**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**
| x | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|--------------------------------------------------------------------------------------------------------|

 

**Forthe quarterly period ended June 30, 2006**

**or**
| o | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|---------------------------------------------------------------------------------------------------------|

 

**Forthe transition period from**                  to

**CommissionFile Number 001-15951**

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**AVAYA INC.**

(Exact name of registrantas specified in its charter)

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

 

**(908) 953-6000**(Registrant’s telephone number, including area code)

**None**

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

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

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

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

 

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

Asof July 31, 2006, 456,968,444 shares of Common Stock, $.01 par value ofthe registrant 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 |            | 33         |       |
| 3.                                     |       | Quantitative and Qualitative Disclosures About Market  Risk                                 |            | 66         |       |
| 4.                                     |       | Controls and Procedures                                                                     |            | 66         |       |
| **PART II  OTHER INFORMATION**    |       |
| 1.                                     |       | Legal  Proceedings                                                                          |            | 67         |       |
| 1A.                                    |       | Risk Factors                                                                                |            | 67         |       |
| 2.                                     |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                |            | 67         |       |
| 5.                                     |       | Other  Information                                                                          |            | 67         |       |
| 6.                                     |       | Exhibits                                                                                    |            | 68         |       |
|                                   |       | Signatures                                                                                  |            | 69         |       |
|                                        |            |                                                                                             |                 |            |            |          |  |  |

 

This QuarterlyReport on Form 10-Q contains trademarks, service marks andregistered marks of Avaya Inc. and its subsidiaries and other companies,as indicated. Unless otherwise provided in this Quarterly Report on Form 10-Q,trademarks identified by ® and TM are registered trademarks or trademarks,respectively, of Avaya Inc. or its subsidiaries. All other trademarks are theproperties of their respective owners.

2

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**Part I—FinancialInformation**

**Item 1.   *Financial Statements.***

**AVAYAINC.CONSOLIDATED STATEMENTS OF INCOME**

| ** **                                                                                         | ** ** | **Three months ended** | ** ** | **Nine months ended**                          | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **June 30,**                | ** ** | **June 30,**                                        | ** ** |
| ***Dollars in millions, except per share amounts (unaudited)*** | ** ** | ** **                       | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| REVENUE                                                                                            |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales of products                                                                                  |       |                             | $          | 636                                                      |       |   |   | $ | 566 |   |   |   | $ | 1,820 |   |   |   | $ | 1,663 |   |   |
| Services                                                                                           |       |                             | 504        |                                                     |       |   | 497 |   |   |   | 1,492 |   |   |   | 1,472 |   |   |
| Rental and managed services                                                                        |       |                             | 157        |                                                     |       |   | 173 |   |   |   | 472 |   |   |   | 471 |   |   |
|                                                                                               |       |                             | 1,297      |                                                     |       |   | 1,236 |   |   |   | 3,784 |   |   |   | 3,606 |   |   |
| COSTS                                                                                              |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales of products                                                                                  |       |                             | 304        |                                                     |       |   | 265 |   |   |   | 856 |   |   |   | 755 |   |   |
| Services                                                                                           |       |                             | 334        |                                                     |       |   | 325 |   |   |   | 972 |   |   |   | 972 |   |   |
| Rental and managed services                                                                        |       |                             | 71         |                                                     |       |   | 71 |   |   |   | 201 |   |   |   | 198 |   |   |
|                                                                                               |       |                             | 709        |                                                     |       |   | 661 |   |   |   | 2,029 |   |   |   | 1,925 |   |   |
| GROSS MARGIN                                                                                       |       |                             | 588        |                                                     |       |   | 575 |   |   |   | 1,755 |   |   |   | 1,681 |   |   |
| OPERATING  EXPENSES                                                                                |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative                                                                |       |                             | 423        |                                                     |       |   | 406 |   |   |   | 1,207 |   |   |   | 1,169 |   |   |
| Research and development                                                                           |       |                             | 115        |                                                     |       |   | 93 |   |   |   | 318 |   |   |   | 296 |   |   |
| Restructuring charges                                                                              |       |                             | 22         |                                                     |       |   | — |   |   |   | 42 |   |   |   | — |   |   |
| TOTAL OPERATING EXPENSES                                                                           |       |                             | 560        |                                                     |       |   | 499 |   |   |   | 1,567 |   |   |   | 1,465 |   |   |
| OPERATING INCOME                                                                                   |       |                             | 28         |                                                     |       |   | 76 |   |   |   | 188 |   |   |   | 216 |   |   |
| Other income (expense), net                                                                        |       |                             | 5          |                                                     |       |   | 4 |   |   |   | 16 |   |   |   | (34 | ) |   |
| Interest expense                                                                                   |       |                             | —     |                                                     |       |   | (3 | ) |   |   | (3 | ) |   |   | (18 | ) |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE INCOME  TAXES                                             |       |                             | 33         |                                                     |       |   | 77 |   |   |   | 201 |   |   |   | 164 |   |   |
| (Benefit from) provision for income taxes                                                          |       |                             | (11        | )                                                        |       |   | (117 | ) |   |   | 48 |   |   |   | (99 | ) |   |
| INCOME FROM CONTINUING OPERATIONS                                                                  |       |                             | 44         |                                                     |       |   | 194 |   |   |   | 153 |   |   |   | 263 |   |   |
| (LOSS) FROM DISCONTINUED OPERATIONS                                                                |       |                             | —     |                                                     |       |   | — |   |   |   | — |   |   |   | (2 | ) |   |
| **NET INCOME**                                                                                     |       | ** **                       | **$**      | **44**                                                   |       | ** ** | ** ** | **$** | **194** |   | ** ** | ** ** | **$** | **153** |   | ** ** | ** ** | **$** | **261** |   |   |
| **Earnings  Per Common Share—Basic:**                                                         |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from continuing operations                                                      |       |                             | $          | 0.10                                                     |       |   |   | $ | 0.41 |   |   |   | $ | 0.33 |   |   |   | $ | 0.56 |   |   |
| (Loss) per share from discontinued operations                                                      |       |                             | —     |                                                     |       |   | — |   |   |   | — |   |   |   | (0.01 | ) |   |
| Earnings per share                                                                                 |       |                             | $          | 0.10                                                     |       |   |   | $ | 0.41 |   |   |   | $ | 0.33 |   |   |   | $ | 0.55 |   |   |
| **Earnings  Per Common Share—Diluted:**                                                       |       |                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from continuing operations                                                      |       |                             | $          | 0.10                                                     |       |   |   | $ | 0.40 |   |   |   | $ | 0.32 |   |   |   | $ | 0.54 |   |   |
| Earnings per share from discontinued operations                                                    |       |                             | —     |                                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Earnings per  share                                                                                |       |                             | $          | 0.10                                                     |       |   |   | $ | 0.40 |   |   |   | $ | 0.32 |   |   |   | $ | 0.54 |   |   |
|                                                                                                    |            |                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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**AVAYAINC.CONSOLIDATED BALANCE SHEETS**
| *Dollars in millions, except per share amounts (unaudited)*                                                                                                                                        | ** ** | ** ** | ** ** | **June 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                            |       |       |       |                        |       |                             |       |   |   |
| Current assets:                                                                                                                                                                                                                       |       |       |       |                        |       |                             |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                             |       |       | $          | 822                         |       |                             |       | $ | 750 |   |   |
| Accounts receivable, less allowances of $51 million  and $58 million as of June 30, 2006 and September 30, 2005,  respectively                                                                                              |       |       | 818        |                        |       |                             | 862        |   |   |
| Inventory                                                                                                                                                                                                                             |       |       | 296        |                        |       |                             | 288        |   |   |
| Deferred tax asset, net                                                                                                                                                                                                               |       |       | 149        |                        |       |                             | 143        |   |   |
| Other current assets                                                                                                                                                                                                                  |       |       | 178        |                        |       |                             | 128        |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                                                 |       |       | 2,263      |                        |       |                             | 2,171      |   |   |
| Property, plant and equipment, net                                                                                                                                                                                                    |       |       | 678        |                        |       |                             | 738        |   |   |
| Deferred tax asset, net                                                                                                                                                                                                               |       |       | 866        |                        |       |                             | 911        |   |   |
| Intangible assets                                                                                                                                                                                                                     |       |       | 294        |                        |       |                             | 337        |   |   |
| Goodwill                                                                                                                                                                                                                              |       |       | 948        |                        |       |                             | 914        |   |   |
| Other assets                                                                                                                                                                                                                          |       |       | 174        |                        |       |                             | 148        |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                                     |       | ** ** | **$**      | **5,223**                   |       | ** **                       | ** ** | **$** | **5,219** |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                        |       |       |       |                        |       |                             |       |   |   |
| Current liabilities:                                                                                                                                                                                                                  |       |       |       |                        |       |                             |       |   |   |
| Accounts payable                                                                                                                                                                                                                      |       |       | $          | 395                         |       |                             |       | $ | 402 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                                       |       |       | 306        |                        |       |                             | 300        |   |   |
| Deferred revenue                                                                                                                                                                                                                      |       |       | 268        |                        |       |                             | 244        |   |   |
| Other current liabilities                                                                                                                                                                                                             |       |       | 319        |                        |       |                             | 373        |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                                            |       |       | 1,288      |                        |       |                             | 1,319      |   |   |
| Benefit obligations                                                                                                                                                                                                                   |       |       | 1,624      |                        |       |                             | 1,561      |   |   |
| Deferred tax liability, net                                                                                                                                                                                                           |       |       | 82         |                        |       |                             | 96         |   |   |
| Other liabilities                                                                                                                                                                                                                     |       |       | 270        |                        |       |                             | 282        |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                                        |       |       | 1,976      |                        |       |                             | 1,939      |   |   |
| 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, 457,975,112 and  471,328,963 issued (including 403,195 and 207,053 treasury shares) as of  June 30, 2006 and September 30, 2005, respectively |       |       | 5          |                        |       |                             | 5          |   |   |
| Additional paid-in-capital                                                                                                                                                                                                            |       |       | 2,689      |                        |       |                             | 2,895      |   |   |
| Retained earnings (accumulated deficit)                                                                                                                                                                                               |       |       | 100        |                        |       |                             | (53        | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                                                  |       |       | (830       | )                           |       |                             | (883       | ) |   |
| Less: Treasury stock at cost                                                                                                                                                                                                          |       |       | (5         | )                           |       |                             | (3         | ) |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                      |       |       | 1,959      |                        |       |                             | 1,961      |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                  |       | ** ** | **$**      | **5,223**                   |       | ** **                       | ** ** | **$** | **5,219** |   |   |

 

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

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**AVAYAINC.CONSOLIDATED STATEMENTS OF CASH FLOWS**
|                                                                                                           | ** **   | **Nine months ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------|--------------|---------------------------------|------------|
| ** **                                                                                                | ** **   | **June 30,**               | ** ** |
| ***Dollars in millions (unaudited)***                                                      | *** *** | *** ***                    | ** ** | **   2006   ** | ** ** | **2005** | ** ** |
| **OPERATING ACTIVITIES:**                                                                                 |         |                            |       |   |   |   |   |
| Net income                                                                                                |         |                            | $          | 153 |   |   | $ | 261 |   |
| Less: Loss from  discontinued operations, net                                                             |         |                            | —     |   |   | (2 | ) |
| Income from continuing  operations                                                                        |         |                            | 153        |   |   | 263 |   |
| Adjustments to reconcile income from continuing  operations to net cash provided by operating activities: |         |                            |       |   |   |   |   |
| Depreciation and  amortization                                                                            |         |                            | 202        |   |   | 202 |   |
| Amortization of  restricted stock units                                                                   |         |                            | 11         |   |   | 7 |   |
| Share-based compensation                                                                                  |         |                            | 11         |   |   | — |   |
| Restructuring charges                                                                                     |         |                            | 42         |   |   | — |   |
| Deferred income taxes                                                                                     |         |                            | 24         |   |   | (7 | ) |
| Impairment charges                                                                                        |         |                            | 29         |   |   | — |   |
| Reversal of liabilities  related to tax settlements                                                       |         |                            | (25        | ) |   | (116 | ) |
| Provision for  uncollectible receivables                                                                  |         |                            | 8          |   |   | 11 |   |
| Loss on extinguishment  of debt, net                                                                      |         |                            | —     |   |   | 44 |   |
| Purchased in -process  research and development                                                           |         |                            | —     |   |   | 4 |   |
| Unrealized losses on  foreign currency exchange                                                           |         |                            | 11         |   |   | 14 |   |
| Adjustments for other  non-cash items, net                                                                |         |                            | (1         | ) |   | (8 | ) |
| Changes in operating assets and liabilities, net of  effects of acquired businesses:                      |         |                            |       |   |   |   |   |
| Receivables                                                                                               |         |                            | 40         |   |   | (19 | ) |
| Inventory                                                                                                 |         |                            | (4         | ) |   | 2 |   |
| Restricted cash                                                                                           |         |                            | 1          |   |   | 9 |   |
| Accounts payable                                                                                          |         |                            | (12        | ) |   | (29 | ) |
| Payroll and benefits                                                                                      |         |                            | 42         |   |   | (134 | ) |
| Restructuring reserve                                                                                     |         |                            | (56        | ) |   | — |   |
| Accrued interest payable  on long-term debt                                                               |         |                            | —     |   |   | (28 | ) |
| Deferred revenue                                                                                          |         |                            | 29         |   |   | (3 | ) |
| Other assets and  liabilities                                                                             |         |                            | (49        | ) |   | (26 | ) |
| NET CASH PROVIDED BY  OPERATING ACTIVITIES                                                                |         |                            | 456        |   |   | 186 |   |
| **INVESTING ACTIVITIES:**                                                                                 |         |                            |       |   |   |   |   |
| Capital expenditures                                                                                      |         |                            | (83        | ) |   | (97 | ) |
| Capitalized software  development costs                                                                   |         |                            | (53        | ) |   | (44 | ) |
| Acquisitions of  businesses, net of cash acquired                                                         |         |                            | —     |   |   | (383 | ) |
| (Payments for)  discontinued operations                                                                   |         |                            | —     |   |   | (3 | ) |
| Proceeds from sales of  property, plant and equipment                                                     |         |                            | 2          |   |   | 30 |   |
| Other investing  activities, net                                                                          |         |                            | (5         | ) |   | 19 |   |
| NET CASH (USED FOR)  INVESTING ACTIVITIES                                                                 |         |                            | (139       | ) |   | (478 | ) |
| **FINANCING ACTIVITIES:**                                                                                 |         |                            |       |   |   |   |   |
| Issuance of common stock                                                                                  |         |                            | 20         |   |   | 45 |   |
| Repurchase of common  stock                                                                               |         |                            | (256       | ) |   | (47 | ) |
| Repayment of long-term  debt                                                                              |         |                            | (14        | ) |   | (576 | ) |
| Other financing  activities, net                                                                          |         |                            | —     |   |   | (4 | ) |
| NET CASH (USED FOR)  FINANCING ACTIVITIES                                                                 |         |                            | (250       | ) |   | (582 | ) |
| Effect of exchange rate  changes on cash and cash equivalents                                             |         |                            | 5          |   |   | (8 | ) |
| Net increase (decrease)  in cash and cash equivalents                                                     |         |                            | 72         |   |   | (882 | ) |
| Cash and cash  equivalents at beginning of fiscal year                                                    |         |                            | 750        |   |   | 1,617 |   |
| Cash and cash equivalents at end of period                                                                |         |                            | $          | 822 |   |   | $ | 735 |   |
|                                                                                                           |              |                                 |            |  |  |  |  |  |  |  |  |

 

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

5

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**AVAYA INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

**1.**   Backgroundand Basis of Presentation

***Background***

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

***Basis of Presentation***

The accompanying unaudited Consolidated FinancialStatements as of June 30, 2006 and for the three and nine months ended June 30,2006 and 2005, have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialstatements and the rules and regulations of the United States Securitiesand Exchange Commission (“SEC”) for interim financial statements, and should beread in conjunction with the Company’s Consolidated Financial Statements andother financial information for the fiscal year ended September 30, 2005,included in its Annual Report on Form 10-K filed with the SEC on December 13,2005. In the Company’s opinion, the unaudited interim Consolidated FinancialStatements reflect all adjustments, consisting of normal and recurringadjustments, necessary for a fair presentation of the financial condition,results of operations and cash flows for the periods indicated.

Certain prior year amounts have been reclassified toconform to the current interim period presentation, including the followingitems:

·       Debtmaturing within one year (including capital lease obligations) of $5 million asof September 30, 2005 has been reclassified to “Other current liabilities” to conform to the current periodpresentation.

·       Long-termdebt (including capital lease obligations) of $25 million as of September 30,2005 has been reclassified to “Other  liabilities” to conform to the current periodpresentation.

The reclassificationsdescribed above did not affect the split between current and long-termliabilities. The consolidated results of operationsfor the interim periods reported are not necessarily indicative of the resultsto be experienced for the entire fiscal year.

**2.**   Summaryof Significant Accounting Policies

***Share-based Compensation***

On October 1, 2005,the Company adopted Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires themeasurement and recognition of compensation expense for all share-based paymentawards made to employees and directors including employee stock options andemployee stock purchases related to the 2003 Employee Stock Purchase Plan (“employeestock purchases”) based on estimated fair values. SFAS 123(R) supersedesthe Company’s previous accounting under Accounting Principles Board Opinion No. 25,“Accounting for 

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StockIssued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005,the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating toSFAS 123(R). The Company has applied 

the provisions of SAB 107in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of October 1, 2005, the first day of the Company’sfiscal year 2006. The Company’s Consolidated Financial Statements as of and forthe three and nine months ended June 30, 2006 reflect the impact of SFAS123(R). In accordance with the modified prospective transition method, theCompany’s Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Share-basedcompensation expense recognized under SFAS 123(R) for the three and ninemonths ended June 30, 2006 was $3 million and $11 million, respectively,on a pre-tax basis and was related to stock options and the discount onemployee stock purchases. There was no share-based compensation expense relatedto employee stock options and employee stock purchases recognized during thethree or nine months ended June 30, 2005.

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

Share-based compensation expense recognized during thecurrent period is based on the value of the portion of share-based paymentawards that is ultimately expected to vest. SFAS 123(R) requires forfeituresto be estimated at the time of grant in order to estimate the amount ofshare-based awards that will ultimately vest. The estimate is based on theCompany’s historical rates of forfeiture. Share-based compensation expenserecognized in the Company’s Consolidated Statements of Income for the three andnine months ended June 30, 2006 includes (i) compensation expense forshare-based payment awards granted prior to, but not yet vested as of September 30,2005, based on the grant-date fair value estimated in accordance with the proforma provisions of SFAS 123 and (ii) compensation expense for theshare-based payment awards granted subsequent to September 30, 2005, basedon the grant-date fair value estimated in accordance with the provisions ofSFAS 123(R). As share-based compensation expense recognized in the ConsolidatedStatements of Income for the three and nine months ended June 30, 2006 isbased on awards ultimately expected to vest, it has been reduced for estimatedforfeitures. In the Company’s pro forma information required under SFAS 123 forthe periods prior to fiscal 2006, the Company accounted for forfeitures as theyoccurred.

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

On November 10, 2005,the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. SFAS123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based 

7

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Payment Awards.” Thealternative transition method includes simplified methods to establish the beginningbalance of the additional paid-in capital pool (“APIC pool”) related to the taxeffects of employee share-based compensation, and to determine the subsequentimpact on the APIC pool and Consolidated Statements of Cash Flows of the taxeffects of employee share-based compensation awards that are outstanding uponadoption of SFAS 123(R). The Company is in the process of evaluating whether toadopt the provisions of SFAS 123(R)-3.

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

| ** **                                                                        | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ***Dollars in millions, except per share amounts*** | ** ** | ** **                       | ** ** | **June 30, 2006**     | ** ** | **June 30, 2006** | ** ** |
| Income from continuing  operations before income taxes                            |       |                             | $          | 3                               |       |   |   | $ | 11 |   |   |
| In come from continuing  operations                                               |       |                             | $          | 2                               |       |   |   | $ | 8 |   |   |
| Net income available to  common stockholders                                      |       |                             | $          | 2                               |       |   |   | $ | 8 |   |   |
| Earnings per Common Share — Basic :                                          |       |                             |       |                            |       |   |   |   |   |
| Income from continuing  operations                                                |       |                             | $          | —                          |       |   |   | $ | 0.02 |   |   |
| Net  income                                                                       |       |                             | $          | —                          |       |   |   | $ | 0.02 |   |   |
| Earnings per Common Share —  Diluted :                                       |       |                             |       |                            |       |   |   |   |   |
| Income  from continuing operations                                                |       |                             | $          | —                          |       |   |   | $ | 0.02 |   |   |
| Net income                                                                        |       |                             | $          | —                          |       |   |   | $ | 0.02 |   |   |
|                                                                                   |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

| ** **                                                                                                                 | ** ** | **Three months ended** | ** **                  | **Nine months ended** | ** **                  |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-----------------------------|---------------------------------|-----------------------------|
| ***Dollars in millions, except per share amounts***                                          | ** ** | ** **                       | **June 30, 2005** | ** **                      | **June 30, 2005** | ** ** |
| Net income available to  common stockholders , as reported                                                                 |       |                             | $                           | 194                             |                        |   |   | $ | 261 |   |   |
| Add : Stock-based  employee compensation expense included in reported net income, net of related  tax effects              |       |                             | 1                           |                            |                        |   | 4 |   |   |
| Deduct: Total  stock-based compensation expense determined under the fair value based method  , net of related tax effects |       |                             | (9                          | )                               |                        |   | (28 | ) |   |
| Net income available to  common stockholders , pro forma                                                                   |       |                             | $                           | 186                             |                        |   |   | $ | 237 |   |   |
| Earnings per Common  Share — Basic:                                                                                   |       |                             |                        |                            |                        |   |   |   |   |
| As reported                                                                                                                |       |                             | $                           | 0.41                            |                        |   |   | $ | 0.55 |   |   |
| Pro forma                                                                                                                  |       |                             | $                           | 0.39                            |                        |   |   | $ | 0.50 |   |   |
| Earnings per Common Share  — Diluted :                                                                                |       |                             |                        |                            |                        |   |   |   |   |
| As reported                                                                                                                |       |                             | $                           | 0.40                            |                        |   |   | $ | 0.54 |   |   |
| Pro forma                                                                                                                  |       |                             | $                           | 0.38                            |                        |   |   | $ | 0.49 |   |   |
|                                                                                                                            |            |                                  |                             |                                 |                             |  |  |  |  |  |  |  |  |

 

***Change in Vacation Policy***

Effective January 1,2006, the Company changed its policy with respect to vacation carryover forsubstantially all U.S. nonrepresented employees. For these employees, vacationcarryover into future fiscal years is no longer permitted. The Company alsochanged its accrual period to correspond with the Company’s fiscal year ratherthan calendar year. This change resulted in a $21 million reduction in thevacation accrual during the nine months ended June 30, 2006. Thisreduction is comprised of vacation days forfeited at the end of the calendaryear and a reduction in the liability due to a higher than historical amount ofvacation days taken from October 1, 2005 through December 31, 2005.The reduction was recorded in cost of goods sold and operating expenses in bothof our operating segments and corporate/other unallocated amounts based on thefunctional areas of the affected employees.

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***Impairment of Internal Use Software***

The Company recorded a non-cash pre-tax impairmentcharge of approximately $28 million in the third quarter of fiscal 2006. Thischarge is related to the development of three components of internal-usesoftware designed to simplify the process of creating tickets for serviceorders, the process of taking an order through its systems and other aspects ofits financial systems.

The impairment was recognized and measured inaccordance with the provisions of SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets” and AICPA Statement of Position 98-1,“Accounting for Costs of Computer Software Developed or Obtained for InternalUse.” During fiscal 2006, the Company commenced an assessment of all of itsinternal-use software and its SAP architecture as well as the development of aninformation technology (“IT”) roadmap. This evaluation resulted in the decisionto maximize the use of new SAP licenses and the Company concluded, during thethird quarter of fiscal 2006, that it was no longer probable that theinternal-use software described above would be completed or placed intoservice. This decision was further reinforced based upon several third quarterevents including the evaluation and advice of third party consultants that theprevious software components would not be economical to complete and cessationof discussions with an external IT service vendor on a potential outsourcedknowledge management solution that would have utilized one of the threesoftware components.

The internal-use softwarewhich was recorded as a corporate asset and not allocated to either of theCompany’s segments, must be reported at the lower of its carrying amount orfair value, which was determined to be zero. The charge of $28 million isrecorded in the selling, general and administrative expenses line item in theCompany’s Consolidated Statements of Income for the corporate / otherunallocated amounts caption for the three and nine months ended June 30,2006.

***Revenue Recognition***

The Company derives revenue primarily from the saleand service of communication systems and applications. In accordance with SECStaff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB 104”),revenue is recognized when persuasive evidence of an arrangement exists,delivery has occurred, the fee is fixed and determinable, collectibility isreasonably assured, contractual obligations have been satisfied and title andrisk of loss have been transferred to the customer.

The Company’s products aresold directly through its worldwide sales force and indirectly through itsglobal network of distributors, dealers, value-added resellers and systemintegrators. The purchase price of the Company’s products typically includesinstallation and a warranty for up to one year. Revenue from the direct salesof products that include installation services is recognized at the time theproducts are installed, after satisfaction of all the terms and conditions ofthe underlying customer contract. When the Company provides a combination ofproducts and services to customers, the arrangement is evaluated under EmergingIssues Task Force Issue (“EITF”) No. 00-21, “Revenue Arrangementswith Multiple Deliverables” (“EITF 00-21”), which is effective for theCompany for transactions entered into after July 1, 2003. EITF 00-21addresses certain aspects of accounting by a vendor for arrangements underwhich the vendor will perform multiple revenue generating activities. Theapplication of EITF 00-21 did not have a material effect on the Company’sconsolidated results of operations, financial position or cash flows.

The Company’s indirect sales to distributionpartners are generally recognized at the time of shipment if all contractual obligationshave been satisfied. The Company accrues a provision for estimated salesreturns and other allowances and deferrals relating to inventory levels held bydistributors, promotional marketing programs, etc. as a reduction of revenue atthe time of revenue recognition, as required by EITF 01-9,“Accounting forConsideration Given by a Vendor to a Customer” and SAB 104.

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The Company also derives revenue from: (i) supplementalmaintenance services, including services provided under contracts to monitor andoptimize customers’ communications network performance, and on a time andmaterials basis; (ii) professional services for implementation andintegration of converged voice and data networks, network security and unifiedcommunications; and (iii) managed services provided to customers who havechosen bundled solutions and enhanced services not included in basicmaintenance contracts for messaging and other parts of communications systems.Maintenance contracts typically have terms that range from one to five years.Contracts for professional services typically have terms that range from two tofour weeks for standard solutions and from six months to one year forcustomized solutions. Contracts for managed services typically have terms thatrange from one to seven years. Revenue from services performed under managedservices arrangements, professional services and services performed undermaintenance contracts is accounted for in accordance with FASB TechnicalBulletin No. 90-1 “Accounting for Separately Priced ExtendedWarranty and Product Maintenance Contracts,” and is deferred and recognizedratably over the term of the underlying customer contract or at the end of thecontract, when obligations have been satisfied. For services performed on atime and materials basis, revenue is recognized upon performance.

The Company also sellsproprietary voice application software products. The Company recognizes revenuerelated to these sales in accordance with AICPA Statement of Position 97-2,“Software Revenue Recognition.” In multiple element software arrangements, theCompany allocates revenue to each element based on its relative fair value. Thefair value of any undelivered element is determined using vendor-specificobjective evidence (“VSOE”) or, in the absence of VSOE for all elements, theresidual method when VSOE exists for all of the undelivered elements. In theabsence of fair value for a delivered element, the Company first allocatesrevenue based on VSOE of the undelivered elements and the residual revenue tothe delivered elements. Where VSOE of the undelivered element cannot bedetermined, the Company defers revenue for the delivered elements until theundelivered elements are delivered.

**3.**   RecentAccounting Pronouncements 

**FIN 48**

In July 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes - an interpretation of SFAS No. 109” (“FIN 48”). FIN 48 clarifiesthe accounting for uncertainty in income tax positions that the Company hastaken or expects to take with respect to a tax refund. The pronouncementprescribes a more-likely-than-not threshold for recognition as well asmeasurement criteria for changes in such tax positions for financial statementpurposes. In addition, FIN 48 also requires additional qualitative and quantitativedisclosures or unrecognized tax benefits to be included in the notes to thefinancial statements. The Company will be required to adopt the provisions ofFIN 48 beginning in fiscal 2008. The Company is currently assessing the impactof the adoption of FIN 48 on its Consolidated Financial Statements.

**SFAS 156**

In March 2006, theFASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets -an amendment of FASB Statement SFAS No. 140” (“SFAS 156”). SFAS 156simplifies the accounting for loan servicing rights and the financialinstruments used to hedge risks associated with those rights. SFAS 156 requiresthat servicing rights be valued initially at fair value, and subsequentlyaccounted for at either fair value, or amortized over the economic life of therelated lease. The Company will adopt the provisions of SFAS 156 beginning infiscal 2007. The implementation of SFAS 156 is not expected to have a materialimpact on the Company’s Consolidated Financial Statements.

**SFAS 155**

In February 2006, theFASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments - an amendment to FASB Statements No. 133 and 140” (“SFAS 155”).SFAS 155 simplifies 

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theaccounting for certain hybrid financial instruments containing embedded derivatives.SFAS 155 allows fair value measurement for any hybrid financial instrument thatcontains an embedded derivative that otherwise would require bifurcation underSFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” Inaddition, it amends SFAS 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities” to allow a qualifyingspecial-purpose entity to hold a derivative financial instrument that pertainsto a beneficial interest other than another derivative financial instrument.The Company will adopt the provisions of SFAS 155 beginning in fiscal 2007. Theimplementation of SFAS 155 is not expected to have a material impact on theCompany’s Consolidated Financial Statements.

**FIN 47**

In March 2005,the FASB issued Interpretation No. 47, “Accounting for Conditional AssetRetirement Obligations, an Interpretation of FASB Statement No. 143” (“FIN47”). FIN 47 clarifies the term “conditional asset retirement obligation” usedin FASB Statement No. 143, “Accounting for Asset Retirement Obligations,”and refers to a legal obligation to perform an asset retirement activity inwhich the timing and (or) method of settlement are conditional on a futureevent that may or may not be within the control of the Company. The obligationto perform the asset retirement activity is unconditional even thoughuncertainty exists about the timing and (or) method of settlement. Accordingly,FIN 47 requires the Company to recognize a liability for the fair value of aconditional asset retirement obligation if the fair value of the liability canbe reasonably estimated. The fair value of a liability for the conditionalasset retirement obligation is to be recognized when incurred. FIN 47 will beadopted by the Company in the fourth quarter of fiscal 2006 and is not expectedto have a material impact on the Company’s Consolidated Financial Statements.

**SFAS 154**

In December 2004, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections - areplacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS154”). SFAS 154 changes the requirements for the accounting for, and reportingof, a change in accounting principle. SFAS 154 requires that a voluntary changein accounting principle be applied retrospectively with all prior periodfinancial statements presented using the new accounting principle. The Companywill adopt the provisions of SFAS 154 beginning in fiscal 2007. Theimplementation of SFAS 154 is not expected to have a material impact on theCompany’s Consolidated Financial Statements.

**4.**   BusinessCombinations

***Acquisition of Tenovis***

On November 18, 2004, the Company completed itsacquisition of Tenovis Germany GmbH (“Tenovis”). Tenovis is the parent companyof Avaya-Tenovis GmbH & Co. KG (formerly Tenovis GmbH & Co.KG), a major European provider of enterprise communications systems andservices. The acquisition of Tenovis significantly expanded the Company’sEuropean operations and increased the Company’s access to European customers,particularly in Germany. At the date of acquisition, the Company recordedTenovis’s accounts receivable, inventory, fixed assets, liabilities andidentified intangibles at estimated fair value. The remainder of the purchaseprice in excess of the net assets acquired was recorded as goodwill, which wasallocated $400 million to the Global Communications Solutions (“GCS”) segmentand $206 million to the Avaya Global Services (“AGS”) segment. None of thegoodwill, intangibles or in-process research and development amounts isexpected to be deductible for tax purposes. The Company allocated $298 millionto intangible assets (including contractual customer relationships, existingtechnology and trademarks) based on valuation studies performed with theassistance of third party valuation consultants. These intangible assets arebeing amortized over their estimated useful lives. The weighted average usefullives of the existing technology, customer relationships and trademarks are 5 

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years, 6 years and 1.5years, respectively. In addition, the Company allocated $1 million toin-process research and development, which was charged to research anddevelopment expense in the Consolidated Statements of Income during the firstquarter of fiscal 2005.

The following tablesummarizes the estimated fair values of the acquired assets and assumedliabilities as of the acquisition date:

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

 

The Company recorded a restructuring liability of $106million in connection with the acquisition to reflect the estimate ofrestructuring-related costs in accordance with EITF 95-3, “Recognition ofLiabilities in Connection with a Purchase Business Combination.” This liabilityis for costs incurred to terminate Tenovis employees as part of the integrationof Tenovis operations. The plan, which was completed during fiscal 2005,provided for the termination of certain employees across various Tenovisfunctional groups and subsidiaries, including sales, operations, finance andhuman resources. Most of the terminations were completed by June 30, 2006.The Company paid cash of $8 million and $36 million for termination benefitsduring the three and nine months ended June 30, 2006, respectively. Duringthe second quarter of fiscal 2006, the Company increased the restructuringliability by $5 million for higher-than-originally-expected per employeeseparation payments in Germany, which is included in the ConsolidatedStatements of Income. The accrual of $39 million as of June 30, 2006reflects the estimated remaining termination payments adjusted for foreigncurrency fluctuations since the acquisition date.

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

The following unaudited pro forma financialinformation presents the Company’s results for the nine months ended June 30,2005 as if the Tenovis acquisition had occurred at the beginning of the period,as compared with the as reported results for the same period in fiscal 2006:

| ** **                                                                        | ** ** | **Nine months ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ***Dollars in millions, except per share amounts*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                        | ** ** | **(as reported)**                             | ** ** | **(pro forma)** | ** ** |
| Revenue                                                                           |       |                                               | $          | 3,784 |   |   |   | $ | 3,709 |   |   |
| Net income                                                                        |       |                                               | $          | 153 |   |   |   | $ | 235 |   |   |
| Earnings per  share—basic                                                    |       |                                               | $          | 0.33 |   |   |   | $ | 0.50 |   |   |
| Earnings per share—diluted                                                   |       |                                               | $          | 0.32 |   |   |   | $ | 0.48 |   |   |
|                                                                                   |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |

 

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The pro forma results for the nine months ended June 30,2005 have been prepared for comparative purposes only and include certainadjustments such as additional estimated depreciation and amortization expenseas a result of identifiable intangible assets arising from the acquisition. Thepro forma results are not necessarily indicative of the results of operationsthat actually would have resulted had the acquisition been in effect at thebeginning of the period or of future results.

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

The second non-consolidated VIE is a non-U.S.telecommunications hardware product manufacturer and service provider. TheCompany has agreed to purchase from the VIE certain amounts of products andservices, and the VIE has contracted for the Company to provide certain ITservices and purchasing services with respect to raw materials. These contractsexpire in August 2007. During the three and nine months ended June 30,2006, the Company purchased products and services aggregating $9 million and$28 million, respectively. Additionally, the Company is required to pay monthlyrental subsidies on the VIE’s premises, and in the event the VIE is unable topay its portion of the rental payments, the Company is liable for their portionas well. During the nine months ended June 30, 2006, the Company paid aninsignificant amount in connection with rental subsidies. The maximum exposureto loss as of June 30, 2006 for the remainder of the agreement is theminimum purchase order commitments and the minimum service levels for servicecontracts of $6 million.

The one consolidated VIEwas related to secured floating rate notes assumed with the acquisition ofTenovis, all of which were repaid during fiscal 2005. Therefore, this VIE nolonger exists.

***Discontinued Operations***

There was no revenue orincome before income taxes from discontinued operations for the three or ninemonths ended June 30, 2006. During the nine months ended June 30,2005, the Company incurred a $2 million loss on the sale of the Company’sConnectivity Solutions business primarily as the result of the finalization ofa working capital adjustment in accordance with the terms of the asset purchaseagreement.

**5.**   Goodwilland Intangible Assets

Thechanges in the carrying value of goodwill for the nine months ended June 30,2006 by operating segment are as follows:

| ** **                                 | ** ** | **Global**         | ** ** | **Avaya**     | ** ** | ** **   | ** ** |
|--------------------------------------------|------------|--------------------|------------|---------------|------------|--------------|------------|
| ** **                                 | ** ** | **Communications** | ** ** | **Global**    | ** ** | ** **   | ** ** |
| ***Dollars in millions***        | ** ** | ** **         | ** ** | **Solutions** | ** ** | **Services** | ** ** | **Total** | ** ** |
| **Balance  as of September 30, 2005** | ** ** | ** **         | **$**      | **642**       | ** ** | ** **   | ** ** | **$** | **272** | ** ** | ** ** | **$** | **914** |   |
| Impact of foreign  currency fluctuations   |       |               | 22         |          |       |         | 12         |   |   | 34 |   |
| **Balance as of June 30, 2006**       | ** ** | ** **         | **$**      | **664**       | ** ** | ** **   | ** ** | **$** | **284** | ** ** | ** ** | **$** | **948** | ** ** |
|                                            |            |                    |            |               |            |              |            |  |  |  |  |  |  |  |  |  |

** **

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

| ** **                                    | ** ** | **June 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **Gross**                   | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**                | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ***Dollars in millions***           | ** ** | ** **                  | ** ** | **Amount**                       | ** ** | **Accumulated** | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| Existing  technology                          |       |                        | $          | 103                              |       |   |   | $ | 53 |   |   | $ | 50 |   |   | $ | 101 |   |   |   | $ | 41 |   |   | $ | 60 |   |
| Customer  relationships and other intangibles |       |                        | 294        |                             |       |   | 83 |   |   | 211 |   |   | 288 |   |   |   | 45 |   |   | 243 |   |
| **Total  amortizable intangible assets**      | ** ** | ** **                  | **$**      | **397**                          | ** ** | ** ** | ** ** | **$** | **136** | ** ** | ** ** | **$** | **261** | ** ** | ** ** | **$** | **389** | ** ** | ** ** | ** ** | **$** | **86** | ** ** | ** ** | **$** | **303** |   |
| Minimum pension  adjustment, net of tax       |       |                        | 33         |                             |       |   | — |   |   | 33 |   |   | 34 |   |   |   | — |   |   | 34 |   |
| **Total intangible assets**                   |       |                        | **$**      | **430**                          | ** ** | ** ** | ** ** | **$** | **136** | ** ** | ** ** | **$** | **294** | ** ** | ** ** | **$** | **423** | ** ** | ** ** | ** ** | **$** | **86** | ** ** | ** ** | **$** | **337** |   |
|                                               |            |                             |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the nine months ended June 30, 2006,amortization and the impact of foreign currency fluctuations resulted in adecrease of $42 million in the net amortizable intangible assets balance. Theweighted average useful life of the existing technology, customer relationshipsand other intangibles are 5, 6 and 5 years, respectively.

Amortization expense forthe Company’s acquired intangible assets was $15 million and $48 million forthe three and nine months ended June 30, 2006, respectively, and was $16million and $42 million for the three and nine months ended June 30, 2005,respectively. Estimated future amortization expense as of June 30, 2006 isshown in the following table:

| *** ***                        | ** ** | ** ** | ** ** | **Expected future**      | ** ** |
|-------------------------------------|------------|------------|------------|-------------------------------|------------|
| ***Dollars in millions*** | ** ** | ** ** | ** ** | **amortization expense** | ** ** |
| Remainder of fiscal 2006            |       |       | $          | 17                            |       |   |
| 2007                                |       |       | 60         |                          |       |
| 2008                                |       |       | 60         |                          |       |
| 2009                                |       |       | 59         |                          |       |
| 2010                                |       |       | 46         |                          |       |
| 2011 and thereafter                 |       |       | 19         |                          |       |
| **Future amortization expense**     | ** ** | ** ** | **$**      | **261**                       | ** ** | ** ** |
|                                     |            |            |            |                               |            |  |  |  |  |

** **

The minimum pensionadjustment, net of tax, represents unrecognized prior service costs associatedwith the recording of a minimum pension liability in prior fiscal years. Thisintangible asset may be eliminated or adjusted as necessary when the amount ofminimum pension liability is reassessed, which is conducted on an annual basis.

**6.**   SupplementaryFinancial Information

***Statement of IncomeInformation***

| ** **                                   | ** ** | **Three months**       | ** ** | **Nine months**         | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **ended June 30** | ** ** | **ended June 30,** | ** ** |
| ***Dollars in millions***          | ** ** | ** **                  | ** ** | **2006**                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **OTHER INCOME (EXPENSE), NET**              |       |                        |       |                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                              |       |                        | $          | 9                            |       |   |   | $ | 6 |   |   |   | $ | 24 |   |   | $ | 18 |   |
| (Loss) gain on foreign currency transactions |       |                        | (1         | )                            |       |   | 2 |   |   |   | (3 | ) |   | — |   |
| (Loss) on long-term debt extinguishment, net |       |                        | —     |                         |       |   | (1 | ) |   |   | — |   |   | (44 | ) |
| Other, net                                   |       |                        | (3         | )                            |       |   | (3 | ) |   |   | (5 | ) |   | (8 | ) |
| **Total other income (expense),  net**       | ** ** | ** **                  | **$**      | **5**                        | ** ** | ** ** | ** ** | **$** | **4** | ** ** | ** ** | ** ** | **$** | **16** | ** ** | ** ** | **$** | **(34** | **)** |
|                                              |            |                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Balance SheetInformation***

| ***Dollars in millions***                                     | ** ** | ** ** | ** ** | **June 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------|------------|
| **INVENTORY:**                                                          |       |       |       |                        |       |                             |       |   |   |
| Finished goods                                                          |       |       | $          | 289                         |       |                             |       | $ | 274 |   |   |
| Raw materials                                                           |       |       | 7          |                        |       |                             | 14         |   |   |
| **Total  inventory**                                                    |       |       | **$**      | **296**                     | ** ** | ** **                       | ** ** | **$** | **288** |   |   |
| **PROPERTY, PLANT AND EQUIPMENT, NET:**                                 |       |       |       |                        |       |                             |       |   |   |
| Land and improvements                                                   |       |       | $          | 55                          |       |                             |       | $ | 41 |   |   |
| Buildings and improvements                                              |       |       | 452        |                        |       |                             | 430        |   |   |
| Machinery and equipment                                                 |       |       | 649        |                        |       |                             | 640        |   |   |
| Rental equipment                                                        |       |       | 229        |                        |       |                             | 210        |   |   |
| Assets under construction                                               |       |       | 6          |                        |       |                             | 7          |   |   |
| Internal use software                                                   |       |       | 221        |                        |       |                             | 237        |   |   |
| Total property,  plant and equipment                                    |       |       | 1,612      |                        |       |                             | 1,565      |   |   |
| Less: Accumulated  depreciation and amortization                        |       |       | (934       | )                           |       |                             | (827       | ) |   |
| **Property,  plant and equipment, net**                                 | ** ** | ** ** | **$**      | **678**                     | ** ** | ** **                       | ** ** | **$** | **738** |   |   |
| **ACCUMULATED OTHER COMPREHENSIVE LOSS :**                              |       |       |       |                        |       |                             |       |   |   |
| Cumulative translation adjustment                                       |       |       | $          | 102                         |       |                             |       | $ | 48 |   |   |
| Minimum pension liability, net of tax                                   |       |       | (928       | )                           |       |                             | (928       | ) |   |
| Unrealized holding loss on securities classified as  available for sale |       |       | (4         | )                           |       |                             | (3         | ) |   |
| **Accumulated other comprehensive  loss**                               | ** ** | ** ** | **$**      | **(830**                    | **)**      | ** **                       | ** ** | **$** | **(883** | **)** | ** ** |

** **

***Cash Flow Information***

| ** **                                                  | ** ** | **Nine months ended** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------|------------|
| ***Dollars in millions***                         | ** ** | ** **                      | ** ** | **June 30, 2005** | ** ** |
| **CASH USED FOR ACQUISITIONS**                              |       |                            |       |   |   |
| Working capital, other than cash                            |       |                            | $          | (83 | ) |   |
| Property, plant and equipment                               |       |                            | 282        |   |   |
| Goodwill                                                    |       |                            | 677        |   |   |
| Intangibles assets and in process research and  development |       |                            | 349        |   |   |
| Long-term debt                                              |       |                            | (287       | ) |   |
| Other liabilities                                           |       |                            | (555       | ) |   |
| **Net cash used to acquire  businesses**                    | ** ** | ** **                      | **$**      | **383** |   |   |
|                                                             |            |                                 |            |  |  |  |  |  |

 

**7.**   RestructuringPrograms

***Third Quarter 2006 Europe, Middle East and Africa (“EMEA”)Restructuring Plan***

During the third quarterof fiscal 2006, the Company recorded an $18 million restructuring charge forlease termination obligations, net of estimated sublease income, for theclosing and consolidation of certain international office facilities, primarily related to the Company’s Guildford,United Kingdom facility. In addition, the Company recorded a $4 millionrestructuring charge related to employee separations. These charges areincluded in “Restructuring Charges” in the Consolidated Statements of Incomefor the three and nine months ended June 30, 2006. The following tablesummarizes the components of this reserve during the nine months ended June 30,2006:

15

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| ** **                             | ** ** | **Employee**   | ** ** | **Lease**       | ** ** | ** **      | ** ** |
|----------------------------------------|------------|----------------|------------|-----------------|------------|-----------------|------------|
| ** **                             | ** ** | **Separation** | ** ** | **Termination** | ** ** | ** **      | ** ** |
| ***Dollars in millions***    | ** ** | ** **     | ** ** | **Costs**       | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2005 |       |           | $          | —          |       |            |       | $ | — |   |   |   | $ | — |   |   |
| Restructuring  charge                  |       |           | 4          |            |       |            | 18         |   |   |   | 22 |   |   |
| Cash payments                          |       |           | (1         | )               |       |            | —     |   |   |   | (1 | ) |   |
| **Balance as of June 30,  2006**  | ** ** | ** **     | **$**      | **3**           | ** ** | ** **      | ** ** | **$** | **18** | ** ** | ** ** | ** ** | **$** | **21** | ** ** | ** ** |
|                                        |            |                |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |

** **

***Second Quarter 2006 EMEA Restructuring Plan***

Duringthe second quarter of fiscal 2006, the Company recorded a $15 millionrestructuring charge related to employee separations in Germany, which isincluded in “Restructuring Charges” in the Consolidated Statements of Incomefor the nine months ended June 30, 2006. This restructuring plan is aresult of the Company’s continuing efforts to improve the region’s operationalperformance. The following table summarizes the components of this reserveduring the nine months ended June 30, 2006:

| ** **                             | ** ** | **Employee**   | ** **  |
|----------------------------------------|------------|----------------|-------------|
| *** ***                           | ** ** | **Separation** | ** **  |
| ***Dollars in millions***    | ** ** | ** **     | ** **  | **Costs** | ** ** |
| Balance as of  September 30, 2005 | ** ** |           | **$**— | ** ** |   |
| Restructuring charge                   |       |           | 15          |   |   |
| Cash payments                          |       |           | (4          | ) |   |
| **Balance as of June 30,  2006**  | ** ** | ** **     | **$**       | **11** | ** ** | ** ** |
|                                        |            |                |             |  |  |  |  |  |

 

***EITF 95-3 Reserve***

Thisreserve reflects the remaining balance associated with employee separationcharges related to the acquisition of Tenovis. This balance is included inother liabilities in the Company’s Consolidated Balance Sheets. The followingtable summarizes the components of this reserve during the nine months endedJune 30, 2006:

| ***Dollars in millions***    | ** ** | ** ** | ** ** | **Employeee  Separation  Costs** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------|------------|
| Balance as of  September 30, 2005 |       |       | $          | 70                               |       |   |
| Cash payments                          |       |       | (36        | )                                |       |
| Restructuring  charge                  |       |       | 5          |                             |       |
| **Balance as of June 30,  2006**  | ** ** | ** ** | **$**      | **39**                           |       |   |

 

The restructuring chargeof $5 million relates to higher than expected per employee separation costs inGermany and is included within “Restructuring Charges” in the ConsolidatedStatements of Income for the nine months ended June 30, 2006 (see Note 4, “BusinessCombinations—Acquisition of Tenovis,” for more information).

16

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***Fourth Quarter 2005 Restructuring Plan***

Duringthe fourth quarter of fiscal 2005, the Company recorded a $22 millionrestructuring charge to reorganize its North American sales and serviceorganizations, consolidate facilities and reduce the workforce in order tooptimize the cost structure. The following table summarizes the activityrelated to this restructuring liability recorded in accordance with SFAS 146, “Accountingfor Costs Associated with Exit or Disposal Activities” for the nine monthsended June 30, 2006:

| ** **                             | ** ** | **Employee**   | ** ** | **Lease**       | ** ** | ** **      | ** ** |
|----------------------------------------|------------|----------------|------------|-----------------|------------|-----------------|------------|
| ** **                             | ** ** | **Separation** | ** ** | **Termination** | ** ** | ** **      | ** ** |
| ***Dollars in millions***    | ** ** | ** **     | ** ** | **Costs**       | ** ** | **Obligations** | ** ** | **Total** | ** ** |
| Balance as of  September 30, 2005 |       |           | $          | 7               |       |            |       | $ | 10 |   |   |   | $ | 17 |   |   |
| Cash payments                          |       |           | (5         | )               |       |            | (4         | ) |   |   | (9 | ) |   |
| **Balance  as of June 30, 2006**  |       | ** **     | **$**      | **2**           |       | ** **      | ** ** | **$** | **6** |   | ** ** | ** ** | **$** | **8** |   |   |
|                                        |            |                |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |

***EITF 94-3 Reserve***

Thisrestructuring reserve reflects the remaining balance associated with thebusiness restructuring charges related to lease terminations recorded in fiscal2000 through 2002 in accordance with EITF 94-3, “Liability Recognitionfor Certain Employee Termination Benefits and Other Costs to Exit an Activity(including Certain Costs Incurred in a Restructuring)” and is included in otherliabilities in the Company’s Consolidated Balance Sheets. The following tablesummarizes the components of this restructuring reserve during the nine monthsended June 30, 2006:

| ** **                             | ** ** | **Lease**       | ** ** |
|----------------------------------------|------------|-----------------|------------|
| ** **                             | ** ** | **Termination** | ** ** |
| ***Dollars in millions***    | ** ** | ** **      | ** ** | **Obligations** | ** ** |
| Balance as of  September 30, 2005 |       |            | $24        |   |   |
| Cash payments                          |       |            | (6         | ) |   |
| **Balance as of June 30 ,  2006** | ** ** | ** **      | **$18**    | ** ** | ** ** |
|                                        |            |                 |            |  |  |  |  |

 

**8. Capital LeaseObligations and Long-Term Debt**

Capitallease obligations and long-term debt consist of the following and areclassified with other current and long-term liabilities:

| ***Dollars in millions***                                                            | ** ** | ** ** | ** ** | **June 30,**

**2006** | ** ** | **September 30,**

**2005** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------|------------|
| Capital lease  obligations:                                                                    |       |       |       |                        |       |                             |       |   |   |
| Current portion—reported in Other Current  Liabilities                                    |       |       | $4         |                        |       |                             | $5         |   |   |
| Capital lease  obligations and long-term  debt :                                               |       |       |       |                        |       |                             |       |   |   |
| 11 1/ 8% Senior Notes , net of discount , premium  and net deferred gain on interest rate swap |       |       | —     |                        |       |                             | 14         |   |   |
| Capital lease obligations (long-term portion)                                                  |       |       | 10         |                        |       |                             | 11         |   |   |
| Total long-term debt—reported in Other Liabilities                                        |       |       | 10         |                        |       |                             | 25         |   |   |
| **Total capital lease obligations  and long-term debt**                                        |       |       | **$14**    |                        |       |                             | **$30**    |   |   |

Through a series oftransactions during fiscal 2005, the Company reduced the carrying value of the 111¤8% Senior Notes due April 2009 (“Senior Notes”) from $294million as of September 30, 2004 to $14 million as of September 30,2005. The remaining 13,205 notes were redeemed at the Company’s option in April 2006for $1,056 each, for a total payment of $14 million.

The Company has enteredinto capital lease obligations for certain equipment and automobiles, for whichpayment obligations extend through fiscal 2010.

17

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***Fair Value of Senior Notes***

As of September 30,2005, there were 13,205 senior notes outstanding. The notes had a carryingvalue of $14 million, which was comprised of the aggregate principal amountoutstanding of $13 million increased for $1 million of unamortized premium, netof discount and the net unamortized deferred gain related to the termination ofinterest rate swap agreements. The notes had a fair value of $15 million basedupon quoted market prices and yields obtained through independent pricingsources for the same or similar types of borrowing arrangements taking intoconsideration the underlying terms of the debt.

***CreditFacility Amendments***

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

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can beoutstanding at any time is $400 million, of which $150 million may be in theform of letters of credit. The credit facility is a five-year revolvingfacility and is not secured by any of the Company’s assets. The credit facilitywas amended in May 2006 to extend the expiration date of the creditfacility to May 24, 2011 and to amend certain definitions resulting inreductions in interest and various fees payable to the lenders. The creditfacility contains affirmative and restrictive covenants, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio ofconsolidated debt to earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, of 2.00 to 1.00,(c) maintaining a minimum ratio of adjusted EBITDA to interest expense of4.00 to 1.00, (d) limitations on the incurrence of 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 not toexceed 50% of consolidated net income of the Company for the fiscal yearimmediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. For fiscal 2006, thecredit facility allows the Company to repurchase, redeem or otherwise acquireshares of its common stock up to an amount not to exceed $461 million. As of June 30,2006, the Company was in compliance with all of the covenants included in thecredit facility.

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

There are currently $43 million of letters of creditissued under the credit facility. There are no other outstanding borrowingsunder the facility and the remaining availability is $357 million as of June 30,2006. The Company believes the credit facility provides it with an importantsource of backup liquidity.

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

18

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**9. Earnings PerShare 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,**               | ** ** |
| ***Dollars in millions, except per share amounts***    | ** ** | ** **                       | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Earnings  Per Common Share**—**Basic:**                                       | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income from  continuing operations available to common stockholders                  |       | $                                | 44         |                            | $          | 194 |   | $ | 153 |   | $ | 263 |   |
| Loss from  discontinued operations                                                   |       | —                           |       | —                          |       | — |   | (2 | ) |
| Net income                                                                           |       | $                                | 44         |                            | $          | 194 |   | $ | 153 |   | $ | 261 |   |
| Earnings per share  from continuing operations                                       |       | $                                | 0.10       |                            | $          | 0.41 |   | $ | 0.33 |   | $ | 0.56 |   |
| Loss per share  from discontinued operations                                         |       | —                           |       | —                          |       | — |   | (0.01 | ) |
| Earnings per  share—basic                                                       |       | $                                | 0.10       |                            | $          | 0.41 |   | $ | 0.33 |   | $ | 0.55 |   |
| Weighted average  shares outstanding—basic                                      |       | 459                              |       | 478                             |       | 465 |   | 473 |   |
| **Earnings  Per Common Share**—**Diluted:**                                     | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income from  continuing operations available to common stockholders                  |       | $                                | 44         |                            | $          | 194 |   | $ | 153 |   | $ | 263 |   |
| Interest charges  associated with LYONs convertible debt , net of tax effects        |       | —                           |       | —                          |       | — |   | 2 |   |
| Income from  continuing operations after assumed conversion of LYONs debt            |       | 44                               |       | 194                             |       | 153 |   | 265 |   |
| Loss from  discontinued operations                                                   |       | —                           |       | —                          |       | — |   | (2 | ) |
| Net income after  assumed conversion of LYONs debt                                   |       | $                                | 44         |                            | $          | 194 |   | $ | 153 |   | $ | 263 |   |
| Earnings per share  from continuing operations                                       |       | $                                | 0.10       |                            | $          | 0.40 |   | $ | 0.32 |   | $ | 0.54 |   |
| Earnings per  share from discontinued operations                                     |       | —                           |       | —                          |       | — |   | — |   |
| Earnings per  share—diluted                                                     |       | $                                | 0.10       |                            | $          | 0.40 |   | $ | 0.32 |   | $ | 0.54 |   |
| **Diluted  Weighted Average Shares Outstanding :**                                   |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares outstanding—basic                                      |       | 459                              |       | 478                             |       | 465 |   | 473 |   |
| Dilutive Potential  Common Shares :                                                  |       |                             |       |                            |       |   |   |   |   |
| Stock Options                                                                        |       | 5                                |       | 5                               |       | 5 |   | 6 |   |
| Restricted Stock Units                                                               |       | 1                                |       | —                          |       | 1 |   | 1 |   |
| Warrants                                                                             |       | —                           |       | 4                               |       | 1 |   | 5 |   |
| LYONs Convertible Debt                                                               |       | —                           |       | —                          |       | — |   | 6 |   |
| Weighted average  shares outstanding—diluted                                    |       | 465                              |       | 487                             |       | 472 |   | 491 |   |
| **Securities  excluded from the computation of diluted earnings per common share :** | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options (1)                                                                    |       | 40                               |       | 38                              |       | 40 |   | 36 |   |
| Warrants (1)                                                                         |       | —                           |       | 5                               |       | — |   | 5 |   |
|                                                                                 |       | 40                               |       | 43                              |       | 40 |   | 41 |   |
|                                                                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |

 

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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.

19

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On April 19, 2005,the Board of Directors authorized a share repurchase plan (the “plan”). Underthe provisions of the plan, Avaya may use up to $500 million of cash torepurchase shares of its outstanding common stock through April 2007. Forfiscal 2006, the credit facility limits the Company’s ability to make dividendpayments or distributions or to repurchase, redeem or otherwise acquire sharesof Avaya common stock to $461 million (which represents 50% of consolidated netincome for the Company for fiscal 2005). During the nine months ended June 30,2006, the Company repurchased and retired 22,534,200 shares of common stock atan average purchase price of $11.37 per share, for a total of $256 million.From July 1, 2006 through August 9, 2006, the Company repurchased andretired 5,630,000 shares at an average purchase price of $9.25 per share, foran additional $52 million. Approximately $85 million is available through April 2007for further share repurchases under the plan. These repurchases are made atmanagement’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.

**10. Income Taxes**

Thefollowing table provides the (benefit from) provision for income taxes for thethree and nine months ended June 30, 2006 and 2005:

| ** **                                 | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **June 30,**                | ** ** | **June 30,**               | ** ** |
| ***Dollars in millions***        | ** ** | ** **                       | ** ** | ** 2006 **            | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| (Benefit from)  provision for income taxes |       |                             | $          | (11                             | )          |   | $ | (117 | ) |   | $ | 48 |   |   | $ | (99 | ) |
|                                            |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The benefit from income taxes for the three monthsended June 30, 2006 was primarily due to an $18 million tax benefitassociated with transfer pricing adjustments and a $3 million tax benefitresulting from a non-U.S. audit settlement. These benefits were partiallyoffset by provisions for U.S. federal, state and non-U.S taxes, resulting in aneffective tax benefit rate of 33.1%. The provision for income taxes for thenine months ended June 30, 2006 is comprised of U.S. federal, state andnon-U.S. taxes, and was partially offset by the favorable adjustments notedabove, resulting in an effective tax rate of 23.9%.

On September 30, 2000, Lucent Technologies Inc.(“Lucent”) contributed its enterprise networking business to us and distributedall of the outstanding shares of our capital stock to its shareowners (“thedistribution”). The benefit from income taxes for the three and nine monthsended June 30, 2005 was primarily due to a $116 million benefit from thesettlement of certain U.S. federal and state income tax matters from yearsprior to the distribution in accordance with the Tax Sharing Agreement betweenus and Lucent, partially offset by a provision for state and non-U.S. taxes.

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

20

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**11. BenefitObligations**

Thecomponents of net periodic benefit cost for the three and nine months ended June 30,2006 and 2005 are provided in the table below:

| ** **                                      | ** ** | **Pension Benefits —** | ** ** | **Pension Benefits —** | ** ** | **Postretirement**                 | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **U.S.**                              | ** ** | **Non-U.S.**                          | ** ** | **Benefits — U.S.** | ** ** |
| ** **                                      | ** ** | **Three months ended**      | ** ** | **Three months ended**      | ** ** | **Three months ended**   | ** ** |
| ** **                                      | ** ** | **June 30,**                     | ** ** | **June 30,**                     | ** ** | **June 30,**                  | ** ** |
| ***Dollars in millions***             | ** ** | ** **                            | ** ** | **2006**                              | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Components of Net  Periodic Benefit Cost        |       |                                  |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                    |       | $                                     | 4          |                                  | $          | 5                                  |       |   | $ | 4 |   |   |   | $ | 2 |   |   |   | $ | 1 |   |   |   | $ | 2 |   |   |
| Interest cost                                   |       | 41                                    |       | 43                                    |       |                               | 4          |   |   |   | 3 |   |   |   | 8 |   |   |   | 9 |   |   |
| Expected return on plan assets                  |       | (51                                   | )          | (55                                   | )          |                               | (1         | ) |   |   | (1 | ) |   |   | (2 | ) |   |   | (3 | ) |   |
| Amortization of unrecognized prior service cost |       | 1                                     |       | 2                                     |       |                               | —     |   |   |   | — |   |   |   | 4 |   |   |   | 2 |   |   |
| Recognized net actuarial loss                   |       | 14                                    |       | 8                                     |       |                               | —     |   |   |   | — |   |   |   | 1 |   |   |   | 1 |   |   |
| Settlement loss                                 |       | —                                |       | —                                |       |                               | —     |   |   |   | 1 |   |   |   | — |   |   |   | — |   |   |
| **Net periodic benefit cost**                   | ** ** | **$**                                 | **9**      |                                  | **$**      | **3**                              |       | ** ** | **$** | **7** | ** ** | ** ** | ** ** | **$** | **5** | ** ** | ** ** | ** ** | **$** | **12** | ** ** | ** ** | ** ** | **$** | **11** | ** ** | ** ** |
|                                                 |            |                                       |            |                                       |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                      | ** ** | **Pension Benefits —** | ** ** | **Pension Benefits —** | ** ** | **Postretirement**                 | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **U.S.**                              | ** ** | **Non-U.S.**                          | ** ** | **Benefits — U.S.** | ** ** |
| ** **                                      | ** ** | **Nine months ended**       | ** ** | **Nine months ended**       | ** ** | **Nine months ended**    | ** ** |
| ** **                                      | ** ** | **June 30,**                     | ** ** | **June 30,**                     | ** ** | **June 30,**                  | ** ** |
| ***Dollars in millions***             | ** ** | ** **                            | ** ** | **2006**                              | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Components of Net Periodic  Benefit Cost**    |       |                                  |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                    |       | $                                     | 13         |                                  | $          | 13                                 |       |   | $ | 9 |   |   |   | $ | 7 |   |   |   | $ | 3 |   |   |   | $ | 4 |   |   |
| Interest cost                                   |       | 124                                   |       | 127                                   |       |                               | 12         |   |   |   | 9 |   |   |   | 25 |   |   |   | 29 |   |   |
| Expected return on plan assets                  |       | (154                                  | )          | (163                                  | )          |                               | (1         | ) |   |   | (1 | ) |   |   | (6 | ) |   |   | (8 | ) |   |
| Amortization of unrecognized prior service cost |       | 4                                     |       | 5                                     |       |                               | —     |   |   |   | — |   |   |   | 12 |   |   |   | 7 |   |   |
| Recognized net actuarial loss                   |       | 42                                    |       | 26                                    |       |                               | —     |   |   |   | — |   |   |   | 2 |   |   |   | 4 |   |   |
| Settlement loss                                 |       | —                                |       | —                                |       |                               | —     |   |   |   | 1 |   |   |   | — |   |   |   | — |   |   |
| **Net periodic benefit cost**                   |       | **$**                                 | **29**     | ** **                            | **$**      | **8**                              | ** ** | ** ** | **$** | **20** | ** ** | ** ** | ** ** | **$** | **16** | ** ** | ** ** | ** ** | **$** | **36** | ** ** | ** ** | ** ** | **$** | **36** | ** ** |   |
|                                                 |            |                                       |            |                                       |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The U.S. information presented above reflects theimpact of remeasurement of benefits with respect to represented employees,effective June 1, 2006, for the new collective bargaining agreements withthe Communications Workers of America and International Brotherhood ofElectrical Workers (see Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—“Employees” section).

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 30,2006, the Company made payments for these U.S. and non-U.S. pension benefitstotaling $5 million and $8 million, respectively. Estimated payments for theseU.S. and non-U.S. pension benefits for the remainder of fiscal 2006 are $2million and $3 million, respectively.

The Company also providescertain retiree medical benefits for U.S. employees, which are not pre-funded.Consequently, the Company makes payments as these benefits are disbursed. Forthe nine months ended June 30, 2006, the Company made payments totaling$37 million for these retiree medical benefits. Estimated payments for theseretiree medical benefits are $12 million for the remainder of fiscal 2006.

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**12. StockCompensation Plans**

The Company has a stockcompensation plan which provides for the issuance to eligible employees ofnonqualified stock options and restricted stock units with respect to shares ofAvaya common stock. In addition, the Company has an employee stock purchaseplan under which eligible employees have the ability to purchase shares ofAvaya common stock at 85% of average of the high and low per share tradingprice of Avaya’s common stock on the New York Stock Exchange on the lasttrading day of each month.

**Stock Options**

Stock options are generally granted with an exerciseprice equal to or above the market value of a share of common stock on the dateof grant. Stock options granted prior to fiscal 2004 are for a contractual termof ten years or fewer and generally vest within four years from the grant-date.Options granted in fiscal 2004 or afterwards have a contractual term of sevenyears and vest in three years. For the nine months ended June 30, 2006,approximately $10 million of compensation expense related to stock options wasrecognized. At the 2004 Annual Meeting of Shareholders, the Avaya Inc. 2004Long Term Incentive Plan (the “Plan”) was approved. The Plan became thesuccessor plan to, and no further grants have been made from, the Company’sfour previous existing plans: the 2000 Long Term Incentive Plan, the 2000 StockCompensation Plan for Non-employee Directors, the Broad Based Stock Option Planand the Long Term Incentive Plan for Management Employees (the “Existing Plans”).The consolidation of the Existing Plans into the Plan resulted in an aggregatereduction in the number of shares eligible for awards under the existing plans.As of June 30, 2006, there were 14 million stock options authorized forgrant to purchase Avaya common stock under the Plan.

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

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

Share-based compensation expense recognized in theConsolidated Statement of Income for the nine months ended June 30, 2006is based on awards ultimately expected to vest, reduced for estimatedforfeitures. SFAS 123(R) requires forfeitures to be estimated at the timeof grant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates. Forfeitures were estimated based on the Company’shistorical experience. In the Company’s pro forma information required underSFAS 123 for the periods prior to fiscal 2006, the Company accounted forforfeitures as they occurred.

The fair value of each stock option grant made duringfiscal 2006 was estimated on the grant-date using the lattice-binomial modelwith the following weighted average assumptions:

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| ** **                          | ** ** | **Nine months ended** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **June 30, 2006**     | ** ** |
| WEIGHTED AVERAGE  ASSUMPTIONS:      |       |                            |       |   |   |
| Dividend yield                      |       |                            | 0.00       | % |   |
| Expected volatility                 |       |                            | 58.57      | % |   |
| Risk-free interes t rate            |       |                            | 4.40       | % |   |
| Annual forfeiture rate              |       |                            | 5.73       | % |   |
| Expected holding  period (in years) |       |                            | 3.49       |   |   |

 

Thefollowing table summarizes information concerning options outstanding includingthe related transactions under the plan for the nine months ended June 30,2006 and the year ended September 30, 2005:

| ** **                                    | ** ** | **Shares**       | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **(000’s)** | ** ** | **Exercise Price**   | ** ** |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2004 |       | 48,540           |       |                      | $          | 13.35 |   |   |
| Granted                                       |       | 7,189            |       |                      | 14.90      |   |   |
| Exercised                                     |       | (4,421           | )          |                      | 7.84       |   |   |
| Forfeited and Expired                         |       | (2,783           | )          |                      | 15.72      |   |   |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2005 |       | 48,525           |       |                      | 13.95      |   |   |
| Granted                                       |       | 5,199            |       |                      | 11.21      |   |   |
| Exercised                                     |       | (2,334           | )          |                      | 4.40       |   |   |
| Forfeited and Expired                         |       | (1,909           | )          |                      | 15.81      |   |   |
| OPTIONS OUTSTANDING AS  OF JUNE 30, 2006      |       | 49,481           |       |                      | $          | 14.04 |   |   |

 

The weighted-average grant-date fair value of optionsgranted during the nine months ended June 30, 2006 was $4.66 per share.The total intrinsic value under the lattice-binomial model ascribed to theoptions exercised during the nine months ended June 30, 2006 was $16million.

Thefollowing table summarizes the status of the Company’s stock options as of June 30,2006:

| ** **               | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | ** **                              | ** ** | **Average**                             | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **Remaining**                           | ** ** | **Average** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |
| **Range of**        | ** ** | **Shares**                              | ** ** | **Contractual**                         | ** ** | **Exercise** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Exercise** | ** ** | **Value** | ** ** |
| **Exercise Prices** | ** ** | **(000’s)**                        | ** ** | **Life (Years)**                   | ** ** | **Price** | ** ** | **(000’s)** | ** ** | **(000’s)** | ** ** | **Price** | ** ** | **(000’s)** | ** ** |
| $0.01 to $9.70           |       | 8,682                                   |       |                                    | 3.27       |   |   |   | $ | 4.45 |   |   |   | $ | 60,442 |   |   | 7,972 |   |   | $ | 4.48 |   |   |   | $ | 55,248 |   |   |
| $9.71 to $14.79          |       | 15,360                                  |       |                                    | 5.00       |   |   |   | 12.38 |   |   |   | 2,534 |   |   | 9,589 |   |   | 13.15 |   |   |   | 499 |   |   |
| $14.80 to $15.19         |       | 12,109                                  |       |                                    | 4.26       |   |   |   | 14.84 |   |   |   | — |   |   | 12,109 |   |   | 14.84 |   |   |   | — |   |   |
| $15.20 to $19.36         |       | 6,714                                   |       |                                    | 5.05       |   |   |   | 16.17 |   |   |   | — |   |   | 6,714 |   |   | 16.17 |   |   |   | — |   |   |
| $19.36 to $51.21         |       | 6,616                                   |       |                                    | 2.65       |   |   |   | 26.80 |   |   |   | — |   |   | 6,616 |   |   | 26.80 |   |   |   | — |   |   |
| Total                    |       | 49,481                                  |       |                                    |       |   |   |   | $ | 14.04 |   |   |   | $ | 62,976 |   |   | 43,000 |   |   | $ | 14.59 |   |   |   | $ | 55,747 |   |   |

 

The aggregate intrinsicvalue in the preceding table represents the total pre-tax intrinsic value,based on the Company’s average stock price as of June 30, 2006, whichwould have been received by the option holders had all option holders exercisedtheir options as of that date. The total number of in-the-money optionsexercisable as of June 30, 2006 was approximately eight million. Theweighted average remaining contractual life as of June 30, 2006 foroutstanding and exercisable options is 4.21 and 3.93 years, respectively.

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**Restricted StockUnits**

The Company’s Plan permits the granting of restrictedstock units to eligible employees and non-employee Directors at the fair marketvalue of the Company’s common stock at the grant-date and typically becomefully vested over a four-year period. Restricted stock units are payable inshares of the Company’s common stock upon vesting.

Thefollowing table presents a summary of the status of the Company’s nonvestedrestricted stock units (“RSUs”) as of September 30, 2005 and changes inoutstanding RSU’s during the nine months ended June 30, 2006:

| ** **                                   | ** **                | ** ** | ** ** | **Weighted-Average**         | ** ** |
|----------------------------------------------|---------------------------|------------|------------|------------------------------|------------|
| ** **                                   | ** **                | ** ** | ** ** | **Grant-Date**               | ** ** |
| ** **                                   | **Nonvested Shares** | ** ** | ** ** | **Shares (000’s)** | ** ** | **Fair Value** | ** ** |
| Nonvested shares  at September 30, 2005 |                      |       | 3,708      |                         |       |   | $ | 12.08 |   |   |
| Granted                                      |                      |       | 2,249      |                         |       |   | 11.12 |   |   |
| Vested                                       |                      |       | (609       | )                            |       |   | 3.91 |   |   |
| Forfeited                                    |                      |       | (327       | )                            |       |   | 12.72 |   |   |
| Nonvested shares at  June 30, 2006      |                      |       | 5,021      |                         |       |   | $ | 12.60 |   |   |
|                                              |                           |            |            |                              |            |  |  |  |  |  |  |  |

 

As of June 30, 2006,there was approximately $40 million of total unrecognized compensation costrelated to nonvested share-based compensation arrangements granted under thePlan. That cost is expected to be recognized over a weighted average period offour years. Compensation expense related to RSUs was $4 million and $2 millionfor the three months ended June 30, 2006 and 2005, respectively, and was$11 million and $7 million for the nine months ended June 30, 2006 and2005, respectively.

**Performance-BasedRestricted Stock Units**

Performance-based restricted stock units vest upon theachievement of certain targets and are payable in shares of the Company’scommon stock upon vesting, typically over a three-year period. The fair valueis based on the market price of the Company’s common stock on the grant-dateand assumes that the target payout level will be achieved. Compensation cost isadjusted for subsequent changes in the expected outcome of performance-relatedconditions until the vesting date.

On December 15, 2005,the Compensation Committee of the Board of Directors approved awards of 350,000performance-vesting restricted stock units to executive officers of the Companypursuant to the terms of the Plan.

**Employee StockPurchase Plan**

Under the terms of theemployee stock purchase plan, eligible employees may have up to 10% of theireligible compensation deducted from their pay to purchase shares of Avayacommon stock. The per share purchase price is 85% of the average high and lowper share trading price of Avaya’s common stock on the New York Stock Exchangeon the last trading day of each month. For the three and nine months ended June 30,2006, approximately $0.6 million and $1.8 million, respectively, ofcompensation expense related to the employee stock purchase plan was recorded.

**13. OperatingSegments**

The Company reports its operations in two segments -Global Communication Solutions (“GCS”) and Avaya Global Services (“AGS”). TheGCS segment develops, markets and sells communications systems including IPtelephony systems, multi-media contact center infrastructure and convergedapplications in support of customer relationship management, unifiedcommunications applications, appliances such as IP telephone sets andtraditional voice communications systems. The AGS segment develops, markets and

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sells comprehensiveend-to-end global service offerings that enable customers to plan, design,implement, monitor and manage their converged communications networksworldwide.

The GCS segment includes the portion of the rental andmanaged services revenue attributed to the equipment used in connection withthe customer rental and managed services contracts. These contracts attributedto maintenance and other services are 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 fiscalyear, the amount of certain corporate overhead expenses, including targetedannual incentive awards, to be charged to operating segments is determined andfixed for the entire year in the annual plan. The annual incentive awardaccrual is adjusted quarterly based on actual year to date results and those estimatedfor the 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. Restructuring and impairment charges are alsorecorded and reported within the Corporate/Other Unallocated Amounts caption.

Summarized financial information relating to theCompany’s reportable segments is shown in the following table:

| ** **                                 | ** ** | **Reportable Segments** | ** ** | ** **    | ** ** | ** **                | ** ** |
|--------------------------------------------|------------|------------------------------|------------|---------------|------------|---------------------------|------------|
| ** **                                 | ** ** | **Global**                   | ** ** | **Avaya**     | ** ** | **Corporate /Other** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Communications**           | ** ** | **Global**    | ** ** | **Unallocated**           | ** ** | ** ** | ** ** |
| ***Dollars in millions***        | ** ** | ** **                   | ** ** | **Solutions** | ** ** | **Services**              | ** ** | **Amounts** | ** ** | **Total** | ** ** |
| **Three  months ended June 30, 2006** |       |                         |       |          |       |                      |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                         | $          | 704           |       |                      |       | $ | 593 |   |   |   | $ | — |   |   | $ | 1,297 |   |
| Operating income  (loss)                   |       |                         | 36         |          |       |                      | 34         |   |   |   | (42 | ) |   | 28 |   |
| **Three months ended June 30, 2005**  |       |                         |       |          |       |                      |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                         | $          | 648           |       |                      |       | $ | 588 |   |   |   | $ | — |   |   | $ | 1,236 |   |
| Operating income                           |       |                         | 1          |          |       |                      | 37         |   |   |   | 38 |   |   | 76 |   |
| **Nine months ended June 30, 2006**   |       |                         |       |          |       |                      |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                         | $          | 2,026         |       |                      |       | $ | 1,758 |   |   |   | $ | — |   |   | $ | 3,784 |   |
| Operating income  (loss)                   |       |                         | 111        |          |       |                      | 135        |   |   |   | (58 | ) |   | 188 |   |
| **Nine months ended June 30, 2005**   |       |                         |       |          |       |                      |       |   |   |   |   |   |   |   |   |
| Revenue                                    |       |                         | $          | 1,865         |       |                      |       | $ | 1,741 |   |   |   | $ | — |   |   | $ | 3,606 |   |
| Operating income                           |       |                         | 14         |          |       |                      | 120        |   |   |   | 82 |   |   | 216 |   |
|                                            |            |                              |            |               |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

| ***Dollars in millions***                            | ** ** | ** ** | ** ** | **June 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------|------------|
| U.S.                                                           |       |       | $          | 402                         |       |                             |       | $ | 453 |   |   |
| Outside the U.S.:                                              |       |       |       |                        |       |                             |       |   |   |
| Germany                                                        |       |       | 209        |                        |       |                             | 214        |   |   |
| EMEA — Europe / Middle East / Africa (excluding  Germany) |       |       | 47         |                        |       |                             | 52         |   |   |
| APAC — Asia Pacific                                       |       |       | 14         |                        |       |                             | 14         |   |   |
| Americas , non — U.S.                                     |       |       | 6          |                        |       |                             | 5          |   |   |
| Total outside the U.S.                                         |       |       | 276        |                        |       |                             | 285        |   |   |
| Total                                                          |       |       | $          | 678                         |       |                             |       | $ | 738 |   |   |

 

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**14. Commitments andContingencies**

**Legal Proceedings**

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

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

***Commissions Arbitration Demand***

In July 2002, Communications DevelopmentCorporation (“CDC”), a British Virgin Islands corporation, made formal demandfor arbitration for alleged unpaid commissions in an amount in excess of $10million, stemming from the sale of products from Avaya’s businesses that wereformerly owned by Lucent involving the Ministry of Russian Railways. In April 2003,CDC initiated the arbitration before the American Arbitration Association. Theplaintiff alleges that as a result of agreements entered into between theplaintiff and the Company, it is owed commissions on sales by the Company tothe Ministry of Russian Railways on a continuing basis. The Company believesthat the agreements relating to the plaintiff’s claim have expired or do notapply to the products in question. As the sales of products continue, CDC maylikely increase its commission demand. An arbitration hearing originallycommenced in December 2005 has re-commenced in July 2006, with thearbitration panel hearing several days of testimony before adjourning. Thepanel has requested detailed briefing from the parties, which is expected to befiled in late 2006.

As the hearing in thematter is not yet completed, an outcome cannot be predicted and, as a result,we cannot determine if this matter will have an effect on our business or, ifit does, whether its outcome will have a material adverse effect on itsfinancial position, results of operations or cash flows. Due to the uncertaintysurrounding the issues involved in this matter and based on the facts andcircumstances known to date, the Company believes that an estimate of any lossthat may be incurred cannot be made at this time.

***Securities Litigation***

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

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The complaints, which are substantially similar to oneanother, allege, among other things, that the plaintiffs were injured by reasonof certain allegedly false and misleading statements made by us relating to thecost of the Tenovis integration, the disruption caused by changes in thedelivery of our products to the market and reductions in the demand for ourproducts in the U.S., and that based on the foregoing we had no basis toproject our stated revenue goals for fiscal 2005. The Company has been servedwith a number of these complaints. No class has been certified in the actions.The complaints seek compensatory damages plus interest and attorneys’ fees. In August 2005,the court entered an order identifying a lead plaintiff and lead plaintiffs’counsel. A consolidated amended complaint was filed in October 2005.Pursuant to a scheduling order issue by the District Court, defendants filedtheir motion to dismiss the consolidated complaint in December 2005. Ahearing on defendants’ motion to dismiss is scheduled for August 2006.Discovery of the matter has been stayed in accordance with applicable law,pending the outcome of the motion to dismiss.

This matter is 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. Due tothe uncertainty surrounding the issues involved in this matter and based on thefacts and circumstances known to date, the Company believes that an estimate ofany loss that may be incurred cannot be made at this time.

***DerivativeLitigation***

In May and July of 2005, three derivativecomplaints were filed against certain officers and the members of the Board ofDirectors (“Board”) of the Company. Two complaints were filed in the UnitedStates District Court for the District of New Jersey, and one was filed in theSuperior Court of New Jersey - Somerset County. The allegations in each of thecomplaints are substantially similar and include the Company as a nominaldefendant. The complaints allege, among other things, that defendants violatedtheir fiduciary duties by failing to disclose material information and/or bymisleading the investing public about the Company’s business, asserting claimssubstantially similar to those asserted in the actions described above under “SecuritiesLitigation.” The complaints seek contribution from the defendants to theCompany for alleged violations of the securities laws, restitution to theCompany and disgorgement of profits earned by defendants, and fees and costs.

While the parties have agreed to stay these matterspending outcome of the motion to dismiss described in “Securities Litigation”above, these actions are in the early stages of litigation and an outcomecannot be predicted and, as a result, we cannot be assured that these caseswill not have a material adverse effect on our financial position, results ofoperations or cash flows.

***ERISA Class Action—Securities Litigation***

In July 2005, a purported class action lawsuitwas filed in the United States District Court for the District of New Jerseyagainst the Company and certain of its officers, employees and members of theBoard of Directors (the “Directors”), alleging violations of certain laws underthe Employee Retirement Income Security Act of 1974 (“ERISA”). OnOctober 17, 2005, an amended purported class action was filed against usand certain of our officers, employees and Directors. Like the initialcomplaint, the amended complaint purports to be filed on behalf of allparticipants and beneficiaries of the Avaya Inc. Savings Plan, the Avaya Inc.Savings Plan for Salaried Employees and the Avaya Inc. Savings Plan for theVariable Workforce (collectively, the “Plans”), during the period fromOctober 5, 2004 through July 20, 2005. It contains factualallegations substantially similar to those asserted in the matters under theheading of “Securities Litigation.”

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

***ERISA Class Action—Stock Funds***

In April 2006, a purported class action was filedin the United States District Court for the District of New Jersey, allegingthat the Company, certain employees and the Pension and Employee BenefitsInvestment Committee violated the Employee Retirement Income Security Act of1974 (“ERISA”), by including in the Avaya Inc. Savings Plan for SalariedEmployees, the Avaya Inc. Savings Plan and the Avaya Inc. Savings Plan for theVariable Workforce (“Plans”), investment options for the Lucent TechnologiesInc. Stock Fund (“Lucent Fund”) and the Avaya Inc. Stock Fund (“Avaya Fund”)for the period of October 2000 to April 2003 (“Alleged Class Period”).The complaint asserts, among other things, that during the Alleged Class Perioddefendants breached their fiduciary duties under ERISA by violating ERISA’sprovisions against prohibited transactions; offering the Lucent Fund and AvayaFund imprudently as investment options; failing properly to monitor the funds;and, failing properly to monitor the actions of other plan fiduciaries, thuscausing the Plans to suffer damages. The complaint seeks monetary relief onbehalf of the Plans and its participants, and also seeks injunctive relief andcosts, including attorneys’ fees.

This matter is in theearly stages of litigation, and an outcome cannot be predicted and, as aresult, we cannot be assured that this case will not have a material adverseeffect on our financial position, results of operations or cash flows. Due tothe uncertainty surrounding the issues involved in this matter and based on thefacts and circumstances known to date, the Company believes that an estimate ofany loss that may be incurred cannot be made at this time.

***AntitrustLawsuit***

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

Even though Avayaprevailed in the preliminary injunction proceeding, an outcome in this mattercannot be predicted at this time, and we cannot be assured that this case willnot have a material adverse effect on our financial position, results ofoperations or cash flows. Due to the uncertainty surrounding the 

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issuesinvolved in this matter and based on the facts and circumstances known to date,the Company believes that an estimate of any loss that may be incurred cannotbe made at this time.

**Other Matters**

***Government Subpoenas***

On April 29, 2005, the Company received asubpoena to produce documents before a grand jury of the United States DistrictCourt, District of South Carolina, relating to the United States’ investigationof 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 it does,whether its outcome will have a material adverse effect on our financialposition, results of operations or cash flows.

The Company is cooperatingwith the relevant government entities with respect to these subpoenas. Based onthe facts and circumstances known to date, the Company believes that anestimate of any loss that may be incurred with respect to these subpoenascannot be made at this time.

**Environmental,Health and Safety Matters**

The Company is subject to a wide range of governmentalrequirements relating to employee safety and health and to the handling andemission into the environment of various substances used in its operations. TheCompany is subject to certain provisions of environmental laws, particularly inthe United States and Germany, governing the cleanup of soil and groundwatercontamination. Such provisions impose liability for the costs of investigatingand remediating releases of hazardous materials at currently or formerly ownedor operated sites. In certain circumstances, this liability may also includethe cost of cleaning up historical contamination, whether or not caused by theCompany. The Company is currently conducting investigation and/or cleanup ofknown contamination at nine of its current or former facilities either voluntarilyor pursuant to government directives. Based on currently available information,none of the sites is reasonably likely to generate environmental costs thatwill be individually material nor will environmental costs for all sites in theaggregate be material for fiscal 2006. There are no known third parties who maybe responsible for investigation and/or cleanup at these sites and therefore,for purposes of assessing the adequacy of accruals for these liabilities, theCompany has not assumed that it will recover amounts from any third party,including under any insurance coverage or indemnification arrangement. Althoughthe Company does not separately track recurring costs of managing hazardoussubstances and pollutants in ongoing operations, it does not believe them to bematerial.

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

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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 three and nine monthperiods ended June 30, 2006 and 2005 were not material to the Company’sfinancial position, results of operations or cash flows. Payment for theenvironmental costs covered by the reserves may be made over a 30-yearperiod.

**Product Warranties**

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

| ***Dollars in millions***                  | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| Balance as of  September 30, 2005               |       | $          | 30         | ** ** |
| Reductions for  payments and costs to satisfy claims |       | (34        | )          |
| Accruals for  warranties issued during the period    |       | 33         | ** ** |
| Balance as of  June 30, 2006                    |       | $          | 29         | ** ** |

 

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

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $95 million as ofJune 30, 2006, for the purpose of obtaining third party financialguarantees such as letters of credit which ensure the Company’s performance orpayment to third parties. Additionally, the Company has a $400 millioncommitted credit facility, which is discussed in Note 8, “Capital LeaseObligations and Long-Term Debt.” As of June 30, 2006, the Company hadoutstanding an aggregate of $117 million in irrevocable letters of credit underthe committed and uncommitted credit facilities (including $43 million underits $400 million committed credit facility).

***Surety Bonds***

The Company arranges forthe issuance of various types of surety bonds, such as license, permit, bid andperformance bonds, which are agreements under which the surety companyguarantees that the Company will perform in accordance with contractual orlegal obligations. These bonds vary in duration although most are issued andoutstanding from six months to three years. These bonds are backed by $15million of our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is $39million as of June 30, 2006. Historically, no surety bonds have been drawnupon.

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***Purchase Commitments and Termination Fees***

The Company purchases components from a variety ofsuppliers and uses several contract manufacturers to provide manufacturingservices for its products. During the normal course of business, in order to managemanufacturing lead times and to help assure adequate component supply, theCompany enters into agreements with contract manufacturers and suppliers thatallow them to produce and procure inventory based upon forecasted requirementsprovided by the Company. If the Company does not meet these specified purchasecommitments, it could be required to purchase the inventory, or in the case ofcertain agreements, pay an early termination fee. As of June 30, 2006, themaximum potential payment under these commitments was approximately $227million. Historically, the Company has not been required to pay a charge fornot meeting its designated purchase commitments with these suppliers.

The Company’s outsourcingagreement with its most significant contract manufacturer was extended and nowexpires in November 2007. All manufacturing of the Company’s products isperformed in accordance with detailed specifications and product designsfurnished by the Company and is subject to rigorous quality control standards.

***Product Financing Arrangements***

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

In March 2001, the Company entered into a productfinancing arrangement with one U.S. reseller which expired during fiscal 2005.Accordingly, Avaya is no longer obligated to repurchase inventory previouslysold to this reseller in the event the lending institution, which financed thetransaction, repossesses the reseller’s inventory of the Company’s products.

For the Company’s productfinancing arrangement with resellers outside the U.S., in the eventparticipating resellers default on their payment obligations to the lendinginstitution, the Company is obligated under certain circumstances to guaranteerepayment to the lending institution. The repayment amount fluctuates with thelevel of product financing activity. The guarantee repayment amount reported tothe Company from the lending institution was approximately $5 million as of June 30,2006. The Company reviews and sets the maximum credit limit for each resellerparticipating in this financing arrangement. Historically, there have not beenany guarantee repayments by the Company. The estimated fair value of thisguarantee as of June 30, 2006 is not significant. There can be noassurance that the Company will not be obligated to repurchase inventory underthis arrangement in the future.

***Performance Guarantee***

In connection with thesale of Connectivity Solutions and the sale of a portion of the Expanetsbusiness, the Company has assigned its rights and obligations under severalreal estate leases to the acquiring companies (the “assignees”). The remainingterms of these leases vary from one year to eight years. While the Company isno longer the primary obligor under these leases, the lessors have notcompletely released the Company from its obligations, and hold 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, 2006, would be approximately $17million. The Company has assessed the probability of default by the assigneesand has determined it to be remote.

***Credit Facility Indemnification***

In connection with itsobligations under the credit facility described in Note 8, “Capital LeaseObligations and Long-Term Debt - Credit Facility Arrangements,” the Company hasagreed to indemnify the third party lending institutions for costs incurred bythe institutions related to changes in tax law or 

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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***

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

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

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

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

| Overview                                            | ** ** | 33 |   |
|-----------------------------------------------------|------------|----|--------|
| Key Trends and Uncertainties  Affecting Our Results | ** ** | 36 |   |
| Operating Segments                                  | ** ** | 40 |   |
| Results from Continuing  Operations                 | ** ** | 40 |   |
| Liquidity and  Capital Resources                    | ** ** | 51 |   |
| Forward Looking  Statements                         | ** ** | 57 |   |

 

“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 this QuarterlyReport. The matters discussed in “Management’s Discussion and Analysis ofFinancial 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, 2006 and for the threeand nine months ended June 30, 2006 and 2005, have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and the rules and regulationsof the United States Securities and Exchange Commission, or the SEC, forinterim financial statements, and should be read in conjunction with ourConsolidated Financial Statements and other financial information for thefiscal year ended September 30, 2005, which were included in our AnnualReport on Form 10-K filed with the SEC on December 13, 2005. Inour opinion, the unaudited interim Consolidated Financial Statements reflectall adjustments, consisting of normal and recurring adjustments, necessary fora fair 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.

**Overview**

***Products, Applications and Services***

We are a leading provider of communications solutions,comprised of equipment hardware, software and services that help enterprisestransform their businesses by redefining the way they work and interact withtheir customers, employees, business partners, suppliers and others. Our goalis to help our customers optimize their enterprise communications networks in orderto serve their customers better, enabling them to reduce costs and become morecompetitive while preserving the security and reliability of their networks. Akey component of our strategy is to leverage our substantial experience andexpertise in traditional voice communications systems to capitalize on thetransition of these traditional voice systems to Internet Protocol (“IP”) andthe adoption of IP telephony solutions. We believe our comprehensive suite ofIP telephony solutions, communications applications and appliances, assupported by our global services organization and extensive network of businesspartners, transforms the enterprise communications system into a strategicasset for businesses, by enabling them to communicate to “anyone, at any place,at any time and in any way” they choose.

Our productofferings include:

·       IPtelephony solutions;

·       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);

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·       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 professionals of our services organization, togetherwith our network of business partners and our ability to diagnose customernetwork faults remotely, can provide 24-hours-a-day, seven-days-a-weekservice to our customers around the world. Our end-to-end portfolio of servicesofferings provides a single point of accountability and includes:

·       maintenanceservices;

·       professionalservices, consulting, design and network integration;

·       productimplementation; and

·       managedservices.

***Customers and Competitive Advantages***

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

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in approximately 100 other countries. As a result ofour acquisition of Tenovis in November 2004, we have significantlyincreased our presence in Europe, particularly in Germany.

We are focused onthe migration of our customers’ traditional voice communications to a convergednetwork that provides for the integration of voice, data, video and otherapplications traffic on a single network. We offer customers the flexibility toimplement new IP telephony solutions or “IP-enable” their existing voicecommunications systems, thereby preserving some of their existingcommunications technology investments and allowing them to implement IPtelephony at their own pace. Converged networks offer increased functionalityand provide our enterprise customers with the ability to reach the right personat the enterprise, at the right time, in the right place and in the right way,thereby optimizing business interactions and enhancing our customers’ abilityto grow revenue and reduce costs. Our products, applications and services areintended to drive the integration of communications and business processes,making communications an important component of our customers’ businessstrategies.

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

·       clearfocus on the enterprise;

·       extensive voice experienceand expertise, and a reputation for superior products and technology for voiceprocessing and applications;

·       a comprehensive suite ofindustry-leading communications applications, including remote/mobile offeringssuch as speech access, remote agents and softphones, which allow our customersto 

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improve workerproductivity and reduce network and real estate costs by providing securebusiness communications to a dispersed workforce;

·       investment protection fortraditional telephony systems, allowing customers to upgrade and take advantageof the benefits of IP telephony while maintaining a significant portion oftheir previous equipment investment (i.e.“IP-enable” their existing voicecommunications system);

·       a large installed globalcustomer base;

·       world-class contact centerofferings that assist our customers in managing communications with theirclients;

·       a global servicesorganization that offers end-to-end customer solutions, including remote maintenanceand diagnostic services that sense and fix software outages, often beforecustomers even realize there may be a problem; and

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

***Financial Results Summary***

*Revenue*—Revenuewas $3,784 million and $3,606 million for the first nine months of fiscal 2006and 2005, respectively. The $178 million increase was across both of ouroperating segments and all of our regions. All revenue types benefited from afull nine months of Tenovis in fiscal 2006, compared to a partial period lastfiscal year, due to its acquisition on November 18, 2004. Revenues werenegatively impacted by $46 million of unfavorable foreign currencyfluctuations, primarily related to the euro.

*GrossMargin*—Our gross margin for the first nine months of fiscal2006 was 46.4%, roughly flat compared to the same period last fiscal year.

*OperatingExpense*—Our selling, general and administrative (SG&A)expenses increased by $38 million to $1,207 million for the first nine monthsof fiscal 2006, compared to the same period in fiscal 2005. This net increasewas primarily due to expenses associated with a full period of Tenovis, assetimpairment charges and increased employee benefit costs, partially offset bybenefits from the favorable resolution of non-income tax audits in severaljurisdictions, the reduction of a portion of our vacation accrual and savingsfrom headcount reductions.

Our research and development (R&D) expensesincreased due to costs incurred in connection with the design, coding andtesting and other activities associated with the planning stages of new productdevelopment.

We recorded $42 million of restructuring chargesduring the first nine months of fiscal 2006 for lease termination obligationsand employee separation payments in EMEA.

*Profitability*—Wehave reported net income for each of the last 13 consecutive quarters and eachof our operating segments has been profitable on an annual basis for the pasttwo fiscal years. We reported net income of $153 million during the first ninemonths of fiscal 2006, a decline from the net income of $261 million reportedfor the same period in fiscal 2005. The decline in net income is a result of anincrease in the provision for income taxes of $147 million, primarily due to a$116 million discrete tax benefit in fiscal 2005, partially offset by a $37million increase in income from continuing operations before income taxes.Income from continuing operations before income taxes in fiscal 2006 wasaffected by $42 million of restructuring charges as compared to fiscal 2005,which was affected by a $41 million loss from the extinguishment of debt.

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*Liquidity*—Wehave capital lease obligations of $14 million and no funded long-term debt. Weended the third quarter of fiscal 2006 with a cash balance of $822 million, anincrease of $72 million from the beginning of our fiscal year.

**Key Trends andUncertainties Affecting Our Results**

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

The following arethe key factors currently affecting our revenue:

·       *Technology transition*—There areseveral factors that indicate that enterprises are in the midst oftransitioning their traditional communications systems to next-generationcommunications technology. First, although many large companies have begun totransition to IP telephony, IP telephony lines still constitute a smallpercentage of global installed enterprise telephony lines. We have begun to seecompanies that have purchased IP-enabled communications technology start toimplement IP technology across their organizations. In addition, the averageage of non-IP enterprise telephony systems is over ten years. Although thesesystems continue to operate reliably after ten years, enterprises typicallywill consider a new investment in enterprise communications technology at thispoint in the telephony system’s lifecycle. Accordingly, we believe that enterprisesare increasingly considering new investments in enterprise communications and,if they decide to make such investments, may consider IP telephony.Additionally, we believe that IP telephony has gained widespread acceptance inthe marketplace as an alternative replacement option, and we expect to seeincreased demand as the industry continues to go through the mainstreamadoption phase in the product lifecycle. According to the latest availableindustry statistics, approximately half of all lines currently being shippedare IP rather than traditional.

As a result of the technology transition, spending byenterprises on traditional voice communication systems has been declining.Increases in our product revenue attributable to sales of IP telephony systemscontinue to be offset in part by declines in product revenue attributable totraditional voice communication systems.

·       *Competitive environment*—We havehistorically operated, and continue to operate, in an extremely competitiveenvironment. One aspect of this environment is that we regularly face pricingpressures in the markets in which we operate which may negatively impact ourgross margins. This includes not only transactions that may involve competitivebidding, but also price erosion that occurs over many years with the effectthat contracts that were entered into several years ago are renewed at lowerprices. This price erosion affects both our rental and managed services offers,as well as maintenance. We have been able to partly mitigate the effects ofpricing pressures on profitability through our cost reduction initiatives. Inaddition, we are facing competition from companies that offer similar productsand applications to those we offer as part of their larger, bundled offering.For other uncertainties related to the competitive environment in which weoperate, see “Forward Looking Statements—Risks Related To Our Revenue andBusiness Strategy — We face intense competition from our current competitorsand, as the enterprise communications and information technology marketsevolve, may face increased competition from companies that do not currentlycompete directly against us.”

·       *Pressures on services business*—Wecontinue to face challenges in our Avaya Global Services segment. A highcorrelation exists with respect to customers in our direct channel who purchaseproducts also electing to purchase maintenance contracts at the time of theproduct purchase. If the shift in mix of sales of products toward the indirectchannel were to continue, the maintenance business may be negatively affectedas our indirect channel partners have historically had lower attach rates onreselling our services to their end customers. In addition, maintenancerevenues have been affected by changes in scope (i.e. number of ports, number of sites, orhours and levels of 

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coverage) at the time ofcontract renewal, cancellations and increased competition, as well as the priceerosion noted above.

·       *Supply chain issue*—During fiscal 2006, we have experienceddisruption and delays in delivery of certain products from our contractmanufacturers in meeting timelines for our customer requirements. We continueto take actions to correct the causes of these disruptions and delays,including assuring adequate sources of components and materials. Our supplysituation improved in the third quarter of fiscal 2006 and we do not expect thesupply shortage to be significant beyond the fourth quarter of fiscal 2006. See“Outsourcing of Certain Manufacturing Operations” for more information relatedto issues with our outsourced manufacturing operations.

·       *Foreign currency*—Our revenues outside of the U.S. were 42%of our consolidated revenues in the nine months ended June 30, 2006compared to 41% for the same period 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. Revenues for thenine months ended June 30, 2006 included an unfavorable currency impact of$46 million.

·       *Rental business model*—Under the rental business model wehave historically used in EMEA, the rental revenue comprising both product andservices revenue is recognized over the term of the rental agreement andreported as rental and managed services revenue. We have implemented a newoffer to the market in EMEA, whereby we sell products to a third-party financecompany which in turn leases the equipment to the end-user. This arrangementresults in upfront recognition of product revenue rather than the productportion of the rental revenue being recognized over the term of the rentalagreement. Although our revenues to date from this new offer have not beensignificant, if we are successful at implementing this offer, as our currentand new rental customers accept this new leasing offer we expect that sales ofproducts and maintenance revenue will increase and rental and managed servicesrevenue will decrease.

·       *Economic conditions*—An important factor affecting ourability to generate revenue is the effect of general economic conditions on ourcustomers’ willingness to spend on information technology and, particularly,enterprise communications technology. As economic conditions have graduallyimproved in most of our markets over the past few years, we have seen indicationsthat enterprises may be more willing to spend on enterprise communicationstechnology than in the past several years. While the world economy is expectedto grow, variability in employment, corporate profit growth, interest rates,energy prices and other factors in specific markets could impact corporatewillingness to spend on communications technology in the near term.Additionally, the country-to-country variability in worldwide economic growthcould also impact our business as growth rates of developed and more stableeconomies tend to be lower than that of emerging economies, where there couldbe more variables affecting the economic growth.

***Continued Focus on Cost Structure***

As a result of the growth of our revenue and ourcontinued focus on controlling costs, we became profitable in the third quarterof fiscal 2003 and have been profitable in each of the twelve subsequentquarters. During fiscal 2005 and 2006, we continued to focus on controlling ourcosts.

As part of our focus oncontrolling costs, we have reduced the management and back office headcount inour U.S. sales organization and have also reduced the headcount in our servicesbusiness. In addition, during fiscal 2005, we reached agreements with thevarious Works Councils in Europe to reduce our EMEA workforce. Including thosepositions agreed to by the Works Councils, we reduced our workforce byapproximately 800 positions in EMEA, the majority of which have been eliminatedas of June 30, 2006. We have begun to realize the benefits of these prioryear actions in fiscal 2006. During the second quarter 

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offiscal 2006, we recorded $5 million of expense related to higher thanoriginally expected per employee separation costs for these former Tenovisemployees and a restructuring charge of $15 million in order to reduce costsand expenses and to improve operational performance in Germany. Therestructuring plan included a reduction of approximately 150 positions acrossvarious business groups, with employee separation payments determined throughindividual negotiations. As previously disclosed, we anticipated taking furtheractions to reduce our workforce in EMEA during the third quarter of fiscal2006, and recorded an additional charge of $4 million, representing employeeseparation payments for approximately 40 additional positions. We will begin topartially realize the cost saving benefits of these actions during the secondhalf of fiscal 2006 and expect to fully realize the benefits in fiscal 2007. Weare assessing a plan to take further actions in the fourth quarter affectingEMEA and the U.S. in order to further reduce costs and expenses.

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

As further discussed in “Liquidityand Capital Resources,” our cash balance increased by $72 million to $822million as of June 30, 2006. During the nine months ended June 30,2006, we generated positive cash flow from operations of $456 million and used$256 million to repurchase 22,534,200 shares of our common stock in accordancewith a share repurchase plan authorized by the Board of Directors. See Part II,Item 2, “Changes in Securities, Use of Proceeds and Issuer Purchases of EquitySecurities” for more information on the repurchases for the third quarter offiscal 2006. We also continued to use cash for capital expenditures andsoftware development costs.

***Deferred Tax Assets***

As of June 30, 2006,we had $933 million in net deferred tax assets resulting from tax credit carryforwards,net operating losses and other deductible temporary differences, which areavailable to reduce taxable income predominately in the U.S. in future periods.The net deferred tax asset is net of a valuation allowance of $174 million,which was calculated in accordance with the provisions of Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes.” Thevaluation allowance is comprised of $142 million of non-U.S. deferred taxassets and $32 million relating to certain U.S. federal and state deferred taxassets that continue to be fully reserved. Included in the net deferred taxassets is an $82 million net deferred tax liability primarily related to theacquisition of intangible assets in Germany.

***Employees***

As of June 30, 2006, we employed 18,342employees, of which 18,120 are full-time (12,581 are management andnon-represented employees and 5,539 are represented employees covered bycollective bargaining agreements or works councils) and 222 are part-timeemployees (127 are management and non-represented employees and 95 arerepresented employees covered by collective bargaining agreements or workscouncils).

Of the 5,634 full-time and part-time employees coveredby collective bargaining agreements or works councils, 2,880 employees arecovered by collective bargaining agreements in the United States. Not includedin the numbers above are 645 non-represented employees at Avaya GlobalConnectLtd. (“AGC”), our majority-owned subsidiary in India.

Effective May 28,2006, we renewed our collective bargaining agreements with the CommunicationsWorkers of America and the International Brotherhood of Electrical Workers. Theagreements are for a term of three years, ending May 23, 2009. Theagreements provide for a 3% per year wage increase for employees during theduration of the agreements and an initial, one-time 4% increase to future employees’pension benefits after July 1, 2006. Among other terms, the agreementsalso include additional cost sharing by employees and retirees for certainhealth benefits. The agreements change certain benefit levels for the 

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Company’sdefined benefit pension plan and the related other postretirement employeebenefits (OPEB) for represented employees. These changes for representedemployees have been reflected by the Company’s actuary through a re-measurementof the plans and the actuarial assumptions at June 1, 2006. The impact ofthese changes is not expected to have a significant impact on the Company’soverall pension and OPEB expense for the remainder of fiscal 2006. Therepresented employees ratified the agreements in July 2006.

***Outsourcing of Certain Manufacturing Operations***

We have outsourced substantially all of our productmanufacturing operations. Most of these operations have been outsourced to CelesticaInc. (“Celestica”) and are currently manufactured in Mexico, Malaysia and theCzech Republic, although we also have other contract manufacturers. Ouroutsourcing agreement with Celestica was extended and now expires in November 2007.The remaining sources of our manufacturing capacity are outsourced to a numberof other contract manufacturers located in the United Kingdom, France, Germany,China and Israel. All manufacturing of the Company’s products is performed inaccordance with detailed specifications and product designs furnished by theCompany and is subject to rigorous quality control standards.

During the beginning of fiscal 2006, we experienceddisruption and delays in delivery of certain products from our contractmanufacturers in meeting timelines for our customer requirements. The supplysituation improved throughout the third quarter in relation to our requirementsand we are continuing to experience improvements in product commitments in ourfourth quarter. Due to the number of variables involved, it is difficult toquantify a specific impact to the third quarter of fiscal 2006, but we haveworked to correct the causes of these disruptions and delays, and madesignificant progress since the estimated net impact on second quarter’s revenuesof up to $30 million to $35 million. We do not expect these supply issues tohave a significant impact beyond our results for the fourth quarter of fiscal2006.

For more information on risks related to theoutsourcing of certain manufacturing operations, see “Forward LookingStatements—Risks Related To Our Operations—We depend on contract manufacturersto produce the majority of our products and if these manufacturers are unableto fill our orders on a timely and reliable basis, we will likely be unable todeliver our products to meet customer orders or satisfy their requirements.”

We also may from time to time be subject to variousstate, federal and international laws and regulations governing theenvironment, including those restricting the presence of certain substances inelectronic products and making producers of those products financiallyresponsible for the collection, treatment, recycling and disposal of certainproducts. For example, the European Union (“EU”) has enacted the Restriction ofthe Use of Certain Hazardous Substances in Electrical and Electronic Equipment(“RoHS”) and the Waste Electrical and Electronic Equipment (“WEEE”) directives.RoHS prohibits the use of certain substances, including mercury and lead, incertain products put on the market after July 1, 2006. The WEEE directiveobligates parties that place electrical and electronic equipment onto themarket in the EU to put a clearly identifiable mark on the equipment, registerwith and report to EU member countries regarding distribution of the equipment,and provide a mechanism to take back and properly dispose of the equipment.Each EU member country has enacted, or is expected to soon enact, legislationclarifying what is and what is not covered by the WEEE directive in thatcountry. We have met the requirements of the RoHS and WEEE directives,including adhering to the July 1, 2006 deadline for meeting RoHS materialcomposition restrictions. Similar laws and regulations have been or may beenacted in other regions.

We face increasingcomplexity in our product design, logistics and procurement operations as weadjust to new and upcoming requirements relating to the materials compositionof our products. Other environmental regulations may require us to reengineerproducts to utilize components which are more 

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environmentallycompatible and such reengineering and component substitution may result inadditional costs to us. Notwithstanding our ability or willingness toreengineer products or pay additional costs, we still may be adversely affectedif the materials and components that we need are unavailable to us. Inaddition, if we were found to be in violation of these laws, we could besubject to governmental fines, any noncompliant products may be banned fromEuropean markets and our customers may incur liability. Although we do notanticipate any material adverse effects based on the nature of our operationsand the effect of such laws, there is no assurance that such existing laws orfuture laws will not have an adverse effect on us.

***Operating Segments***

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** **                       |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------------------------------|----------------------------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **                         | ** **                       | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** **                       | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $ 648 |       | $          | 707        |       | $          | 661        |       | $                                   | 661        | ** **                         | Global  Communications Solutions | ** ** | $ | 704 | ** ** | $ | 648 |   |   | 54 | % |   |   | 52 | % |   | $ | 56 |   | 8.6 | % |
| 588        |       | 589        |       | 588        |       | 577        |       | Avaya Global  Services              |       | 593                                |                             | 588 |   |   | 46 | % |   |   | 48 | % |   | 5 | ** ** | 0.9 | % |
| $1,236     |       | $          | 1,296      |       | $          | 1,249      |       | $                                   | 1,238      |                               | Total                            |   | $ | 1,297 |   | $ | 1,236 |   |   | 100 | % |   |   | 100 | % |   | $ | 61 | ** ** | 4.9 | % |

 

The increase in revenuescontributed by the GCS segment for the third quarter of fiscal 2006 compared tothe third quarter of fiscal 2005 is due to increases in sales of largecommunications systems to indirect customers in the U.S. The increase in AGSrevenues is primarily associated with 2006 FIFA World Cup events. Overall Avaya’sresults were affected by $4 million of favorable foreign currency impact.

**Results fromContinuing Operations**

***Three Months Ended June 30, 2006 Compared withThree Months Ended June 30, 2005***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 566        |       | $          | 631        |       | $          | 591        |                                | $          | 593                                | ** ** | Sales of products | ** ** | $ | 636 | ** ** | $ | 566 |   |   | 49 | % |   |   | 46 | % |   | $ | 70 |   | 12.4 | % |
| 497        |       | 499        |       | 501        |       | 487        |       | Services                            |       | 504                                |       | 497 |   |   | 39 | % |   |   | 40 | % |   | 7 | ** ** | 1.4 | % |
| 173        |       | 166        |       | 157        |       | 158        |       | Rental and managed  services        |       | 157                                |       | 173 |   |   | 12 | % |   |   | 14 | % |   | (16 | **)** | -9.2 | % |
| $          | 1,236      |       | $          | 1,296      |       | $          | 1,249      |                                | $          | 1,238                              |       | Total revenue |   | $ | 1,297 |   | $ | 1,236 |   |   | 100 | % |   |   | 100 | % |   | $61 | ** ** | 4.9 |   |
|            |            |            |            |            |            |            |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Sales of products for the third quarter of fiscal 2006increased in all regions, including a 15% increase in the U.S. when compared tothe third quarter of fiscal 2005. The increase in sales of products occurred inour indirect channel, particularly related to sales of our large communicationssystems. Services revenue for the third quarter of fiscal 2006 increasedprimarily in the EMEA region due to revenues associated with 2006 FIFA WorldCup events. Rental and managed services for the third quarter of fiscal 2006decreased primarily due to customers reducing the scope of contracted servicesand decreased rental contract renewal rates.

40

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Thefollowing table sets forth a geographic comparison of revenue:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                                                   | ** ** | **Third Fiscal Quarter** |       |
|------------|------------|------------|------------|------------|------------|------------|------------|----------------------------------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                                                   | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions***                            | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** |
| $          | 717        |       | $          | 768        |       | $          | 734        |                                                           | $          | 719                      |       | U .S. |   | $ | 753 |   | $ | 717 |   | 58 | % |   | 58 | % |   | $ | 36 |   | 5.0 | % |
|       |       |       |       |       |       |       |       | Outside the U .S.:                                             |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 206        |       | 194        |       | 186        |       | 182        |       | Germany                                                        |       | 182                      |       | 206 |   | 14 | % |   | 16 | % |   | (24 | ) | -11.7 | % |
| 171        |       | 184        |       | 178        |       | 174        |       | EMEA—Europe / Middle    East / Africa (Excluding Germany) |       | 205                      |       | 171 |   | 16 | % |   | 14 | % |   | 34 |   | 19.9 | % |
| 83         |       | 90         |       | 87         |       | 99         |       | APAC—Asia Pacific                                         |       | 87                       |       | 83 |   | 7 | % |   | 7 | % |   | 4 |   | 4.8 | % |
| 59         |       | 60         |       | 64         |       | 64         |       | Americas , non-U  .S.                                          |       | 70                       |       | 59 |   | 5 | % |   | 5 | % |   | 11 |   | 18.6 | % |
| 519        |       | 528        |       | 515        |       | 519        |       | Total outside the  U .S.                                       |       | 544                      |       | 519 |   | 42 | % |   | 42 | % |   | 25 |   | 4.8 | % |
| $          | 1,236      |       | $          | 1,296      |       | $          | 1,249      |                                                           | $          | 1,238                    |       | Total revenue |   | $ | 1,297 |   | $ | 1,236 |   | 100 | % |   | 100 | % |   | $ | 61 |   | 4.9 | % |
|            |            |            |            |            |            |            |            |                                                                |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues in the U.S. increased for the third quarterof fiscal 2006 compared to the same quarter last fiscal year due to increasesin sales of products through the indirect channel. Decreased revenues inGermany were primarily due to a decline in maintenance services as well asrental and managed services, which have both seen the effects of contracts thatwere entered into several years ago being renewed at lower prices as well ascontract cancellations. The decline in Germany revenue was partially offset byrevenues associated with 2006 FIFA World Cup events. Revenues in EMEA,excluding Germany, increased primarily due to growth in the UK and Russia.Revenues increased for APAC, primarily in Japan, and revenues increased forAmericas, non-U.S, primarily in Canada, Brazil and Mexico.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | **Third Fiscal Quarter** |       |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** |
| $          | 279        |       | $          | 322        |       | $          | 268        |                                | $          | 250                      |       | Direct |   | $ | 277 |   | $ | 279 |   | 44 | % |   | 49 | % |   | $ | (2 | ) | -0.7 | % |
| 287        |       | 309        |       | 323        |       | 343        |       | Indirect                            |       | 359                      |       | 287 |   | 56 | % |   | 51 | % |   | 72 |   | 25.1 | % |
| $          | 566        |       | $          | 631        |       | $          | 591        |                                | $          | 593                      |       | Total sales of  products |   | $ | 636 |   | $ | 566 |   | 100 | % |   | 100 | % |   | $ | 70 |   | 12.4 | % |
|            |            |            |            |            |            |            |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

There was a shift in ourmix of sales of products toward the indirect channel compared to the thirdquarter of fiscal 2005. All regions experienced increases in sales of product throughthe indirect channel. Increases in indirect revenues were most significant inthe U.S and EMEA, primarily related to sales of our large communicationssystems.

***Gross Margin***

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | **Third Fiscal Quarter** |       |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | *** ***                        | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** |
| $          | 301        |       | $          | 337        |       | $          | 314        |                                | $          | 318                      |       | On sales of  products |   | $ | 332 |   | $ | 301 |   | 52.2 | % |   | 53.2 | % |   | $ | 31 |   | 10.3 | % |
| 172        |       | 174        |       | 180        |       | 170        |       | On services                         |       | 170                      |       | 172 |   | 33.7 | % |   | 34.6 | % |   | (2 | ) | -1.2 | % |
| 102        |       | 105        |       | 95         |       | 90         |       | On rental and  managed services     |       | 86                       |       | 102 |   | 54.8 | % |   | 59.0 | % |   | (16 | ) | -15.7 | % |
| $          | 575        |       | $          | 616        |       | $          | 589        |                                | $          | 578                      |       | Total gross margin |   | $ | 588 |   | $ | 575 |   | 45.3 | % |   | 46.5 | % |   | $ | 13 |   | 2.3 | % |
|            |            |            |            |            |            |            |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Overall gross margindollars increased compared to the third quarter of fiscal 2005, while the grossmargin rate decreased in all revenue types and overall. The gross margin rateon sales of products was negatively impacted by higher discounts in the U.S.and EMEA and lower margins associated with indirect channel revenue, partiallyoffset by an increase in volumes and favorable impact of cost reductions. Thegross margin rate on services was negatively impacted by a decline inmaintenance service volumes and 

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implementationand integration costs related to the 2006 FIFA World Cup events, partiallyoffset by the impact of headcount reductions initiated in fiscal 2005. Thegross margin rate on rental and managed services had a significant impact onthe overall gross margin rate decline, and was due to the deployment of a largecustomer engagement with low margins, lower revenues in our rental business inGermany, and reductions in the scope of new contracts.

***Operating expenses***

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                     | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|--------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                     | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|       | $          | 406        |       |       |       | $          | 414        |                           |       |                     | $          | 385 |   |   |   | $ | 399 |   |   | Selling, general and administrative |   | $ | 423 |   | $ | 406 |   | 32.6 | % | 32.8 | % | $ | 17 |   | 4.2 | % |
|       | 93         |       |       |       | 98         |       |       |                           | 97         |                     |       |   | 106 |   |   | Research and development |   | 115 |   | 93 |   | 8.9 | % | 7.6 | % | 22 |   | 23.7 | % |
|       | —     |       |       |       | 22         |       |       |                           | —     |                     |       |   | 20 |   |   | Restructuring charges |   | 22 |   | — |   | 1.7 | % | 0.0 | % | 22 |   | 100.0 | % |
|       | $          | 499        |       |       |       | $          | 534        |                           |       |                     | $          | 482 |   |   |   | $ | 525 |   |   | Total operating  expenses |   | $ | 560 |   | $ | 499 |   | 43.2 | % | 40.4 | % | $ | 61 |   | 12.2 | % |

 

The increase in SG&A expenses is primarily due to$29 million of asset impairment charges, of which $28 million related tocertain internal-use software assets. SG&A expenses also included increasedemployee benefit costs. These charges were partially offset by the $22 millionbenefit from the favorable resolution of non-income tax audits in severaljurisdictions, plus further savings from headcount reductions in both the U.S.and EMEA.

The increase in research and development expenses(R&D) is the result of costs incurred in connection with the design, codingand testing and other activities associated with the planning stages of newproduct development. The costs for products in this stage of development werehigher in the current period than in the comparable period.

Restructuring charges forthe third quarter of fiscal 2006 represent $18 million of lease terminationobligations for the closing and consolidation of international officefacilities and $4 million of employee separation costs in EMEA.

***Other Income, Net***
|          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                     | ** ** | **Third Fiscal Quarter** | ** ** |
|----------|------------|------------|------------|------------|------------|------------|------------|--------------------------------|------------|------------------------------------|------------|
| **3Q05** | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** ** | **2005** | ** ** | **Change** | ** ** |
|     | $          | 4          |       |       |       | $          | 2          |                           |       |                               | $          | 5 |   |   |   | $ | 6 |   |   | Other income ,  net |   |   | $ | 5 |   |   |   | $ | 4 |   |   | $ | 1 |   | 25 | % |
|          |            |            |            |            |            |            |            |                                |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net for thethird quarter of fiscal 2006 primarily represents interest income. Otherincome, net for the same quarter in fiscal 2005 is related primarily to $6million of interest income, partially offset by a $1 million loss on therepayment of $159 million principal amount of secured floating rate notes andother miscellaneous items.

***Interest Expense***
|          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|----------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------------------------------|------------|
| **3Q05** | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** ** | **2005** | ** ** | **Change** | ** ** |
|     | $          | 3          |       |       |       | $          | 1          |                                |       |                               | $          | 1 |   |   |   | $ | 2 |   |   | Interest expense |   |   | $ | — |   |   |   | $ | 3 |   |   | $ | (3 | ) | -100% |   |
|          |            |            |            |            |            |            |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease of interestexpense is due to the reduction of outstanding debt during fiscal 2006.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------------------------------|------------|
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | (117       | )          | $          | (577       | )          |       | $          | 40                                  |       |                               |       | $ | 19 |   |   | (Benefit from)  provision for income taxes |   | $ | (11 | ) | $ | (117 | ) | $ | 106 |   | -91 | % |
|            |            |            |            |            |            |            |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The benefit from income taxes for the third quarter offiscal 2006 was primarily due to an $18 million tax benefit associated withtransfer pricing adjustments and a $3 million tax benefit resulting from anon-U.S. audit settlement These benefits were partially offset by provisionsfor U.S. federal, state and non-U.S taxes, resulting in an effective taxbenefit rate of 33.1%.

The benefit from incometaxes for the third quarter of fiscal 2005 was primarily related 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.

**Segment Results**

***Global Communications Solutions***

The GCS segment sells communications systems and convergedvoice applications designed for both large and small enterprises. Our offeringsin this segment include IP telephony solutions, multi-media contact centerinfrastructure and applications in support of customer relationship management,unified communications applications and appliances, and traditional voicecommunications 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 solutions; 

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

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

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

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

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

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

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

·       associatedappliances, such as telephone handsets; and

·       mediaservers for voice applications used by smaller businesses.

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

·       applicationsin support of customer relationship management; and

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·       messagingfor IP and traditional systems.

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

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                | ** ** | ** **               | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in m illions*** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 393        |       | $          | 445        |       | $          | 413        |                                      | $          | 414                      |       | Large  communications systems |   | $ | 455 |   | $ | 393 |   | 65 | % |   | 61 | % |   | $ | 62 |   | 15.8 | % |
| 93         |       | 91         |       | 88         |       | 94         |       | Small  communications systems             |       | 92                       |       | 93 |   | 13 | % |   | 14 | % |   | (1 | ) | —1.1 | % |
| 151        |       | 164        |       | 151        |       | 141        |       | Converged voice  applications             |       | 144                      |       | 151 |   | 20 | % |   | 23 | % |   | (7 | ) | —4.6 | % |
| 11         |       | 7          |       | 9          |       | 12         |       | Other                                     |       | 13                       |       | 11 |   | 2 | % |   | 2 | % |   | 2 |   | 18.2 | % |
| $          | 648        |       | $          | 707        |       | $          | 661        |                                      | $          | 661                      |       | Total GCS revenue |   | $ | 704 |   | $ | 648 |   | 100 | % |   | 100 | % |   | $ | 56 |   | 8.6 | % |

 

Revenue for GCS increased in all regions with theexception of EMEA due to the continued migration to IP products which exceededthe decline of TDM products. The primary driver for the overall increase wasprimarily due to strengthening sales in the U.S. and benefits from an increasein indirect channel revenue.

Large communication systems benefited from increasedsales of gateways and appliances partially offset by the decline of traditionalTDM products in EMEA. Small communications systems revenues decreased slightlyas a result of lower sales of traditional products in EMEA offset by higher IPOffice sales. Converged voice applications revenues decreased due to lowerdemand for traditional messaging sales partially offset by the rollout of thenew modular messaging release and contact center application sales.

Thefollowing table sets forth operating income of the GCS segment:

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **               | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|            |            |            |            |            |            |            |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |

|   | $ | 1 |   |   |   | $ | 43 |   |   |   | $ | 43 |   |   |   | $ | 32 |   |   | Operating income |   |   | $ | 36 |   |   |   | $ | 1 |   |   |   | 5.1 | % |   |   | 0.2 | % |   | $ | 35 |   | 3500.0 | % |
|--------|---|---|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|---|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|----|--------|--------|---|

 

The increase in operatingincome was primarily due to higher product sales and cost efficiencies,partially offset by pricing pressures in the direct channel and change inchannel mix.

***Avaya Global Services***

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

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

Implementation and integration services - Throughoperation, implementation and integration specialists worldwide, AGS helpscustomers leverage and optimize their multi-technology, multi-vendor environmentsthrough the use of contact centers, unified communication networks, and IPtelephony.

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Managed services - AGS supplements our customers’in-house staff and manages complex multi-vendor, multi-technology networks,optimizes network performance and configurations, backs up systems, detects andresolves faults, performs moves, adds and changes, and manages our customers’trouble tickets and inventory. This category includes customers who have chosena bundled solution with enhanced services not provided in a basic maintenancecontract. With the acquisition of Tenovis, Avaya acquired a business thatincludes both bundled services and products that are sold to customers on amonthly payment or rental payment basis. The managed services businessgenerally involves larger contracts with customers who outsource responsibilityfor their voice applications domain to us. We face challenges in this area,including ensuring that we deliver consistent levels of service globally tothese large, and often multi-national, customers while controlling costs andexpanding the required skill set of our services organization.

The profitability of our services business is alsoaffected by the fixed costs associated with our represented work forces in theU.S. and Europe and includes the impact of increases in employee benefits. Inaddition, our profitability is impacted by the complexities associated withmaintenance of multi-vendor IP networks as compared with closed, proprietaryTDM networks, such as the need to assure a sufficient level of servicetechnicians with IP skills.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                              | ** ** | Third Fiscal Quarter | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------------|------------|--------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                              | ** ** | ** **                     | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions***     | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| $          | 381        |       | $          | 375        |       | $          | 380        |                                    | $          | 366                            |       | Maintenance |   | $ | 375 |   | $ | 381 |   |   | 63 | % |   |   | 65 | % |   | $ | (6 | ) | -1.6 | % |
| 118        |       | 125        |       | 123        |       | 120        |       | Implementation and integration services |       | 130                            |       | 118 |   |   | 22 | % |   |   | 20 | % |   | 12 |   | 10.2 | % |
| 88         |       | 87         |       | 85         |       | 90         |       | Managed services                        |       | 87                             |       | 88 |   |   | 15 | % |   |   | 15 | % |   | (1 | ) | -1.1 | % |
| 1          |       | 2          |       | —     |       | 1          |       | Other                                   |       | 1                              |       | 1 |   |   | 0 | % |   |   | 0 | % |   | — |   | 0.0 | % |
| $          | 588        |       | $          | 589        |       | $          | 588        |                                    | $          | 577                            |       | Total AGS revenue |   | $ | 593 |   | $ | 588 |   |   | 100 | % |   |   | 100 | % |   | $ | 5 |   | 0.9 | % |

 

The increase in AGS revenues was driven by $12 millionof growth in non-U.S. markets, offset by a decline of $7 million in U.S.revenue.

The majority of the non-U.S. growth came fromapproximately $6 million of implementation and integration revenue in EMEArelated to the 2006 FIFA World Cup events, and higher maintenance revenues.This growth was offset by a continued decline in the EMEA rental business.Implementation and integration services revenue also increased in the U.S.,primarily due to professional services growth. The decrease in maintenancerevenue is primarily due to a decline in the U.S. business due to customerchanges in scope and cancellations, and a lack of growth in the U.S. directproduct business. Managed services in the U.S. were unfavorably affected bycustomer changes in scope and cancellations offset by modest increases outsidethe U.S.

Certain services revenue generated by AGC which waspreviously categorized as “Other” has been reclassified to maintenance revenuefor all periods presented.

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

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **                         | ** ** | ** ** | ** ** | **Percent of   Revenue** | ** ** | ** ** | ** ** |
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
|            |            |            |            |            |            |            |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |

|   | $ | 37 |   |   |   | $ | 46 |   |   |   | $ | 60 |   |   |   | $ | 41 |   |   | Operating income |   |   | $ | 34 |   |   |   | $ | 37 |   |   |   | 5.7 | % |   |   | 6.3 | % |   | $ | (3 | ) | -8.1 | % |
|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|------------------|--------|--------|---|----|--------|--------|--------|---|----|--------|--------|--------|-----|---|--------|--------|-----|---|--------|---|----|---|------|---|

 

The decrease in operatingincome is due to lower gross margins. Lower margins in managed services areprimarily due to the continued decline of the rental business, in addition tothe deployment of a large customer engagement with low margins. Revenue growthin the low-margin implementation and 

45

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integrationservices business put pressure on margins as did the continued decline of themaintenance service business. This was somewhat offset by headcount reductionsin EMEA and improved operational efficiencies.

**Corporate/Other Unallocated Amounts**

| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Third Fiscal Quarter** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------------------------------|------------|
| **3Q05**   | ** ** | **4Q05**   | ** ** | **1Q06**   | ** ** | **2Q06**   | ** ** | ***Dollars in millions*** | ** ** | **2006**   | ** ** | **2005**   | ** ** | **Change** | ** ** |
|       | $          | 38         |       |       |       | $          | (7         | )                                   |       |       | $          | 4          |       |       | $          | (20                                | )          | Operating (loss) income |   | $ | (42 | ) |   | $ | 38 |   |   | $ | (80 | ) | -211% |   |
|            |            |            |            |            |            |            |            |                                     |            |            |            |            |            |            |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At the beginning of each fiscal year, the amount ofcorporate overhead and certain other expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year in the annual plan. For instance, the annual incentiveaward accrual is adjusted quarterly based on actual year-to-date results andthose estimated for the remainder of the year.

During the third quarter of fiscal 2006, the operatingloss of $42 million is primarily due to restructuring charges of $22 millionand impairment charges of $29 million primarily related to certain internal-usesoftware assets. The restructuring charges are comprised of $18 million forlease termination obligations and $4 million for employee separation costs inGermany. These items were partially offset by $22 million related to thefavorable resolution of non-income tax audits in several jurisdictions duringthe quarter.

During the third quarter of fiscal 2005, the operatingincome of $38 million was affected primarily by an adjustment to employeeincentive awards, as well as other over/under absorption of corporate overheadsagainst plan.

***Nine Months Ended June 30, 2006 Compared withNine Months Ended June 30, 2005***

***Revenue***

The following table sets forth a comparison of revenueby type:
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Sales of products                   |       | $                                                  | 1,820      |   | $ | 1,663 |   |   | 47 | % |   |   | 46 | % |   | $ | 157 |   | 9.4 | % |
| Services                            |       | 1,492                                              |       | 1,472 |   |   | 39 | % |   |   | 41 | % |   | 20 |   | 1.4 | % |
| Rental and  managed services        |       | 472                                                |       | 471 |   |   | 12 | % |   |   | 13 | % |   | 1 |   | 0.2 | % |
| Total revenue                       |       | $                                                  | 3,784      |   | $ | 3,606 |   |   | 100 | % |   |   | 100 | % |   | $ | 178 |   | 4.9 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All revenue types were favorably impacted by a fullperiod of revenues associated with Tenovis in fiscal 2006 compared to a partialperiod in fiscal 2005 and negative impact of $46 million of unfavorablecurrency fluctuations. In addition, sales of products increased mostsignificantly in the U.S., primarily due to higher sales of large and smallcommunications systems. Services revenue was negatively affected by customerchanges in scope and cancellations in the U.S. and EMEA. Excluding the fullperiod of Tenovis, rental and managed services for the third quarter of fiscal2006 decreased primarily due to customers reducing the scope of services, contractsbeing renewed at lower prices and contract cancellations.

46

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Thefollowing table sets forth a geographic comparison of revenue:
|                                                              | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions***                          | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| U.S.                                                         |       | $                                                  | 2,206      |   | $ | 2,140 |   |   | 58 | % |   |   | 59 | % |   | $ | 66 |   | 3.1 | % |
| Outside the U.S.:                                            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                      |       | 550                                                |       | 530 |   |   | 15 | % |   |   | 15 | % |   | 20 |   | 3.8 | % |
| EMEA—Europe /  Middle East / Africa (Excluding Germany) |       | 557                                                |       | 512 |   |   | 15 | % |   |   | 14 | % |   | 45 |   | 8.8 | % |
| APAC—Asia Pacific                                       |       | 273                                                |       | 246 |   |   | 7 | % |   |   | 7 | % |   | 27 |   | 11.0 | % |
| Americas,  non-U.S.                                          |       | 198                                                |       | 178 |   |   | 5 | % |   |   | 5 | % |   | 20 |   | 11.2 | % |
| Total outside the  U.S.                                      |       | 1,578                                              |       | 1,466 |   |   | 42 | % |   |   | 41 | % |   | 112 |   | 7.6 | % |
| Total revenue                                                |       | $                                                  | 3,784      |   | $ | 3,606 |   |   | 100 | % |   |   | 100 | % |   | $ | 178 |   | 4.9 | % |
|                                                              |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues in all regions increased compared to thefirst nine months of fiscal 2005. Increases in U.S. revenues were due toincreases in sales of products, particularly to our indirect customers. Germanyand EMEA, to a lesser extent, increased primarily due to a full period ofrevenues associated with Tenovis compared to a partial period in fiscal 2005. Thesefavorable items were partially offset by $53 million of unfavorable foreigncurrency impacts in EMEA, primarily related to the euro. The increase inrevenues in APAC relates primarily to an increase in revenues associated withAGC and increased product sales throughout the region. Revenue in Americas,non-U.S. increased compared to the same period of fiscal 2005 due to anincrease in services revenue and $7 million of favorable foreign currencyimpacts which offset a decline in sales of products in the region.

Thefollowing table sets forth a comparison of revenue from sales of products bychannel:
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Direct                              |       | $                                                  | 795        |   | $ | 805 |   |   | 44 | % |   |   | 48 | % |   | $ | (10 | ) | -1.2 | % |
| Indirect                            |       | 1,025                                              |       | 858 |   |   | 56 | % |   |   | 52 | % |   | 167 |   | 19.5 | % |
| Total sales of products             |       | $                                                  | 1,820      |   | $ | 1,663 |   |   | 100 | % |   |   | 100 | % |   | $ | 157 |   | 9.4 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our mix of sales ofproducts shifted toward indirect compared to the same period in fiscal 2005.Increases in both large and small communications systems, especially in theU.S. and EMEA, contributed to an increase in indirect revenue through ourbusiness partners.

***Gross Margin***

Thefollowing table sets forth a comparison of gross margin by type:
|                                     | ** **   | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|--------------|----------------------------------------------------|------------|
| ** **                          | ** **   | ** **                                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | *** *** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| On sales of  products               |         | $                                                  | 964        |   | $ | 908 |   | 53.0 | % | 54.6 | % | $ | 56 |   | 6.2 | % |
| On services                         |         | 520                                                |       | 500 |   | 34.9 | % | 34.0 | % | 20 |   | 4.0 | % |
| On rental and  managed services     |         | 271                                                |       | 273 |   | 57.4 | % | 58.0 | % | (2 | ) | -0.7 | % |
| Total gross margin                  |         | $                                                  | 1,755      |   | $ | 1,681 |   | 46.4 | % | 46.6 | % | $ | 74 |   | 4.4 | % |
|                                     |              |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

47

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Gross margin dollarsincreased primarily due to the full period impact of Tenovis, which has lowergross margin rates, while the overall gross margin rate was slightly lower ascompared to the same period in fiscal 2005. The largest factors behind the declinein gross margin percentage on the sales of products were the full period impactof Tenovis, higher product discounts in the U.S. and lower margins associatedwith indirect channel revenues, partially offset by cost reductions. Grossmargin on services revenue increased due to cost reductions initiated in priorperiods and a reduction of a portion of our vacation accrual. The decrease ingross margin dollars and rate on rental and managed services was primarily dueto price erosion which result in contracts being renewed at lower prices overthe last several years and customer cancellations.

***Operating expenses***
|                                      | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions***  | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Selling, general  and administrative |       | $                                                  | 1,207      |   | $ | 1,169 |   | 31.9 | % | 32.4 | % | $ | 38 |   | 3.3 | % |
| Research and  development            |       | 318                                                |       | 296 |   | 8.4 | % | 8.2 | % | 22 |   | 7.4 | % |
| Restructuring  charges               |       | 42                                                 |       | — |   | 1.1 | % | 0.0 | % | 42 |   | 100.0 | % |
| Total operating expenses             |       | $                                                  | 1,567      |   | $ | 1,465 |   | 41.4 | % | 40.6 | % | $ | 102 |   | 7.0 | % |
|                                      |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in SG&A expenses is primarily due tothe full period’s impact of the Tenovis operations, which has a higher coststructure, in addition to $29 million in asset impairment charges primarilyrelated to certain internal-use software assets. SG&A expense for thecurrent period also includes increased employee benefit costs. These items werepartially offset by a $7 million benefit related to the reduction of a portionof our vacation accrual as a result of a change in company policy eliminatingcarryover vacation days for U.S. non-represented employees, the $22 millionbenefit from the favorable resolution of non-income tax audits in severaljurisdictions, and savings from headcount reductions.

The increase in R&D is the result of costsincurred in connection with the design, coding and testing and other activitiesassociated with the planning stages of new product development. The costs forproducts in this stage of development were higher in the current period than inthe comparable period. The current period also included a $3 million benefitrelated to the reduction of a portion of our vacation accrual as a result of achange in Company policy. The nine months ended June 30, 2005 included $4million of acquired inprocess R&D expenses recorded upon the acquisitionsof Spectel and Tenovis.

Restructuring charges forthe nine months ended June 30, 2006 represent $24 million of employeeseparation costs in EMEA, comprised of $19 million in order to reduce costs andexpenses and to improve the region’s operational performance and $5 million ofexpense related to higher than originally expected per employee separationcosts for former Tenovis employees than estimated at the time of acquisition.Also included in the restructuring charge for the nine months ended June 30,2006 is $18 million of lease termination obligations for certain internationaloffice facilities.

***Other Income(Expense), Net***
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Other income  (expense), net        |       |                                               | $          | 16 |   |   | $ | (34 | ) | $ | 50 |   | 147 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net, for thenine months ended June 30, 2006 primarily represents interest income.Other expense, net, for the same period in fiscal 2005 is related primarily toa $41 million loss on the repurchase of $271 million aggregate principal amountof our senior notes and a $3 million loss on the 

48

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repaymentof $262 million principal amount of our secrued floating rate notes, partiallyoffset by $18 million of interest income.

***Interest Expense***
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Interest expense                    |       |                                               | $          | 3 |   |   |   | $ | 18 |   |   | $ | (15 | ) | -83 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the nine months ended June 30,2006, interest expense decreased as a result of a lower debt principal balanceoutstanding during the period. As of June 30, 2006 we have capital leaseobligations of $14 million.

***Provision for(Benefit from) Income Taxes***
|                                            | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|
| ***Dollars in millions***        | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Provision for  (benefit from) income taxes |       |                                               | $          | 48 |   |   | $ | (99 | ) | $ | 147 |   | -148 | % |
|                                            |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The provision for income taxes for the nine monthsended June 30, 2006 is comprised of U.S. federal, state and non-U.S.taxes, and was primarily offset by the $18 million tax effect associated withtransfer pricing adjustments. The provision for income taxes for the ninemonths ended June 30, 2006 resulted in an effective rate of 23.9%.

The benefit from income taxes for the same period offiscal 2005 was primarily due to a $116 million benefit from the settlement of certainU.S. federal and state income tax matters from years prior to the distributionin accordance with the Tax Sharing Agreement between us and Lucent, partiallyoffset by a provision for state and foreign income taxes.

**Segment Results**

***Global Communications Solutions***

Thefollowing table sets forth revenue by similar class of products within the GCSsegment:
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Large  communications systems       |       | $                                                  | 1,282      |   | $ | 1,140 |   |   | 62 | % |   |   | 61 | % |   | $ | 142 |   | 12.5 | % |
| Small  communications systems       |       | 274                                                |       | 240 |   |   | 14 | % |   |   | 13 | % |   | 34 |   | 14.2 | % |
| Converged voice  applications       |       | 436                                                |       | 446 |   |   | 22 | % |   |   | 24 | % |   | (10 | ) | -2.2 | % |
| Other                               |       | 34                                                 |       | 39 |   |   | 2 | % |   |   | 2 | % |   | (5 | ) | -12.8 | % |
| Total GCS revenue                   |       | $                                                  | 2,026      |   | $ | 1,865 |   |   | 100 | % |   |   | 100 | % |   | $ | 161 |   | 8.6 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue for GCS increased in all regions except forEMEA, which was affected by approximately $7 million of unfavorable foreigncurrency impacts. The primary driver for the overall increase was strengtheningsales in the U.S. GCS also benefited from an increase in indirect channelrevenue.

The increase in total revenue for GCS was primarilyattributable to the continued migration to IP products which exceeded thedecline of traditional TDM products. Large communication systems benefited fromincreased sales of gateways and appliances and higher sales of CommunicationsManager. Increased small communications systems revenues is a result of greaterIP Office sales offset by lower sales of traditional products in EMEA.Converged voice applications revenues decreased slightly due to lower 

49

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demand for traditionalmessaging sales offset by the rollout of a new modular messaging release andcontact center application sales.

Thefollowing table sets forth operating income of the GCS segment:
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Operating income                    |       | $                                                  | 111        |   |   | $ | 14 |   |   |   | 5.5 | % |   |   | 0.8 | % |   | $ | 97 |   | 692.9 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome was primarily due to higher product sales, partially offset by pricingpressures in the direct channel.

***Avaya Global Services***

Thefollowing table sets forth revenue by similar class of services within the AGSsegment:
|                                          | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions***      | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Maintenance                              |       | $                                                  | 1,121      |   | $ | 1,130 |   |   | 64 | % |   |   | 65 | % |   | $ | (9 | ) | -0.8 | % |
| Implementation  and integration services |       | 373                                                |       | 345 |   |   | 21 | % |   |   | 20 | % |   | 28 |   | 8.1 | % |
| Managed services                         |       | 262                                                |       | 263 |   |   | 15 | % |   |   | 15 | % |   | (1 | ) | -0.4 | % |
| Other                                    |       | 2                                                  |       | 3 |   |   | 0 | % |   |   | 0 | % |   | (1 | ) | -33.3 | % |
| Total AGS revenue                        |       | $                                                  | 1,758      |   | $ | 1,741 |   |   | 100 | % |   |   | 100 | % |   | $ | 17 |   | 1.0 | % |
|                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The overall increase in AGS revenue for the ninemonths ended June 30, 2006 is due to an increase of approximately $49million in revenue outside the U.S., primarily in EMEA resulting from a fullperiod of revenues associated with Tenovis, offset by a decrease of $32 millionin the U.S. revenue.

The increase in AGS revenue was partially attributableto a full period of revenues associated with Tenovis in fiscal 2006 compared toa partial period in fiscal 2005, as well as an increase in implementationrevenues. This increase was partially offset by a decline in the U.S.maintenance revenue. Lower revenues in existing contract-related maintenancewere primarily due to changes in scope and cancellations. Implementation andintegration services increased in the U.S., EMEA and Americas, non-U.S.Excluding the impact of the business associated with Tenovis, total AGS revenuewould have declined compared to the first nine months of fiscal 2005.

Prioryear revenue amounts have been reclassified to conform to the nine months endedJune 30, 2006 reporting period. The following table sets forth operatingincome of the AGS segment:
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Operating income                    |       | $                                                  | 135        |   | $ | 120 |   |   | 7.7 | % |   |   | 6.9 | % |   | $ | 15 |   | 12.5 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in operatingincome is due to higher gross margins primarily in the U.S. Slightly highergross margins are primarily due to the impact of cost reductions in fiscal2005, as well as improved operational efficiencies in the management ofinventory levels. The slightly higher gross margins were partially offset byincreased costs due to a full period of Tenovis in 2006 compared to a partialperiod in 2005.

50

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**Corporate/Other Unallocated Amounts**
|                                     | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ***Dollars in millions*** | ** ** | ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| Operating (loss) income             |       | $                                                  | (58        | ) |   | $ | 82 |   |   | $ | (140 | ) | -171 | % |
|                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Operating loss of $58 million was recorded inCorporate / Other Unallocated Amounts for the nine months ended June 30,2006 and was primarily related to a $29 million impairment charge primarilyrelated to certain internal-use software assets, costs in EMEA (comprised of$19 million in order to reduce costs and expenses and to improve Germany’soperational performance, and $5 million of expense related to higher thanoriginally expected per employee separation costs for former Tenovisemployees), as well as certain real estate expenses. These costs were partiallyoffset by lower accruals for employee incentive awards and a $22 millionbenefit from the favorable resolution of non-income tax audits in severaljurisdictions.

The primary driver of the$82 million operating income in Corporate / Other Unallocated Amounts for thenine months ended June 30, 2005 was an adjustment to employee incentiveawards due to year-to-date operating performance being below target.

**Results ofDiscontinued Operations**

The $2 million loss fromdiscontinued operations during the nine months ended June 30, 2005 wasprimarily the result of the finalization of the working capital adjustmentrelated to the sale of our Connectivity Solutions business, in accordance withthe asset purchase agreement.

**Liquidity andCapital Resources**

During the nine monthsended June 30, 2006, we generated positive cash flow from operations of$456 million. We used $256 million during the nine months ended June 30,2006 to continue our program to repurchase and retire our shares of commonstock. We also used $136 million to acquire capitalized assets and developsoftware. Cash and cash equivalents increased by $72 million to $822 millionover the nine months ended June 30, 2006.

***Sources and Uses of Cash for the Nine Months Ended June 30,2006***

Acondensed statement of cash flows for the nine months ended June 30, 2006and 2005 follows:
|                                                               | ** ** | **Nine months  ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ***Dollars in millions***                           | ** ** | ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net cash provided by  (used for):                             |       |                                           |       |   |   |
| Operating activities                                          |       | $                                              | 456        |   | $ | 186 |   |
| Investing activities                                          |       | (139                                           | )          | (478 | ) |
| Financing activities                                          |       | (250                                           | )          | (582 | ) |
| Effect of  exchange rate changes on cash and cash equivalents |       | 5                                              |       | (8 | ) |
| Net increase  (decrease) in cash and cash equivalents         |       | 72                                             |       | (882 | ) |
| Cash and cash equivalents at beginning of year                |       | 750                                            |       | 1,617 |   |
| Cash and cash  equivalents at end of period                   |       | $                                              | 822        |   | $ | 735 |   |
|                                                               |            |                                                |            |  |  |  |  |  |  |

 

***Operating Activities***

Our net cash provided by operating activities was $456million for the nine months ended June 30, 2006, compared to $186 millionfor the nine months ended June 30, 2005. Cash provided by operating 

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activities was primarilydriven by profitable operations and improvements in working capital management.Specific items affecting our cash flows are discussed below:

*Lowerincentive payments*—During the nine months ended June 30,2006, discretionary employee awards were paid but were lower than the management incentives paid during the sameperiod last fiscal year. Payments are based on the prior fiscal year’sperformance.

*Decreasein Net Income*—We generated net income of $153 million for thenine months ended June 30, 2006 compared to $261 million in the sameperiod in fiscal 2005. This decline of $108 million was due primarily to $42million of restructuring charges and $29 million of asset impairment charges,offset by the inclusion of a full period’s results of Tenovis, continued costreductions and the favorable resolution of non-income tax audits in severaljurisdictions. Net income for the nine months ended June 30, 2005 includeda $116 million benefit from the settlement of certain U.S. federal and stateincome tax matters.

*Accounts Receivable, Net*—Thefollowing summarizes our accounts receivable, net and related metrics:
|                                                                              | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ***Dollars in millions***                                          | ** ** | ** **        | ** ** | **2006**               | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Accounts  receivable, gross                                                  |       | $                 | 869        |                   |       | $          | 920        |   |   | $ | (51 | ) |
| Allowance for  doubtful accounts                                             |       | (51               | )          |                   | (58        | )          |       | 7 |   |
| Accounts  receivable, net                                                    |       | $                 | 818        |                   |       | $          | 862        |   |   | $ | (44 | ) |
| Allowance for  doubtful accounts as a percent of  accounts receivable, gross |       | 5.9               | %          |                   | 6.3        | %          |       | -0.4 | % |
| Days sales outstanding  (DSO)                                                |       | 57 days           |       |                   | 60 days    |       |       | -3 days |   |
| Past due receivables as  a percent of  account receivable, gross             |       | 19.3              | %          |                   | 21.7       | %          |       | -2.4 | % |
|                                                                              |            |                   |            |                        |            |            |            |  |  |  |  |  |  |  |

The decrease in accountsreceivable and DSO was primarily a result of an improvement in our collectionsin North America.

*Inventory*—Thefollowing summarizes our inventory and inventory turnover:
|                                     | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ***Dollars in millions*** | ** ** | ** **        | ** ** | **2006**               | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Finished goods                      |       | $                 | 289        |                   |       | $          | 274        |   |   | $ | 15 |   |
| Raw materials                       |       | 7                 |       |                   | 14         |       |       | (7 | ) |
| Total inventory                     |       | $                 | 296        |                   |       | $          | 288        |   |   | $ | 8 |   |
| Inventory turnover                  |       | 9.6 times         |       |                   | 9.4 times  |       |       | + 0.2 times |   |
|                                     |            |                   |            |                        |            |            |            |  |  |  |  |  |  |  |

 

Inventory remained roughly unchanged compared to theend of our last fiscal year.

*Accounts Payable*—Thefollowing summarizes our accounts payable:
|                                     | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ***Dollars in millions*** | ** ** | ** **        | ** ** | **2006**               | ** ** | **2005**   | ** ** | **Change** | ** ** |
| Accounts payable                    |       | $                 | 395        |                   |       | $          | 402        |   |   | $ | (7 | ) |
| Days payable  outstanding           |       | 50 days           |       |                   | 53 days    |       |       | -3 days |   |
|                                     |            |                   |            |                        |            |            |            |  |  |  |  |  |  |  |

 

Accounts payable decreasedduring the nine months ended June 30, 2006 due to lower spending inconnection with our cost savings initiatives.

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***Investing Activities***

Net cash used for investing activities was $139million in the nine months ended June 30, 2006, compared with $478 millionin the same period in fiscal 2005. Activities in the current period include $83million for capital expenditures and $53 million for capitalized softwaredevelopment costs.

Activities in thecomparable period in fiscal 2005 included $383 million, net, used foracquisitions, primarily Tenovis and Spectel plc. We also used $97 million forcapital expenditures and $44 million for capitalized software developmentcosts, and received proceeds of $30 million from the sale of one of ourcorporate aircraft.

***Financing Activities***

Net cash used for financing activities was $250million in the nine months ended June 30, 2006, compared with $582 millionin the same period in fiscal 2005. Activities in the current period include$256 million to repurchase our common stock pursuant to our stock repurchaseplan and $14 million to repay our senior notes, partially offset by $20 millionof cash received in connection with the issuance of common stock under ouremployee stock purchase plan and the exercise of options under our stock optionplans.

Activities in thecomparable period in fiscal 2005 included $314 million to repurchasesubstantially all of our senior notes in a public tender offer, $262 million torepay our outstanding principal of secured floating rate notes and $47 millionto repurchase our common stock pursuant to our stock repurchase plan. Theseuses of cash were partially offset by $45 million of cash received inconnection with the issuance of common stock under our employee stock purchaseplan and the exercise of options under our stock option plans.

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

***Future Cash Requirements***

Our primary future cash requirements will be to fundworking capital, share repurchases, capital expenditures, restructuringpayments and benefit obligations.

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

·       *Share repurchase plan*—Inaccordance with the share repurchase plan authorized by the Board of Directorsin April 2005, we may use up to $500 million of cash to repurchase sharesof our outstanding common stock through April 2007. For fiscal 2006, ourcredit facility described below limits our ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares of ourcommon stock during fiscal 2006 to $461 million (which represents 50% ofconsolidated net income for the Company for fiscal 2005). Since the start ofthe plan through June 30, 2006, we paid $363 million to repurchase andretire our shares. From July 1, 2006 through August 9, 2006, we paidan additional $52 million to repurchase and retire our shares, leavingapproximately $85 million available for further share repurchases according tothe limitations of the plan. These repurchases are made at management’sdiscretion in the open market or in privately negotiated transactions incompliance with applicable securities laws and other legal requirements and aresubject to market conditions, share price and other factors. See Note 9, “EarningsPer Share of Common Stock,” to our Consolidated Financial Statements forfurther information.

·       *Capital expenditures*—Weexpect to spend approximately $64 million for capital expenditures andcapitalized software development costs during the fourth quarter of fiscal2006.

·       *Restructuring payments*—We expect to make termination payments to formeremployees and lease termination obligations aggregating approximately $30million during the fourth quarter of fiscal 2006.

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·       *Benefit Obligations*—Forthe fourth quarter of fiscal 2006, we estimate we will make payments totaling$2 million for certain U.S. pension benefits that are not pre-funded, andcontributions totaling $3 million for non-U.S. plans. Under current law, wewill not be required to make a contribution to our U.S. pension plans in fiscal2006 to satisfy minimum statutory funding requirements. However, we arecurrently evaluating whether to make a voluntary cash contribution to ourpension plan during the fourth quarter of fiscal 2006. For the fourth quarterof fiscal 2006, we also estimate we will make payments totaling $12 million forretiree medical benefits that are not pre-funded.

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

***Future Sources of Liquidity***

We expect our primary source of cash during theremainder of fiscal 2006 to be positive net cash provided by operatingactivities. We expect that growth in our revenues and continued focus onaccounts receivable, inventory management and cost containment will enable usto continue to generate positive net cash from operating activities.

We and a syndicate of lenders are currently party to a$400 million revolving credit facility (see Note 8 “Capital Lease Obligationsand Long-Term Debt” to our Consolidated Financial Statements), which expires inMay 2011. Our existing cash and cash equivalents and net cash provided byoperating activities may be insufficient if we face unanticipated cash needssuch as the funding of a future acquisition or other capital investment.Furthermore, if we acquire a business in the future that has existing debt, ourdebt service requirements may increase, thereby increasing our cash needs.

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

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $822 million as of June 30, 2006 and our net cash providedby operating activities will be sufficient to meet our future cash requirementsdescribed above. Our ability to meet these requirements will depend on ourability to generate cash in the future, which is subject to general economic,financial, competitive, legislative, regulatory and other factors that arebeyond our control.

***Uncertainties Regarding Our Liquidity***

We believe thefollowing uncertainties exist regarding our liquidity:

·       *Ability to Increase Revenue*—Ourability to generate net cash from operating activities has been a primarysource of our liquidity. If our revenues were to decline, our ability togenerate net cash from operating activities in a sufficient amount to meet ourcash needs could be adversely affected.

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

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

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·       *Pension Reform*—Thereare various pension legislation reform proposals being considered by the U.S.Congress. The reform proposals could cause a significant increase in ourrequired pension contributions beginning in fiscal 2007.

***Fair Value of Financial Instruments***

The estimated aggregate fair value of the senior noteswas $15 million as of September 30, 2005. The fair value was based uponquoted market prices and yields obtained through independent pricing sourcesfor the same or similar types of borrowing arrangements taking intoconsideration the underlying terms of the debt.

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

We conduct our business on a multi-national basis in awide variety of foreign currencies. We are therefore subject to the riskassociated with foreign currency exchange rates and interest rates that couldaffect our results of operations, financial position and cash flows. We manageour exposure to these market risks through our regular operating and financingactivities and, when deemed appropriate, through the use of derivativefinancial instruments. We use derivative financial instruments to reduceearnings and cash flow volatility associated with foreign exchange ratechanges. Derivative financial instruments are used as risk management tools andnot for speculative or trading purposes. As of June 30, 2006 and September 30,2005, the estimated fair values of our foreign currency forward contracts were$3 million and $6 million, respectively, and were included in other currentliabilities. The estimated fair values of these forward contracts were based onmarket quotes obtained through independent pricing sources.

***Debt Ratings***

Our ability to obtainexternal financing and the related cost of borrowing is affected by our debtratings, which are periodically reviewed by the major credit rating agencies.As of June 30, 2006, we had a long-term corporate family rating of Ba3with a positive outlook from Moody’s and a corporate credit rating of BB with astable outlook from Standard & Poor’s.

These ratings are not recommendations to buy, sell orhold securities. The ratings are subject to change or withdrawal at any time bythe respective credit rating agencies. Each credit rating should be evaluatedindependently of any other ratings.

***Credit Facility***

Our credit facilitycontains affirmative and restrictive covenants that we 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 credit facility alsolimits our ability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of our common stock to an amount not toexceed 50% of consolidated net income for the fiscal year immediately precedingthe fiscal year in which such dividend, purchase, redemption, retirement oracquisition is paid or made. For fiscal 2006, the credit facility allows us torepurchase, redeem or otherwise acquire shares of our common stock up to anamount not to exceed $461 million. As of June 30, 2006, we were incompliance with all of the covenants included in the credit facility.

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The credit facilityprovides that we may use up to $1 billion in cash (excluding transaction fees)and assumed debt for acquisitions completed after February 23, 2005,provided that we are in compliance with the terms of the agreement. Theacquisition amount will be permanently increased to $1.5 billion after ourconsolidated adjusted EBITDA for any period of twelve consecutive months equalsor exceeds $750 million.

There are currently $43 million of letters of creditissued under the credit facility. There are no other outstanding borrowingsunder the facility and the remaining availability is $357 million as of June 30,2006. We believe the credit facility provides us with an important source ofbackup liquidity.

**CriticalAccounting Policies and Estimates**

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

·       Revenuerecognition;

·       Collectibilityof accounts receivable;

·       Inventories;

·       Deferredtax assets and tax liabilities;

·       Themeasurement of long-lived assets, including goodwill, the impairment of whichwould impact operating expenses;

·       Restructuringprograms;

·       Pensionand post-retirement benefits costs;

·       Accountingfor stock options; and

·       Commitmentsand contingencies.

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

During the nine months ended June 30, 2006,management believes there have been no significant changes to the items that wedisclosed as our critical accounting polices and estimates in Management’sDiscussion and Analysis of Financial Condition and Results of Operations in ourAnnual Report on Form 10-K for the fiscal year ended September 30,2005, with the exception of updates to our revenue recognition policies asdescribed below.

***Revenue Recognition***

We derive revenueprimarily from the sale and service of communication systems and applications.In accordance with SEC Staff Accounting Bulletin No. 104, “RevenueRecognition,” revenue is recognized when persuasive evidence of an arrangementexists, delivery has occurred, the fee is fixed and determinable,collectibility is reasonably assured, contractual obligations have beensatisfied, and title and risk of loss have been transferred to the customer.When we provide a combination of products and 

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services to customers, thearrangement is evaluated under Emerging Issues Task Force Issue No. 00-21,“Revenue Arrangements with Multiple Deliverables,” or EITF 00-21, whichaddresses certain aspects of accounting by a vendor for arrangements underwhich the vendor will perform multiple revenue generating activities. Theapplication of the appropriate accounting guidance to our revenue requiresjudgment and is dependent upon the specific transaction and whether the saleincludes systems, applications, services or a combination of these items. Asour business evolves, the mix of products and services sold may impact thetiming of when revenue and related costs are recognized.

Our products are solddirectly through our worldwide sales force and indirectly through our globalnetwork of distributors, dealers, value-added resellers and system integrators.The purchase price of our systems and applications typically includesinstallation and a warranty for up to one year. Revenue from the direct salesof products that include installation services is recognized at the time theproducts are installed, after satisfaction of all the terms and conditions ofthe underlying customer contract.

Our indirect sales todistribution partners are generally recognized at the time of shipment if allcontractual obligations have been satisfied. We accrue a provision forestimated sales returns and other allowances and deferrals as a reduction ofrevenue at the time of revenue recognition, as required. We accrue a provisionfor estimated sales returns and other allowances and deferrals relating toinventory levels held by distributors, promotional marketing programs, etc. asa reduction of revenue at the time of revenue recognition, as required by EITF01-9, “Accounting for Consideration Given by a Vendor to a Customer” andSAB 104.

Revenue and the relatedcosts from services performed under managed services arrangements, professionalservices and services performed under maintenance contracts are deferred andrecognized ratably over the term of the underlying customer contract or at theend of the contract, when obligations have been satisfied. For servicesperformed on a time and materials basis, revenue is recognized uponperformance.

We also sell proprietaryvoice application software products. We recognize revenue related to thesesales in accordance with AICPA Statement of Position 97-2, “SoftwareRevenue Recognition.” In multiple element software arrangements, we allocaterevenue to each element based on its relative fair value. The fair value of anyundelivered elements is determined using vendor-specific objective evidence (“VSOE”)or, in the absence of VSOE for all elements, the residual method when VSOEexists for all of the undelivered elements. In the absence of fair value for adelivered element, we first allocate revenue based on VSOE of the undeliveredelements and the residual revenue to the delivered elements. Where VSOE of theundelivered element cannot be determined, we defer revenue for the deliveredelements until the undelivered elements are delivered.

Most of our sales require judgments principally in theareas of customer acceptance, returns assessments and collectibility. Theassessment of collectibility is particularly critical in determining whether ornot revenue should be recognized. We assess collectibility based primarily onthe creditworthiness of the customer as determined by credit checks andanalysis, as well as the customer’s payment history. In addition, a significantamount of our revenue is generated from sales of product to distributors. Assuch, our provision for estimated sales returns and other allowances anddeferrals requires significant judgment. We provide for estimated sales returnsand other allowances and deferrals as a reduction of revenue at the time ofrevenue recognition, as required. If these estimates, which are based onhistorical experience, are significantly below the actual amounts, our revenuecould be adversely affected.

**Forward Looking Statements**

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

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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 similarmeaning in connection with any discussion of future operating or financialperformance. From time to time, we also may provide oral or written forward-lookingstatements in other materials we release to the public.

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

Except as may be required under the federal securitieslaws, we undertake no obligation to publicly update forward-lookingstatements, whether as a result of new information, future events or otherwise.You are advised, however, to consult any further disclosures we make on relatedsubjects in our reports to the SEC. Also note that we provide the followingcautionary discussion of risks, uncertainties and possibly inaccurate assumptionsrelevant to our businesses. These are factors that we think could cause ouractual results to differ materially from expected and historical results. Otherfactors besides those listed here could also adversely affect us. Thisdiscussion is provided as permitted by the Private Securities Litigation ReformAct of 1995.

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

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

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

·       dependenceon new product development;

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

·       supplyissues related to our outsourced manufacturing operations;

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

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

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

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

·       theability to attract and retain qualified employees;

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

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

·       theability to form and implement alliances.

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

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

**A key component ofour strategy is our focus on the development and marketing of advancedcommunications products and applications and related services, including IPtelephony solutions, and this strategy may not be successful or may adverselyaffect our business.**

We are focused onthe development and sales of IP telephony solutions and other advanced communicationsproducts and applications and related services. In order to execute thisstrategy successfully, we must continue to:

·       trainour sales staff and distribution partners to sell new types of products,applications and services and improve our marketing and promotion of suchproducts, applications and services; and do so cost effectively;

·       researchand continue development of innovative IP telephony solutions and otherproducts and applications that use modes of communications other than voice,which has historically been our core area of expertise;

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

·       acquirekey technologies through licensing, development contracts, strategic alliancesand acquisitions;

·       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 service more complex, multi-vendor IPnetworks, versus a traditional closed, proprietary TDM network, and in generalensure that there is a sufficient level of service technicians with IP skills;

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

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

·       developrelationships with new types of channel partners who are capable of bothselling more advanced products and extending the Company’s reach into new andexisting markets; and

·       expandour geographic scope.

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If we do not successfully execute this strategy, ouroperating results may be adversely affected. Moreover, even if we successfullyaddress these challenges, our operating results may still be adversely affectedif the market opportunity for advanced communications products, applicationsand services, including IP telephony solutions, does not develop in the waysthat we anticipate. The ratio of revenue attributable to IP telephony solutionsversus traditional voice communication systems is expected to increase as moreand more companies convert to IP telephony solutions. IP telephony linesconstitute a small percentage of global installed enterprise telephony linesand if IP telephony does not gain widespread acceptance in the marketplace asan alternative replacement option for enterprise telephony systems our overallrevenue and operating results may be adversely affected. As the industry beginsto go through the mainstream adoption phase, we cannot predict whether:

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

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

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

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

**Revenue generatedby our traditional enterprise voice communications systems has been decliningfor the last several years and if we do not successfully execute our strategyto substitute new technology or expand our sales in market segments with highergrowth rates, our revenue and operating results may continue to be adverselyaffected.**

We are executing a strategy to capitalize on products,advanced communications and devices that provide higher growth opportunities,including IP telephony solutions. Many of the products and applications,including IP telephony solutions, have not yet been widely adopted byenterprises.  We have been experiencingdeclines in revenue from our traditional enterprise voice communicationsbusiness. We expect, based on various industry reports, that the demand forthese traditional systems will continue to decline over time. 

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

Our traditional enterprise voice communicationssystems and the advanced communications products and applications describedabove are a part of our Global Communications Solutions segment. If we areunsuccessful in executing our strategy, the contribution to our results fromthis segment may fail to grow or may decline and our overall operating resultsmay be adversely affected. Our Avaya Global Services segment may also beadversely affected to the extent that services revenues are related to sales ofthese products and applications.

**We face intensecompetition from our current competitors and, as the enterprise communicationsand information technology markets evolve, may face increased competition fromcompanies that do not currently compete directly against us.**

Historically, our GCS businesses have competed againstother providers of enterprise voice communications solutions such as Nortel NetworksCorporation, Siemens Aktiengesellschaft, Alcatel S.A. and NEC Corporation. Aswe focus on the development and marketing of advanced communications solutions, such as IP telephonysolutions, we face intense competition from these providers of voicecommunications solutions as wellas from data networking companies such as Cisco Systems, Inc. and3Com Corp. We face competition in the small and medium business marketfrom many competitors, including Cisco, Nortel, Alcatel, NEC, MatsushitaElectric Corporation of America, Inter-Tel, 

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Incorporated, 3Com Corp.,and Mitel Networks Corp., although the market for these products is fragmented.Our AGS segment competes primarily with NextiraOne, LLC, Black Box Corporation,Siemens and Verizon Communications Inc. as well as many consulting firms. Inaddition, because the market for our products is subject to rapid technologicalchange, as the market evolves we may face competition in the future fromcompanies that do not currently compete in the enterprise communicationsmarket, including companies that currently compete in other sectors of theinformation technology, communications and software industries orcommunications companies that serve residential rather than enterprisecustomers. In particular, as the convergence of enterprise voice and datanetworks becomes more widely deployed by enterprises, the business, informationtechnology and communication applications deployed on converged networks becomemore integrated. We may face increased competition from current leaders ininformation technology infrastructure, information technology, personal andbusiness applications and the software that connects the network infrastructureto those applications. Competition from these potential market entrants maytake many forms, including offering products and applications similar to thosewe offer as part of a larger, bundled offering. In addition, these technologiescontinue to move from a proprietary environment to an open standards-basedenvironment.

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

In addition, existing customers of data networkingcompanies that compete against us may be more inclined to purchase enterprisecommunications solutions fromtheir current data networking vendor than from us. Also, as communications anddata networks converge, we may face competition from systems integrators thatwere traditionally 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.

**Although ourrevenue has continued to increase since 2003, we have recently experienceddifficulties in significantly growing our revenue other than throughacquisitions.**

Although our revenue increased from $3,796 million infiscal 2003 to $4,069 million in fiscal 2004 and to $4,902 million in fiscal2005, we have recently experienced difficulty in significantly growing ourrevenue.  In addition, our operatingresults for fiscal 2005 include the operating results of Tenovis fromNovember 18, 2004, as well as other acquisitions.  Revenues for the nine months ended June 30,2006 and 2005 were $3,784 million and $3,606 million, respectively. 

One factor that significantly affects our operatingresults is the impact of economic conditions on the willingness of enterprisesto make capital investments, particularly in enterprise communicationstechnology and related services. Although general economic conditions haveimproved in recent years, we believe that enterprises continue to be concernedabout their ability to increase revenues and thereby increase theirprofitability. Accordingly, they have tried to maintain or improveprofitability through cost 

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control and constrainedcapital spending. Because it is not certain whether enterprises will increasespending on enterprise communications technology significantly in the nearterm, we could experience continued pressure on our ability to increase ourrevenue. Our ability to grow revenue is also affected by other factors, such ascompetitive pricing pressures and price erosion, see “Management’s Discussionand Analysis of Financial Condition and Results of Operations—Key Trends andUncertainties Affecting Our Revenue—Competitive environment’’ and “—Pressureson services business.”

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

***Risks Related To Our Operations***

**If we are unable toeffectively integrate acquired businesses into ours, our operating results maybe adversely affected. Even if we are successful, the integration of thesebusinesses has required, and will likely continue to require, significantresources and management attention.**

We may not be able to successfully integrate acquiredbusinesses into ours, and therefore we may not be able to realize the intendedbenefits from an 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 were inadequate or flawed,we could 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. To the extent that the Company expandsinternationally through acquisitions and fails to identify and respond tocross-cultural employee issues appropriately, it may fail to retain employeesacquired through those acquisitions, which may negatively impact itsintegration efforts.  Acquisitionscould also have a negative impact on our results of operations if it issubsequently determined that goodwill or other acquired intangible assets areimpaired, thus resulting in an impairment charge in a future period.  Finally, acquisitions often necessitaterestructurings in order to control costs and expenses and optimize the the operational performanceof the combined entity.  Theserestructurings are more difficult due to labor laws and required approvals whenthe acquired business is a company operating in multiple jurisdictions, whichmay hinder completion of restructuring actions in a timely and efficient mannerand delay anticipated cost savings.

**We depend oncontract manufacturers to produce the majority of our products and if thesemanufacturers are unable to fill our orders on a timely and reliable basis, wewill likely be unable to deliver our products to meet customer orders orsatisfy their requirements.**

We have outsourced substantially all of ourmanufacturing operations. Our ability to realize the intended benefits of ourmanufacturing outsourcing initiative depends on the willingness and ability ofour contract manufacturers to produce our products. We may experiencesignificant disruption to our operations by outsourcing too much of ourmanufacturing. If a contract manufacturer terminates its relationship with usor is unable to fill our orders on a timely basis, we may be unable to deliverthe affected products to meet our customers’ orders, which could delay ordecrease our revenue or otherwise have an adverse effect on our operations.  As discussed in Item 2, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Outsourcing of Certain Manufacturing Operations,” we have recently experiencedthese types of disruptions and delays and they have impacted our ability tomeet timelines for our customer requirements. In addition, we periodically review our product manufacturing operationsand consider appropriate changes as necessary. Although we endeavor to appropriately manage any disruption intransitioning from one contract manufacturer to another contract 

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manufacturer, we mayexperience significant disruption to our operations during any contractmanufacturer transition, and did experience such a disruption recently whilemaking this type of transition.

We rely on outside sources for the supply of thecomponents of our products and for the finished products that we purchase fromthird parties.  Delays or shortagesassociated with these components could cause significant disruption to ouroperations.

For moreinformation concerning the risks associated with our contract manufacturersoperating internationally, please see “Forward Looking Statements–Risks RelatedTo Our Operations–As our international business has grown significantly in thelast fiscal year, changes in economic or political conditions in a specificcountry or region could negatively affect our revenue, costs, expenses andfinancial condition.”

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

We protect our intellectual property through patents,trademarks, trade secrets, copyrights, confidentiality and nondisclosureagreements and other measures.  Despiteour efforts, protecting our intellectual property is difficult and not alwayscertain, and the measures we take may not provide adequate protection for ourproprietary rights, particularly in countries that do not have well-developedjudicial systems or laws that adequately protect intellectual property rights.Patent filings by third parties, whether made before or after the date of ourfilings, could render our intellectual property less valuable. Competitors maymisappropriate our intellectual property, disputes as to ownership ofintellectual property may arise and our intellectual property may otherwisefall into the public domain or be independently developed by competitors.  We believe that developing new products andtechnology that are unique to Avaya is critical to our success.

We rely on the security of our information systems,among other things, to protect our proprietary information and information ofour customers. If we do not maintain adequate security procedures over ourinformation systems, we may be susceptible to computer hacking, cyberterrorismor other unauthorized attempts by third parties to access our proprietaryinformation or that of our customers. Even if we are able to maintainprocedures that are adequate to address current security risks, hackers,cyberterrorists or other unauthorized users may develop new techniques thatwill enable them to successfully circumvent our current security procedures.The failure to protect our proprietary information 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.

**As ourinternational business has grown significantly in the last fiscal year, changesin economic or political conditions in a specific country or region couldnegatively affect our revenue, costs, expenses and financial condition.**

We conduct significant sales and customer supportoperations in countries outside of the United States and also depend onnon-U.S. operations of our contract manufacturers and our distributionpartners. For the nine months ended June 30, 2006 and 2005, we derived 42% and 41%of our revenue, respectively, from sales outside the United States.  Our future international operating results,including our ability to import our products to, export our products from, orsell our products in various countries, could be materially adversely affectedby a variety of uncontrollable and changing factors.  These factors include political conditions,economic conditions, legal and regulatory constraints, currency regulations,health or similar issues, natural disasters and other matters in any of thecountries or regions in which we currently operate or intend to operate in thefuture.  Currently, we have concernsabout weakness and uncertainty in European economies, including highunemployment levels and low economic growth forecasts, particularly in Germanywhere we have a high concentration of our business resulting from the Tenovisacquisition.

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Other factors which may impact our internationaloperations include foreign trade, environmental, monetary and fiscal policies,laws, regulations and other activities of foreign governments, agencies andsimilar organizations, and risks associated with having facilities located incountries which have historically been less stable than the United States.  Forexample, the EU has enacted the RoHS and WEEE directives, which are discussedin “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Key Trends and Uncertainties Affecting Our Results—ManufacturingOperations.”

Additional risks inherent in our internationaloperations generally include, among others, the costs and difficulties ofmanaging international operations, adverse tax consequences, includingimposition of withholding or other taxes on payments by subsidiaries, andgreater difficulty in enforcing intellectual property rights.  Our effectivetax rates in the future could be adversely affected if the geographicaldistribution of our earnings and losses is unfavorable in the future, bychanges in the valuation of our deferred tax assets or liabilities, or bychanges in tax laws, regulations, accounting principles, or interpretationsthereof.  The various risksinherent in doing business in the United States generally also exist when doingbusiness outside of the United States, and may be exaggerated by the difficultyof doing business in numerous sovereign jurisdictions due to differences inculture, laws and regulations.

In addition, foreigncurrency exchange rates and fluctuations may have an impact on our futurerevenue, costs or cash flows from our international operations, which couldadversely affect our financial performance. Because a significant portion ofour business is conducted outside the United States, we face exposure tomovements in foreign currency exchange rates which can be adverse. Theseexposures may change over time as business practices evolve, and they couldhave a material adverse impact on our financial results and cash flows.  An increase in the value of the dollar couldincrease the real cost to our customers of our products in those marketsoutside the United States, and a weakened dollar could increase the cost oflocal operating expenses and procurement of raw materials.  

***Risks Related to Contingent Liabilities***

**We may incurliabilities as a result of our obligation to indemnify, and to share certainliabilities with, Lucent in connection with our spin-off from Lucent inSeptember 2000.**

Pursuant to the Contribution and DistributionAgreement, Lucent contributed to us substantially all of the assets,liabilities and operations associated with its enterprise networking businessesand distributed all of the outstanding shares of our common stock to itsstockholders. The Contribution and Distribution Agreement, among other things,provides that, in general, we will indemnify Lucent for all liabilitiesincluding certain pre-distribution tax obligations of Lucent relating to ourbusinesses and all contingent liabilities primarily relating to our businessesor otherwise assigned to us. In addition, the Contribution and DistributionAgreement provides that certain contingent liabilities not directlyidentifiable with one of the parties will be shared in the proportion of 90% byLucent and 10% by us. The Contribution and Distribution Agreement also providesthat contingent liabilities in excess of $50 million that are primarilyrelated to Lucent’s businesses shall be borne 90% by Lucent and 10% by us andcontingent liabilities in excess of $50 million that are primarily relatedto our businesses shall be borne equally by the parties.

We cannot assure you that Lucent will not submit aclaim for indemnification or cost sharing to us in connection with any futurematter. In addition, our ability to assess the impact of matters for which wemay have to indemnify or share the cost with Lucent is made more difficult bythe fact that we do not control the defense of these matters.

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

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From time to time, we receive notices from thirdparties asserting that our proprietary or licensed products, systems andsoftware infringe their intellectual property rights.  We cannot assure you that the number of thesenotices will not increase in the future and that others will not claim that ourproprietary 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. Irrespective of the merits ofthese claims, if someone claimed that our proprietary or licensed systems andsoftware infringed their intellectual property rights, any resulting litigationcould be costly and time consuming and would divert the attention of managementand key personnel from other business issues. The complexity of the technology involved and the uncertainty ofintellectual property litigation increase these risks. These matters may resultin any number of outcomes for us, including entering into licensing agreements,redesigning our products to avoid infringement, being enjoined from sellingproducts that are found to infringe, paying damages if products are found toinfringe, and indemnifying customers from claims as part of ourcontractual obligations.  Royalty orlicense agreements may be very costly or 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 operatingresults. We have made and will likely continue to make investmentsto license and/or acquire the use of third party intellectual propertyrights and technology as part of our strategy to manage this risk, but wecannot assure you that we will be successful. We may also be subject to additional notice and other requirements tothe extent we incorporate open source software into our applications.

In addition, third parties have claimed, and may inthe future claim, that a customer’s use of our products, systems or softwareinfringes the third party’s intellectual property rights. Under certaincircumstances, we may be required to indemnify our customers for some of thecosts and damages related to such an infringement claim. Any indemnificationrequirement could have a material adverse effect on our business and ouroperating results.

**If the distributiondoes not qualify for tax-free treatment, we could be required to pay Lucent orthe Internal Revenue Service a substantial 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 the distributionfails to qualify as a tax-free distribution because of an issuance or anacquisition of our stock or an acquisition of our assets, or some other actionsof ours, then we will be solely liable for any resulting taxes to Lucent.

Second, aside from the Tax Sharing Agreement, underU.S. federal income tax laws, we and Lucent are jointly and severally liablefor Lucent’s U.S. federal income taxes resulting from the distribution beingtaxable. This means that even if we do not have to indemnify Lucent under theTax Sharing Agreement, we may still be liable for all or part of these taxes ifLucent fails to pay them. These liabilities of Lucent could arise from actionstaken by Lucent over which we have no control, including an issuance oracquisition of stock (or acquisition of assets) of Lucent.

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**Item 3.**                        *Quantitative and Qualitative Disclosures About Market Risk.*

See Avaya’s Annual Report on Form 10-K forthe fiscal year ended September 30, 2005 filed with the SEC on December 13,2005. As of June 30, 2006, there has been no material change in thisinformation.

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

*Evaluation of Disclosure Controlsand Procedures.*   Asdescribed in the Company’s Quarterly Report on Form 10-Q for thesecond fiscal quarter of 2006, management identified a “material weakness” inthe Company’s internal control over financial reporting as of March 31,2006. A “material weakness” is a control deficiency, or a combination ofcontrol deficiencies, that results in more than a remote likelihood that amaterial misstatement of our interim or annual financial statements will not beprevented or detected. The controls over communication between the HumanResources and Finance organizations within the Company’s European operationswere not effective to ensure that information related to business restructuringactivities within the EMEA region were appropriately communicated and therelated liability recorded in the proper amount and period in accordance withaccounting principles generally accepted in the United States of America (“U.S.GAAP”). This control deficiency could have resulted in a misstatement ofemployee severance costs, related liabilities and financial statementdisclosures. This matter did not, in fact, have any impact on the Company’sfinancial statements as these issues were identified and properly accounted forwithin the Company’s unaudited interim consolidated financial statements forthe second quarter of fiscal 2006.

The Company undertook aremediation plan in response to the identification of this material weaknessthat resulted in certain changes in the Company’s internal control overfinancial reporting as described below. The remediation plans described belowwere put into effect late in the Company’s third fiscal quarter of 2006.Management believes that the remediation actions taken have addressed theissue, but also believes that it is prudent to review the operation and resultsof testing of the controls during the fourth fiscal quarter to ensure theirsustainability. Therefore, the Company has concluded that the material weaknessidentified in its Quarterly Report on Form 10-Q for the secondquarter of fiscal 2006 still existed as of June 30, 2006.

As of the end of theperiod covered by this report, the Company’s management, under the supervisionand with the participation of the Company’s principal executive officer andprincipal financial officer, evaluated the effectiveness of the design andoperation of the Company’s disclosure controls and procedures (as such term isdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)). Based onthis evaluation and in light of the material weakness described above, ourprincipal executive officer and principal financial officer have concluded (1) thatthe Company’s disclosure controls and procedures were not effective to ensurethat information required to be disclosed by the Company in reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in SEC rules and forms, and (2) thatthe Company’s disclosure controls and procedures were not effective to ensurethat information required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is accumulated and communicated to theCompany’s management, including the principal executive officer and principalfinancial officer, as appropriate to allow timely decisions regarding requireddisclosure.

*Changes in Internal Control overFinancial Reporting.*   Inresponse to the identified material weakness noted above, our management, withoversight from the Company’s Audit Committee, has dedicated resources tosupport the Company’s efforts to improve its internal control over financialreporting in this area. Our remediation efforts have included (i) implementingnew policies and procedures, and related controls in the affected area, (ii) additionaltraining to the Human Resources and Finance organizations in Germany onaccounting for employee separation obligations under U.S. GAAP, (iii) cross-functionalmanagement of restructuring activities and related reserves with enhancedFinance oversight, 

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(iv) improvement ofthe Company’s existing internal representation letter process to provideadditional assurances as to the adequacy of severance/restructuring reservesand associated internal controls over such reserves and (v) theappointment of a person with significant U.S. GAAP experience in Germany. Webelieve that these remediation efforts have improved our internal control overfinancial reporting, as well as our disclosure controls and procedures.

There were no changes in our internal control overfinancial reporting during the third quarter of fiscal 2006, other than theremediation actions described above and actions related thereto, that havematerially affected, or are reasonably likely to materially affect our abilityto record, process, summarize and report financial information.

**PART II. OTHER INFORMATION**

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

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

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

See Part I, Item 2, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

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

(c) Issuer Purchasesof Equity Securities 

| ** **                    | ** ** | ** **            | ** ** | ** **          | ** ** | ** **            | ** ** | **Approximate**                        | ** ** |
|-------------------------------|------------|-----------------------|------------|---------------------|------------|-----------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | ** **            | ** ** | ** **          | ** ** | **Total number** | ** ** | **dollar value of**          | ** ** |
| ** **                    | ** ** | **Total number** | ** ** | **Average**         | ** ** | **of shares**    | ** ** | **shares that may**          | ** ** |
| ** **                    | ** ** | **of shares**    | ** ** | **price paid** | ** ** | **purchased as** | ** ** | **yet be purchased as** | ** ** |
| **Period**                    | ** ** | ** **            | ** ** | **purchased**       | ** ** | **per share**    | ** ** | **part of program**          | ** ** | **part of program** | ** ** |
| April 1—30          |       |                  | —     |                |       |                  | —     |                                   |       |   | 28,941,800 |   |   |   | $ | 199,968,395 |   |   |
| May 1—31            |       |                  | 5,117,400  |                |       |                  | $          | 12.32                                  |       |   |   | 34,059,200 |   |   |   | $ | 136,908,350 |   |   |
| June 1—30           |       |                  | —     |                |       |                  | —     |                                   |       |   | 34,059,200 |   |   |   | $ | 136,908,350 |   |   |
| Third quarter of fiscal  2006 |       |                  | 5,117,400  |                |       |                  |       |                                   |       |   |   |   |   |   |   |   |   |
|                               |            |                       |            |                     |            |                       |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

From July 1, 2006 through August 9, 2006, werepurchased and retired 5,630,000 shares at an average purchase price of $9.25per share, for an additional $52 million, leaving approximately $85 millionavailable under the limitations of the plan.

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

On July 24, 2006, theCompany announced that its Chairman, Chief Executive Officer and President,Donald K. Peterson, stepped down as Chief Executive Officer and Presidenteffective immediately. Mr. Peterson will remain Chairman of the Board ofDirectors until September 30, 2006. Louis J. D’Ambrosio, who had been theCompany’s Senior Vice President and President, Global Sales and Marketing sinceNovember 2005, has been elected by the Company’s Board of Directors tobecome President and Chief Executive Officer.

Mr. D’Ambrosio wasthe Company’s Group Vice President, Global Sales, Channels & Marketingfrom January 2004 until November 2005, and was the Group VicePresident, Avaya Global Services from the time he joined the Company in December 2002until December 2003. Prior to December 2002, he served in a number ofexecutive positions with International Business Machines Corporation, including

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most recently as VicePresident of Worldwide Sales and Marketing—Software Business. Mr. D’Ambrosiojoined IBM in 1987.

The Company also announced on July 24, 2006 theappointment of Michael C. Thurk, its Senior Vice President and President,Global Communications Solutions since November 2005, to the newly-createdposition of Chief Operating Officer. Mr. Thurk was the Company’s GroupVice President, Global Communications Solutions from October 2004 until November 2005,the Group Vice President, Enterprise Communications Group from August 2002until September 2004 and the Group Vice President, Systems, from January 2002until July 2002. Prior to joining Avaya, Mr. Thurk held variouspositions at Ericsson from June 1998 until December 2001, includingPresident, Ericsson Datacom Inc. and Vice President, Division Data Backbone andOptical Networks.

**Item 6.**                        *Exhibits*.

3.1          Restated Certificate ofIncorporation of Avaya Inc.(1)

3.2          Amended and RestatedBy-laws of Avaya Inc., as amended on July 18, 2002.(2)

10.1   Summary of the Avaya Inc.Non-Employee Director Compensation Program (as of May 2006).(3)

10.2   Amendment No. 2, dated May 26,2006, to the Credit Agreement, dated as of February 23, 2005, among AvayaInc. and Avaya International Sales Limited, as borrowers, a syndicate oflenders, and Citicorp USA, Inc., as agent for the lenders.(4)

31.1   Certification of Louis J. D’Ambrosiopursuant 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 Louis J. D’Ambrosiopursuant 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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*                    Filedherewith.

(1)          Incorporated byreference from Avaya’s Registration Statement on Form 10 (Reg. No. 1-15951).

(2)          Incorporated byreference from Avaya’s Quarterly Report on Form 10-Q for the quarterended June 30, 2002.

(3)          Incorporated byreference from Avaya’s Current Report on Form 8-K dated May 11,2006.

(4)          Incorporated byreference from Avaya’s Current Report on Form 8-K dated May 30,2006.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                     | AVAYA INC. |
|---------------------|------------|
|                | By:        | /s/  AMARNATH K. PAI |
|                |       | Amarnath K. Pai |
|                |       | *Vice-President  Finance Operations and Corporate Controller  (Principal Accounting Officer)* |
| August 9, 2006 |       |

 

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