $116million benefit from the settlement of certain U.S. federal and state incometax matters from years prior to the distribution in accordance with the TaxSharing Agreement between us and Lucent, partially offset by a provision forstate and foreign income taxes. The benefit for the comparable period lastfiscal year primarily related to an $89 million benefit related to settlementof certain tax matters for periods prior to the distribution in accordance withthe Tax Sharing Agreement between us and Lucent, partially offset by aprovision for state and foreign income taxes.

**Segment Results**

As discussed above, wechanged our operating segment structure effective October 2004. Theresults for the periods presented have been reclassified to reflect our newsegment structure.

***Global Communications Solutions***

Thefollowing table sets forth revenue by similar class of products within the GCSsegment:
| ** **                    | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**                  | ** ** |
| Large  Communications Systems |       | $                                                  | 1,140      |   | $ | 874 |   | 61 | % | 59 | % | $ | 266 |   | 30.4 | % |
| Small  Communications Systems |       | 240                                                |       | 169 |   | 13 | % | 11 | % | 71 |   | 42.0 | % |
| Converged Voice  Applications |       | 446                                                |       | 393 |   | 24 | % | 27 | % | 53 |   | 13.5 | % |
| Other                         |       | 39                                                 |       | 43 |   | 2 | % | 3 | % | (4 | ) | -9.3 | % |
| Total revenue                 |       | $                                                  | 1,865      |   | $ | 1,479 |   | 100 | % | 100 | % | $ | 386 |   | 26.1 | % |

 

The increase in total revenue for all GCS productclasses was primarily attributable to the acquisition of Tenovis. LargeCommunications Systems also benefited from increased sales of IP products whichexceeded the decrease in TDM sales. The increase in Small CommunicationsSystems revenues attributable to Tenovis was partially offset by lower U.S.sales volumes, mainly in the indirect channel due to lower purchases by ourU.S. indirect channel partners. Inaddition to the increased revenue from Tenovis, Converged VoiceApplications also benefited from higher volumes in sales of OEM softwareproducts.

Thefollowing table sets forth operating income of the GCS segment:
| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | ** 2005 **                               | ** ** | ** 2004 ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       |                                               | $          | 14 |   |   |   | $ | 16 |   |   |   | 0.8 | % |   |   | 1.1 | % |   |   | $ | (2 | ) |   | -12.5 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operating income was primarily due tothe effects of unfavorable product mix, including increased sales ofthird-party or OEM software products. The decrease is also a result of higherSG&A costs and increased R&D spending over the prior year due to theacquisition of Tenovis.

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***Avaya Global Services***

Thefollowing table sets forth revenue by similar class of services within the AGSsegment:
| ** **                               | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                               | ** ** | **Dollars in millions**                  | ** ** |
| Maintenance                              |       | $ 1,121                                       |       | $ 1,064 |   | 64 | % | 71 | % | $ 57 |   | 5.4 | % |
| Implementation  and integration services |       | 342                                                |       | 243 |   | 20 | % | 16 | % | 99 |   | 40.7 | % |
| Rental and  managed services             |       | 263                                                |       | 203 |   | 15 | % | 13 | % | 60 |   | 29.6 | % |
| Other                                    |       | 15                                                 |       | — |   | 1 | % | 0 | % | 15 |   | n/a |   |
| Total revenue                            |       | $ 1,741                                       |       | $ 1,510 |   | 100 | % | 100 | % | $ 231 |   | 15.3 | % |

 

The increase in revenue for AGS was primarilyattributable to the acquisition of Tenovis and sales of new services, partiallyoffset by lower volumes and pricing pressures in maintenance and rental andmanaged services revenues in the U.S.

Tenovis generated revenue for each of the servicelines. Lower volumes in existing contract-related maintenance sales wereprimarily due to changes in contract scope for U.S. customers and pricingpressures, and were partially offset by increases in maintenance revenues dueto sales of new services and off-warranty sales. Implementation and integrationservices revenues benefited from the trending of product sales in recentquarters and increases in our infrastructure implementation business. Rentaland managed services revenues in the U.S. were unfavorably affected by customerchanges in scope, pricing pressures and cancellations, as well as lower salesof telephony equipment to the U.S. managed services customers.

Thefollowing table sets forth operating income of the AGS segment:
| ** **       | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------|------------|----------------------------------------------------|------------|
| ** **       | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **   2005   **       | ** ** | **   2004   ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**                  | ** ** |
| Operating income |       |                                               | $ 120 |   |   |   | $ 184 |   |   |   | 6.9 | % |   |   | 12.2 | % |   | $ (64 | ) | -34.8 | % |
|                  |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operatingincome for the year to date period is primarily due to the lower gross marginand the additional expenses attributable to Tenovis. The U.S. businessexperienced a lower proportion of higher-margin maintenance and managedservices annual contracts and a higher proportion of implementation andintegration services, which traditionally have lower margins. The decrease ingross margin was partially offset by the cost savings as a result of headcount reductions taken during this fiscalyear.

**Corporate/OtherUnallocated Amounts**

Revenues that are not associated with one of ouroperating segments are presented under the Corporate/ Other Unallocated Amountscaption. Revenue of $4 million in the nine months ended June 30, 2004represents certain sales associated with the acquisition of Expanets. Thesesales were not allocated to one of our operating segments because the saleswere of non-Avaya products that were ordered prior to the acquisition, and wereconsummated subsequent to the closing of the acquisition.

Operating income of $82million in the nine months ended June 30, 2005 is primarily due to lowercorporate overhead expenses mainly driven by a reduction of the estimatedannual incentive award expenses, as well as lower than expected information technologyand other corporate expenses. At the beginning of each fiscal year, the amountof certain corporate overhead expenses, including targeted 

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annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year in the annual plan. The annual incentive award accrual isadjusted quarterly based on actual year to date results and those estimated forthe remainder of the year. This adjustment of the annual incentive awardaccrual, as well as any other over/under absorption of corporate overheadexpenses against plan, is recorded and reported within the Corporate/OtherUnallocated Amounts caption.

**Results of Discontinued Operations**

The $2 million loss fromdiscontinued operations is primarily related to the result of the finalizationof the working capital adjustment related to the sale of our ConnectivitySolutions business, in accordance with the asset purchase agreement.

**Liquidity and Capital Resources**

During the first nine months of fiscal 2005, wefocused on reducing the amount of our debt, while balancing our cash needs forstrategic acquisitions. As a result, our cash and cash equivalents decreased to$735 million as of June 30, 2005 from $1,617 million as of September 30,2004.

As part of ourde-leveraging strategy, we called for redemption and then repurchased all ofour remaining outstanding LYONs (after substantially all the holders of LYONsconverted their LYONs into Avaya common stock shortly before the repurchasedate) and repurchased substantially all of our outstanding senior notes duringthe first quarter of fiscal 2005. These reductions in debt were partiallyoffset by the closing of the Tenovis acquisition and the assumption of certainrelated debt, of which we have repaid all except amounts relating to capitallease obligations arising subsequent to the acquisition. The impact of thesetransactions is described in the “Investing Activities” and “FinancingActivities” discussions below. Primarily as a result of these actions, wereduced our debt balance from $593 million as of September 30, 2004 to $31million as of June 30, 2005.

***Sources and Uses of Cash for the Nine Months Ended June 30,2005***

Acondensed statement of cash flows for the nine-month period ended June 30,2005 and 2004 follows:
| ** **                                                                             | ** ** | **Nine months  ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
| ** **                                                                             | ** ** | **Dollars in millions**              | ** ** |
| Net cash provided  by (used for):                                                      |       |                                           |       |   |   |
| Operating activities from continuing operations                                        |       | $  186                               |       | $  355 |   |
| Investing activities from continuing operations                                        |       | (478                                           | )          | 63 |   |
| Financing activities from continuing operations                                        |       | (582                                           | )          | (70 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                          |       | (8                                             | )          | 4 |   |
| Net (decrease)  increase in cash and cash equivalents from continuing operations  |       | (882                                           | )          | 352 |   |
| Net decrease in cash and cash equivalents from  discontinued operations                |       | —                                         |       | (21 | ) |
| Cash and cash equivalents at beginning of year                                         |       | 1,617                                          |       | 1,192 |   |
| Cash and cash  equivalents at end of period                                            |       | $  735                               |       | $ 1,523 |   |

 

***Operating Activities***

Our net cash provided by operating activities fromcontinuing operations was $186 million for the nine-month period ended June 30,2005, compared to $355 million for the comparable nine-month period 

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in fiscal 2004. Thedecrease in cash provided by operating activities was primarily driven byhigher incentive payments, partially offset by an increase in net income.

*Higherincentives*—The first nine months of fiscal 2005included payments of management incentives based on the full fiscal year 2004performance, whereas the payments made during the first nine months of fiscal2004 were based on only the second half of fiscal 2003. The higher payments arealso attributable to our significantly increased profitability in fiscal 2004compared to fiscal 2003.

*Increasein net income*—Net income of $261 million for the firstnine months of fiscal 2005 represents a $65 million increase from thecomparable period. This increase was primarily due to a $116 million benefitrelated to a tax settlement, lower interest expense due to lower debt levelsand cost reduction efforts.

Changes in our working capital accounts are addressedbelow.

*Accounts Receivable, Net*—Thefollowing summarizes our accounts receivable and related metrics:
| ** **                                                                 | ** ** | **June 30,**                        | ** ** | **September 30,**                                                           | ** **                               | ** ** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------------------------------|------------------------------------------|------------|------------|
| ** **                                                                 | ** ** | **2005**                                 | ** ** | **      2004      ** | ** **                               | **Change** | ** ** |
| ** **                                                                 | ** ** | **Dollars in millions**        | ** ** |
| Accounts  receivable, gross                                                |       | $      861 |       |                                                                             | $      744 |       |       | $          117 |   |
| Allowance for  doubtful accounts                                           |       | (48                                      | )          |                                                                             | (48                                      | )          |       | — |   |
| Accounts  receivable, net                                                  |       | $      813 |       |                                                                             | $      696 |       |       | $          117 |   |
| Allowance for doubtful accounts as a percent of  gross accounts receivable |       | 5.6                                      | %          |                                                                             | 6.5                                      | %          |       | -0.9  pts |   |
| Days sales outstanding (DSO)                                               |       | 59 days                                  |       |                                                                             | 58 days                                  |       |       | + 1 day |   |
| Past due  receivables as a percent of gross receivables                    |       | 23.8                                     | %          |                                                                             | 13.3                                     | %          |       | +10.5 pts |   |

 

The increase in the accounts receivable balance since September 30,2004 is primarily due to the acquisition of Tenovis.

As of June 30, 2005, the allowance for doubtfulaccounts includes Tenovis’ post-acquisition allowance for doubtful accounts,while the allowance at the acquisition date was netted against Tenovis’ grossaccounts receivable.

The past due receivables percentage has increased by10.5 percentage points since fiscal year end, driven by Tenovis receivables forwhich the majority of rental customers have net payment terms of 10 days. Historically,Tenovis’ customers do not meet these terms, thus creating a significantpercentage falling overdue on the eleventh day. Typically, Avaya’s paymentterms are approximately 30 days.

*Inventory*—Thefollowing summarizes our inventory and inventory turnover:
| ** **                         | ** ** | **June 30,**                                          | ** ** | **September 30,** | ** **                                                 | ** ** | ** ** |
|------------------------------------|------------|------------------------------------------------------------|------------|------------------------|------------------------------------------------------------|------------|------------|
| ** **                         | ** ** | **2005**                                                   | ** ** | **2004**               | ** **                                                 | **Change** | ** ** |
| ** **                         | ** ** | **Dollars in millions**                          | ** ** |
| Finished goods                     |       | $         312 |       |                   | $         221 |       |       | $              91 |   |
| Work in process  and raw materials |       | 16                                                         |       |                   | 18                                                         |       |       | (2 | ) |
| Total inventory                    |       | $         328 |       |                   | $         239 |       |       | $              89 |   |
| Inventory  turnover                |       | 8.1 times                                                  |       |                   | 9.0 times                                                  |       |       | -0.9  times |   |

 

Tenovis accounts for the majority of the $89 millionincrease in inventory levels since September 30, 2004. In addition, due tothe lower levels of purchases made by our indirect channel partners andincreased lead times for inventories purchased from our contract manufacturersin the second quarter of fiscal 2005, 

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there was an increase in ourinventory holdings. During the third quarter of fiscal 2005, we reduced ourinventory levels to adjust for the new level of purchases by our indirectchannel partners.

Additionally, the acquisition of Tenovis had anegative impact on our inventory turnover.

*Accounts Payable*—Thefollowing summarizes our accounts payable:
| ** **       | ** ** | **June 30,**                 | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|------------------|------------|-----------------------------------|------------|------------------------|------------|------------|------------|
| ** **       | ** ** | **2005**                          | ** ** | **2004**               | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions** | ** ** |
| Accounts payable |       |                              | $ 390 |                   |       |       | $ 345 |   |   |   | $ 45 |   |   |
|                  |            |                                   |            |                        |            |            |            |  |  |  |  |  |  |

 

Our accounts payableincreased primarily as a result of trade payables recorded related to ouracquisitions.

***InvestingActivities***

Net cash used forinvesting activities was $478 million for the first nine months of fiscal 2005,compared with net cash provided by financing activities of $63 million for thesame period last year. Activities in the nine-month period ended June 30,2005 include $383 million, net, used for acquisitions, including $265 millionfor Tenovis and $110 million for Spectel. We also used $97 million for capitalexpenditures and $44 million for capitalized software development costs, and received proceeds of $30 million from thesale of one of our corporate aircraft.

***FinancingActivities***

Net cash used forfinancing activities was $582 million for the first nine months of fiscal 2005,compared with $70 million for the same period last year. Cash used in thecurrent period consisted primarily of $314 million to repurchase substantiallyall of our senior notes in a public tender offer, $262 million to repay ouroutstanding principal of secured floating rate notes and $47 million torepurchase our common stock pursuant to our stock repurchase plan. These usesof cash were partially offset by $45 million of cash received in connectionwith the issuance of common stock under our employee stock purchase plan andthe exercise of options under our stock option plans.

***Cash Flows ofDiscontinued Operations***

Discontinued operationsdid not use or provide cash for the first nine months of fiscal 2005. Net cashused in discontinued operations for the same period last year was $15 millionfor Connectivity Solutions and $6 million for Expanets.

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

***Future CashRequirements***

Our primary future cashrequirements will be for working capital requirements and capital expenditures,for benefit payments in connection with the restructuring of Tenovis and forshare repurchases.

Specifically,we expect our short-term primary cash requirements to be as follows:

·       *Capital expenditures*—We expect to spendapproximately $64 million for capital expenditures and approximately $15million for capitalized software development costs during the remainder offiscal 2005.

·       *Restructuring payments*—We expect to makeTenovis employee termination payments aggregating approximately $63 millionduring the fourth quarter of fiscal 2005 and during fiscal 2006.

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·       *Share Repurchase Plan*—In accordance withthe share repurchase plan authorized by the Board of Directors on April 19,2005, we may use up to $500 million of cash to repurchase shares of ouroutstanding common stock over the next two years. Our credit facility currentlyprovides us with the ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of our common stock in fiscal 2005 up to anamount not to exceed $250 million. See Note 8, “Long-Term Debt,” to ourconsolidated financial statements for further information concerning thelimitations under the credit facility. Repurchases under the plan will be madeat management’s discretion in the open market or in privately negotiatedtransactions in compliance with applicable securities laws and other legalrequirements and are subject to market conditions, share price, the terms ofAvaya’s credit facility and other factors. As of June 30, 2005, approximately$453 million was available for share repurchases under the plan subject to thelimitation in our credit facility noted above.

·       *Lucent Tax Settlement*—We will make a $31 million net paymentto Lucent in the fourth quarter of fiscal 2005. This payment is comprised of a$39 million liability to Lucent resulting from the resolution of federal incometax audit matters for the years 1999 and 2000 and certain state tax matterswhich were prior to our separation from Lucent, partially offset by an $8 milliontax refund claim due to us that will be settled and recorded in the fourthquarter of fiscal 2005.

We expect to call forredemption the outstanding senior notes in April 2006 for approximately$14 million. See Note 8, “Long-Term Debt,” to our consolidated financialstatements for more information on the senior notes. In addition, we may use cash in the future to make strategicacquisitions.

***Future Sources ofLiquidity***

We expect our primarysource of cash during the fourth quarter of fiscal 2005 to be positive net cashprovided by operating activities. We expect that growth in our revenues andcontinued focus on accounts receivable and inventory management and costcontainment will enable us to continue to generate positive net cash fromoperating activities. We expect to receive approximately $22 million from thesale of one of our corporate aircraft during the fourth quarter of fiscal 2005.

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $735 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.

We and a syndicate oflenders are currently party to a credit facility of $400 million (see Note 8, “Long-TermDebt” to our consolidated financial statements), which expires in February 2010.Our existing 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 generatesufficient cash from operations, face unanticipated cash needs such as the needto fund significant strategic acquisitions or do not otherwise have sufficientcash and cash equivalents, we may need to incur additional debt or issue equity.In order to meet our cash needs we may, from time to time, borrow under ourcredit facility or issue other long- or short-term debt or equity, if themarket and the terms of our existing debt instruments permit.

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***UncertaintiesRegarding Our Liquidity***

Webelieve the following uncertainties exist regarding our liquidity:

·       *Ability to Increase Revenue*—Our ability to generate net cashfrom operating activities has been a primary source of our liquidity. If ourrevenue were to stagnate or decline, our ability to generate net cash fromoperating activities in a sufficient amount to meet our cash needs could beadversely affected.

·       *Impact of Tenovis Acquisition*—Our recent acquisition ofTenovis could affect our liquidity as the integration of Tenovis’s business andoperations into ours will require significant cash resources.

·       *Debt Ratings*—Our ability to obtain external financing andthe related cost of borrowing are affected by our debt ratings. See “DebtRatings.”

·       *Future Acquisitions*—We may from time to time in the futuremake additional acquisitions. Such acquisitions may require significant amountsof cash or may result in increased debt service requirements to the extent weassume or incur debt in connection with such acquisitions.

***Fair Value ofFinancial Instruments***

The estimated aggregatefair market value of the senior notes decreased from September 30, 2004 by$315 million to $15 million as of June 30, 2005 due to the repurchaseof $271 million principal amount of these senior notes, and the correspondingdecreases in the net premium and termination of the interest rate swaps. TheLYONs estimated aggregate fair value as of September 30, 2004 was $307million, and was completely eliminated following the redemption of allremaining LYONs on December 20, 2004. The secured floating rate noteswhich were assumed in the Tenovis acquisition in November 2004 were repaidduring the second and third quarters of fiscal 2005. In connection with thisrepayment, we terminated the related interest rate swaps. The fair marketvalues are based upon quoted market prices and yields obtained throughindependent pricing sources for the same or similar types of borrowingarrangements taking into consideration the underlying terms of the debt.

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

We conduct our business ona multi-national basis in a wide variety of foreign currencies. We are thereforesubject to the risk associated with foreign currency exchange rates andinterest rates that could affect our results of operations, financial positionand cash flows. We manage our exposure to these market risks through ourregular 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 June 30,2005 and September 30, 2004, the estimated fair values of our foreigncurrency forward contracts were a loss of $17 million and a gain of$8 million, respectively, and were included in other current assets. Theestimated fair values of these forward contracts were based on market quotesobtained through independent pricing sources.

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***Debt Ratings***

Our ability to obtainexternal financing and the related cost of borrowing is affected by our debtratings, which are periodically reviewed by the major credit rating agencies. Debtratings and outlooks as of June 30, 2005 and September 30, 2004 areas follows:
| ** **                       | ** ** | **June 30, 2005**                   | ** **          | **September 30, 2004** | ** ** |
|----------------------------------|------------|-----------------------------------------------|---------------------|----------------------------------|------------|
| ** **                       | ** ** | **  Debt Ratings  ** | ** **          | **Outlook**                      | ** ** | **Debt Ratings** | ** ** | **Outlook** | ** ** |
| Moody’s:                    |       |                                          |                |                             |       |   |   |   |   |   |   |   |   |
| Issuer rating                    |       |                                          | B1                  |                             |       | Positive |   |   | B2 |   |   | Positive |   |
| Senior notes                     |       |                                          | withdrawn during Q2 |                             |       | B1 |   |   | Positive |   |
| Senior implied rating            |       |                                          | Ba3                 |                             |       | Positive |   |   | B1 |   |   | Positive |   |
| Standard & Poor’s: |       |                                          |                |                             |       |   |   |   |   |   |   |   |   |
| Long-term senior unsecured debt  |       |                                          | withdrawn during Q2 |                             |       | B |   |   | Positive |   |
| Senior notes                     |       |                                          | withdrawn during Q1 |                             |       | B+ |   |   | Positive |   |
| Corporate credit                 |       |                                          | BB                  |                             |       | Stable |   |   | B+ |   |   | Positive |   |

 

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. The credit facility wasamended in May 2005 to provide us with the ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquireshares of our common stock in fiscal 2005 up to an amount not to exceed $250million. As of June 30, 2005, we were in compliance with all of thecovenants included in the credit facility.

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 June 30, 2005,there are $55 million of letters of credit issued under the creditfacility. There are no other outstanding borrowings under the facility and theremaining availability is $345 million. We believe the credit facility providesus with an important source of backup liquidity. See Note 8, “Long-Term Debt,”to our consolidated financial statements, for a more detailed discussion of ourcredit facility.

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**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 2004 Annual Report to Shareholders and in any other publicstatements we make *may turn out to be wrong*.They can be affected by inaccurate assumptions we might make or by known orunknown risks and uncertainties. Many factors mentioned in the discussion belowwill be important in determining future results.

Consequently, no forward-looking statement canbe guaranteed and you are cautioned not to place undue reliance on theseforward-looking statements. Actual future results may vary materially.

Except as may be required under the federal securitieslaws, we undertake no obligation to publicly update forward-lookingstatements, whether as a result of new information, future events or otherwise.You are advised, however, to consult any further disclosures we make on relatedsubjects in our 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 could also adversely affectus. 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;

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

·       dependenceon new product development;

·       themix of our products and services;

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

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

·       disruptionassociated with the re-alignment of our sales and marketing efforts;

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

·       theeconomic, political and other risks associated with international sales andoperations, including increased exposure to currency fluctuations and toEuropean economies as a result of our acquisition of Tenovis;

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·       theability to successfully integrate acquired companies, including Tenovis, whichhas required significant management time and attention;

·       theability to attract and retain qualified employees;

·       controlof costs and expenses;

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

·       theability 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***

**Although our revenue has continued to increase since2003, we experienced significant revenue declines during 2001, 2002 and 2003. Inaddition, our U.S. revenues for the quarters ended March 31, 2005 and June 30,2005 declined compared to the same quarters last year. If business capitalspending, particularly for enterprise communications products, applications andservices, does not improve or deteriorates, our revenue may not grow or may decline,and our operating results may be adversely affected.**

Our revenue for the fiscal years ended September 30,2001, 2002 and 2003 was $5,473 million, $4,387 million and $3,796million, respectively. The decline in revenue over this period is attributableto, among other things, declines in the market for our traditional business,enterprise voice communications systems, and the effect of general economicconditions on our customers’ willingness to spend on enterprise communicationstechnology during the last several years. The decline in revenue contributed toour net losses for the fiscal years ended September 30, 2001, 2002 and2003 of $352 million, $666 million and $88 million,respectively, and our accumulated deficit in the amount of $974 million asof September 30, 2004.

Our revenue increased from $3,796 million in fiscal2003 to $4,069 in fiscal 2004 and from $2,993 million in the first ninemonths of fiscal 2004 to $3,606 million in the first nine months of fiscal 2005.Our operating results for the first nine months of fiscal 2005 include theoperating results of Tenovis from November 18, 2004, as well as otheracquisitions. Excluding these acquisitions, our revenues decreased slightlycompared to the nine months ended June 30, 2004.

Our operating results are significantly affected bythe impact of economic conditions on the willingness of enterprises to makecapital investments, particularly in enterprise communications technology andrelated services. Although general economic conditions have improved in recentyears, we believe that enterprises continue to be concerned about their abilityto increase revenues and thereby increase their profitability. Accordingly,they have tried to maintain or improve profitability through cost control andconstrained capital spending. Because it is not certain whether enterpriseswill increase spending on enterprise communications technology significantly inthe near term, we could experience continued pressure on our ability toincrease our revenue.

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

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**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 expand our sales in market segmentswith higher growth rates, our revenue and operating results may continue to beadversely affected.**

We have been experiencing declines in revenue from ourtraditional business, enterprise voice communications systems. We expect, basedon various industry reports, the market segments for these traditional systemsto continue to decline. We are executing a strategy to capitalize on products,advanced communications and appliances that provide higher growth opportunitiesin our market, including IP telephony systems. Many of the products andapplications, including IP telephony systems, have not yet been widely adoptedby enterprises.

Although revenue from sales of IP telephony systemshave exceeded the decline in revenue from sales of traditional enterprise voicecommunications systems, even if we continue to be successful in increasing ourrevenue from sales of IP telephony systems, if revenue from sales oftraditional enterprise voice communications systems declines faster thanrevenue from sales of IP telephony systems increases, our overall revenue andoperating results may 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, reducing ouroverall operating results. Our Avaya Global Services segment may also beadversely affected to the extent that services revenues are related to sales ofthese products and applications.

**A keycomponent of our strategy is our focus on the development and marketing ofadvanced communications products and applications and related services,including IP telephony systems, and this strategy may not be successful or mayadversely affect our business.**

We arefocused on the development and sales of IP telephony systems 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;

·       researchand develop more IP telephony systems and other products and applications thatuse modes of communications other than voice, which has historically been ourcore area of expertise;

·       increasethe performance and reliability of new products and ensure that the performanceand reliability of these products meets 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;

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·       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 not successfullyexecute this strategy, our operating results may be adversely affected.Moreover, even if we successfully address these challenges, our operatingresults may still be adversely affected if the market opportunity for advancedcommunications products, applications and services, including IP telephonysystems, does not develop in the ways that we anticipate. The ratio of revenueattributable to IP telephony systems versus traditional voice communicationsystems is expected to increase as more and more companies convert to IPtelephony systems. IP telephony lines still constitute a very small percentageof global installed enterprise telephony lines and if IP telephony does notgain widespread acceptance in the marketplace as an alternative replacementoption for enterprise telephony systems our overall revenue and operatingresults may be adversely affected. Because this market opportunity is in itsearly stages, we cannot predict whether:

·       thedemand for advanced communications products, applications, and services,including IP telephony systems, 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

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

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

Historically, our GCS businesses have competed againstother providers of enterprise voice communications systems such as NortelNetworks Corporation, Siemens Aktiengesellschaft, Alcatel S.A. and NECCorporation. As we focus on the development and marketing of advancedcommunications systems, such as IP telephony systems, we face intensecompetition from these providers of voice communications systems as well asfrom data networking companies such as Cisco Systems, Inc. and 3Com Corp.We face competition in the small and medium business market from manycompetitors, including Cisco, Nortel, Alcatel, NEC, Matsushita ElectricCorporation of America, Inter-Tel, Incorporated, 3Com Corp., and Mitel NetworksCorp., although the market for these products is fragmented. Our AGS segmentcompetes primarily with NextiraOne, LLC, Norstan, Inc., Siemens andVerizon 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.

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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, thesecompetitors 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 systems from theircurrent data networking vendor than from us. Also, as communications and datanetworks converge, we may face competition from systems integrators that weretraditionally focused on data network integration. We cannot predict withprecision which competitors may enter our markets in the future, what form suchcompetition may take or whether we will be able to respond effectively to theentry of new competitors into our markets or the rapid evolution in technologyand product development that has characterized our markets. In addition, inorder to effectively compete with any new market entrant, we may need to makeadditional investments in our business or use more capital resources than ourbusiness currently requires or reduce prices, which may adversely affect ourprofitability.

***Risks Related To Our Operations***

**If we are unable to effectively integrate the Tenovisbusiness into ours, our operating results may be adversely affected. Even if weare successful, the integration of these businesses has required, and willlikely continue to require, significant resources and management attention,including the effort required to implement disclosure controls and proceduresand to extend our internal control over financial reporting to Tenovis.**

We may not be able to successfully integrate acquiredbusinesses into ours, and therefore we may not be able to realize the intendedbenefits from the acquisition. If we fail to successfully integrate theseacquisitions or if they fail to perform as we anticipated, our existingbusinesses and our revenue and operating results could be adversely affected.If the due diligence and audit of the operations of these acquired businessesperformed by us and by third parties on our behalf was inadequate or flawed, wecould later discover unforeseen financial or business liabilities, or theacquired businesses may not perform as expected. Additionally, acquisitionscould result in difficulties assimilating acquired operations and products, andthe diversion of capital and management’s attention away from other businessissues and opportunities. Acquisitions could also have a negative impact on ourresults of operations if it is subsequently determined that goodwill or otheracquired intangible assets are impaired, thus resulting in an impairment chargein a future period.

In November 2004, we acquired all of the issuedshare capital of Tenovis, a company incorporated and headquartered in Germany,with offices in Austria, Belgium, France, Germany, Italy, Spain, Switzerlandand the Netherlands. From an operational standpoint, the Tenovis integrationeffort was and remains substantial, and requires more significant managerialresources and attention than anticipated. The Tenovis acquisition may be mademore complicated by the fact that it is the largest acquisition we have made todate and we have relatively little experience integrating acquisitions outsidethe United States. Integration of acquired companies in general may result inproblems related to integration of technology, management, personnel orproducts, and we have experienced certain of these problems with Tenovis.

In addition, we are continuing to implement disclosurecontrols and procedures and to extend our internal control over financialreporting to Tenovis. At the same time, we are preparing for our assessment andour external auditor’s review of our internal control over financial reportingin fiscal 2005. This overall assessment is a costly and complex task that issubject to evolving standards, and requires large amounts of 

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internal personnelresources as well as consultants, significant management time and attention,and material amounts of training. Implementing disclosure controls and procedures,extending internal control over financial reporting and performing the requiredassessment at the acquired businesses will likely require additionalsignificant resources and management attention, make our overall assessment andintegration of these acquisitions more complex and may otherwise disrupt ouroperations.

Our ability to implementdisclosure controls and procedures and to extend our internal control overfinancial reporting to Tenovis is made more difficult by several factors thatare set forth in our previously filed Form 10-Q’s for the first andsecond quarters of fiscal 2005.

**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 themajority of our manufacturing operations. Our ability to realize the intendedbenefits of our manufacturing outsourcing initiative depends on the willingnessand ability of our contract manufacturers to produce our products. We mayexperience significant disruption to our operations by outsourcing too much ofour manufacturing. If a contract manufacturer terminates its relationship withus or is unable to fill our orders on a timely basis, we may be unable todeliver the affected products to meet our customers’ orders, which could delayor decrease our revenue or otherwise have an adverse effect on our operations. Additionally,our outsourcing agreement with our most significant contract manufacturer,Celestica, expires in May 2006. The agreement will automatically renew forsuccessive one-year terms unless either party elects to terminate theagreement by giving notice to the other party six months prior to theexpiration of the renewal term. We rely on outside sources for the supply ofthe components of our products and for the finished products that we purchasefrom third parties. Delays or shortages associated with these components couldcause significant disruption to our operations.

**If we are unable toprotect our proprietary rights, our business and future prospects may beharmed.**

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 toownership of intellectual property may arise and our intellectual property mayotherwise become known or independently developed by competitors. The failureto protect our intellectual property could seriously harm our business andfuture prospects because we believe that developing new products and technologythat are unique to us is critical to our success. If we do not obtainsufficient international protection for our intellectual property, ourcompetitiveness in international markets could be significantly impaired, whichwould limit our growth and future revenue.

In addition, we rely onthe security of our information systems, among other things, to protect ourproprietary information and information of our customers. If we do not maintainadequate security procedures over our information systems, we may besusceptible to computer hacking, cyberterrorism or other unauthorized attemptsby third parties to access our proprietary information or that of our customers.Even if we are able to maintain procedures that are adequate to address currentsecurity risks, hackers, cyberterrorists or other unauthorized users maydevelop new techniques that will enable them to successfully circumvent ourcurrent security procedures. The failure to protect our proprietary informationor to comply adequately with data privacy laws could seriously harm ourbusiness and future prospects or expose us to claims by our customers,employees or others that we did not adequately protect their proprietaryinformation.

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***Risks Related to Contingent Liabilities***

**We may 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 its stockholders.The Contribution and Distribution Agreement, among other things, provides that,in general, we will indemnify Lucent for all liabilities including certainpre-distribution tax obligations of Lucent relating to our businesses and allcontingent liabilities primarily relating to our businesses or otherwiseassigned to us. In addition, the Contribution and Distribution Agreementprovides that certain contingent liabilities not directly identifiable with oneof the parties will be shared in the proportion of 90% by Lucent and 10% by us.The Contribution and Distribution Agreement also provides that contingentliabilities in excess of $50 million that are primarily related to Lucent’sbusinesses shall be borne 90% by Lucent and 10% by us and contingent liabilitiesin excess of $50 million that are primarily related to our businessesshall be borne equally by the parties.

Please see Note 13, Commitments andContingencies—Legal Proceedings, to our Consolidated FinancialStatements for a description of certain matters involving Lucent for which wehave assumed responsibility under the Contribution and Distribution Agreement.

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

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

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

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

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

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

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

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

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

See Avaya’s Annual Reporton Form 10-K for the fiscal year ended September 30, 2004 filedwith the SEC on December 13, 2004. As of June 30, 2005, there hasbeen no material change in this information.

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

a) *Evaluation of disclosurecontrols and procedures*.   We have established disclosurecontrols and procedures to ensure that material information relating to us,including our consolidated subsidiaries, is made known to the officers whocertify our reports and to other members of senior management and the Board ofDirectors.

Based on their evaluation as of the end of the periodcovered by this Quarterly Report on Form 10-Q, and subject to thelimitations noted below and in our Form 10-Q’s for the first andsecond fiscal quarters of 2005 as to control systems and our operations ofTenovis, 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) are effectiveto ensure that the information required to be disclosed by us in reports thatwe file or submit under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified inSEC rules and forms.

The Company’s disclosurecontrols are designed to provide a reasonable level of assurance that thestated objectives are met. The Company’s management, including the principalexecutive officer and principal financial officer, does not expect that theCompany’s disclosure controls or internal controls will prevent all errors andall fraud. A control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. The design of a control system must also reflect thefact that there are resource constraints, with the benefits of controlsconsidered relative to their costs. Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within the Company have beenprevented or detected. Because of the inherent limitations in a control system,misstatements due to error or fraud may occur and not be prevented or detected.

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*b) Changes ininternal controls.*

*Tenovis*

We disclosed in our Form 10-Q’s for thefirst and second fiscal quarters of 2005 various issues related to theintegration of Tenovis and the implementation of disclosure controls andprocedures and internal control over financial reporting to Tenovis. Wecontinue to face these issues with respect to Tenovis and are working tocomplete the implementation of these controls and procedures and strengthenthose controls and procedures so that they are comparable to those used in ourother operations. To date, we have successfully implemented controls andprocedures over some of these processes in some of the geographic regions inwhich Tenovis operates, however, significant portions of our implementationplan are still in process.

Other than as described above there were nosignificant changes in our internal control over financial reporting during ourfirst fiscal quarter that have materially affected, or are reasonably likely tomaterially affect our ability to record, process, summarize and reportfinancial information.

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**PART II**

**Item1.**                        *Legal Proceedings*.

See Note 13, “Commitmentsand Contingencies” to the consolidated financial statements.

**Item 2.**                        *Changes in Securities, Use of Proceeds and Issuer Purchases of EquitySecurities.*

On April 19,2005, the Board of Directors authorized a share repurchase plan. Under theprovisions of this plan, Avaya is authorized to repurchase up to $500 millionof its outstanding common stock over the next two years. The Company’s creditfacility currently provides us with the ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquireshares of our common stock in fiscal 2005 up to an amount not to exceed $250million. See Note 8, “Long-Term Debt,” to our consolidated financial statementsfor further information concerning the limitations under the credit facility. Repurchasesunder the plan will be made at management’s discretion in the open market or inprivately negotiated transactions in compliance with applicable securities lawsand other legal requirements and are subject to market conditions, share price,the terms of Avaya’s credit facility and other factors. The following tablesets forth the repurchase activity during the third quarter of fiscal 2005:
| ** **                    | ** ** | **Number of  shares  purchased** | ** ** | **Average  price per  share ** | ** ** | **Total number  of shares  purchased as  part of program ** | ** ** | **Approximate  dollar value of  shares that may  yet be purchased as  part of program*** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 20 - April 30 |       | 4,075,000                             |       |                                     | $          | 8.23                                                                                      |       |                                                                                                                                  |       | 4,075,000 |   |   |   | $ | 466,457,152 |   |   |
| May 1 - May 31      |       | 1,500,000                             |       |                                     | $          | 8.79                                                                                      |       |                                                                                                                                  |       | 1,500,000 |   |   |   | $ | 453,273,245 |   |   |
| June 1 - June 30    |       | —                                |       |                                     | $          | —                                                                                    |       |                                                                                                                                  |       | — |   |   |   | $ | 453,273,245 |   |   |
| Third quarter of  fiscal 2005 |       | 5,575,000                             |       |                                     | $          | 8.38                                                                                      |       |                                                                                                                                  |       | 5,575,000 |   |   |   |   |   |   |

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*       Subject to the limitation in our credit facility noted above.

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

None.

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

None.

**Item5.**                        *Other Information*.

We make available free ofcharge, through our investor relations’ website, *http://investors.Avaya.com*,all of our filings with the SEC as soon as reasonably practicable after suchmaterial is electronically filed with or furnished to the SEC.

**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**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized. 
|                     | AVAYA INC. |
|---------------------|------------|
|                | By:        | /s/  AMARNATH K. PAI |
|                |       | Amarnath  K. Pai |
|                |       | *Vice-President  Finance Operations and  Corporate Controller  (Principal Accounting Officer)* |
| August 9, 2005 |       |   |

 

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