**Exhibit 13**

**FINANCIAL REVIEW**

**Avaya Inc.**

**Tableof Contents**
| **Selected Financial Data**                                                                      | **2**  | ** ** |
|--------------------------------------------------------------------------------------------------|--------|------------|
| **Management’s Discussion and  Analysis of Financial Condition and Results of Operations**  | **5**  | ** ** |
| **Management’s Report on  Internal Control Over Financial Reporting**                       | **38** | ** ** |
| **Report of Independent  Registered Public Accounting Firm**                                     | **39** | ** ** |
| **Consolidated Statements of  Income**                                                           | **41** | ** ** |
| **Consolidated Balance Sheets**                                                                  | **42** | ** ** |
| **Consolidated Statements of Changes  in Stockholders’ Equity and of Comprehensive Income** | **43** | ** ** |
| **Consolidated Statements of Cash Flows**                                                        | **44** | ** ** |
| **Notes to  Consolidated Financial Statements**                                                  | **45** | ** ** |

 

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**SELECTED FINANCIALDATA**

The following table sets forth selected financialinformation derived from our audited consolidated financial statements as ofand for the five fiscal years ended September 30, 2006. The selectedfinancial information for all periods should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” andthe Consolidated Financial Statements and the notes thereto, in order tounderstand further the factors that may affect the comparability of the datapresented in the selected financial data table.

The following itemsaffect the comparability of the selected financial information for the yearspresented:

·  During fiscal 2006 and 2005, respectively, werecorded $104 million and $22 million of restructuring charges related toemployee separation and lease termination costs in EMEA and the U.S.

·  During fiscal 2006 and 2005, we repurchasedand retired 29,909,400 and 11,525,000 shares of our common stock, respectively,in accordance with the share repurchase plan authorized by the Board ofDirectors on April 19, 2005.

·  During fiscal 2006, we repaid the remainingportion of our senior notes, leaving long-term and short-term capital leaseobligations as our only debt. These obligations were then reclassified to OtherCurrent Liabilities and Other Liabilities, respectively.

·  During the fourth quarter of fiscal 2005, werecorded a $590 million net tax benefit related to the reversal of a portion ofour deferred tax valuation allowance.

·  In September 2005, we acquired NimcatNetworks Incorporated, a leading developer of embedded peer-to-peer IP call processing softwareheadquartered in Canada. We paid $38 million in cash, net of cashreceived. Nimcat results have been consolidated as of September 16, 2005.

·  In November 2004, we acquired TenovisGermany GmbH, a major European provider of enterprise communications systemsand services. We paid $265 million in cash, including transaction fees and netof cash received, and assumed $287 million in debt. Tenovis results have beenconsolidated as of November 18, 2004. The acquisition of Tenovis resultedin a significant increase to our consolidated revenues and expenses. The proforma impact on fiscal 2005 of the Tenovis acquisition is included in theaccompanying notes to the Consolidated Financial Statements.

·  In October 2004, we acquired Spectel plc,a leading provider of audio conferencing solutions incorporated in Ireland. Wepaid $110 million in cash, including transaction fees and net of cash received.Spectel results have been consolidated as of October 4, 2004.

·  In August 2004, we paid $24 million incash to increase our ownership in Tata Telecom Ltd., a leading voicecommunications solution provider in India, from 25.5% to 59.1%. This wasaccomplished through the acquisition of 25.1% of the issued share capital ofTata Telecom from the Tata Group, and an additional 8.5% through a public tenderoffer conducted pursuant to statutory requirements in India. As a result ofacquiring a majority interest, the Tata Telecom results have been consolidatedas of August 4, 2004. Tata Telecom has been renamed Avaya GlobalConnectLimited (“AGC”).

·  In January 2004, we sold certain assetsand liabilities of our Connectivity Solutions segment to CommScope, Inc. Accordingly,the statement of operations and balance sheet information reflects the resultsof the disposal group as discontinued operations for all periods presented.

·  In November 2003,we acquired substantially all of the assets and assumed certain liabilities ofExpanets for a purchase price of $117 million. Upon the closing, we decided tosell a portion of the 

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Expanets business that previously distributed othervendors’ products and accounted for this portion of the business as a componentof discontinued operations. This portion was sold in a series of transactionsduring December 2003 and January 2004.

**Statement of Operations Information**

| ** **                                                                 | ** ** | **Year ended September 30,**                                     | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                 | ** ** | **Dollars in millions, except per share amounts** | ** ** |
| Revenue                                                                    |       | $                                                                               | 5,148      |   | $ | 4,902 |   | $ | 4,069 |   | $ | 3,796 |   | $ | 4,387 |   |
| Gross margin                                                               |       | 2,390                                                                           |       | 2,297 |   | 1,945 |   | 1,639 |   | 1,864 |   |
| Gross margin as a  percent of revenue                                      |       | 46.4                                                                            | %          | 46.9 | % | 47.8 | % | 43.2 | % | 42.5 | % |
| Selling, general  and administrative expenses                              |       | 1,595                                                                           |       | 1,583 |   | 1,274 |   | 1,240 |   | 1,502 |   |
| Selling, general  and administrative expenses as a percent of revenue |       | 31.0                                                                            | %          | 32.3 | % | 31.3 | % | 32.7 | % | 34.2 | % |
| Research and  development expenses                                         |       | 428                                                                             |       | 394 |   | 348 |   | 336 |   | 436 |   |
| Research and  development expenses as a percent of revenue                 |       | 8.3                                                                             | %          | 8.0 | % | 8.6 | % | 8.9 | % | 9.9 | % |
| Restructuring  charges                                                     |       | 104                                                                             |       | 22 |   | — |   | — |   | 209 |   |
| Operating income  (loss)                                                   |       | 263                                                                             |       | 298 |   | 323 |   | 63 |   | (354 | ) |
| Provision for  (benefit from) income taxes                                 |       | 83                                                                              |       | (676 | ) | (49 | ) | 84 |   | 273 |   |
| Income (loss)  from continuing operations                                  |       | 201                                                                             |       | 923 |   | 291 |   | (128 | ) | (677 | ) |
| (Loss) income  from discontinued operations                                |       | —                                                                          |       | (2 | ) | 5 |   | 40 |   | 11 |   |
| Net income (loss)                                                          |       | $                                                                               | 201        |   | $ | 921 |   | $ | 296 |   | $ | (88 | ) | $ | (666 | ) |
| Earnings (loss)  per common share—basic:                              |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Earnings (loss)  per share from continuing operations                      |       | $                                                                               | 0.43       |   | $ | 1.95 |   | $ | 0.66 |   | $ | (0.34 | ) | $ | (2.47 | ) |
| Earnings per  share from discontinued operations                           |       | —                                                                          |       | — |   | 0.01 |   | 0.11 |   | 0.03 |   |
| Earnings (loss)  per share                                                 |       | $                                                                               | 0.43       |   | $ | 1.95 |   | $ | 0.67 |   | $ | (0.23 | ) | $ | (2.44 | ) |
| Earnings (loss)  per common share—diluted:                            |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Earnings (loss)  per share from continuing operations                      |       | $                                                                               | 0.43       |   | $ | 1.89 |   | $ | 0.63 |   | $ | (0.34 | ) | $ | (2.47 | ) |
| Earnings per  share from discontinued operations                           |       | —                                                                          |       | — |   | 0.01 |   | 0.11 |   | 0.03 |   |
| Earnings (loss) per  share                                                 |       | $                                                                               | 0.43       |   | $ | 1.89 |   | $ | 0.64 |   | $ | (0.23 | ) | $ | (2.44 | ) |

 

**Balance Sheet Information**

| ** **                                 | ** ** | **September 30,**            | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|
| ** **                                 | ** ** | **2006**                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                 | ** ** | **Dollars in millions** | ** ** |
| Total assets                               |       | $                                 | 5,200      |   | $ | 5,219 |   | $ | 4,159 |   | $ | 4,057 |   | $ | 3,897 |   |
| Cash and cash  equivalents                 |       | 899                               |       | 750 |   | 1,617 |   | 1,192 |   | 597 |   |
| Goodwill                                   |       | 941                               |       | 914 |   | 257 |   | 146 |   | 144 |   |
| Debt, excluding  capital lease obligations |       | —                            |       | 14 |   | 593 |   | 953 |   | 933 |   |
| Total stockholders’  equity           |       | 2,086                             |       | 1,961 |   | 794 |   | 200 |   | — |   |
|                                            |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Other Information**

| ** **                                                    | ** ** | **September 30,**            | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                    | ** ** | **2006**                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions** | ** ** |
| Net cash  (debt)(1)                                           |       | $                                 | 899        |   | $ | 736 |   | $ | 1,024 |   | $ | 239 |   | $ | (336 | ) |
| Cash flow from  operating activities of continuing operations |       | 647                               |       | 334 |   | 479 |   | 169 |   | 86 |   |
| Capital  expenditures                                         |       | 117                               |       | 147 |   | 81 |   | 57 |   | 104 |   |
| Capitalized  software development costs                       |       | 71                                |       | 59 |   | 38 |   | 29 |   | 34 |   |
| Number of employees(2)                                        |       | 18,525                            |       | 19,100 |   | 14,900 |   | 16,900 |   | 18,800 |   |
|                                                               |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)   We use net cash (debt) as an indicator of ourbalance sheet position relative to our future cash needs. In addition, webelieve that the presentation of net cash provides useful information toinvestors about our liquidity. The following table provides the reconciliationof this measure to the most directly comparable GAAP measure:

| ** **                                                                                                           | ** ** | **September 30,**            | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                           | ** ** | **2006**                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                           | ** ** | **Dollars in millions** | ** ** |
| Cash and cash  equivalents                                                                                           |       | $                                 | 899        |   | $ | 750 |   | $ | 1,617 |   | $ | 1,192 |   | $ | 597 |   |
| Debt, excluding  capital lease obligations of $13 and $16 as of September 30, 2006  and 2005, respectively |       | —                            |       | 14 |   | 593 |   | 953 |   | 933 |   |
| Net cash (debt)                                                                                                      |       | $                                 | 899        |   | $ | 736 |   | $ | 1,024 |   | $ | 239 |   | $ | (336 | ) |

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(2)   Amountsexclude approximately 700 AGC employeees as of September 30, 2006. Forfiscal years 2003 and 2002, employee numbers include employees of ConnectivitySolutions.

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**MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**
| Overview                                                             | ** ** | 5  |   |
|----------------------------------------------------------------------|------------|----|--------|
| Key Trends and Uncertainties  Affecting Our Results                  |       | 7  |   |
| Acquisitions and Divestitures                                        |       | 10 |   |
| Results from Continuing Operations                                   |       | 11 |   |
| Segment Results                                                      |       | 14 |   |
| Results of Discontinued  Operations                                  |       | 24 |   |
| Liquidity and Capital Resources                                      |       | 25 |   |
| Guarantees of Indebtedness  and Other Off-Balance Sheet Arrangements |       | 30 |   |
| Legal Proceedings and  Environmental, Health and Safety Matters      |       | 30 |   |
| Quantitative and Qualitative  Disclosures About Market Risk          |       | 30 |   |
| Recent Accounting  Pronouncements                                    |       | 31 |   |
| Recent Tax Legislation                                               |       | 32 |   |
| The  Application of Critical Accounting Policies                     |       | 32 |   |

 

“Management’s Discussionand Analysis of Financial Condition and Results of Operations” should be readin conjunction with the Consolidated Financial Statements and the notesincluded elsewhere in this Annual Report. The matters discussed in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”contain certain forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995. Please see Item 1A. “RiskFactors,” included elsewhere in this Annual Report for a discussion of the useof forward-looking statements.

**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. Ourstrategy is to evolve our communication solutions into intelligentcommunications. A key component of our strategy is to leverage our substantialexperience and expertise in traditional voice communications systems tocapitalize on the transition of these traditional voice systems to InternetProtocol (“IP”), and the adoption of IP telephony solutions. We believe ourcomprehensive suite of IP telephony solutions, communications applications andappliances, as supported by our global services organization and extensivenetwork of business partners, transforms the enterprise communications systeminto a strategic asset for businesses, by enabling them to communicate to “anyone,at any place, at any time and in any way” they choose.

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

***Customers and Competitive Advantages***

Our customer base is diverse, ranging in size fromsmall businesses employing a few employees to large government agencies andmultinational companies with over 100,000 employees. Our customers 

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include enterprisesoperating in a broad range of industries around the world, including financialservices, manufacturing, media and communications, professional services,health care, education and government.

We operate in approximately 50 countries and sellproducts and services through a network of business partners, distributors anddealers who have customers in nearly 100 other countries. As a result of ouracquisition of Tenovis in November 2004, we have significantly increased ourpresence in Europe, particularly in Germany. For fiscal 2006, approximately 42%of our revenues were generated outside the U.S.

We are focused on the migration of our customers’traditional voice communications to a converged network that provides for theintegration of voice, data, video and other applications traffic on a singlenetwork. We offer customers the flexibility to implement new IP telephonysolutions or “IP-enable” their existing Avaya voice communications systems,thereby preserving some of their existing communications technology investmentsand allowing them to implement IP telephony at their own pace. Convergednetworks offer increased functionality and provide our enterprise customerswith the ability to reach the right person at the enterprise, at the righttime, in the right place and in the right way, thereby optimizing businessinteractions and enhancing our customers’ ability to grow revenue and reducecosts. Our products, applications and services are driving the integration ofcommunications and business processes, making communications an importantcomponent of our customers’ business strategies.

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

·  clear focus on the enterprise;

·  extensive voice experience and expertise, anda reputation for superior products and technology for voice processing andapplications;

·  a comprehensive suite of industry-leadingcommunications applications, including remote/mobile offerings such as speechaccess, remote agents and softphones, which allow our customers to improveworker productivity and reduce network and real estate costs by providingsecure business communications to a dispersed workforce;

·  investment protection for traditionaltelephony systems, allowing customers to upgrade and take advantage of thebenefits of IP telephony while maintaining a significant portion of theirprevious equipment investment (*i.e.* “IP-enable”their existing voice communications system);

·  a large installed global customer base;

·  world-class contact center offerings thatassist our customers in managing communications with their clients;

·  a global services organization that offersend-to-end customer solutions, including remote maintenance and diagnosticservices that sense and fix software outages, often before customers evenrealize there may be a problem; and

·  strategic alliances with world-class businesspartners, including our large network of software development partners whodevelop vertical and other software applications that work with our telephonyand contact center offerings to meet specific customer needs.

**Financial ResultsSummary**

*Revenue—**Revenue*was $5,148million and $4,902 million for fiscal 2006 and 2005, respectively. The $246million increase was across both of our operating segments and all of ourgeographic regions. Revenues benefited from a full year of Tenovis in fiscal2006, compared to a partial period last fiscal year, 

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due to its acquisition on November 18,2004. Revenues for fiscal 2006 were negatively impacted by $35 million ofunfavorable currency fluctuations as compared to fiscal 2005, primarily relatedto the euro.

*GrossMargin—**Our*gross margin for fiscal 2006was 46.4%, compared to 46.9% last fiscal year. The gross margin decline infiscal 2006 was primarily attributable to the decline in gross margin on salesof products and rental and managed services. The decline in gross margin on thesale of products was due to a combination of several factors, including anincrease in indirect channel sales, higher discounts and unfavorable currencyimpact. The decline in gross margin on rental and managed services wasprimarily due to price erosion and customer cancellations of higher margincontracts.

*OperatingExpenses—**Our*selling, general andadministrative (SG&A) expenses increased by $12 million to $1,595million for fiscal 2006 compared to fiscal 2005. This net increase wasprimarily due to expenses associated with a full period of Tenovis, $29 millionof asset impairment charges primarily related to certain internal-use softwareassets and increased employee benefit costs, partially offset by savings fromthe resolution of non-income tax audits, a reduction of a portion of ourvacation accrual, and headcount reductions.

In fiscal 2006, our research and development (R&D)expenses increased by $34 million to $428 million due to costsincurred in connection with the design, coding and testing andother activities associated with the planning stages of new product development.

We also recorded $104 million of restructuring chargesduring fiscal 2006 for employee separation costs and lease terminationobligations in EMEA and the U.S. These charges represented an increase from $22million of restructuring charges recorded during fiscal 2005.

*Profitability—**We* have reported netincome for each of the last 14 consecutive quarters and each of our operatingsegments has been profitable on an annual basis for the past three fiscal years.We reported operating income of $263 million for fiscal 2006, a decline of $35million from fiscal 2005. The impact of increased revenues was partially offsetby restructuring charges, increased investment in R&D and a slight declinein our gross margin rate. We reported net income of $201 million during fiscal2006 compared to net income of $921 million reported for fiscal 2005. Thedecline in net income is primarily the result of a $590 million tax benefitincluded in our fiscal 2005 net income related to the reversal of a portion ofour deferred tax valuation allowance, as well as $123 million of additionaldiscrete tax benefits in fiscal 2005. In fiscal 2006, the provision for incometaxes of $83 million included a $7 million benefit for non-U.S. audit settlements.

*Liquidity—**We*ended fiscal 2006with a cash balance of $899 million, an increase of $149 million from thebeginning of our fiscal year. During fiscal 2006, we generated cash fromoperations of $647 million for the fiscal year. As of September 30, 2006,we have capital lease obligations of $13 million and no funded long-termindebtedness.

**Key Trends andUncertainties Affecting Our Results**

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

The following arethe key factors currently affecting our revenue:

·  *Technology transition*—Our growthstrategy relies heavily on capturing a significant share of the spending byenterprises on their transition of technology from traditional communicationssystems to IP telephony. There are several factors that indicate thatenterprises are in the midst of transitioning their traditional communicationssystems to next-generation communications technology. Although many largecompanies have begun to transition to IP telephony, IP telephony lines stillconstitute a small percentage of global installed enterprise telephony lines.We have begun to see companies that have purchased IP-enabled communicationstechnology start to implement IP 

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technology across theirorganizations. In addition, the average age of non-IP enterprise telephonysystems is over ten years. Although these systems continue to operate reliablyafter ten years, we believe that enterprises typically will consider a newinvestment in enterprise communications technology at this point in thetelephony system’s lifecycle. Accordingly, we believe that enterprises areincreasingly considering new investments in enterprise communications and, ifthey decide to make such investments, may consider IP telephony. Additionally,we believe that IP telephony has gained widespread acceptance in themarketplace 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 aresult of the technology transition, spending by enterprises on traditionalvoice communication systems has been declining. Increases in our productrevenue attributable to sales of IP telephony systems continue to be offset inpart by declines in product revenue attributable to traditional voicecommunication systems.

·  *Competitive environment*—Wehave historically operated, and continue to operate, in an extremelycompetitive environment. However, the migration of traditional technology to IPtelephony has resulted in an increased number of competitors offering similarproducts and applications. One aspect of this environment is that we regularlyface pricing pressures in the markets in which we operate which may negativelyimpact our gross margins. In addition, we also face pricing pressure whenlong-term maintenance and managed services contracts expire. They are typicallyrenewed at lower prices due to continuing competitive pressure and expectationsfrom the marketplace to acquire technology at lower costs. The impact of theprice erosion affects both our rental and managed services offers, as well asmaintenance. We have been able to partially mitigate the effects of pricingpressures on profitability through our cost reduction initiatives.

For other uncertainties related to the competitiveenvironment in which we operate, see Item 1A.“Risk Factors—Risks RelatedTo Our Revenue and Business Strategy—Weface intense competition from our current competitors and, as the enterprisecommunications and information technology markets evolve, may face increasedcompetition from companies that do not currently compete directly against us.”

·  *Pressures on servicesbusiness*—Due to advances in technology, our customers continue toexpect traditional services to be at lower prices to them. In addition, ourcustomers routinely look for opportunities to reduce their IT and relatedcosts. A high correlation exists with respect to customers in our directchannel who purchase products also electing to purchase maintenance contractsat the time of the product purchase. Maintenance revenues have been affected byreductions in scope of contracted services (*i.e*. number ofports, number of sites, or hours and levels of coverage) at the time ofcontract renewal, cancellations and increased competition, as well as the priceerosion noted above. These factors have resulted in challenges to our AvayaGlobal Services segment. We have been able to partially offset these impacts byfocusing on new types of services such as professional and managed services. Thesenew types of services may have lower margins than our traditional services. Inaddition, we have also been able to reduce our costs to minimize the impact onour operating income.

·  *Supplychain issues*—During fiscal 2006, we experienced disruption anddelays in delivery of certain products from our contract manufacturers inmeeting timelines for our customer requirements. We worked with our contractmanufacturers to correct the causes of these disruptions and delays, and whilewe believe these issues from the second and third quarters of fiscal 2006 havebeen resolved as of the end of our fiscal year, there can be no assurance thatwe will not experience similar issues in 

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the future. Please seeItem 1. “Business—Manufacturing and Supplies,” included elsewhere in thisAnnual Report for more discussion on issues associated with our supply chain.

·  *Foreign currency—*Ourrevenues outside of the U.S. were 42% of our consolidated revenues forfiscal 2006 compared to 41% for fiscal 2005. Any strengthening of the U.S.dollar against other currencies, particularly the euro, will have a negativeimpact on our reported revenues and, to a lesser degree, on our profitability.Conversely, any weakening of the U.S. dollar will have a positive impact. Revenuesfor fiscal 2006 include an unfavorable currency impact of $35 million ascompared to fiscal 2005.

·  *Economicconditions—*An important factor affecting our ability to generaterevenue is the effect of general economic conditions on our customers’willingness to spend on information technology and, particularly, enterprisecommunications technology. As economic conditions have gradually improved inmost of our markets over the past few years, we have seen indications thatenterprises 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 worldwideeconomic growth could also impact our business as growth rates of developed andmore stable economies tend to be lower than that of emerging economies, wherethere could be more variables affecting the economic growth.

***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 13 subsequent quarters. Duringfiscal 2005 and 2006, we continued to focus on controlling our costs.

As part of our focus on controlling costs, we reducedthe management and back office headcount in our U.S. sales organization,reduced the headcount in our services business, and consolidated officefacilities, resulting in a $22 million restructuring charge during the fourthquarter of fiscal 2005. In addition, during fiscal 2005, we reached agreementswith the various Works Councils in Europe to reduce our EMEA workforce. Includingthose positions agreed to by the Works Councils, we reduced our workforce byapproximately 800 positions in EMEA, all of which had been eliminated as of September 30,2006. We began to partially realize the benefits of these actions in fiscal2006.

During fiscal 2006, we recorded charges of $83 millionfor employee separation payments related to 555 positions. These positionsconsisted of 340 reductions in EMEA and 215 reductions in the U.S., andrepresented service technicians, sales and certain other functions. We alsorecorded charges of $21 million for lease termination obligations for theclosing and consolidation of certain international office locations.

We began to partiallyrealize the cost saving benefits during fiscal 2006 and expect to continue torealize the benefits in fiscal 2007. We may take further actions in fiscal 2007primarily in EMEA 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 and cash equivalents balance increased by $149million to $899 million as of September 30, 2006. During fiscal 2006, wegenerated positive cash flow from operations of $647 million. We made avoluntary cash contribution of $42 million to our U.S. pension plans. We alsoused $328 million to repurchase 29,909,400 shares of our common stock inaccordance with a share repurchase plan authorized by the Board of Directors. Inaddition, in fiscal 2006, we used cash of $188 million for capital expendituresand software development costs.

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***Deferred Tax Assets***

As of September 30, 2006, we had $863million in net deferred tax assets resulting from tax credit carryforwards, netoperating losses and other deductible temporary differences, which areavailable to reduce taxable income predominately in the U.S. in future periods.The net deferred tax assets include a valuation allowance of $194 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 $161 million of non-U.S. deferred taxassets and $33 million relating to certain U.S. federal and state deferred taxassets that continue to be fully reserved. Also included in the net deferredtax assets is a $77 million net deferred tax liability related to theacquisition of intangible assets in Germany.

**Acquisitions andDivestitures**

***Acquisition of Tenovis***

On November 18, 2004,we acquired all of the issued share capital of Tenovis, a major Europeanprovider of enterprise communications systems and services. We paid $381million in cash (which includes $10 million of transaction fees that were notpaid to the sellers) and assumed $287 million in debt, including $17 million ofcapital lease obligations for the Company. Additionally, we acquired cash andcash equivalents of $116 million, resulting in a net cash outlay of $265million related to the acquisition. We also recorded $314 million of pensionliabilities in connection with this acquisition. Tenovis results have beenconsolidated as of November 18, 2004.

***Other Acquisitions***

On September 16, 2005, we acquired NimcatNetworks (“Nimcat”) for $38 million in cash. Nimcat was a privately heldCompany headquartered in Canada and a leading developer of embeddedpeer-to-peer IP call processing software. Peer-to-peer networking isa network that relies on the computing power and bandwidth of theparticipants in the network rather than concentrating them in a small numberof servers. These networks are useful for many purposes, including filesharing containing audio, video, data and real-time data, suchas telephony traffic. Nimcat results have been consolidated as of September 16,2005.

On October 4, 2004, we acquired Spectel for $110million in cash (which includes $6 million of transaction fees that were notpaid to the sellers), net of cash acquired of $3 million. Spectel was a companyincorporated in Ireland and a leading provider of audio conferencingsolutions.Spectel results have been consolidated as of October 4, 2004.

See the discussions inNote 4 “Business Combinations and Other Transactions” to our ConsolidatedFinancial Statements for more information relating to these acquisitiontransactions.

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**Results FromContinuing Operations**

***Fiscal Year Ended September 30, 2006 Compared withFiscal Year Ended September 30, 2005***

***Revenue***

Thefollowing table sets forth a comparison of revenue by type:

| ** **                   | ** ** | **Year ended September 30,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**           | ** ** |
| Sales of products            |       | $                                           | 2,510      |   | $ | 2,294 |   |   | 49 | % |   |   | 47 | % |   | $ | 216 |   | 9 | % |
| Services                     |       | 2,002                                       |       | 1,971 |   |   | 39 | % |   |   | 40 | % |   | 31 |   | 2 | % |
| Rental and  managed services |       | 636                                         |       | 637 |   |   | 12 | % |   |   | 13 | % |   | (1 | ) | 0 | % |
| Total revenue                |       | $                                           | 5,148      |   | $ | 4,902 |   |   | 100 | % |   |   | 100 | % |   | $ | 246 |   | 5 | % |

 

Overall revenue grew by 5%, partially helped by thefull year impact of revenues associated with Tenovis in fiscal 2006 compared toa partial period in fiscal 2005 due to its acquisition on November 18,2004. We estimate that total fiscal 2005 revenue would have been $5,005 millionon a pro forma basis if Tenovis revenues had been realized for a full fiscalyear rather than a partial period. This impacted primarily the services andrental and managed services revenues. Overall revenues were negatively impactedby $35 million of unfavorable currency fluctuations when compared to fiscal2005.

Sales of products revenue increased 9%. Revenue in theU.S. and international regions grew at a comparable rate. Continued strongdemand for our IP telephony solutions, partially offset by the decline of TDMproducts, helped generate the growth in revenue from sales of products.

Services revenue grew by 2% when compared to fiscal2005, primarily due to the full year impact of revenues associated with Tenovis.The growth in implementation and integration services revenues associated withthe growth in product sales was partially offset by a reduction in maintenancerevenues.

Rental and managed services revenue was flat in fiscal2006 when compared to fiscal 2005, despite the full year impact of revenuesassociated with Tenovis compared to a partial period in fiscal 2005. Excludingthe full year impact of revenues associated with Tenovis, we estimate thatrental and managed services revenue would have declined by approximately $70million due to price erosion, cancellations of rental contract renewals andcustomers converting from traditional rental and managed service agreements toseparate sales of products and maintenance services.

Thefollowing table sets forth a geographic comparison of revenue:

| ** **                                              | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                              | ** ** | **Dollars in millions**           | ** ** |
| U.S.                                                    |       | $                                           | 2,994      |   | $ | 2,908 |   |   | 58 | % |   |   | 59 | % |   | $ | 86 |   | 3 | % |
| Outside the U.S:                                        |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                 |       | 733                                         |       | 724 |   |   | 14 | % |   |   | 15 | % |   | 9 |   | 1 | % |
| EMEA (excluding Germany)—Europe/Middle East/Africa |       | 765                                         |       | 696 |   |   | 15 | % |   |   | 14 | % |   | 69 |   | 10 | % |
| Total EMEA                                              |       | 1,498                                       |       | 1,420 |   |   | 29 | % |   |   | 29 | % |   | 78 |   | 5 | % |
| APAC—Asia Pacific                                  |       | 383                                         |       | 336 |   |   | 8 | % |   |   | 7 | % |   | 47 |   | 14 | % |
| Americas, non-U.S.                                      |       | 273                                         |       | 238 |   |   | 5 | % |   |   | 5 | % |   | 35 |   | 15 | % |
| Total outside the U.S.                                  |       | 2,154                                       |       | 1,994 |   |   | 42 | % |   |   | 41 | % |   | 160 |   | 8 | % |
| Total revenue                                           |       | $                                           | 5,148      |   | $ | 4,902 |   |   | 100 | % |   |   | 100 | % |   | $ | 246 |   | 5 | % |

 

11

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Overall revenue grew by 5%, helped by strong growth inIP telephony in APAC and Americas, non-U.S. In the U.S., the increase of9% in product sales was partially offset by reductions in services and managedservices revenues, resulting in a net growth of 3%. The full period of revenuesassociated with Tenovis in fiscal 2006 benefited primarily Germany, and therest of EMEA to lesser extent. This was partially offset by $38 million of unfavorablecurrency impact in EMEA.

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

| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**           | ** ** |
| Direct                  |       | $                                           | 1,097      |   | $ | 1,078 |   |   | 44 | % |   |   | 47 | % |   |   | $ | 19 |   |   | 2 | % |
| Indirect                |       | 1,413                                       |       | 1,216 |   |   | 56 | % |   |   | 53 | % |   |   | 197 |   |   | 16 | % |
| Total sales of products |       | $                                           | 2,510      |   | $ | 2,294 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 216 |   |   | 9 | % |

 

Sales of products throughthe direct channel accounted for 44% of the revenue from product sales as comparedto 47% in fiscal 2005. Strong growth in APAC, where we sell primarily throughthe indirect channel, partially contributed to the shift in the channel mix. Inaddition, demand for our products through the indirect channel was strong inthe U.S., particularly for the small communications systems which are normallytransacted through the indirect channel, contributing to a further shift in thechannel mix. Despite increased demand from our U.S. business partners, theirinventory levels as measured by days-on-hand, were relatively flat as of September 30,2006 when compared to September 30, 2005.

***Gross Margin***

The following table sets forth a comparison of grossmargin by type:

| ** **                      | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**           | ** ** |
| On sales of  products           |       | $                                           | 1,342      |   | $ | 1,245 |   |   | 53.5 | % |   |   | 54.3 | % |   |   | $ | 97 |   |   | 8 | % |
| On services                     |       | 682                                         |       | 674 |   |   | 34.1 | % |   |   | 34.2 | % |   |   | 8 |   |   | 1 | % |
| On rental and  managed services |       | 366                                         |       | 378 |   |   | 57.5 | % |   |   | 59.3 | % |   |   | (12 | ) |   | -3 | % |
| Total gross margin              |       | $                                           | 2,390      |   | $ | 2,297 |   |   | 46.4 | % |   |   | 46.9 | % |   |   | $ | 93 |   |   | 4 | % |

 

Overall gross margin rate was 46.4% in fiscal 2006,resulting in a half a percentage point decline when compared to fiscal 2005.The declines in the margin rates for sales of products and rental and managedservices were the primary contributors to the overall decline in the grossmargin rate.

The decline in the gross margin percentage on thesales of products was due to a combination of several factors, includingincreased mix of indirect channel sales, higher discounts and unfavorablecurrency impact. These were partially offset by the benefits from higher salesvolume, higher-margin software products and product cost reductions.

Gross margin percentage on services in fiscal 2006 wasroughly flat when compared to fiscal 2005. The impact of reductions inmaintenance revenues and an increase in employee benefit costs were offset byother employee cost reductions and a reduction of a portion of our vacationaccrual as a result of a change in company policy eliminating carryovervacation days for U.S. non-represented employees.

The decline in grossmargin dollars and percentage on rental and managed services was primarily dueto price erosion which has resulted in rental contracts being renewed at lowerprices, as well as customer cancellations of higher margin contracts, primarilyrelated to traditional rental and managed services, entered into in prioryears.

12

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***Operating Expenses***

The following table sets forth a comparison ofoperating expenses:

| ** **                           | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| ** **                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **Change** | ** ** |
| ** **                           | ** ** | **Dollars in millions**           | ** ** |
| Selling, general  and administrative |       | $                                           | 1,595      |   | $ | 1,583 |   |   | 31.0 | % |   |   | 32.3 | % |   | $ | 12 |   | 1 | % |
| Research and  development            |       | 428                                         |       | 394 |   |   | 8.3 | % |   |   | 8.0 | % |   | 34 |   | 9 | % |
| Restructuring  charges               |       | 104                                         |       | 22 |   |   | 2.0 | % |   |   | 0.5 | % |   | 82 |   | 373 | % |
| Total operating expenses             |       | $                                           | 2,127      |   | $ | 1,999 |   |   | 41.3 | % |   |   | 40.8 | % |   | $ | 128 |   | 6 | % |

 

The increase in SG&A expenses is primarily due tothe full period impact of the Tenovis operations, $29 million of assetimpairment charges primarily related to certain internal-use software assetsand increased employee benefit costs. These items were partially offset by the$22 million benefit from the favorable resolution of non-income tax audits inseveral jurisdictions recorded in the third quarter, savings from headcountreductions and the $7 million benefit related to the reduction of a portion ofour vacation accrual.

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 fiscal 2006 than in fiscal2005. Fiscal 2005 included $7 million of in-process R&D expensesrecorded upon the acquisitions of Spectel, Tenovis and Nimcat.

Restructuring charges forfiscal 2006 represent $52 million of employee separation costs in EMEA,comprised of $47 million in order to reduce costs and expenses and to improvethe region’s operational performance and $5 million of expense related tohigher than originally expected per employee separation costs for formerTenovis employees than estimated at the time of acquisition. Fiscal 2006charges also include $31 million of employee separation costs in the U.S.primarily related to workforce reductions for represented service technicians. Alsoincluded in the restructuring charge for fiscal 2006 is $21 million of leasetermination obligations for the closing or consolidation of certaininternational office facilities. The restructuring charge recorded in fiscal2005 was primarily related to employee reductions and consolidation of officespace in the U.S.

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

| ** **                   | ** ** | **Year ended September 30,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**           | ** ** |
| Other income  (expense), net |       |                                        | $          | 24 |   |   | $ | (32 | ) |   | $ | 56 |   |   | 175 | % |
|                              |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net of $24 million for fiscal 2006represents $36 million of interest income, partially offset by a $5 millionloss on foreign currency transactions and $7 million of other miscellaneouscharges.

Other expense, net forfiscal 2005 consisted of a $41 million loss on the repurchase of $271 millionprincipal amount of senior notes, a $3 million loss on the repayment of $262million principal amount of secured floating rate notes and other costs relatedto the repayment of our debt and $12 million of other miscellaneous charges,partially offset by $24 million of interest income.

13

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***Interest Expense***

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Interest expense |       |                                        | $          | (3 | ) |   | $ | (19 | ) |   | $ | 16 |   |   | 84 | % |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For fiscal 2006, interest expense decreased as aresult of a lower debt principal balance outstanding during the period due tothe repayment of the remaining senior notes.

Overall debt decreasedprimarily due to the repurchases of our senior notes, as well as the conversioninto common stock of our LYONs and the redemption for cash of the remainingLYONs in the first quarter of fiscal 2005. This decrease was partially offsetby interest expense associated with the debt assumed in the Tenovisacquisition, which was then repaid during the second and third quarters offiscal 2005.

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

| ** **                                 | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                 | ** ** | **Dollars in millions**           | ** ** |
| Provision for  (benefit from) income taxes |       |                                        | $          | 83 |   |   | $ | (676 | ) |   | $ | 759 |   |   | -112 | % |
|                                            |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In fiscal 2006, the provision for income taxes is comprised of U.S.federal, state and non-U.S. taxes and includes a $7 million benefit fornon-U.S. audit settlements. The provision for fiscal 2006 resulted in aneffective tax rate of 29.2%

In fiscal 2005, thebenefit from income taxes included a $590 million net tax benefit due to therealization of certain deferred tax assets upon the reversal of a portion ofthe valuation allowance that had been recorded in prior periods. In addition,the benefit included a $124 million income tax benefit which was comprised of a$109 million tax benefit resulting from the resolution of U.S. federal incometax audit matters for the years 1999 and 2000 and a $15 million benefit due tocertain state matters that arose prior to our separation from Lucent.

**Segment Results**

***Global Communications Solutions (“GCS”)***

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

Large communicationssystems are IP and traditional telephony systems marketed to large enterprises.These systems include:

·  media servers which provide call processing onthe customer’s local area network;

·  media gateways which support traffic routingbetween traditional voice and IP telephony solutions;

·  associated appliances, such as telephonehandsets and related software applications;

·  Avaya Integrated Management, a Web-basedcomprehensive set of tools that manages complex voice and data networkinfrastructures;

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·  Avaya Communications Manager, a voiceapplication software that manages call processing, facilitates secure customerinteractions across a variety of media and supports a range of Avaya and third-partyapplications; and

·  Avaya Extension to Cellular, whichtransparently bridges any cellular phone to any Avaya communications server.

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

·  Avaya IP Office, an IP telephony solution for smalland medium-sized enterprises;

·  traditional key systems, Partner® , MerlinMagix® , Merlin LegendTM and I5 brands;

·  associated appliances, such as telephonehandsets; and

·  media servers for voice applications used bysmaller businesses.

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

·  applications in support of customerrelationship management; and

·  messaging for 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 the GCSsegment:

| ** **                    | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**           | ** ** |
| Large  communications systems |       | $                                           | 1,765      |   | $ | 1,585 |   |   | 63 | % |   |   | 61 | % |   |   | $ | 180 |   |   | 11 | % |
| Small  communications systems |       | 370                                         |       | 331 |   |   | 13 | % |   |   | 13 | % |   |   | 39 |   |   | 12 | % |
| Converged voice  applications |       | 605                                         |       | 610 |   |   | 22 | % |   |   | 24 | % |   |   | (5 | ) |   | -1 | % |
| Other                         |       | 46                                          |       | 46 |   |   | 2 | % |   |   | 2 | % |   |   | — |   |   | 0 | % |
| Total revenue                 |       | $                                           | 2,786      |   | $ | 2,572 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 214 |   |   | 8 | % |

 

Overall GCS revenue grew by 8%, partially helped bythe full year impact of revenues associated with Tenovis in fiscal 2006.  Currency fluctuations impacted the growthnegatively by approximately one percentage point.

GCS revenues were helped by strong growth in large aswell as small communications systems. Increases in large communications systemswere primarily due to increased sales of media gateways, IP associatedappliances and servers. Increases in small communications systems wereprimarily due to growth in Avaya IP Office, Partner and IP-associatedappliances, partially offset by lower sales of traditional appliances andMerlin products. Converged voiceapplications revenues decreased due to lower demand for traditional messagingsales partially offset by the rollout of IP messaging and contact centerapplication sales. On a geographic basis, GCS revenue grew in doubledigits in the U.S. and in APAC, offset by lower growth in EMEA.

15

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Thefollowing table sets forth operating income of the GCS segment:

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Operating income |       | $                                           | 197        |   |   | $ | 57 |   |   |   | 7.1 | % |   |   | 2.2 | % |   |   | $ | 140 |   |   | 246 | % |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The majority of theincrease in operating income for fiscal 2006 is due to leverage from highervolume, the favorable impacts of cost improvements and higher-margin softwareproducts, partially offset by higher discounts. The remainder of theimprovement in operating income is due to a decrease in SG&A expenses ascompared with fiscal 2005.

***Avaya Global Services (“AGS”)***

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 andoptimizes customers’ network performance ensuring availability and keepscommunication networks current with the latest software releases. In the eventof an outage, our services team helps customers restore their networks.

*Implementationand integration services—**Through* operation,implementation and integration specialists worldwide, AGS helps customersleverage and optimize their multi-technology, multi-vendor environments throughthe use of contact centers, unified communication networks, and IP telephony.

*Managedservices—**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 workforces in theU.S. and EMEA and includes the impact of increases in employee benefit costs.In addition, our profitability is impacted by the complexities associated withmaintenance of multi-vendor IP networks as compared with closed, proprietaryTDM networks, such as the need to assure a sufficient level of servicetechnicians with IP skills.

16

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

| ** **                               | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                               | ** ** | **Dollars in millions**           | ** ** |
| Maintenance                              |       | $                                           | 1,495      |   | $ | 1,506 |   |   | 63 | % |   |   | 65 | % |   |   | $ | (11 | ) |   | -1 | % |
| Implementation  and integration services |       | 510                                         |       | 469 |   |   | 22 | % |   |   | 20 | % |   |   | 41 |   |   | 9 | % |
| Managed services                         |       | 355                                         |       | 350 |   |   | 15 | % |   |   | 15 | % |   |   | 5 |   |   | 1 | % |
| Other                                    |       | 2                                           |       | 5 |   |   | 0 | % |   |   | 0 | % |   |   | (3 | ) |   | -60 | % |
| Total revenue                            |       | $                                           | 2,362      |   | $ | 2,330 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 32 |   |   | 1 | % |

 

Overall AGS revenue growth has benefited from the fullyear impact of Tenovis in fiscal 2006, which favorably impacted all classes ofservices within AGS. Excluding this impact, overall AGS revenues would havebeen relatively flat when compared to fiscal 2005. Excluding the impact ofTenovis, the decline in the U.S. was mostly offset by increases in APAC andAmericas, non-U.S.

The decline in maintenance revenue occurred primarilyin the U.S. due to reductions in scope of contracted services, cancellationsand price erosion. The decline in maintenance revenue in the U.S. was mostlyoffset by growth in APAC and Latin America, where our strategy to directlyservice our global customers is yielding growth in maintenance services.

Implementation and integration services revenue grewin all regions in fiscal 2006, partially due to increased product sales. Inaddition, strong performance in professional services, particularly in theU.S., contributed to the growth in implementation and integration services whencompared to fiscal 2005.

Excluding the full-year benefit from Tenovis in fiscal2006, managed services revenue would have declined due to reductions in scopeand cancellations of contracted services and price erosion on new contractsprimarily in the 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 AGS segment:

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Operating income |       | $                                           | 171        |   | $ | 166 |   |   | 7.2 | % |   |   | 7.1 | % |   |   | $ | 5 |   |   | 3 | % |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Overall AGS operatingincome was relatively flat both in dollars as well as a percentage of revenue. Despitegrowth in AGS revenues by $32 million, the change in revenue mix related tomanaged services and from higher-margin maintenance revenue to lower-marginimplementation revenue, negatively impacted the AGS gross margin andprofitability. In addition, an increase in employee benefit costs negativelyimpacted AGS profitability. These impacts were offset by cost  reductions and the $9 million benefit fromthe reversal of a portion of our vacation accrual.

**Corporate / Other Unallocated Amounts**

| ** **               | ** ** | **Year ended September 30,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions**           | ** ** |
| Operating (loss)  income |       | $                                           | (105       | ) |   | $ | 75 |   |   |   | $ | (180 | ) |   |
|                          |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

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At the beginning of each fiscal year, the amount ofcorporate overhead and certain other expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year. Any adjustment of the annual incentive accrual, as well asany other over/under absorption of corporate overhead expenses against plan isrecorded within Corporate/Other Unallocated Amounts. In addition, certaindiscrete items, such as charges relating to restructuring actions and assetimpairments, are not allocated to the operating segments and remain inCorporate/Other Unallocated Amounts.

During fiscal 2006, the operating loss of $105 millionis primarily due to restructuring charges of $104 million and impairmentcharges of $29 million primarily related to certain internal-use softwareassets. The restructuring charges are comprised of $21 million for leasetermination obligations and $83 million for employee separation costs in EMEAand the U.S. These items were partially offset by $22 million related to thefavorable resolution of non-income tax audits in several jurisdictions duringthe third quarter and an adjustment to employee incentive awards due to theCompany’s actual performance compared with targeted performance.

Operating income of $75million during fiscal 2005 was affected primarily by an adjustment to employeeincentive awards, as well as other over/under absorption of corporate overheadsagainst plan. In fiscal 2005, we incurred discretionary employee annualincentive awards of $25 million, which was less than would have been recordedif we had met our fiscal 2005 targets regarding operating income, operatingcash flows and revenues.

**Fourth QuarterItems**

Revenues increased by $68million in the fourth quarter of fiscal 2006 compared to the fourth quarter offiscal 2005 primarily due to increases in sales of products through ourindirect channel. Operating income decreasedby $7 million to $75 million, primarily due to restructuring charges, partiallyoffset by higher gross margins for the quarter which were driven by highersales volumes. Net income for the quarter was $48 million, a $612 milliondecrease from fiscal 2005 due to the benefit from income taxes for the fourthquarter of fiscal 2005 which included a $590 million reversal of a portion ourdeferred tax valuation allowance, as described in Note 12 “Income Taxes” to ourConsolidated Financial Statements.

***Fiscal Year Ended September 30, 2005 Comparedwith Fiscal Year Ended September 30, 2004***

***Revenue***

The primary driver of the increase in ourrevenues for fiscal 2005 compared to fiscal 2004 was our acquisition ofTenovis. Revenues in fiscal 2005 were also positively impacted by theacquisition of the majority interest in AGC in the fourth quarter of fiscal2004, as well as currency fluctuations. This impact was partially offset bydeclines in U.S. sales of both products and services. The decline in U.S.revenues was primarily attributable to the following:

·  We announced changes in our go-to-marketstrategy to realign our sales and marketing efforts. As we focused our directsales efforts on our larger enterprise customers, the benefits took longer thanexpected to materialize, resulting in a disruption to our sales effortsduring fiscal 2005. This disruption primarily affected our U.S. business. Weworked to minimize the effects of this disruption and continued to implementthe realignment through fiscal 2005.

·  We continued to see declines in revenues fromour U.S. services business, particularly in the maintenance and managedservices lines of business, primarily due to renegotiations by customers oftheir contracts to change the scope of existing contracts, pricing pressuresand cancellations.

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·  We devoted significant management attentionand resources to the Tenovis integration. Early in fiscal 2005, theseintegration efforts diverted management’s time and attention away from otherbusiness issues.

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

Thefollowing table sets forth a comparison of revenue by type:

| ** **                   | ** ** | **Year ended September 30,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                   | ** ** | **Dollars in millions**           | ** ** |
| Sales of products            |       | $                                           | 2,294      |   | $ | 2,048 |   |   | 47 | % |   |   | 50 | % |   | $ | 246 |   |   | 12 | % |   |
| Services                     |       | 1,971                                       |       | 1,761 |   |   | 40 | % |   |   | 43 | % |   | 210 |   |   | 12 | % |   |
| Rental and  managed services |       | 637                                         |       | 260 |   |   | 13 | % |   |   | 7 | % |   | 377 |   |   | 145 | % |   |
| Total revenue                |       | $                                           | 4,902      |   | $ | 4,069 |   |   | 100 | % |   |   | 100 | % |   | $ | 833 |   |   | 20 | % |   |

 

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

Thefollowing table sets forth a geographic comparison of revenue:

| ** **                                              | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                                              | ** ** | **Dollars in millions**           | ** ** |
| U.S.                                                    |       | $                                           | 2,908      |   | $ | 3,089 |   |   | 59 | % |   |   | 76 | % |   | $ | (181 | ) | -6 | % |
| Outside the U.S.:                                       |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany                                                 |       | 724                                         |       | 45 |   |   | 15 | % |   |   | 1 | % |   | 679 |   | 1509 | % |
| EMEA (excluding Germany)—Europe/Middle East/Africa |       | 696                                         |       | 493 |   |   | 14 | % |   |   | 12 | % |   | 203 |   | 41 | % |
| Total EMEA                                              |       | 1,420                                       |       | 538 |   |   | 29 | % |   |   | 13 | % |   | 882 |   | 164 | % |
| APAC—Asia Pacific                                  |       | 336                                         |       | 226 |   |   | 7 | % |   |   | 6 | % |   | 110 |   | 49 | % |
| Americas, non-U.S.                                      |       | 238                                         |       | 216 |   |   | 5 | % |   |   | 5 | % |   | 22 |   | 10 | % |
| Total outside the U.S.                                  |       | 1,994                                       |       | 980 |   |   | 41 | % |   |   | 24 | % |   | 1,014 |   | 103 | % |
| Total revenue                                           |       | $                                           | 4,902      |   | $ | 4,069 |   |   | 100 | % |   |   | 100 | % |   | $ | 833 |   | 20 | % |

 

U.S. revenues were down against the comparable perioddue to the disruption from the realignment of our sales and marketing effortsas well as decreases in the scope of existing maintenance contracts and pricingpressures in our services business as described above.

Higher revenues in Germany were almost entirelyattributable to the acquisition of Tenovis. The majority of the increase inrevenues in EMEA (excluding Germany) was due to the acquisition of Tenovis, andwas also a result of increased acceptance of IP telephony, and increasedwillingness of customers to spend on converged communications technology. Thisincreased acceptance resulted in higher sales of large communications systems. Inaddition, currency translation had a positive impact as the euro strengthenedagainst the U.S. dollar for most of the period. Revenues in APAC benefited fromthe acquisition of a majority ownership interest in AGC as well as highervolumes in China and Japan, particularly in connection with sales to ourcustomers in the financial services industry. Revenues in the 

19

----

Americas, non-U.S. regionbenefited from higher volumes associated with the call center business due tothe expansion and upgrade of the installed base in Latin America.

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

| ** **              | ** ** | **Year ended September 30,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **              | ** ** | **Dollars in millions**           | ** ** |
| Direct                  |       | $                                           | 1,078      |   | $ | 923 |   |   | 47 | % |   |   | 45 | % |   |   | $ | 155 |   |   | 17 | % |
| Indirect                |       | 1,216                                       |       | 1,125 |   |   | 53 | % |   |   | 55 | % |   |   | 91 |   |   | 8 | % |
| Total sales of products |       | $                                           | 2,294      |   | $ | 2,048 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 246 |   |   | 12 | % |

 

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

***Gross Margin***

| ** **                      | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **Dollars in millions**           | ** ** |
| On sales of  products           |       | $                                           | 1,245      |   | $ | 1,120 |   |   | 54.3 | % |   |   | 54.7 | % |   |   | $ | 125 |   |   | 11 | % |
| On services                     |       | 674                                         |       | 697 |   |   | 34.2 | % |   |   | 39.6 | % |   |   | (23 | ) |   | -3 | % |
| On rental and  managed services |       | 378                                         |       | 128 |   |   | 59.3 | % |   |   | 49.2 | % |   |   | 250 |   |   | 195 | % |
| Total gross margin              |       | $                                           | 2,297      |   | $ | 1,945 |   |   | 46.9 | % |   |   | 47.8 | % |   |   | $ | 352 |   |   | 18 | % |

 

Gross margin on the sales of products increasedprimarily due to additional sales volumes gained from the acquisition ofTenovis, the increased proportion of software to hardware in our product mixand the benefits associated with our ongoing cost reduction initiatives.However, while the acquisition of Tenovis added additional gross margin indollars, as a percent of revenue, our overall gross margin gains were more thanoffset by the lower margin rates achieved by Tenovis.

Gross margin on services decreased mainly due to theimpact of lower revenues in the U.S., as well as the impact of thesignificantly lower margin Tenovis services business. In addition, grossmargins were negatively impacted by changes in revenue mix, including a higherproportion of government contracts and wire installations, as well as a higherproportion of implementation services revenues, which generate lower marginsthan those achieved by annuity contracts. These declines in gross margin werepartially offset by cost savings as a result of headcount reductions takenduring this fiscal year.

Gross margin on rental andmanaged services increased due primarily to the acquisition of Tenovis, whichwas partially offset by lower revenues associated with U.S. managed services. Theimprovement in gross margin percentage was due to the higher margins achievedby the Tenovis rental business.

***Operating Expenses***

| ** **                           | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| ** **                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** | **Change** | ** ** |
| ** **                           | ** ** | **Dollars in millions**           | ** ** |
| Selling, general  and administrative |       | $                                           | 1,583      |   | $ | 1,274 |   |   | 32.3 | % |   |   | 31.3 | % |   |   | $ | 309 |   |   | 24 | % |
| Research and  development            |       | 394                                         |       | 348 |   |   | 8.0 | % |   |   | 8.6 | % |   |   | 46 |   |   | 13 | % |
| Restructuring  charges               |       | 22                                          |       | — |   |   | 0.5 | % |   |   | 0.0 | % |   |   | 22 |   |   | 100 | % |
| Total operating expenses             |       | $                                           | 1,999      |   | $ | 1,622 |   |   | 40.8 | % |   |   | 39.9 | % |   |   | $ | 377 |   |   | 23 | % |

 

20

----

Our SG&A expenses consist primarily of salaries,commissions, benefits and other items. The increase in SG&A expenses wasprimarily due to the acquisition of Tenovis, and to a lesser extent our otheracquisitions, which resulted in higher SG&A expenses in dollar terms and asa percent of revenue. Included with SG&A expenses was approximately $52million of amortization of intangible assets as a result of our acquisitions ofTenovis and Spectel. These negative impacts associated with our acquisitionswere partially offset by improved operational efficiencies.

Our R&D expenses consist primarily of salaries andbenefits, and overall increased due to our fiscal 2005 acquisitions. Inaddition, in connection with our acquisitions of Tenovis, Spectel and Nimcatduring fiscal 2005, we allocated $7 million to in-process research anddevelopment which was charged to R&D expense during the period.

Our restructuring chargesfor fiscal 2005 were recorded in connection with the reorganization of ourNorth American sales and services organizations. This charge consisted ofseverance and one-time employee termination benefits of $12 million related tothe termination of employees in the North America region across many businessfunctions and job classes, as well as costs of $10 million related to theconsolidation of excess facilities.

***Other Expense, Net***

| ** **          | ** ** | **Year ended September 30,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **          | ** ** | **Dollars in millions**           | ** ** |
| Other expense,  net |       | $                                           | (32        | ) | $ | (15 | ) |   | $ | (17 | ) |   | -113% |   |
|                     |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

Other expense, net for fiscal 2005 consisted primarilyof a $41 million loss on the repurchase of $271 million principal amount ofsenior notes, a $3 million loss on the repayment of $262 million principalamount of secured floating rate notes and other costs related to the repaymentof our debt, partially offset by $24 million of interest income.

Other expense, net forfiscal 2004 consisted primarily of a $42 million loss associated with theredemption and repurchase of $356 million principal amount of our senior notes.This was partially offset by $19 million of interest income generated primarilyfrom invested cash and $7 million of foreign currency transaction gains.

***Interest Expense***

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Interest expense |       | $                                           | (19        | ) | $ | (66 | ) | $ | 47 |   | 71 | % |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |

 

The decrease in interest expense was due to loweryear-over-year debt levels. Overall debt decreased primarily due to therepurchases of our senior notes in fiscal 2004 and 2005, as well as theconversion into common stock of our LYONs and the redemption for cash of theremaining LYONs in fiscal 2005. This decrease was partially offset by interestexpense associated with the debt assumed in the Tenovis acquisition, which wasthen repaid during fiscal 2005.

Interest expense forfiscal 2004 primarily included $53 million of interest on our senior notes and$15 million of interest for the amortization of debt discount, premium anddeferred financing costs related primarily to our LYONs, which were issued inOctober 2001.

21

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***Benefit from IncomeTaxes***

| ** **                 | ** ** | **Year ended September 30,** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                 | ** ** | **Dollars in millions**           | ** ** |
| Benefit from  income taxes |       | $                                           | (676       | ) | $ | (49 | ) |   | $ | (627 | ) |   | 1280 | % |
|                            |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

In fiscal 2005, we recorded a benefit for income taxesof $676 million as compared with a $49 million benefit in fiscal 2004. Thebenefit for fiscal 2005 included a $590 million net tax benefit due to therealization of certain deferred tax assets upon the reversal of a portion ofthe valuation allowance that had been recorded in prior periods. The $590million benefit was net of a tax provision recorded for the year. In addition,the $676 million benefit included a $124 million income tax benefit which wascomprised of $109 million tax benefit resulting from the resolution of U.Sfederal income tax audit matters for the years 1999 and 2000 and a $15 millionbenefit due to certain state matters that arose prior to our separation fromLucent.

Based upon a detailed analysis of historical andexpected book and taxable income, we determined that the realization of certaindeferred tax assets for which there was a valuation allowance was considered tobe more likely than not for purposes of reversing the valuation allowance. Therefore,a portion of the valuation allowance was reversed resulting in a net taxbenefit of $590 million. We recorded pre-tax income from continuing operationsin 2005 and 2004, with income levels rising each year. In addition, we were nolonger in a three-year cumulative loss position for book purposes. Weconsidered this positive evidence regarding the future realization of deferredtax assets, which was primarily based on actual historical book results, tooutweigh any negative evidence that may have existed.

The remaining valuation allowance of $165 million asof September 30, 2005 was comprised of $142 million relating to foreigndeferred tax assets for which we have determined, based on historical resultsand projected future book and taxable income levels, that a valuation allowanceshould remain. The foreign valuation allowance included approximately $120million relating to our German operations.

The benefit for fiscal2004 of $49 million included an $89 million income tax benefit which wascomprised of $102 million tax benefit resulting from the resolution of U.S.federal income tax audit matters for the pre-distribution years 1990 through1998 offset by $13 million due to certain state tax matters and otheradjustments that arose prior to our separation from Lucent.

**Segment Results**

***GlobalCommunications Solutions***

| ** **                    | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                    | ** ** | **Dollars in millions**           | ** ** |
| Large  communications systems |       | $                                           | 1,585      |   | $ | 1,210 |   |   | 61 | % |   |   | 59 | % |   |   | $ | 375 |   |   | 31 | % |
| Small  communications systems |       | 331                                         |       | 228 |   |   | 13 | % |   |   | 11 | % |   |   | 103 |   |   | 45 | % |
| Converged voice  applications |       | 610                                         |       | 552 |   |   | 24 | % |   |   | 27 | % |   |   | 58 |   |   | 11 | % |
| Other                         |       | 46                                          |       | 54 |   |   | 2 | % |   |   | 3 | % |   |   | (8 | ) |   | -15 | % |
| Total revenue                 |       | $                                           | 2,572      |   | $ | 2,044 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 528 |   |   | 26 | % |

 

The increase in total revenue for all GCS productclasses was primarily attributable to the acquisition of Tenovis. Largecommunications systems also benefited from increased sales of IP products. Theincrease in small communications systems revenues attributable to Tenovis waspartially offset by lower U.S. sales volumes, mainly in the indirect channeldue to lower purchases by our U.S. indirect channel 

22

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partners. In addition to the increased revenue fromTenovis, converged voice applications also benefited from higher volumesin sales of third party, or OEM software products.

Thefollowing table sets forth operating income of the GCS segment:

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Operating income |       |                                        | $          | 57 |   |   |   | $ | 71 |   |   |   | 2.2 | % |   |   | 3.5 | % |   |   | $ | (14 | ) |   | -20% |   |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operatingincome was primarily due to the effects of a decrease in operating marginresulting from an unfavorable product mix, including increased sales of OEMsoftware products which generate lower margins than sales of our products. Thedecrease was also a result of higher SG&A costs and increased R&Dspending over the prior year due to the acquisition of Tenovis, Spectel andRouteScience.

***Avaya GlobalServices***

| ** **                               | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Mix** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                               | ** ** | **Dollars in millions**           | ** ** |
| Maintenance                              |       | $                                           | 1,506      |   | $ | 1,422 |   |   | 65 | % |   |   | 70 | % |   |   | $ | 84 |   |   | 6 | % |
| Implementation  and integration services |       | 469                                         |       | 338 |   |   | 20 | % |   |   | 17 | % |   |   | 131 |   |   | 39 | % |
| Managed services                         |       | 350                                         |       | 260 |   |   | 15 | % |   |   | 13 | % |   |   | 90 |   |   | 35 | % |
| Other                                    |       | 5                                           |       | 1 |   |   | 0 | % |   |   | 0 | % |   |   | 4 |   |   | 400 | % |
| Total revenue                            |       | $                                           | 2,330      |   | $ | 2,021 |   |   | 100 | % |   |   | 100 | % |   |   | $ | 309 |   |   | 15 | % |

 

The increase in revenue for AGS was primarilyattributable to the acquisition of Tenovis and sales of new services, partiallyoffset by a decline in maintenance and managed services revenues in the U.S.

Tenovis generated revenue for each of the servicelines. Lower revenues in existing contract-related maintenance were primarilydue to cancellations, changes in contract scope and pricing pressures for U.S.customers. This was partially offset by increases in sales of new services andoff-warranty sales of services. Implementation and integration servicesrevenues benefited from the favorable trending of product sales in recentquarters and growth in our infrastructure implementation business. Managedservices revenues in the U.S. were unfavorably affected by customer changes inscope, pricing pressures and cancellations, as well as lower sales of telephonyequipment to the U.S. managed services customers.

Thefollowing table sets forth operating income of the AGS segment:

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Percent of  Revenue** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Operating income |       | $                                           | 166        |   | $ | 249 |   |   | 7.1 | % |   | 12.3 | % |   | $ | (83 | ) |   | -33% |   |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in operatingincome for fiscal 2005 is due to lower gross margin and additional expensesattributable to Tenovis. Additionally, the U.S. business experienced a lowerproportion of higher-margin annuity services such as maintenance and a higherproportion of implementation and integration services, which traditionally havelower margins. The decrease in gross margin was partially offset by the costsavings resulting from headcount reductions taken during fiscal 2005.

23

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**Corporate / Other Unallocated Amounts**

| ** **       | ** ** | **Year ended September 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **       | ** ** | **Dollars in millions**           | ** ** |
| Revenue          |       |                                        | $          | — |   |   |   | $ | 4 |   |   |   | $ | (4 | ) |   |
| Operating income |       |                                        | $          | 75 |   |   |   | $ | 3 |   |   |   | $ | 72 |   |   |

 

Revenue of $4 million in fiscal 2004 represented salesassociated with the acquisition of Expanets, Inc., a subsidiary ofNorthwestern Corporation (Expanets). These sales were not allocated to one ofour operating segments because the sales were of non-Avaya products that werein the Expanets pipeline prior to the acquisition, and were consummatedsubsequent to the closing of our acquisition of Expanets.

Operating income for bothfiscal years was mainly due to the actual corporate overhead and certain otherexpenses being lower than that estimated. In fiscal 2005, the Company incurreddiscretionary employee annual incentive awards of $25 million, which was $80million less than would have been recorded if we had met our fiscal 2005targets regarding operating income, operating cash flows and revenues. Thesignificantly lower employee incentive awards, as well as any other over/underabsorption of corporate overheads against plan, was recorded withinCorporate/Other Unallocated Amounts.

***Results of DiscontinuedOperations***

As aresult of their divestitures, we classified our Connectivity Solutions businessand the portions of the Expanets business that previously distributed non-Avayaproducts as discontinued operations. The table below summarizes the operatingresults of the businesses included in (loss) income before income taxes fromdiscontinued operations, as well as the gain recognized on the sale ofConnectivity Solutions.

| ** **                                                            | ** ** | **Year ended September 30,**                                      | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| ** **                                                            | ** ** | **Dollars in millions**                                                | ** ** |
| Revenue from  discontinued operations:                                |       |                                                                             |       |   |   |   |   |   |   |
| Connectivity Solutions                                                |       |                                                                             | $          | — |   |   |   | $ | 168 |   |   |
| Expanets                                                              |       |                                                                             | —     |   |   |   | 8 |   |   |
| Total revenue from discontinued operations                            |       |                                                                             | $          | — |   |   |   | $ | 176 |   |   |
| (Loss) income  before income taxes from discontinued operations:      |       |                                                                             |       |   |   |   |   |   |   |
| Connectivity Solutions                                                |       |                                                                             |       |   |   |   |   |   |   |
| Results of  operations                                                |       |                                                                             | $          | (2 | ) |   |   | $ | (71 | ) |   |
| Gain on sale                                                          |       |                                                                             | —     |   |   |   | 84 |   |   |
| Total (loss)  income before income taxes for Connectivity Solutions   |       |                                                                             | (2         | ) |   |   | 13 |   |   |
| Expanets:                                                             |       |                                                                             |       |   |   |   |   |   |   |
| Results of  operations                                                |       |                                                                             | —     |   |   |   | (7 | ) |   |
| Total (loss) income  before income taxes from discontinued operations |       |                                                                             | $          | (2 | ) |   |   | $ | 6 |   |   |

 

The results of operations for Connectivity Solutionsfor fiscal 2004 included a charge of $48 million comprised of a $24 millionpension and postretirement curtailment loss and a $24 million settlement lossrecognized upon the transfer of pension and postretirement benefit assets andliabilities to CommScope. Upon the transfer of these pension and postretirement benefit assetsand liabilities to CommScope, an offsetting gain of $48 million was recognizedand included in the $84 million gain on sale of discontinued operations for theassumption of these liabilities by CommScope.

The amounts presented forExpanets for fiscal 2004 represent the results generated by the portion of theExpanets business that previously distributed non-Avaya products from the dateof acquisition on 

24

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November 25,2003, through June 30, 2004. We divested that entire portion of theExpanets business as of June 30, 2004.

**Liquidity andCapital Resources**

During fiscal 2006, wegenerated positive cash flow from operations of $647 million. We made avoluntary cash contribution of $42 million to our U.S. pension plans. We alsoused $328 million during fiscal 2006 to continue our program to repurchase andretire shares of our common stock. In addition, we used $188 million to acquirecapitalized assets and develop software technology. Cash and cash equivalentsincreased by $149 million to $899 million as of September 30, 2006.

***Sourcesand Uses of Cash for the Fiscal Year Ended September 30, 2006***

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

| ** **                                                    | ** ** | **Year ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**       | ** ** |
| Net cash provided  by (used for):                             |       |                                    |       |   |   |
| Operating activities                                          |       | $                                       | 647        |   | $ | 334 |   |
| Investing activities                                          |       | (189                                    | )          | (558 | ) |
| Financing activities                                          |       | (315                                    | )          | (638 | ) |
| Effect of  exchange rate changes on cash and cash equivalents |       | 6                                       |       | (5 | ) |
| Net increase (decrease) in cash and cash equivalents          |       | 149                                     |       | (867 | ) |
| Cash and cash equivalents at beginning of year                |       | 750                                     |       | 1,617 |   |
| Cash and cash  equivalents at end of year                     |       | $                                       | 899        |   | $ | 750 |   |

 

***Operating Activities***

Our net cash provided by operating activities was $647million for fiscal 2006, compared to $334 million for fiscal 2005. Cashprovided by operating activities was primarily driven by profitable operations.Specific items affecting our cash flows are discussed below:

*Incentivepayments—**During*fiscal 2006, discretionaryemployee awards were paid but were lower than the management incentives paidduring fiscal 2005. Payments are based on the prior fiscal year’s performance.

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

| ** **                                                                  | ** ** | **September 30,**            | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                          | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **                                                                  | ** ** | **Dollars in millions** | ** ** |
| Accounts  receivable, gross                                                 |       | $                                 | 928        |   | $ | 920 |   | $ | 8 |   |
| Allowance for  doubtful accounts                                            |       | (57                               | )          | (58 | ) | 1 |   |
| Accounts  receivable, net                                                   |       | $                                 | 871        |   | $ | 862 |   | $ | 9 |   |
| Allowance for doubtful accounts as a percent of  accounts receivable, gross |       | 6.1                               | %          | 6.3 | % | -0.2  pts |   |
| Days sales outstanding (DSO)                                                |       | 57 days                           |       | 60 days |   | -3  days |   |
| Past due  receivables as a percent of accounts receivable, gross            |       | 17.8                              | %          | 21.7 | % | -3.9  pts |   |

 

The decrease in DSO and past-due percentage wasprimarily a result of an improvement in our collections efforts on a globalbasis.

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

| ** **          | ** ** | **September 30,**            | ** ** |
|---------------------|------------|-----------------------------------|------------|
| ** **          | ** ** | **2006**                          | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **          | ** ** | **Dollars in millions** | ** ** |
| Finished goods      |       | $                                 | 281        |   | $ | 274 |   | $ | 7 |   |
| Raw materials       |       | 4                                 |       | 14 |   | (10 | ) |
| Total inventory     |       | $                                 | 285        |   | $ | 288 |   | $ | (3 | ) |
| Inventory  turnover |       | 10.2 times                        |       | 9.4 times |   | + 0.8 times |   |

 

*Accounts Payable—**The*followingsummarizes our accounts payable and days payable outstanding:

| ** **               | ** ** | **September 30,**            | ** ** |
|--------------------------|------------|-----------------------------------|------------|
| ** **               | ** ** | **2006**                          | ** ** | **2005** | ** ** | **Change** | ** ** |
| ** **               | ** ** | **Dollars in millions** | ** ** |
| Accounts payable         |       | $                                 | 418        |   | $ | 402 |   | $ | 16 |   |
| Days payable outstanding |       | 51                                |       | 53 |   | -2  days |   |
|                          |            |                                   |            |  |  |  |  |  |  |  |

 

***Investing Activities***

Net cash used for investing activities was $189million in fiscal 2006, compared with $558 million in fiscal 2005. Activitiesin fiscal 2006 included $188 million for capital expenditures, including $71million of capitalized software development costs.

Fiscal 2005 activitiesprimarily include $421 million, net, used for acquisitions, including $265million for Tenovis, $110 million for Spectel and $38 million for Nimcat. Weused $206 million for capital expenditures, including $59 million ofcapitalized software development costs, and we received proceeds of $52 million from the sale of our corporateaircraft.

***Financing Activities***

Net cash used for financing activities was $315million in fiscal 2006, compared with $638 million in fiscal 2005. Activitiesin the current year include $328 million to repurchase shares of our commonstock pursuant to our stock repurchase plan and $14 million to repay our seniornotes, partially offset by $28 million of cash received in connection with theissuance of common stock under our employee stock purchase plan and theexercise of options under our stock option plans.

Net cash used in fiscal2005 consisted primarily of $314 million to repurchase substantially all of oursenior notes in a public tender offer, $262 million to repay the outstandingprincipal of Tenovis’ secured floating rate notes and $107 million torepurchase and retire shares of our common stock pursuant to our stockrepurchase plan. These uses of cash were partially offset by $49 million ofcash received in connection with the issuance of common stock under ouremployee stock purchase plan and the exercise of options under our stock optionplans.

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***Contractual Obligations and Sources of Liquidity***

***Contractual Obligations***

Thefollowing table summarizes our contractual obligations as of September 30,2006:

| ** **                                                         | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                         | ** ** | ** **                                | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More than** | ** ** |
| ** **                                                         | ** ** | **Total**                                 | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **5 years** | ** ** |
| ** **                                                         | ** ** | **In millions**                      | ** ** |
| Capital lease  obligations(1)                                      |       | $                                         | 13         |   |   | $ | 4 |   |   |   | $ | 9 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating lease  obligations(2)                                    |       | 704                                       |       |   | 139 |   |   |   | 209 |   |   |   | 124 |   |   |   | 232 |   |   |
| Purchase  obligations with contract manufacturers and suppliers(3) |       | 197                                       |       |   | 197 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Other purchase  obligations(4)                                     |       | 115                                       |       |   | 115 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                                                              |       | $                                         | 1,029      |   |   | $ | 455 |   |   |   | $ | 218 |   |   |   | $ | 124 |   |   |   | $ | 232 |   |   |

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(1)   Thepayments due for capital lease obligations do not include future payments forinterest.

(2)   Contractual obligations for operating leases include $39 millionof future minimum lease payments that have been accrued for in accordance withaccounting principles generally accepted in the U.S. pertaining torestructuring and exit activities.

(3)   We purchasecomponents from a variety of suppliers and use several contract manufacturersto provide manufacturing services for our products. During the normal course ofbusiness, in order to manage manufacturing lead times and to help assureadequate component supply, we enter into agreements with contract manufacturersand suppliers that allow them to produce and procure inventory based uponforecasted requirements provided by us. If we do not meet these specifiedpurchase commitments, we could be required to purchase the inventory. See Note17, “Commitments and Contingencies—Guarantees of Indebtedness and OtherOff-Balance Sheet Arrangements—Purchase Commitments and Termination Fees” toour Consolidated Financial Statements.

(4)   Otherpurchase obligations represent an estimate of contractual obligations in theordinary course of business, other than commitments with contract manufacturersand suppliers, for which we have not received the goods or services as of September 30,2006. Although contractual obligations are considered enforceable and legallybinding, the terms generally allow us the option to cancel, reschedule, andadjust our requirements based on our business needs prior to the delivery ofgoods or performance of services.

Our primary future cash requirements will be to fundworking capital, share repurchases, capital expenditures, restructuringpayments, employee incentive payments and benefit obligations. In addition, wemay use cash in the future to make strategic acquisitions.

Specifically, weexpect our primary cash requirements for fiscal 2007 to be as follows:

·  *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. Since the start of theplan through September 30, 2006, we paid $435 million to repurchase andretire our shares, leaving approximately $65 million available for furthershare repurchases according to the limitations of the plan. These repurchasesare made at management’s discretion in the open market or in privatelynegotiated transactions in compliance with applicable securities laws and otherlegal requirements and are subject to market conditions, share price and otherfactors. See Note 11, “Earnings Per Share of Common Stock,” to our ConsolidatedFinancial Statements for further information.

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·  *Capitalexpenditures*—We expect to spend approximately $240 million forcapital expenditures and capitalized software development costs during fiscal2007.

·  *Restructuringpayments—*We expect to make payments of approximately $90 millionduring fiscal 2007 for employee separation costs and lease terminationobligations associated with restructuring actions we have taken. We may makeadditional cash payments if we initiate further restructuring actions duringfiscal 2007.

·  *Employeeincentive payments—*Based on our actual results compared to ourcorporate targets (operating income, revenue growth and operating cash flow)established for incentive payments under the Avaya, Inc. Short TermIncentive Plan (“STIP”) for fiscal 2006, we made cash payments aggregating $90million to our employees during the first quarter of fiscal 2007.

·  *Benefit obligations*—In fiscal 2007, we estimate we will makepayments totaling $6 million for certain U.S. pension benefits that arenot pre-funded, a $2 million contribution to satisfy the minimum statutoryfunding requirements in the U.S. and contributions totaling $12 million fornon-U.S. plans. For fiscal 2007, we also estimate we will make paymentstotaling $63 million for retiree medical benefits that are not pre-funded.

***Future Sources of Liquidity***

We expect our primary source of cash during fiscal2007 to be positive net cash provided by operating activities. We expect thatgrowth in profitable revenues and continued focus on accounts receivable,inventory management and cost containment will enable us to continue togenerate 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 LeaseObligations and Long-Term Debt” to our Consolidated Financial Statements),which expires in May 2011. Our existing cash and cash equivalents and netcash provided by operating activities may be insufficient if we faceunanticipated cash needs such as the funding of a future acquisition or othercapital investment. Furthermore, if we acquire a business in the future thathas existing debt, our debt service requirements may increase, therebyincreasing our cash needs.

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

Based on past performanceand current expectations, we believe that our existing cash and cashequivalents of $899 million as of September 30, 2006 and our net cashprovided by operating activities will be sufficient to meet our future cashrequirements described above. Our ability to meet these requirements will dependon our ability to generate cash in the future, which is subject to generaleconomic, financial, competitive, legislative, regulatory and other factorsthat are beyond our control.

***Uncertainties Regarding Our Liquidity***

We believe thefollowing uncertainties exist regarding our liquidity:

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

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

·  *Future Acquisitions—*We may from time to time in the futuremake acquisitions. Such acquisitions may require significant amounts of cash ormay result in increased debt service requirements to the extent we assume orincur debt in connection with such acquisitions.

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

***Contributions to Pension Plan***

During 2006, we made a voluntary cash contribution of$42 million to our U.S. pension plans.

During June 2004, wemade a voluntary contribution of $111 million of our common stock to fund ourU.S. management pension plan. The contribution was funded with a combination of2,448,602 shares of treasury stock and 4,510,646 shares of newly issued commonstock. The per share value of common stock contributed to the pension plan was$15.95, which represented the average of the opening and closing share price onJune 9, 2004, the date of the contribution. As of the date of thecontribution, the treasury stock had a carrying value of $27 million. Thedifference between the $27 million carrying value and the $39 million fairvalue of the treasury stock contributed was recorded as an increase toadditional paid-in capital. As a result of this contribution, we were notrequired to make a contribution to satisfy minimum statutory fundingrequirements for our U.S. pension plans during fiscal 2004, 2005 or 2006.

***Credit Facility***

Our credit facility contains affirmative andrestrictive covenants that we must comply with, including: (a) periodicfinancial reporting requirements, (b) maintaining a maximum ratio ofconsolidated debt to earnings before interest, taxes, depreciation andamortization, adjusted for certain business restructuring charges and relatedexpenses and non-cash charges, referred to as adjusted EBITDA, of 2.00 to 1.00,(c) maintaining a minimum ratio of adjusted EBITDA to interest expense of4.00 to 1.00, (d) limitations on the incurrence of subsidiaryindebtedness, (e) limitations on liens, (f) limitations on investmentsand (g) limitations on the creation or existence of agreements thatprohibit liens on our properties. The credit facility also limits ourability to make dividend payments or distributions or to repurchase,redeem or otherwise acquire shares of our common stock to an amount notto exceed 50% of consolidated net income for the fiscal year immediatelypreceding the fiscal year in which such dividend, purchase, redemption,retirement or acquisition is paid or made. For fiscal 2006, the credit facilityallowed us to repurchase, redeem or otherwise acquire shares of our commonstock up to an amount not to exceed $461 million, which equaled 50% of our consolidated net income forfiscal 2005. On September 8, 2006, the credit facility was amended toprovide that the Company may use an additional $500 million during the periodfrom October 1, 2006 through September 30, 2008 for such activities,over the amount provided for under the 50% of consolidated net income test eachyear. As of September 30, 2006, we were in compliance with all of thecovenants included in the credit facility.

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

There are currently $35million of letters of credit issued under the credit facility. There areno other outstanding borrowings under the facility and the remainingavailability is $365 million as of September 30, 2006. We believe thecredit facility provides us with an important source of backup liquidity.

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

We are party to severaltypes of agreements, including surety bonds, purchase commitments, productfinancing arrangements and performance guarantees, which are fully discussed inNote 17, “Commitments and Contingencies” to our Consolidated Financial Statements.

**Legal Proceedingsand Environmental, Health and Safety Matters**

We are subject to certainlegal proceedings as fully discussed in Note 17, “Commitments and Contingencies—LegalProceedings” to our Consolidated Financial Statements.

**Quantitative and QualitativeDisclosures About Market Risk**

***Foreign Currency Transactions***

***RecordedTransactions******—We*********utilize foreign currencyforward contracts primarily to manage short-term exchange rate exposures oncertain receivables, payables and loans residing on foreign subsidiaries’books, which are denominated in currencies other than the subsidiary’sfunctional currency. For fiscal 2006 and 2005, the changes in the fair value ofthe foreign currency forward contracts were substantially offset by changesresulting from the revaluation of the hedged items.

The fair value of foreign currency forward contractsis sensitive to changes in currency exchange rates. A 10% appreciation intraded-against foreign currency value from the prevailing market rates wouldhave had a negative impact of $39 million and $37 million,respectively, for fiscal 2006 and 2005. Conversely, a 10% depreciation wouldhave had a positive impact of $36 million and $27 million,respectively, for fiscal 2006 and 2005.

***Forecasted Transactions******—From***time totime, we use foreign currency forward contracts to offset certain forecastedforeign currency transactions primarily related to the purchase or sale ofproduct expected to occur during the ensuing twelve months. The change in thefair value of foreign currency forward contracts is recognized as other incomeor expense in the period in which the exchange rates change. For fiscal 2006and 2005, these gains and losses were not material to our results ofoperations.

***Interest Rate Swap Agreements***

During the first and second quarters of 2004, weentered into a total of five interest rate swap agreements each having anotional amount of $50 million and a maturity date of April 2009, whichmatched the notional amount of the senior notes outstanding. The interest rateswaps effectively converted $250 million of the senior notes from fixed ratedebt into floating rate debt. During the third and fourth quarters of fiscal2004, we terminated all five of our interest rate swap agreements as weanticipated further repurchases of the senior notes.

In November 2001,Tenovis Finance Limited entered into two interest rate swap agreements, eachwith an original notional amount of Euro 150 million, which matched thenotional amount of the secured floating rate notes outstanding. Mirroring thesecured floating rate notes, the interest rate swaps had a 

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final maturity date of November 2007.These interest rate swap agreements were executed in order to convert thesecured notes floating rate debt into fixed rate debt. During fiscal 2005, werepaid the outstanding principal amount of the secured floating rate notes andconcurrently terminated the two interest rate swaps.

See Note 9, “Derivativesand Other Financial Instruments” to our Consolidated Financial Statements forfurther details related to these interest rate swap agreements.

**Recent AccountingPronouncements**

***SFAS 158***

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Post Retirement Plans—an amendment of FASB Statements No 87,88, 106 and 132(R)” (“SFAS 158”). SFAS 158 improves reporting ofobligations for pensions and other post-retirement benefits byrecognizing the over-funded or under-funded status of plans as an asset orliability. The pronouncement does not change how plan assets and benefitobligations are measured under FAS 87 and FAS 106, nor does it change theapproach for measuring annual benefit cost reported in earnings. Rather, iteliminates the provisions that permit plan assets and obligations to be measuredas of a date not more than three months prior to the balance sheet date,instead requiring measurement as of the reporting date. In addition, thepronouncement requires previously unrecognized items, such as actuarial gainsand unrecognized prior service costs or credits to be recognized on the balancesheet as a component of other comprehensive income. The Company will adopt theprovisions of SFAS 158 in fiscal 2007. Upon adoption of SFAS 158, the Companywill record an increase in the pension liability recognized on the ConsolidatedBalance Sheets of approximately $1 million with an offset to othercomprehensive income. Additionally, the Company will record an increase inother post-retirement liability obligations recognized on the Consolidated BalanceSheets of approximately $227 million with an offset to other comprehensiveincome.

***SFAS 157***

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

***SAB 108***

In September 2006,the SEC issued SAB 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements”**(“SAB 108”)*.*SAB 108 provides interpretive guidance on how the effectsof the carryover or reversal of prior year misstatements should be consideredin quantifying a current year misstatement. The pronouncement prescribes anapproach whereby the effect of all unrecorded identified errors should beconsidered on all of the financial statements rather than just either theeffect on the balance sheet or the income statement. The Company will adopt theprovisions of SAB 108 beginning in fiscal 2007. The adoption of SAB 108 is notexpected to have a material impact on the Company’s Consolidated FinancialStatements.

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***FIN 48***

In July 2006, the FASB issued FASBInterpretation No. 48 “Accounting for Uncertainty in Income Taxes (aninterpretation of FASB Statement No. 109)” (“FIN 48”). FIN 48 clarifiesthe accounting for uncertainty in tax positions and requires that companiesrecognize in their financial statements the impact of a tax position, if thatposition is more likely than not of being sustained on audit, based on thetechnical merits of the position. The Company will be required to adopt theprovisions of FIN 48 beginning in fiscal 2008, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings as well as requiring additional disclosures. The Company iscurrently assessing the impact of the adoption of FIN 48 on its ConsolidatedFinancial Statements.

***SFAS 156***

In March 2006, theFASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—anamendment of FASB Statement SFAS No. 140” (“SFAS 156”). SFAS 156 simplifiesthe accounting for loan servicing rights and the financial instruments used tohedge risks associated with those rights. SFAS 156 requires that servicingrights be valued initially at fair value, and subsequently accounted for ateither fair value, or amortized over the economic life of the related lease. TheCompany will adopt the provisions of SFAS 156 beginning in fiscal 2007. Theadoption of SFAS 156 is not expected to have a material impact on the Company’sConsolidated 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 the accounting for certain hybrid financial instrumentscontaining embedded derivatives. SFAS 155 allows fair value measurement for anyhybrid financial instrument that contains an embedded derivative that otherwisewould require bifurcation under SFAS 133, “Accounting for DerivativeInstruments and Hedging Activities.” In addition, it amends SFAS 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities” to allow a qualifying special-purpose entity to hold a derivativefinancial instrument that pertains to a beneficial interest other than anotherderivative financial instrument. The Company will adopt the provisions of SFAS155 beginning in fiscal 2007. The adoption of SFAS 155 is not expected to havea material impact on the Company’s Consolidated Financial Statements.

**Recent Tax Legislation**

On October 22, 2004,the American Jobs Creation Act of 2004, or 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 determined that it will not repatriate earnings pursuant to theAmerican Jobs Creation Act of 2004.

**The Application ofCritical Accounting Policies**

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

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assumptionsor conditions were to prevail, the results could be materially different fromour reported results.

***Revenue Recognition***

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

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

Our indirect sales of products to distributionpartners are generally recognized at the time of shipment if all contractualobligations have been satisfied. We accrue a provision for estimated salesreturns and other allowances and deferrals as a reduction of revenue at thetime of revenue recognition, as required. We calculate the provision for salesreturns and allowances based on a quarterly analysis of actual historicalreturns and allowances in relation to current quarter sales, and determine therequired allowance. This analysis requires a significant amount of judgment. Ifthe accrued provision is higher or lower than required based on our quarterlyanalysis, the provision is adjusted against revenue.

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

Most of our sales require judgment principally in theareas of customer acceptance, returns assessment and collectibility. Theassessment of collectibility is particularly critical in determining whether ornot revenue should be recognized. We assess collectibility based primarily 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.

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 element 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 

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theundelivered elements. In the absence of fair value for a delivered element, wefirst allocate revenue based on VSOE of the undelivered elements and theresidual revenue to the delivered elements. Where VSOE of the undeliveredelement cannot be determined, we defer revenue for the delivered elements untilthe undelivered elements are delivered.

***Collectibility of Accounts Receivable***

Our accounts receivableare recorded net of an allowance for doubtful accounts. As discussed above, weaccrue for the allowance based on an analysis of historical trends. In order torecord our accounts receivable at their net realizable value, we also assesstheir collectibility. A considerable amount of judgment is required in order tomake this assessment including a detailed analysis of the aging of ourreceivables and the current creditworthiness of our customers and an analysisof historical bad debts and other adjustments. We have recorded allowances forreceivables which we believe are uncollectible, including amounts for theresolution of potential credit and other collection issues such as disputedinvoices, customer satisfaction claims and pricing discrepancies. However,depending on how such potential issues are resolved, or if the financialcondition of any of our customers were to deteriorate and their ability to makerequired payments became impaired, increases in these allowances may berequired. We actively manage our accounts receivable to minimize credit risk,and as of September 30, 2006, we have no individual customer thatconstitutes more than 10% of our accounts receivable.

***Inventories***

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

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

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

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

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***Long-Lived Assets***

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

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

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

***Restructuring Programs***

We recorded restructuring charges during the fourthquarter of fiscal 2005 and during fiscal 2006. The restructuring chargesinclude employee termination benefits as well as accruals for vacating leasedpremises and terminating operating leases. In connection with our acquisitionof Tenovis in fiscal 2005, we recorded restructuring charges in accordance withEITF 95-3 for termination benefits to be paid to former Tenovis employees.In prior years, we recorded restructuring charges in accordance with EITF 94-3,the balance of which relates to leased premises that have been vacated.

A significant amount ofjudgment is required in estimating the amount of restructuring charges torecord. Estimates used to determine employee termination benefit payments maydiffer from the actual amounts paid. In addition, estimates used to establishreserves related to real estate lease obligations may be adjusted based on newinformation. Because certain of our real estate lease obligations extendthrough fiscal 2021, assumptions were made as to the timing, availability andamount of sublease income that we expect to receive. In making these assumptions,we considered many variables such as the vacancy rates of commercial realestate in the local markets and the market rate for sublease rentals. Therequirement to project sublease income for many years into the future, ourestimates and assumptions regarding the commercial real estate market that weused to calculate future sublease income may be materially different fromactual sublease income. If our sublease income estimates were too high, wewould incur additional real estate lease obligation charges. Conversely, if oursublease income estimates were too low, we would be required to reverse chargesand recognize income.

***Pension and Postretirement Benefit Costs***

We sponsor non-contributory defined benefit pensionplans covering the majority of our U.S. employees and retirees, andpostretirement benefit plans for U.S. retirees that include healthcare benefitsand life insurance coverage. Certain non-U.S. operations have variousretirement benefit programs 

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covering substantially allof their employees. Some of these programs are considered to be defined benefitpension plans for accounting purposes.

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

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

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

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

***Commitments and Contingencies***

We are subject to legalproceedings related to environmental, product, employment, intellectualproperty, licensing and other matters. In addition, we are subject toindemnification and liability sharing claims by Lucent under the terms of theContribution and Distribution Agreement. In order to determine the amount ofreserves required, we assess the likelihood of any adverse judgments oroutcomes to these matters as well as potential ranges of probable losses. Adetermination of the amount of reserves required for these contingencies ismade after analysis of each individual issue. The estimates of requiredreserves may change in the future due to new developments in each matter orchanges in approach such as a change 

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insettlement strategy. Assessing the adequacy of any reserve for matters forwhich we may have to indemnify Lucent is especially difficult, as we do notcontrol the defense of those matters and have limited information. In addition,estimates are made for our repurchase obligations related to products sold tovarious distributors who obtain financing from certain third party lendinginstitutions, as described in Note 17, “Commitments and Contingencies” toour Consolidated Financial Statements.

***Accounting for Stock Options***

During fiscal 2005 and prior years, we accounted forstock options in accordance with Accounting Principles Board Opinion 25 anddisclosed the pro forma effect of expensing stock options in accordance with SFAS123. Effective October 2005, we have adopted SFAS 123(R), which requiresus to recognize compensation expense in our financial statements for the fairvalue of stock options we issue. Both SFAS 123 and SFAS 123(R) requiremanagement to make assumptions regarding the expected life of the options, theexpected liability of the options and other items in determining estimated fairvalue. Changes to the underlying assumptions may have significant impact on theunderlying value of the stock options, which could have a material impact onour financial statements.

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**Management’s Reporton Internal Control Over Financial Reporting**

Managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rule 13a-15(f).Management (with the participation of our principal executive officer andprincipal financial officer) conducted an evaluation of the effectiveness ofinternal control over financial reporting based on the framework in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). Basedon this evaluation, management concluded that internal control over financialreporting was effective as of September 30, 2006 based on criteria inInternal Control—Integrated Framework issued by COSO. Management’s assessmentof the effectiveness of internal control over financial reporting as of September 30,2006 has been audited by PricewaterhouseCoopers LLP, an independent registeredpublic accounting firm, and PricewaterhouseCoopers LLP has issued anattestation report on management’s assessment of the effectiveness of theCompany’s internal control over financial reporting, which is included herein. 

| /s/ LOUIS J. D’AMBROSIO             |   | /s/ GARRY K. MCGUIRE                                                         |
|------------------------------------------|--------|------------------------------------------------------------------------------|
| *President  and Chief Executive Officer* |   | *Chief  Financial Officer and Senior Vice President,  Corporate Development* |
| December 8,  2006                   |   | December 8,  2006                                                       |

 

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors and Shareholders of AvayaInc.:

We have completedintegrated audits of Avaya Inc.’s 2006 and 2005 consolidated financialstatements and of its internal control over financial reporting as of September 30,2006, and an audit of its 2004 consolidated financial statements in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates). Our opinions, based on our audits, are presented below.

***Consolidatedfinancial statements***

In our opinion, the consolidated financial statementslisted in the index appearing under Item 15(a)(1) of this Form 10-Kpresent fairly, in all material respects, the financial position of Avaya Inc.and its subsidiaries (the “Company”) at September 30, 2006 and 2005, andthe results of their operations and their cash flows for each of the threeyears in the period ended September 30, 2006 in conformity with accountingprinciples generally accepted in the United States of America. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 2 tothe consolidated financial statements, the Company changed the manner in whichit accounts for share-based compensation effective October 1, 2005.

***Internalcontrol over financial reporting***

Also, in our opinion, management’s assessment,included in the accompanying Management’s Report on Internal Control OverFinancial Reporting appearing in Exhibit 13 of the Form 10-K,that the Company maintained effective internal control over financial reportingas of September 30, 2006 based on criteria established in *Internal Control*—*Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), is fairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of September 30, 2006, basedon criteria established in *Internal Control*—*Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal 

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control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directors ofthe company; and (iii) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations,internal control over financial reporting may not prevent or detectmisstatements. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

PricewaterhouseCoopers LLPFlorham Park, New JerseyDecember 8, 2006

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**AVAYA INC.CONSOLIDATED STATEMENTS OF INCOME**

| ** **                                                       | ** ** | **Year ended September 30,**                                 | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                       | ** ** | **Dollars in millions, except per  share amounts** | ** ** |
| REVENUE                                                          |       |                                                                        |       |   |   |   |   |
| Sales of products                                                |       | $                                                                           | 2,510      |   | $ | 2,294 |   | $ | 2,048 |   |
| Services                                                         |       | 2,002                                                                       |       | 1,971 |   | 1,761 |   |
| Rental and managed services                                      |       | 636                                                                         |       | 637 |   | 260 |   |
|                                                             |       | 5,148                                                                       |       | 4,902 |   | 4,069 |   |
| COSTS                                                            |       |                                                                        |       |   |   |   |   |
| Sales of products                                                |       | 1,168                                                                       |       | 1,049 |   | 928 |   |
| Services                                                         |       | 1,320                                                                       |       | 1,297 |   | 1,064 |   |
| Rental and managed services                                      |       | 270                                                                         |       | 259 |   | 132 |   |
|                                                             |       | 2,758                                                                       |       | 2,605 |   | 2,124 |   |
| GROSS MARGIN                                                     |       | 2,390                                                                       |       | 2,297 |   | 1,945 |   |
| OPERATING  EXPENSES                                              |       |                                                                        |       |   |   |   |   |
| Selling, general and administrative                              |       | 1,595                                                                       |       | 1,583 |   | 1,274 |   |
| Research and development                                         |       | 428                                                                         |       | 394 |   | 348 |   |
| Restructuring charges                                            |       | 104                                                                         |       | 22 |   | — |   |
| TOTAL OPERATING EXPENSES                                         |       | 2,127                                                                       |       | 1,999 |   | 1,622 |   |
| OPERATING INCOME                                                 |       | 263                                                                         |       | 298 |   | 323 |   |
| Other income (expense), net                                      |       | 24                                                                          |       | (32 | ) | (15 | ) |
| Interest expense                                                 |       | (3                                                                          | )          | (19 | ) | (66 | ) |
| INCOME FROM CONTINUING OPERATIONS BEFORE INCOME  TAXES           |       | 284                                                                         |       | 247 |   | 242 |   |
| Provision for (benefit from) income taxes                        |       | 83                                                                          |       | (676 | ) | (49 | ) |
| INCOME FROM CONTINUING OPERATIONS                                |       | 201                                                                         |       | 923 |   | 291 |   |
| (LOSS) INCOME FROM DISCONTINUED OPERATIONS, NET OF  INCOME TAXES |       | —                                                                      |       | (2 | ) | 5 |   |
| **NET INCOME**                                                   | ** ** | **$**                                                                       | **201**    | ** ** | **$** | **921** | ** ** | **$** | **296** | ** ** |
| **Earnings  Per Common Share—Basic:**                       | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings per share from continuing operations                    |       | $                                                                           | 0.43       |   | $ | 1.95 |   | $ | 0.66 |   |
| Earnings per share from discontinued operations                  |       | —                                                                      |       | — |   | 0.01 |   |
| Earnings per share                                               |       | $                                                                           | 0.43       |   | $ | 1.95 |   | $ | 0.67 |   |
| **Earnings  Per Common Share—Diluted:**                     | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings per share from continuing operations                    |       | $                                                                           | 0.43       |   | $ | 1.89 |   | $ | 0.63 |   |
| Earnings per share from discontinued operations                  |       | —                                                                      |       | — |   | 0.01 |   |
| Earnings per  share                                              |       | $                                                                           | 0.43       |   | $ | 1.89 |   | $ | 0.64 |   |

 

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

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**AVAYA INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                        | ** ** | **As of September 30,**                                      | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **      2006     **  | ** ** | **     2005      ** | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **Dollars in millions,  except per share amounts** | ** ** |
| **ASSETS**                                                                                                                                                                                                        |       |                                                                        |       |   |   |   |   |   |   |
| Current assets:                                                                                                                                                                                                   |       |                                                                        |       |   |   |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                         |       |                                                                        | $          | 899 |   |   |   | $ | 750 |   |   |
| Accounts receivable, less allowances of $57 million  and $58 million as of September 30, 2006 and 2005, respectively                                                                                         |       |                                                                        | 871        |   |   |   | 862 |   |   |
| Inventory                                                                                                                                                                                                         |       |                                                                        | 285        |   |   |   | 288 |   |   |
| Deferred income taxes, net                                                                                                                                                                                        |       |                                                                        | 153        |   |   |   | 143 |   |   |
| Other current assets                                                                                                                                                                                              |       |                                                                        | 151        |   |   |   | 128 |   |   |
| TOTAL CURRENT  ASSETS                                                                                                                                                                                             |       |                                                                        | 2,359      |   |   |   | 2,171 |   |   |
| Property, plant and equipment, net                                                                                                                                                                                |       |                                                                        | 668        |   |   |   | 738 |   |   |
| Deferred income taxes, net                                                                                                                                                                                        |       |                                                                        | 787        |   |   |   | 911 |   |   |
| Intangible assets                                                                                                                                                                                                 |       |                                                                        | 263        |   |   |   | 337 |   |   |
| Goodwill                                                                                                                                                                                                          |       |                                                                        | 941        |   |   |   | 914 |   |   |
| Other assets                                                                                                                                                                                                      |       |                                                                        | 182        |   |   |   | 148 |   |   |
| **TOTAL  ASSETS**                                                                                                                                                                                                 | ** ** | ** **                                                                  | **$**      | **5,200** |   | ** ** | ** ** | **$** | **5,219** |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                    |       |                                                                        |       |   |   |   |   |   |   |
| Current liabilities:                                                                                                                                                                                              |       |                                                                        |       |   |   |   |   |   |   |
| Accounts payable                                                                                                                                                                                                  |       |                                                                        | 418        |   |   |   | 402 |   |   |
| Payroll and benefit obligations                                                                                                                                                                                   |       |                                                                        | 348        |   |   |   | 300 |   |   |
| Deferred revenue                                                                                                                                                                                                  |       |                                                                        | 286        |   |   |   | 244 |   |   |
| Other current liabilities                                                                                                                                                                                         |       |                                                                        | 335        |   |   |   | 373 |   |   |
| TOTAL CURRENT  LIABILITIES                                                                                                                                                                                        |       |                                                                        | 1,387      |   |   |   | 1,319 |   |   |
| Benefit obligations                                                                                                                                                                                               |       |                                                                        | 1,350      |   |   |   | 1,561 |   |   |
| Deferred income taxes, net                                                                                                                                                                                        |       |                                                                        | 77         |   |   |   | 96 |   |   |
| Other liabilities                                                                                                                                                                                                 |       |                                                                        | 300        |   |   |   | 282 |   |   |
| TOTAL NON-CURRENT  LIABILITIES                                                                                                                                                                                    |       |                                                                        | 1,727      |   |   |   | 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, 452,203,778 and 471,328,963 issued (including 461,429 and  207,053 treasury shares) as of September 30, 2006 and 2005, respectively |       |                                                                        | 5          |   |   |   | 5 |   |   |
| Additional paid-in-capital                                                                                                                                                                                        |       |                                                                        | 2,637      |   |   |   | 2,895 |   |   |
| Retained earnings (accumulated deficit)                                                                                                                                                                           |       |                                                                        | 148        |   |   |   | (53 | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                                              |       |                                                                        | (698       | ) |   |   | (883 | ) |   |
| Less: treasury stock at cost                                                                                                                                                                                      |       |                                                                        | (6         | ) |   |   | (3 | ) |   |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                                  |       |                                                                        | 2,086      |   |   |   | 1,961 |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                              | ** ** | ** **                                                                  | **$**      | **5,200** |   | ** ** | ** ** | **$** | **5,219** |   |   |

 

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

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**AVAYA INC.CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND OF COMPREHENSIVEINCOME**

| ** **                                                                                 | ** ** | ** **                                                            | ** **  | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | ** **   | ** ** | ** **             | ** ** | ** **        | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|-------------|------------|------------|----------------|------------|-----------------|------------|-------------------|------------|--------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                 | ** ** | ** **                                                            | ** **  | ** ** | ** ** | **Additional** | ** ** | **Accumulated** | ** ** | **Other**         | ** ** | ** **   | ** ** | **Total**              | ** ** | ** **        | ** ** |
| ** **                                                                                 | ** ** | **Number**                                                            | ** **  | **Common** | ** ** | **Paid-In**    | ** ** | **(Deficit)**   | ** ** | **Comprehensive** | ** ** | **Treasury** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                 | ** ** | **of Shares**                                                    | ** **  | **Stock**  | ** ** | **Capital**    | ** ** | **Surplus**     | ** ** | **Loss**          | ** ** | **Stock**    | ** ** | **Equity**             | ** ** | **Income**        | ** ** |
| ** **                                                                                 | ** ** | **Dollars in millions, shares in thousands** | ** **  |
| **Balance as of September 30, 2003**                                                  | ** ** |                                                                  | **418,556** | ** ** |       |           | **$**      | **4**           | ** ** |              |       | **$**        | **2,151**  | ** **             |       |              | **$**      | **(1,270** | **)** |   |   | **$** | **(679** | **)** |   |   | **$** | **(6** | **)** |   |   | **$** | **200** | ** ** |   |   | ** ** | ** ** |   |
| Issuance of common stock through public offering                                           |       |                                                                  | 14,039      |       |       |           | 1          | ** **      |       |              | 248        |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 249 |   |   |   |   |   |   |
| Issuance of common stock for pension contribution funding                             |       |                                                                  | 6,959       |       |       |           |       | ** **      |       |              | 84         |         |       |                   |       | ** **        |       |   |   |   |   |   | 27 |   |   |   | 111 |   |   |   |   |   |   |
| Issuance of common stock to employees under the stock purchase plan              |       |                                                                  | 1,055       |       |       |           |       | ** **      |       |              | 91         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 91 |   |   |   |   |   |   |
| Issuance of common stock for Lucent Shareowners Settlement                                 |       |                                                                  | 1,822       |       |       |           |       | ** **      |       |              | 21         |         |       |                   |       | ** **        |       |   |   |   |   |   | 3 |   |   |   | 24 |   |   |   |   |   |   |
| Other stock transactions                                                                   |       |                                                                  | 15,138      |       |       |           |       | ** **      |       |              | (3         | )            |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | (3 | ) |   |   |   |   |   |
| Purchase of treasury stock                                                                 |       |                                                                  | (1,741      | )          |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   |   |   |   | (24 | ) |   |   | (24 | ) |   |   |   |   |   |
| Net income                                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   | 296        | ** **        |       |   |   |   |   |   |   |   |   |   | 296 |   |   |   | $ | 296 |   |   |
| Minimum pension liability, net of tax effect of $65 and valuation  allowance of ($65) |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | (166 | ) |   |   |   |   |   |   | (166 | ) |   |   | (166 | ) |   |
| Unrealized holding losses on available for sale securities                            |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | (3 | ) |   |   |   |   |   |   | (3 | ) |   |   | (3 | ) |   |
| Cumulative translation adjustment for sale of Connectivity  Solutions                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | (32 | ) |   |   |   |   |   |   | (32 | ) |   |   | (32 | ) |   |
| Foreign currency translation                                                               |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | 51 |   |   |   |   |   |   |   | 51 |   |   |   | 51 |   |   |
| Total comprehensive income                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   |   | ** ** |   |   | **$** | **146** | ** ** |   |
| **Balance as of September 30, 2004**                                                  | ** ** |                                                                  | **455,828** | ** ** |       |           | **$**      | **5**           | ** ** |              |       | **$**        | **2,592**  | ** **             |       |              | **$**      | **(974** | **)** |   |   | **$** | **(829** | **)** |   |   | **$** | **—** | ** ** |   |   | **$** | **794** | ** ** |   |   | ** ** | ** ** |   |
| Issuance of common stock in connection with LYONs exchange offer, net  of tax              |       |                                                                  | 20,546      |       |       |           |       | ** **      |       |              | 299        |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 299 |   |   |   |   |   |   |
| Retirement of common shares repurchased                                                    |       |                                                                  | (11,525     | )          |       |           |       | ** **      |       |              | (107       | )            |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | (107 | ) |   |   |   |   |   |
| Issuance of common stock to employees under the stock purchase plan              |       |                                                                  | 1,419       |       |       |           |       | ** **      |       |              | 49         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 49 |   |   |   |   |   |   |
| Tax benefits from employee stock option plans                                              |       |                                                                  | —      |       |       |           |       | ** **      |       |              | 50         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 50 |   |   |   |   |   |   |
| Other stock transactions                                                                   |       |                                                                  | 5,061       |       |       |           |       | ** **      |       |              | 12         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 12 |   |   |   |   |   |   |
| Purchase of treasury stock                                                                 |       |                                                                  | (207        | )          |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   |   |   |   | (3 | ) |   |   | (3 | ) |   |   |   |   |   |
| Net income                                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   | 921        | ** **        |       |   |   |   |   |   |   |   |   |   | 921 |   |   |   | $ | 921 |   |   |
| Minimum pension liability, net of tax effect of $15                                        |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | (13 | ) |   |   |   |   |   |   | (13 | ) |   |   | (13 | ) |   |
| Foreign currency translation                                                               |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | (41 | ) |   |   |   |   |   |   | (41 | ) |   |   | (41 | ) |   |
| Total comprehensive income                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | **$** | **867** | ** ** |   |
| **Balance as of September 30, 2005**                                                  | ** ** |                                                                  | **471,122** | ** ** |       |           | **$**      | **5**           | ** ** |              |       | **$**        | **2,895**  | ** **             |       |              | **$**      | **(53** | **)** |   |   | **$** | **(883** | **)** |   |   | **$** | **(3** | **)** |   |   | **$** | **1,961** | ** ** |   |   | ** ** | ** ** |   |
| Retirement of common shares repurchased                                                    |       |                                                                  | (29,909     | )          |       |           |       | ** **      |       |              | (328       | )            |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | (328 | ) |   |   |   |   |   |
| Issuance of common stock to employees under the stock purchase plan              |       |                                                                  | 1,409       |       |       |           |       | ** **      |       |              | 28         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 28 |   |   |   |   |   |   |
| Tax benefits from employee stock option plans                                              |       |                                                                  | —      |       |       |           |       | ** **      |       |              | 12         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 12 |   |   |   |   |   |   |
| Amortization of vested restricted stock units                                         |       |                                                                  | —      |       |       |           |       | ** **      |       |              | 13         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 13 |   |   |   |   |   |   |
| Other stock transactions                                                                   |       |                                                                  | 9,581       |       |       |           |       | ** **      |       |              | 17         |         |       |                   |       | ** **        |       |   |   |   |   |   |   |   |   |   | 17 |   |   |   |   |   |   |
| Purchase of treasury stock                                                                 |       |                                                                  | (461        | )          |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   |   |   |   | (3 | ) |   |   | (3 | ) |   |   |   |   |   |
| Net income                                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   | 201        | ** **        |       |   |   |   |   |   |   |   |   |   | 201 |   |   |   | $ | 201 |   |   |
| Minimum pension liability, net of tax effect of $78                                        |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | 137 |   |   |   |   |   |   |   | 137 |   |   |   | 137 |   |   |
| Foreign currency translation                                                               |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   | 48 |   |   |   |   |   |   |   | 48 |   |   |   | 48 |   |   |
| Total comprehensive income                                                                 |       |                                                                  |        |       |       |           |       | ** **      |       |              |       |         |       |                   |       | ** **        |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |   | **$** | **386** | ** ** |   |
| **Balance as of September 30, 2006**                                                  | ** ** |                                                                  | **451,742** | ** ** |       |           | **$**      | **5**           | ** ** |              |       | **$**        | **2,637**  | ** **             |       |              | **$**      | **148** | ** ** |   |   | **$** | **(698** | **)** |   |   | **$** | **(6** | **)** |   |   | **$** | **2,086** |   |   |   |   |   |   |

 

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

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**AVAYA INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                         | ** ** | **Year ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                         | ** ** | **Dollars in millions**           | ** ** |
| **OPERATING  ACTIVITIES:**                                                                                         |       |                                        |       |   |   | (revised) |   |
| Net income                                                                                                         |       | $                                           | 201        |   | $ | 921 |   | $ | 296 |   |
| Less: (loss) income from  discontinued operations, net                                                             |       | —                                      |       | (2 | ) | 5 |   |
| Income from continuing  operations                                                                                 |       | 201                                         |       | 923 |   | 291 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities from continuing operations: |       |                                        |       |   |   |   |   |
| Business restructuring  charges (reversals), net                                                                   |       | 104                                         |       | 17 |   | (1 | ) |
| Depreciation and  amortization                                                                                     |       | 269                                         |       | 272 |   | 147 |   |
| Amortization of  restricted stock units                                                                            |       | 15                                          |       | 10 |   | 15 |   |
| Share-based compensation                                                                                           |       | 15                                          |       | — |   | — |   |
| Provision for  uncollectible receivables                                                                           |       | 10                                          |       | 18 |   | 9 |   |
| Deferred taxes, including  reversal of valuation allowance                                                         |       | 16                                          |       | (601 | ) | 8 |   |
| Impairment charges                                                                                                 |       | 29                                          |       | — |   | — |   |
| Reversal of tax  liabilities related to audit settlement                                                           |       | (7                                          | )          | (124 | ) | (47 | ) |
| Loss on extinguishment of  debt, net                                                                               |       | —                                      |       | 44 |   | 42 |   |
| Litigation settlements                                                                                             |       | —                                      |       | — |   | (23 | ) |
| Purchased in-process  research and development                                                                     |       | —                                      |       | 7 |   | — |   |
| Unrealized gains (losses)  on foreign currency exchange                                                            |       | 12                                          |       | (2 | ) | 29 |   |
| Adjustments for other  non-cash items, net                                                                         |       | —                                      |       | (2 | ) | 8 |   |
| Changes in operating assets and liabilities, net of  effects of acquired businesses:                               |       |                                        |       |   |   |   |   |
| Receivables                                                                                                        |       | (18                                         | )          | (68 | ) | 2 |   |
| Inventory                                                                                                          |       | 6                                           |       | 56 |   | 34 |   |
| Restricted cash                                                                                                    |       | 1                                           |       | 9 |   | 28 |   |
| Accounts payable                                                                                                   |       | 13                                          |       | (15 | ) | — |   |
| Payroll and benefits                                                                                               |       | 33                                          |       | (89 | ) | 77 |   |
| Voluntary contribution to  pension plan                                                                            |       | (42                                         | )          | — |   | — |   |
| Accrued interest payable  on long-term debt                                                                        |       | (2                                          | )          | (17 | ) | (70 | ) |
| Restructuring reserve                                                                                              |       | (76                                         | )          | (17 | ) | (24 | ) |
| Deferred revenue                                                                                                   |       | 50                                          |       | 2 |   | 16 |   |
| Other assets and  liabilities                                                                                      |       | 18                                          |       | (89 | ) | (62 | ) |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES FROM CONTINUING  OPERATIONS                                             |       | 647                                         |       | 334 |   | 479 |   |
| Net cash (used  for) operating activities from discontinued operations                                             |       | —                                      |       | — |   | (21 | ) |
| NET CASH PROVIDED  BY OPERATING ACTIVITIES                                                                         |       | 647                                         |       | 334 |   | 458 |   |
| **INVESTING ACTIVITIES:**                                                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital expenditures                                                                                               |       | (117                                        | )          | (147 | ) | (81 | ) |
| Capitalized software  development costs                                                                            |       | (71                                         | )          | (59 | ) | (38 | ) |
| Acquisitions of  businesses, net of cash acquired                                                                  |       | —                                      |       | (421 | ) | (128 | ) |
| (Payments for) proceeds  from sales of discontinued operations                                                     |       | —                                      |       | (3 | ) | 260 |   |
| Proceeds from sale of  Commscope common stock                                                                      |       | —                                      |       | — |   | 28 |   |
| Proceeds from sale of  property, plant and equipment                                                               |       | 7                                           |       | 52 |   | — |   |
| Investments in marketable  securities                                                                              |       | —                                      |       | — |   | (9 | ) |
| Other investing  activities, net                                                                                   |       | (8                                          | )          | 20 |   | (11 | ) |
| NET CASH (USED  FOR) PROVIDED BY INVESTING ACTIVITIES  FROM CONTINUING OPERATIONS                                  |       | (189                                        | )          | (558 | ) | 21 |   |
| **FINANCING ACTIVITIES:**                                                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Issuance of common stock                                                                                           |       | 28                                          |       | 49 |   | 342 |   |
| Repurchase of common  stock                                                                                        |       | (328                                        | )          | (107 | ) | — |   |
| Repayment of long-term  debt                                                                                       |       | (14                                         | )          | (580 | ) | (404 | ) |
| Other financing  activities, net                                                                                   |       | (1                                          | )          | — |   | (2 | ) |
| NET CASH (USED  FOR) FINANCING ACTIVITIES FROM CONTINUING OPERATIONS                                               |       | (315                                        | )          | (638 | ) | (64 | ) |
| Effect of exchange  rate changes on cash and cash equivalents                                                      |       | 6                                           |       | (5 | ) | 10 |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                              |       | 149                                         |       | (867 | ) | 425 |   |
| Cash and cash  equivalents at beginning of fiscal year                                                             |       | 750                                         |       | 1,617 |   | 1,192 |   |
| Cash and cash  equivalents at end of fiscal year                                                                   |       | $                                           | 899        |   | $ | 750 |   | $ | 1,617 |   |

 

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

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

**1.   Descriptionof Business**

***Background***

Avaya Inc. (the “Company,”“Avaya,” “we,” or “us”) provides communications systems, applications andservices for enterprises, including businesses, government agencies and otherorganizations. Our product offerings include Internet Protocol (“IP”) telephonysystems and traditional voice communications systems, multi-media contactcenter infrastructure and applications in support of customer relationshipmanagement, unified communications applications and appliances, such as IPtelephone sets. The term “traditional” with respect to “voice communications,” “enterprisevoice communications,” “telephony,” “voice telephony,” “voice systems,” or “TDM,”refers to circuit-based enterprise voice communications. The Company supportsits broad customer base with comprehensive global service offerings that enableour customers to plan, design, implement, monitor and manage theircommunications networks.

**2.   Summary ofSignificant Accounting Policies**

***Principles of Consolidation***

The Consolidated Financial Statements include theaccounts of Avaya and its subsidiaries. All intercompany transactions andbalances have been eliminated in consolidation.

Certain prior yearbalance sheet amounts have been reclassified to conform to the September 30,2006 presentation, including the following items:

·  Debt maturing within one year (includingcapital lease obligations) of $5 million as of September 30, 2005 has beenreclassified to “Other current liabilities”.

·  Long-term debt (including capital leaseobligations) of $25 million as of September 30, 2005 has been reclassifiedto “Other liabilities”.

The Company revised itsConsolidated Statements of Cash Flows to separately disclose the operating,investing and financing cash flows from discontinued operations. In its priorfilings, the Company previously reported cash flows from discontinuedoperations in total on the Consolidated Statements of Cash Flows with furtherdisclosure in the Notes. There were no cash flows from discontinuedoperations during fiscal 2006 or 2005, and $21 million of cash used foroperating activities for discontinued operations during fiscal 2004.

***Use of Estimates***

The Consolidated FinancialStatements and related disclosures are prepared in conformity with accountingprinciples generally accepted in the United States of America. Management isrequired to make estimates and assumptions that affect the reported amounts ofassets and liabilities, the disclosure of contingent assets and liabilities atthe date of the financial statements, and revenue and expenses during theperiod reported. These estimates include assessing the collectibility ofaccounts receivable, sales returns and allowances, the use and recoverabilityof inventory, the realization of deferred tax assets, business restructuringreserves, pension and postretirement benefit costs, the fair value of assetsand liabilities acquired in business combinations, and useful lives andimpairment of tangible and intangible assets, among others. The markets for theCompany’s products are characterized by intense competition, rapidtechnological development and frequent new product introductions, all of whichcould affect the future recoverability of the Company’s assets. Estimates andassumptions are reviewed periodically and the 

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effectsof revisions are reflected in the Consolidated Financial Statements in theperiod they are determined to be necessary. Actual results could differ fromthese estimates.

***Foreign Currency Translation***

Balance sheet accounts ofthe Company’s foreign operations are translated from foreign currencies intoU.S. dollars at period-end exchange rates while income and expenses aretranslated at average exchange rates during the period. Translation gains orlosses related to net assets located outside the U.S. are shown as a componentof accumulated other comprehensive loss in stockholders’ equity. Gains andlosses resulting from foreign currency transactions, which are denominated incurrencies other than the entity’s functional currency, are included in theConsolidated Statements of Income.

***Revenue Recognition***

The Company derives revenue primarily from the saleand service of communications 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 are sold directly through itsworldwide sales force and indirectly through its global network ofdistributors, dealers, value-added resellers and system integrators. Thepurchase price of the Company’s products typically includes installation and awarranty for up to one year. Revenue from the direct sales of products thatinclude installation services is recognized at the time the products areinstalled, after satisfaction of all the terms and conditions of the underlyingcustomer contract. When the Company provides a combination of products andservices to customers, the arrangement is evaluated under Emerging Issues TaskForce Issue (“EITF”) No. 00-21, “Revenue Arrangements with MultipleDeliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspectsof accounting by a vendor for arrangements under which the vendor will performmultiple revenue-generating activities.

The Company’s indirect sales to****distribution partners are generallyrecognized at the time of shipment if all contractual obligations have beensatisfied. The Company accrues a provision for estimated sales returns andother allowances and deferrals relating to inventory levels held by distributors,promotional marketing programs, etc. as a reduction of revenue at the time ofrevenue recognition, as required by EITF 01-9, “Accounting forConsideration Given by a Vendor to a Customer” and SAB 104.

The Company also derives revenue from: (i) supplementalmaintenance services, including services provided under contracts to monitorand optimize customers’ communications network performance, and on a time-and-materialsbasis; (ii) professional services for implementation and integration ofconverged voice and data networks, network security and unified communications;and (iii) managed services provided to customers who have chosen bundledsolutions and enhanced services not included in basic maintenance contracts formessaging and other parts of communications systems. Maintenance contractstypically have terms that range from one to five years. Contracts forprofessional services typically have terms that range from two to four weeksfor standard solutions and from six months to one year for customized solutions.Contracts for managed services typically have terms that range from one toseven years. Revenue from services performed under managed servicesarrangements, professional services and services performed under maintenancecontracts is accounted for in accordance with FASB Technical Bulletin No. 90-1“Accounting for Separately Priced Extended Warranty and Product MaintenanceContracts,” and is deferred and recognized ratably over the term of theunderlying customer contract or at the end of the contract, when obligationshave been satisfied. For services performed on a time and materials basis,revenue is recognized upon performance.

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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.

***Research and Development Costs and SoftwareDevelopment Costs***

Research and development costs are charged to expenseas incurred. The costs incurred for the development of communications softwarethat will be sold, leased or otherwise marketed, however, are capitalized whentechnological feasibility has been established. These capitalized costs aresubject to an ongoing assessment of recoverability based on anticipated futurerevenues and changes in hardware and software technologies. Costs that arecapitalized include direct labor and related overhead.

Amortization ofcapitalized software development costs begins when the product is available forgeneral release to customers. Amortization is recognized on aproduct-by-product basis on the greater of either the ratio of current grossrevenues to the total of current and anticipated future gross revenues, or thestraight-line method over a period of up to two years. Unamortized capitalizedsoftware development costs determined to be in excess of net realizable valueof the product are expensed immediately. As of September 30, 2006 and2005, the Company had unamortized software development costs of $100 millionand $73 million, respectively. Amortization expense of $42 million, $36million and $28 million was recorded for fiscal 2006, 2005 and 2004,respectively, and was included as a component of cost of products.

***Cash and Cash Equivalents***

All highly liquidinvestments with original maturities of three months or fewer when purchasedare considered to be cash equivalents. These short-term investments are statedat cost, which approximates market value. The Company’s cash and cashequivalents are invested in various investment grade institutional money marketaccounts, bank term deposits and commercial paper.

***Accounts Receivable***

Accounts receivable arerecorded net of reserves for sales returns and allowances, and provisions fordoubtful accounts. The allowances are based on analyses of historical trends,aging of accounts receivable balances and on the creditworthiness of customersas determined by credit checks and analyses, as well as customers’ paymenthistory.

***Inventory***

Inventory includes goodsawaiting sale (finished goods) and goods to be consumed directly or indirectlyin production (raw materials and supplies). Included with finished goodsinventory is equipment that is being installed at customer locations forvarious installations that are not yet complete. Inventory is stated at thelower of cost, determined on a first-in, first-out basis, or market. Reservesto reduce the inventory to market value are based on current inventory levels,historical usage and product life cycles for the various inventory types.

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***Property, Plant and Equipment***

Property, plant andequipment are stated at cost less accumulated depreciation. Depreciation isdetermined using a straight-line method over the estimated useful lives of thevarious asset classes. Estimated lives range from three to 10 years formachinery and equipment, five years for rental equipment and up to40 years for buildings.

Major improvements arecapitalized and minor replacements, maintenance and repairs are charged toexpense as incurred. Upon retirement or disposal of assets, the cost andrelated accumulated depreciation are removed from the Consolidated BalanceSheets and any gain or loss is reflected in the Consolidated Statements ofIncome.

***Internal Use Software***

Certain costs of computer software developed orobtained for internal use are capitalized and amortized on a straight-line basisover three to seven years. General and administrative costs, overhead,maintenance and training, as well as the cost of software that does not addfunctionality to the existing system, are expensed as incurred. As of September 30,2006 and 2005, the Company had unamortized internal use software costs of $88million and $131 million, respectively.

The Company recorded a non-cash impairment charge of approximately $28million before taxes in the third quarter of fiscal 2006. This charge isrelated to software developed for three components of internal-use softwaredesigned to simplify the process of creating tickets for service orders, theprocess of taking an order through its systems and other aspects of itsfinancial systems.

The impairment was recognized and measured in accordance with theprovisions of SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets” and AICPA Statement of Position 98-1, “Accountingfor Costs of Computer Software Developed or Obtained for Internal Use.” Duringfiscal 2006, the Company performed an assessment of all of its internal-usesoftware and its SAP architecture as well as the development of an informationtechnology (“IT”) roadmap. This evaluation resulted in the decision to maximizethe use of new SAP licenses, and the Company concluded, during the thirdquarter of fiscal 2006, that it was no longer probable that the internal-usesoftware described above would be completed or placed into service.

The internal-use softwarewas recorded as a corporate asset and not allocated to either of the Company’ssegments, and was reported at the lower of its carrying amount or fair value,which was determined to be zero. The charge of $28 million is recorded inthe selling, general and administrative expenses line item in the Company’sConsolidated Statements of Income for the corporate / other unallocated amountscaption for fiscal 2006.

***Goodwill, Other Intangible and Long-lived Assets***

Goodwill is the excess of the purchase price over thefair values assigned to the net assets acquired in business combinations. Goodwillis not amortized, but instead is subject to periodic testing for impairment. Goodwillof a reporting unit, which is one level below the Company’s operating segments,is tested for impairment on an annual basis or between annual tests if eventsoccur or circumstances change indicating that the fair value of a reportingunit may be below its carrying amount. Goodwill impairment is determined usinga two-step approach in accordance with SFAS 142 using a discounted cash flowapproach based on forward looking information regarding market share and costsfor each reporting unit as well as an appropriate discount rate.

Intangible and otherlong-lived assets are reviewed for impairment whenever events such as productdiscontinuance, product dispositions or other changes in circumstances indicatethat the carrying amount 

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may notbe recoverable. In reviewing for impairment, the Company compares the carryingvalue of the relevant assets to the estimated undiscounted future cash flowsexpected from the use of the assets and their eventual disposition. When theestimated undiscounted future cash flows are less than their carrying amount,an impairment loss is recognized equal to the difference between the assets’fair value and its carrying value. Intangible assets include existingtechnology, customer relationships, trademarks and other intangibles.

***Investments***

The Company’s investment portfolio as of September 30,2006 consists primarily of investments that are generally concentrated in theemerging communications technology industry. These investments are carried atmarket value, if readily determinable, or cost, and are included in otherassets. Investments that are carried at market value are reported at fair valuewith the unrealized gains or losses recorded in other comprehensive income.

During fiscal 2006, theCompany had investments accounted for under the cost and equity methods inaddition to investments carried at fair value. The Company’s share of earningsor losses from equity method investments is recorded in other income (expense),net. Investments are periodically reviewed for impairment and written downwhenever declines in fair value below carrying value are considered to be otherthan temporary. In making this determination, the Company considers, amongother factors, sustained decreases in quoted market prices and a series ofhistoric and projected operating losses by the investee. During fiscal 2004,the Company acquired a controlling interest in AGC, which was previouslyaccounted for as an equity method investment. As of September 30, 2006 and2005, the Company had investments of $10 million and $11 million,respectively, which are included in other current assets on the ConsolidatedBalance Sheets.

***Financial Instruments***

The Company uses various financial instruments,including interest rate swap agreements and foreign currency forward contracts,to manage and reduce risk to the Company by generating cash flows that offsetthe cash flows of certain transactions in foreign currencies or underlyingfinancial instruments in relation to their amount and timing. The Company’sderivative financial instruments are used as risk management tools and not forspeculative or trading purposes. These derivative instruments represent assetsand liabilities and are classified as other current assets or other currentliabilities on the Consolidated Balance Sheets. Gains and losses on the changesin the fair values of the Company’s derivative instruments are included in otherincome (expense), net.

As permitted under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities” (“SFAS 133”), the Company haselected not to designate its forward contracts as hedges thereby precluding theuse of hedge accounting for these instruments.

The Company also utilizesnon-derivative financial instruments including letters of credit andcommitments to extend credit.

***Restructuring Programs***

The Company accounts for exit or disposal activitiesinitiated after December 31, 2002, in accordance with SFAS No. 146, “AccountingFor Costs Associated with Exit or Disposal Activities” (“SFAS 146”).

In accordance with SFAS 146, a businessrestructuring is defined as an exit activity that includes but is not limitedto a program that is planned and controlled by management, and materiallychanges either the scope of a business or the manner in which that business isconducted. Business restructuring charges 

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include (i) one-timetermination benefits related to employee separations, (ii) contracttermination costs and (iii) other associated costs such as consolidatingor closing facilities and relocating employees.

A liability is recognizedand measured at its fair value for one-time termination benefits once the planof termination is communicated to affected employees and it meets all of thefollowing criteria: (i) management commits to a plan of termination, (ii) theplan identifies the number of employees to be terminated and their jobclassifications or functions, locations and the expected completion date, (iii) theplan establishes the terms of the benefit arrangement and (iv) it isunlikely that significant changes to the plan will be made or the plan will bewithdrawn. Contract termination costs include costs to terminate a contract orcosts that will continue to be incurred under the contract without benefit tothe Company. A liability is recognized and measured at its fair value when theCompany either terminates the contract or ceases using the rights conveyed bythe contract. A liability is recognized and measured at its fair value forother associated costs in the period in which the liability is incurred.

***Pension and Postretirement Benefit Obligations***

The Company maintainsdefined benefit pension plans covering the majority of its employees, whichprovide benefit payments to vested participants upon retirement. The Companyalso provides certain postretirement healthcare and life insurance benefits toeligible employees. These pension and other postretirement benefit plans are accountedfor in accordance with SFAS 87, “Employers’ Accounting for Pensions” and SFAS106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,”which require costs and the related obligations and assets arising from thepension and other postretirement benefit plans to be accounted for based onactuarially-determined estimates. The plans use different factors, includingage, years of service and eligible compensation, to determine****the benefit amount for eligibleparticipants. The Company funds its pension plans in compliance with applicablelaws. See Note 13 “Benefit Obligations” for a discussion of amendmentsmade to the Company’s pension and postretirement plans which froze benefitaccruals and additional participation in the plans for its U.S. managementemployees effective December 31, 2003.

***Share-based Compensation***

On October 1, 2005, the Company adopted SFAS 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 Stock Issued to Employees” (“APB 25”) for periods beginning infiscal 2006. In March 2005, the SEC issued Staff Accounting Bulletin No. 107(“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions ofSAB 107 in 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 twelve months ended September 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 fiscal 2006 was $15million on a pre-tax basis and was related to stock options and the discount onemployee stock purchases under the plans described in Note 14, “StockCompensation Plans” to our Consolidated Financial Statements. There was noshare-based compensation expense related to employee stock options and employeestock purchases recognized during fiscal 2005.

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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 relatedto stock options had been recognized in the Company’s Consolidated Statementsof Income, 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) requiresforfeitures to be estimated at the time of grant in order to estimate theamount of share-based awards that will ultimately vest. The estimate is basedon the Company’s historical rates of forfeiture. Share-based compensationexpense recognized in the Company’s Consolidated Statement of Income for fiscal2006 includes (i) compensation expense for share-based payment awardsgranted prior to, but not yet vested as of September 30, 2005, based onthe grant-date fair value estimated in accordance with the pro forma provisionsof SFAS 123 and (ii) compensation expense for the share-based paymentawards granted subsequent to September 30, 2005, based on the grant-datefair value estimated in accordance with the provisions of SFAS 123(R). Asshare-based compensation expense recognized in the Consolidated Statements ofIncome for fiscal 2006 is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. In the Company’s pro forma informationrequired under SFAS 123 for the periods prior to fiscal 2006, the Companyaccounted for forfeitures as they occurred.

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

On November 10, 2005, the Financial AccountingStandards Board (“FASB”) issued FASB Staff Position No. SFAS 123(R)-3,“Transition Election Related to Accounting for Tax Effects of Share-BasedPayment Awards.” The alternative transition method includes simplified methodsto establish the beginning balance of the additional paid-in capital pool (“APICpool”) related to the tax effects of employee share-based compensation, and todetermine the subsequent impact on the APIC pool and Consolidated Statements ofCash Flows of the tax effects of employee share-based compensation awards thatare outstanding upon adoption of SFAS 123(R). The Company has elected to adoptthe alternative transition method provided in this FASB Staff Position forcalculating the tax effects of share-based compensation pursuant to SFAS123(R).

Share-based compensation expense reduced the Company’sresults of operations as follows:

| ** **                               | ** ** | **Year ended**                                                              | ** ** |
|------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **    September 30, 2006    ** | ** ** |
| ** **                               | ** ** | **Dollars in millions,  except per share amounts**      | ** ** |
| Income before  income taxes              |       |                                                                             | $          | 15 |   |   |
| Net income                               |       |                                                                             | $          | 9 |   |   |
| Earnings per  Common Share—Basic:   |       |                                                                             | $          | 0.02 |   |   |
| Earnings per Common  Share—Diluted: |       |                                                                             | $          | 0.02 |   |   |

 

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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”):

| ** **                                                                                                            | ** ** | **Year ended September 30,**                                      | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| ** **                                                                                                            | ** ** | **Dollars in millions,  except per share amounts**      | ** ** |
| Net income, as  reported                                                                                              |       |                                                                             | $          | 921 |   |   |   | $ | 296 |   |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects          |       |                                                                             | 6          |   |   |   | 9 |   |   |
| (Deduct): Total  stock compensation expense determined under the fair value based method, net  of related tax effects |       |                                                                             | (69        | ) |   |   | (31 | ) |   |
| Net income, pro  forma                                                                                                |       |                                                                             | $          | 858 |   |   |   | $ | 274 |   |   |
| Earnings per Common  Share—Basic:                                                                                |       |                                                                             |       |   |   |   |   |   |   |
| As reported                                                                                                           |       |                                                                             | $          | 1.95 |   |   |   | $ | 0.67 |   |   |
| Pro forma                                                                                                             |       |                                                                             | 1.81       |   |   |   | 0.63 |   |   |
| Earnings per  Common Share—Diluted:                                                                              |       |                                                                             |       |   |   |   |   |   |   |
| As reported                                                                                                           |       |                                                                             | $          | 1.89 |   |   |   | $ | 0.64 |   |   |
| Pro forma                                                                                                             |       |                                                                             | 1.76       |   |   |   | 0.60 |   |   |

 

In July 2005, theCompany’s Board of Directors approved the acceleration of the vesting ofcertain outstanding stock options exercisable for Avaya common stock. Based onthis action, all stock options outstanding as of July 26, 2005 having anexercise price greater than or equal to $13 per share vested and became fullyexercisable as of that date. Aside from the acceleration of the vesting date,the terms and the conditions of the stock option award agreements governing theunderlying stock options grants remained unchanged. As a result of this action,options to purchase approximately 10.2 million shares became exercisable. Thisaction will result in stock option expense to be recorded in the ConsolidatedStatements of Income over fiscal 2006, 2007 and 2008 in accordance with SFAS123(R) in an amount approximately $62 million lower on a pre-tax basisthan the expense would have been if the vesting had not been accelerated. As aresult of the accelerated vesting, the pro forma stock-based employeecompensation expense for fiscal 2005 increased by $62 million.

***Change in Vacation Policy***

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

***Income Taxes***

Income taxes are accountedfor under the asset and liability method. Under this method, deferred tax assetsand liabilities are recognized for the estimated future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases, and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities aremeasured using enacted tax rates in effect for the year in which thosetemporary differences are expected to be 

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recoveredor settled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in the Consolidated Statements of Income in the period thatincludes the enactment date. A valuation allowance is recorded to reduce thecarrying amounts of deferred tax assets if it is more likely than not that suchassets will not be realized.

***Other Comprehensive Income (Loss)***

Other comprehensive income(loss) is recorded directly to a separate section of stockholders’ equity inaccumulated other comprehensive loss and includes unrealized gains and lossesexcluded from the Consolidated Statements of Income. These unrealized gains andlosses consist of adjustments to the minimum pension liability, foreigncurrency translation, and unrealized losses on securities classified asavailable-for-sale. The minimum pension liability adjustment represents theexcess of the additional pension liability over the unrecognized prior servicecost.

***Reclassifications***

Certain prior year amountshave been reclassified to conform to the current year presentation.

**3.   RecentAccounting Pronouncements**

***SFAS 158***

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Post Retirement Plans—an amendment of FASB Statements No 87,88, 106 and 132(R)” (“SFAS 158”). SFAS 158 improves reporting of obligationsfor pensions and other post-retirement benefits by recognizing the over-fundedor under-funded status of plans as an asset or liability. The pronouncementdoes not change how plan assets and benefit obligations are measured under FAS87 and FAS 106 nor does it change the approach for measuring annual benefitcost reported in earnings. Rather, it eliminates the provisions that permitplan assets and obligations to be measured as of a date not more than threemonths prior to the balance sheet date, instead requiring measurement as of thereporting date. In addition, the pronouncement requires previously unrecognizeditems, such as actuarial gains and unrecognized prior service costs or creditsto be recognized on the balance sheet as a component of other comprehensiveincome (loss). The Company will adopt the provisions of SFAS 158 in fiscal 2007.Upon adoption of SFAS 158, the Company will record an increase in the pensionliability recognized on the Consolidated Balance Sheets of approximately $1million with an offset to other comprehensive income. Additionally, the Companywill record an increase in other post-retirement liability obligationsrecognized on the Consolidated Balance Sheets of approximately $227 millionwith an offset to other comprehensive income.

***SFAS 157***

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS157 defines fair value and establishes a framework for measuring fair value inGAAP. The pronouncement describes fair value as being based on a hypotheticaltransaction to sell an asset or transfer a liability at a specific measurementdate, as considered from the perspective of a market participant who holds theasset or owes the liability. In addition, fair value should be viewed as amarket-based based measurement, not an entity-specific measurement. Thereforefair value should be determined based on the assumptions that marketparticipants would use in pricing an asset or liability, including all risksassociated with that asset or liability. SFAS 157 will be effective for theCompany beginning in fiscal 2009. The adoption of SFAS 157 is not expected tohave a material impact on the Company’s Consolidated Financial Statements.

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***SAB 108***

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

***FIN 48***

In July 2006, the FASB issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes (aninterpretation of FASB Statement No. 109)” (“FIN 48”). FIN 48 clarifiesthe accounting for uncertainty in tax positions and requires that companiesrecognize in their financial statements the impact of a tax position, if thatposition is more likely than not of being sustained on audit, based on thetechnical merits of the position. The Company will be required to adopt theprovisions of FIN 48 beginning in fiscal 2008, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings as well as requiring additional disclosures. The Company iscurrently assessing the impact of the adoption of FIN 48 on its ConsolidatedFinancial Statements.

***SFAS 156***

In March 2006, theFASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—anamendment 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 adoption of SFAS 156 is not expected to have a material impacton 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 the accounting for certain hybrid financial instrumentscontaining embedded derivatives. SFAS 155 allows fair value measurement for anyhybrid financial instrument that contains an embedded derivative that otherwisewould require bifurcation under SFAS 133, “Accounting for DerivativeInstruments and Hedging Activities.” In addition, it amends SFAS 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities” to allow a qualifying special-purpose entity to hold a derivativefinancial instrument that pertains to a beneficial interest other than anotherderivative financial instrument. The Company will adopt the provisions of SFAS155 beginning in fiscal 2007. The adoption of SFAS 155 is not expected to havea material impact on the Company’s Consolidated Financial Statements.

**4.   BusinessCombinations and Other Transactions**

***Acquisition of Traverse***

On November 9, 2006,the Company acquired Traverse Networks, Inc. (“Traverse”) for $15 millionin cash. Traverse is a privately-held developer of enterprise mobilitysolutions for unified communications based in California. Results from Traversewill be included in the Company’s Consolidated Financial Statements effective November 9,2006.

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***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’s Europeanoperations 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 GCS segment and $206 million to the Avaya GlobalServices (“AGS”) segment. None of the goodwill, intangibles or in-processresearch and development amounts is expected to be deductible for tax purposes.The Company allocated $298 million to intangible assets (including contractualcustomer relationships, existing technology and trademarks) based on valuationstudies performed with the assistance of third party valuation consultants.These intangible assets are being amortized over their weighted averageestimated useful lives of 5 years, 6 years and 1.5 years, respectively. Inaddition, the Company allocated $1 million to in-process research anddevelopment, which was charged to research and development expense in theConsolidated Statements of Income during fiscal 2005.

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

| ** **                                                        | ** ** | **Final**                         | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                        | ** ** | **Purchase Price**           | ** ** |
| ** **                                                        | ** ** | **Allocation**                    | ** ** |
| ** **                                                        | ** ** | **Dollars in millions** | ** ** |
| Cash                                                              |       |                              | $          | 116 |   |   |
| Rental equipment                                                  |       |                              | 132        |   |   |
| Fixed assets                                                      |       |                              | 144        |   |   |
| Intangible assets  and in-process research & development |       |                              | 299        |   |   |
| Long-term debt                                                    |       |                              | (287       | ) |   |
| Deferred tax  liability                                           |       |                              | (119       | ) |   |
| Restructuring                                                     |       |                              | (106       | ) |   |
| Pension liability                                                 |       |                              | (314       | ) |   |
| Working capital  and other assets and liabilities                 |       |                              | (90        | ) |   |
| **Net liabilities 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 $46 million and $30 million for termination benefitsduring fiscal 2006 and 2005, respectively. During fiscal 2006, the Companyincreased the restructuring liability by $5 million forhigher-than-originally-expected per employee separation payments in Germany,which is included in the Consolidated Statements of Income. The accrual of $30million as of September 30, 2006 reflects the estimated remainingtermination payments adjusted for currency fluctuations since the acquisitiondate.

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

Thefollowing unaudited pro forma financial information presents the Company’sresults for fiscal 2005 and 2004 as if the Tenovis acquisition had occurred atthe beginning of each period:

| ** **                      | ** ** | **Year ended September 30,**                                                  | ** ** |
|---------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **       2005       ** | ** ** | **       2004       ** | ** ** |
| ** **                      | ** ** | **Dollars in millions, except  per share amounts**                  | ** ** |
| Revenue                         |       |                                                                                         | $          | 5,005 |   |   |   | $ | 5,073 |   |   |
| Net income                      |       |                                                                                         | $          | 895 |   |   |   | $ | 212 |   |   |
| Earnings per  share—basic  |       |                                                                                         | $          | 1.89 |   |   |   | $ | 0.48 |   |   |
| Earnings per share—diluted |       |                                                                                         | $          | 1.83 |   |   |   | $ | 0.47 |   |   |

 

The pro forma results are not necessarily indicativeof the results of operations that actually would have resulted had theacquisition been in effect at the beginning 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. One consolidated VIE was related tosecured floating rate notes assumed with the acquisition of Tenovis, all ofwhich were repaid during fiscal 2005. Therefore, this VIE no longer exists.

In accordance with FIN 46(R), “Consolidation ofVariable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46(R)”),the Company is not required to apply the provisions of FIN 46(R) to two ofthe VIEs because it is unable to obtain the information necessary to performthe accounting required for consolidation. Although the Company has made aneffort to gather the required information, management of these two VIEs hasformally 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 secondnon-consolidated VIE is a non-U.S. telecommunications hardware productmanufacturer and service provider. The Company has agreed to purchase from theVIE certain amounts of products and services, and the VIE has contracted forthe Company to provide certain IT services and purchasing services with respectto raw materials. These contracts expire in August 2007. During fiscal2006 and 2005, the Company purchased products and services from this VIEaggregating $35 million and $36 million, respectively. Additionally, theCompany is required to pay monthly rental subsidies on the VIE’s premises, andin the event the VIE is unable to pay its portion of the rental payments, theCompany is liable for their portion as well. During fiscal 2006 and 2005, theCompany paid $1 million each fiscal year in connection with rental subsidies. Themaximum exposure to loss of $5 million as of September 30, 2006 for theremainder of the agreement represents the minimum purchase order commitmentsand the minimum service levels for service contracts.

***Other Fiscal 2005 Acquisitions and Transactions***

***The respective purchase prices for the followingacquisitions were not material, either individually or in the aggregate, to theConsolidated Financial Statements of the Company. Therefore, disclosures of pro formafinancial information have not been presented.***

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**Acquisition ofNimcat Networks**

On September 16,2005, the Company acquired Nimcat Networks Incorporated (“Nimcat”) for $38million in cash, net of cash acquired. Nimcat was a privately-held developer ofembedded peer-to-peer IP call processing software headquartered in Ottawa,Canada. Results from Nimcat are included in the Company’s ConsolidatedFinancial Statements beginning on September 16, 2005. In connection withthe acquisition, the Company allocated $3 million to in-process research anddevelopment, which was charged to research and development expense in theConsolidated Statements of Income at the date of the acquisition.

**Acquisition ofSpectel**

On October 4, 2004,the Company completed the purchase of Spectel plc (“Spectel”), a world leaderin audio and web conferencing solutions, for $110 million in cash (including $6million of transaction fees that were not paid to the sellers), net of $3million of cash acquired. The acquisition enabled the Company to continue toexpand its capabilities in conferencing, which is a core businesscommunications technology. In connection with the acquisition, the Companyallocated $3 million to in-process research and development, which was chargedto research and development expense in the Consolidated Statements of Incomeduring the first quarter of fiscal 2005.

***Aircraft Transactions***

During fiscal 2005, theCompany sold two aircraft for $52 million, which was reflected in net cash usedfor investing activities. In November 2004, the Company entered intooperating leases for two new aircraft which were delivered during the secondhalf of fiscal 2005.

***Fiscal 2004 Acquisitions and Divestitures***

**Acquisition of aMajority Interest in Tata Telecom**

On April 2, 2004, the Company announced anagreement with the Tata Group to acquire its shares of Tata Telecom Ltd. (“TataTelecom”), a leading voice communications solutions provider in India,representing 25.1% ownership of Tata Telecom. As of the date of the agreement,the Company owned a 25.5% interest in Tata Telecom. Statutory requirements inIndia mandated that the Company also conduct a public tender offer for aminimum of 20% of the outstanding shares of Tata Telecom at the same price atwhich shares were purchased from the Tata Group. The public tender offer closedin July 2004 with 8.5% of the public shares tendering into the offer. Thesale of the shares by the Tata Group and the tendering shareholders closed on August 4,2004. Avaya paid a total of $24 million in August 2004 related to thisacquisition, of which $17 million was paid to the Tata Group, $6 million waspaid in relation to the public tender offer and Avaya realized a $1 millionloss associated with forward exchange contracts, which were used to hedgeforeign currency risk associated with the acquisition. Following theacquisition of these additional equity interests, the Company now owns 59.1% ofTata Telecom. The Company changed the name of Tata Telecom to AvayaGlobalConnect Limited (“AGC”) and began consolidating its results on August 4,2004.

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**Acquisition ofExpanets**

On November 25, 2003, the Company acquiredsubstantially all of the assets and assumed certain liabilities of Expanets. Expanets,a subsidiary of Northwestern Corp., was a nationwide provider of networkedcommunications and data products and services to small and mid-sized businessesand prior to the acquisition was one of the Company’s largest dealers. Theacquisition allowed the Company to continue providing quality sales and servicesupport for Expanets’ customers and grow its small and mid-sized business. Underthe terms of the asset purchase agreement, the Company paid a purchase price of$117 million, consisting of (i) $55 million in cash paid to Expanets, (ii) $27million paid to a creditor of Expanets to satisfy a debt obligation ofExpanets, (iii) $18 million to Northwestern to finalize working capitaladjustments, (iv) $15 million deposited into an escrow account to satisfycertain liabilities of Expanets and (v) $2 million in business combinationcosts. The results of the Expanets businesses the Company acquired have beenincluded in the Company’s Consolidated Financial Statements from the date ofacquisition on November 25, 2003.

At the date of acquisition, the Company recordedExpanets’ accounts receivable, inventory, fixed assets, liabilities andidentified intangibles at estimated fair value. The remainder of the purchaseprice in excess of the $27 million net assets acquired was recorded as goodwillof $90 million.

Identifiable intangibles consist of $21 million ofcustomer relationships, which are being amortized over 15 years, and $11million of agency relationships, which were being amortized over 10 years. Customerrelationships represent a database of information that acts as a source ofrepeat business for the Company. The information contained in the databaseincludes the preferences of the customer, along with the history of servicesprovided to the customer. Agency relationships represented the relationshipExpanets had with multiple phone carriers across the U.S. that were assumed bythe Company. The Company received a commission for selling phone services toits customers on behalf of the phone carriers.

In connection with theacquisition, in accordance with EITF No. 95-3, the Company recordedliabilities of $21 million for termination obligations, which consisted of $10million of employee separation costs for approximately 1,750 employees and $11million related to the closure of redundant real estate facilities. The Companycompleted the severance payments during fiscal 2004. During fiscal 2006, 2005and 2004, the Company made cash payments of $2 million, $1 million and $11million, respectively. The remaining balance as of September 30, 2006relates to lease obligations will be paid by the end of fiscal 2007.

***Sale ofa Portion of Expanets’ Business***

Upon the closing of the Expanets acquisition, theCompany decided to sell the Expanets businesses that previously distributedother vendors’ products and, accordingly, accounted for this portion ofExpanets’ business as a component of discontinued operations. In the first halfof fiscal 2004, the Company sold, in a series of transactions, certain assetsand liabilities attributed to these businesses for an aggregate considerationof $13 million, $4 million of which was cash consideration and $9 million ofwhich was in the form of notes receivable. During fiscal 2004, the Companydivested this portion of the Expanets business, collected $8 million of thesenotes receivable and wrote off the remainder of the receivables.

Results from discontinuedoperations for these businesses include revenue of $8 million and loss beforeincome taxes of $7 million for fiscal 2004.

**Sale ofConnectivity Solutions**

Duringfiscal 2004, the Company sold certain assets and liabilities of its ConnectivitySolutions business to CommScope, Inc. (“CommScope”) and accounted for thisbusiness as a discontinued operation. The Company received $256 million of cashand 1,761,538 shares of CommScope common stock 

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valued at $33 million on the closing date. The Company paid$9 million in transaction costs relating to the sale. During the second quarterof fiscal 2004, the Company sold all the shares of CommScope common stock andrecognized a pre-tax loss of $5 million, which was included in other income(expense), net.

The Companyrecorded an $84 million pre-tax gain from the sale of Connectivity Solutionsduring fiscal 2004, which is included in income from discontinued operations. Includedin the gain was a reversal of $27 million of certain liabilities that primarilyrepresent employee-related costs for which the Company no longer has anobligation.

The $84 million gain also included the recognition of $32million of foreign currency translation adjustments related to thedivestiture of Connectivity Solutions’ international operations. Acorresponding decrease was recorded in the accompanying Consolidated BalanceSheet during fiscal 2004 through accumulated other comprehensive loss toreflect the realization of foreign currency translation adjustments upon theliquidation of these foreign operations.

***Discontinued Operations***

Therewas no revenue or income from discontinued operations during fiscal 2006. Thefollowing table displays revenue and (loss) income before income taxes fromdiscontinued operations for fiscal 2005 and 2004:

| ** **                                                            | ** ** | **Year ended September 30,**                                      | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| ** **                                                            | ** ** | **Dollars in millions**                                                | ** ** |
| Revenue from  discontinued operations:                                |       |                                                                             |       |   |   |   |   |   |   |
| Connectivity Solutions                                                |       |                                                                             | $          | — |   |   |   | $ | 168 |   |   |
| Expanets                                                              |       |                                                                             | —     |   |   |   | 8 |   |   |
| Total revenue from discontinued operations                            |       |                                                                             | $          | — |   |   |   | $ | 176 |   |   |
| (Loss) income  before income taxes from discontinued operations:      |       |                                                                             |       |   |   |   |   |   |   |
| Connectivity  Solutions                                               |       |                                                                             |       |   |   |   |   |   |   |
| Results of operations                                                 |       |                                                                             | $          | (2 | ) |   |   | $ | (71 | ) |   |
| Gain on sale                                                          |       |                                                                             | —     |   |   |   | 84 |   |   |
| Total (loss) income before income taxes for Connectivity  Solutions   |       |                                                                             | (2         | ) |   |   | 13 |   |   |
| Expanets:                                                             |       |                                                                             |       |   |   |   |   |   |   |
| Results of operations                                                 |       |                                                                             | —     |   |   |   | (7 | ) |   |
| Total (loss)  income before income taxes from discontinued operations |       |                                                                             | $          | (2 | ) |   |   | $ | 6 |   |   |

 

In connection with the closing of the ConnectivitySolutions transaction, the Company recognized a pension and postretirementcurtailment loss of $24 million and a settlement loss of $24 million upon thetransfer of pension and postretirement benefit assets and liabilities toCommScope, and recorded a corresponding increase of $48 million to the benefitobligation. Upon the transfer of these pension and postretirement benefitassets and liabilities to CommScope, an offsetting gain of $48 million wasrecognized and included in the $84 million gain on sale of discontinuedoperations for the assumption of these liabilities by CommScope. These twotransactions resulted in a net zero impact to income from discontinuedoperations for fiscal 2004.

As a result of thetransfer of Connectivity Solutions employees to CommScope during fiscal 2004,the Company remeasured its minimum pension liability related to the pensionplan for represented employees, and in accordance with SFAS No. 87, “Employers’Accounting for Pensions,” the Company recorded an adjustment of $50 million toreduce the additional minimum pension liability. This resulted in a $36 milliondecrease to accumulated other comprehensive loss and a $14 million decrease tointangible assets.

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**5.   Goodwilland Intangible Assets**

The Company conducted the required annual impairmentreview during the fourth quarters of fiscal 2006 and 2005 and determinedthat no goodwill was impaired.

Thechanges in the carrying value of goodwill for fiscal 2006 and 2005 by operatingsegment are as follows:

| ** **                                             | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|--------------|------------|------------|------------|
| ** **                                             | ** ** | **Communications**                | ** ** | **Global**   | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Total**  | ** ** |
| ** **                                             | ** ** | **Dollars in millions** | ** ** |
| **Balance  as of September 30, 2004**             | ** ** |                              | **$**      | **187**      | ** ** |       |       | **$** | **70** | ** ** |   | **$** | **257** | ** ** |
| Goodwill acquired                                      |       |                              |       |         |       |       |       |   |   |   |   |
| Tenovis                                                |       |                              | 400        |         |       |       | 206        |   |   | 606 |   |
| Other acquisitions                                     |       |                              | 87         |         |       |       | 13         |   |   | 100 |   |
| Impact of foreign currency exchange rate fluctuations  |       |                              | (32        | )            |       |       | (17        | ) |   | (49 | ) |
| **Balance  as of September 30, 2005**             | ** ** |                              | **$**      | **642**      | ** ** |       |       | **$** | **272** | ** ** |   | **$** | **914** | ** ** |
| Impact of foreign currency exchange rate  fluctuations |       |                              | 16         |         |       |       | 11         |   |   | 27 |   |
| **Balance as of  September 30, 2006**             | ** ** |                              | **$**      | **658**      | ** ** |       |       | **$** | **283** | ** ** |   | **$** | **941** | ** ** |

 

Thefollowing table presents the components of the Company’s intangible assets asshown in the Consolidated Balance Sheets:

| ** **                                    | ** ** | **September 30, 2006**  | ** ** | **September 30, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **Gross**                         | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Carrying**                      | ** ** | **Accumulated**                  | ** ** | ** ** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Amount**                        | ** ** | **Amortization**                 | ** ** | **Net** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| ** **                                    | ** ** | **Dollars in millions** | ** ** |
| Existing  technology                          |       |                              | $          | 103                              |       |   |   | $ | 57 |   |   | $ | 46 |   |   | $ | 101 |   |   |   | $ | 41 |   |   | $ | 60 |   |
| Customer  relationships and other intangibles |       |                              | 292        |                             |       |   | 94 |   |   | 198 |   |   | 288 |   |   |   | 45 |   |   | 243 |   |
| **Total  amortizable intangible assets**      | ** ** | ** **                        | **$**      | **395**                          |       | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **244** | ** ** | ** ** | **$** | **389** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **303** | ** ** |
| Minimum pension  adjustment, net of tax       |       |                              | 19         |                             |       |   | — |   |   | 19 |   |   | 34 |   |   |   | — |   |   | 34 |   |
| **Total intangible assets**                   | ** ** | ** **                        | **$**      | **414**                          |       | ** ** | ** ** | **$** | **151** |   | ** ** | **$** | **263** | ** ** | ** ** | **$** | **423** |   | ** ** | ** ** | **$** | **86** |   | ** ** | **$** | **337** | ** ** |

 

During fiscal 2006, amortization and the impact offoreign currency fluctuations resulted in a decrease of $59 million in the netamortizable intangible assets balance. The weighted average useful lives of theexisting technology, customer relationships and other intangibles are five andseven years, respectively.

During the first quarter of fiscal 2005, the Companyacquired $298 million of intangible assets in connection with the acquisitionof Tenovis consisting of existing technology of $36 million and customerrelationships and other intangibles aggregating $262 million. Other acquisitionsduring fiscal 2005 resulted in additional existing technology and customerrelationships of $38 million and $7 million, respectively.

The minimum pension adjustment, net of tax, representsunrecognized prior service costs associated with the recording of a minimumpension liability in prior fiscal years. This intangible asset may beeliminated or adjusted as necessary when the amount of minimum pensionliability is reassessed, which is conducted on an annual basis.

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Amortizationexpense for the Company’s acquired intangible assets was $65 million, $59million and $6 million for fiscal 2006, 2005 and 2004, respectively. Themajority of future estimated amortization expense is associated with intangibleassets acquired in the Tenovis acquisition. Estimated future amortizationexpense as of September 30, 2006 is shown in the following table:

| ** **                      | ** ** | **Expected future**          | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **amortization expense**     | ** ** |
| ** **                      | ** ** | **Dollars in millions** | ** ** |
| 2007                            |       |                              | $          | 60 |   |   |
| 2008                            |       |                              | 60         |   |   |
| 2009                            |       |                              | 59         |   |   |
| 2010                            |       |                              | 46         |   |   |
| 2011                            |       |                              | 8          |   |   |
| 2012 and thereafter             |       |                              | 11         |   |   |
| **Future amortization expense** | ** ** | ** **                        | **$**      | **244** |   |   |

 

**6.   SupplementaryFinancial Information**

***Statements ofIncome Information***

| ** **                                                                                | ** ** | **Year ended September 30,**  | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **   2004   ** | ** ** |
| ** **                                                                                | ** ** | **Dollars in millions**            | ** ** |
| **DEPRECIATION AND AMORTIZATION**                                                         | ** ** |                                         | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| INCLUDED  IN COSTS:                                                                       |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Amortization of software development costs                                                |       |                                         | $          | 42 |   |   |   | $ | 36 |   |   |   | $ | 28 |   |   |
| INCLUDED IN  SELLING, GENERAL AND ADMINISTRATIVE EXPENSES:                                |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Amortization of intangible assets                                                         |       |                                         | 65         |   |   |   | 59 |   |   |   | 6 |   |   |
| INCLUDED IN COSTS  AND OPERATING EXPENSES:                                                |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization of property, plant and  equipment and internal use software |       |                                         | 162        |   |   |   | 177 |   |   |   | 113 |   |   |
| **Total  depreciation and amortization**                                                  | ** ** |                                         | **$**      | **269** | ** ** |   |   | **$** | **272** | ** ** |   |   | **$** | **147** | ** ** |   |
| **OTHER  INCOME (EXPENSE), NET**                                                          | ** ** |                                         | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Interest income                                                                           |       |                                         | $          | 36 |   |   |   | $ | 24 |   |   |   | $ | 19 |   |   |
| Gain on assets sold                                                                       |       |                                         | 1          |   |   |   | 1 |   |   |   | — |   |   |
| (Loss) gain on foreign currency transactions                                              |       |                                         | (5         | ) |   |   | — |   |   |   | 7 |   |   |
| Loss on long-term debt extinguishment, net                                                |       |                                         | —     |   |   |   | (44 | ) |   |   | (42 | ) |   |
| Other financing expenses                                                                  |       |                                         | —     |   |   |   | (5 | ) |   |   | (2 | ) |   |
| Miscellaneous, net                                                                        |       |                                         | (8         | ) |   |   | (8 | ) |   |   | 3 |   |   |
| **Total other income (expense),  net**                                                    | ** ** |                                         | **$**      | **24** | ** ** |   |   | **$** | **(32** | **)** |   |   | **$** | **(15** | **)** |   |

 

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***Balance SheetInformation***

| ** **                                   | ** ** | **Year ended September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **Dollars in millions**           | ** ** |
| **VALUATION AND QUALIFYING  ACCOUNTS**       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Allowance  for Accounts Receivable:**      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at beginning of period               |       | $                                           | 58         |   | $ | 48 |   | $ | 86 |   |
| Charged to costs, expenses and other         |       | 12                                          |       | 83 |   | 73 |   |
| Deductions                                   |       | (13                                         | )          | (73 | ) | (111 | ) |
| **Balance at end of period**                 | ** ** | **$**                                       | **57**     | ** ** | **$** | **58** | ** ** | **$** | **48** | ** ** |
| **Deferred  Tax Asset Valuation Allowance:** | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at beginning of period               |       | $                                           | 165        |   | $ | 781 |   | $ | 769 |   |
| Charged to costs and expenses                |       | 33                                          |       | 174 |   | 17 |   |
| Charged to other accounts                    |       | —                                      |       | (16 | ) | 97 |   |
| Deductions/ reversals                        |       | (4                                          | )          | (774 | ) | (102 | ) |
| **Balance  at end of period**                | ** ** | **$**                                       | **194**    | ** ** | **$** | **165** | ** ** | **$** | **781** | ** ** |

 

| ** **                                                              | ** ** | **September 30,**            | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                              | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | **Dollars in millions** | ** ** |
| **INVENTORY**                                                           | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Finished goods                                                          |       | $                                 | 281        |   | $ | 274 |   |
| Raw materials                                                           |       | 4                                 |       | 14 |   |
| **Total  inventory**                                                    | ** ** | **$**                             | **285**    | ** ** | **$** | **288** | ** ** |
| **PROPERTY,  PLANT AND EQUIPMENT, NET**                                 | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Land and improvements                                                   |       | $                                 | 56         |   | $ | 41 |   |
| Buildings and improvements                                              |       | 460                               |       | 430 |   |
| Machinery and equipment                                                 |       | 654                               |       | 640 |   |
| Rental equipment                                                        |       | 230                               |       | 210 |   |
| Assets under construction                                               |       | 8                                 |       | 7 |   |
| Internal use software                                                   |       | 226                               |       | 237 |   |
| Total property,  plant and equipment                                    |       | 1,634                             |       | 1,565 |   |
| Less: Accumulated  depreciation and amortization                        |       | (966                              | )          | (827 | ) |
| **Property,  plant and equipment, net**                                 | ** ** | **$**                             | **668**    | ** ** | **$** | **738** | ** ** |
| **ACCUMULATED  OTHER COMPREHENSIVE LOSS**                               | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Cumulative translation adjustment                                       |       | $                                 | 101        |   | $ | 48 |   |
| Minimum pension liability, net of tax                                   |       | (791                              | )          | (928 | ) |
| Unrealized holding loss on securities classified as  available for sale |       | (8                                | )          | (3 | ) |
| **Accumulated other comprehensive  loss**                               | ** ** | **$**                             | **(698**   | **)** | **$** | **(883** | **)** |

 

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***Supplemental CashFlow Information***

| ** **                                                                      | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                      | ** ** | **Dollars in millions**           | ** ** |
| **ACQUISITION OF BUSINESSES**                                                   | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Fair value of  assets acquired, net of cash acquired                            |       |                                        | $          | — | ** ** |   | $ | 1,625 |   | $ | 262 |   |
| Less: Fair value  of liabilities assumed                                        |       |                                        | —     | ** ** |   | (1,204 | ) | (134 | ) |
| **Acquisition  of businesses, net of cash acquired**                            | ** ** |                                        | **$**      | **—** | ** ** |   | **$** | **421** | ** ** | **$** | **128** | ** ** |
| **OTHER  PAYMENTS**                                                             | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Interest  payments, net of amounts capitalized of $0, $1 and $5, respectively   |       |                                        | $          | 1 | ** ** |   | $ | 19 |   | $ | 61 |   |
| Income tax  payments                                                            |       |                                        | $          | 32 | ** ** |   | $ | 23 |   | $ | 23 |   |
| **NON-CASH  TRANSACTIONS**                                                      | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Issuance of common stock in connection with LYONs  conversion                   |       |                                        | $          | — | ** ** |   | $ | 299 |   | $ | — |   |
| Entrance into capital leases                                                    |       |                                        | —     | ** ** |   | 1 |   | — |   |
| Issuance of common stock for contribution to pension  plan                      |       |                                        | —     | ** ** |   | — |   | 111 |   |
| Issuance of common stock for Lucent Securities  Settlement                      |       |                                        | —     | ** ** |   | — |   | 24 |   |
| Investment in equity securities                                                 |       |                                        | —     | ** ** |   | — |   | 7 |   |
| CommScope common stock received in connection with  Connectivity Solutions sale |       |                                        | —     | ** ** |   | — |   | 33 |   |
| Notes received as part of the sale of Expanets’  non-Avaya business        |       |                                        | —     | ** ** |   | — |   | 9 |   |
| **Total non-cash transactions**                                                 | ** ** |                                        | **$**      | **—** | ** ** |   | **$** | **300** | ** ** | **$** | **184** | ** ** |

 

**7.      Restructuring Programs**

***Fiscal 2006 Restructuring Plan***

Duringfiscal 2006, the Company recorded restructuring charges aggregating $98 millionwhich are included in “Restructuring Charges” in the Consolidated Statements ofIncome for fiscal 2006. The following table summarizes the components of thisreserve during fiscal 2006:

| ** **                                 | ** ** | **Employee**                      | ** ** | **Lease**       | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|-----------------|------------|------------|------------|
| ** **                                 | ** ** | **Separation**                    | ** ** | **Termination** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Costs**                         | ** ** | **Obligations** | ** ** | **Total**  | ** ** |
| ** **                                 | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2005     |       |                              | $          | —          |       |       |       | $ | — |   |   | $ | — |   |
| Charges                                    |       |                              | 78         |            |       |       | 20         |   |   | 98 |   |
| Cash payments                              |       |                              | (8         | )               |       |       | (3         | ) |   | (11 | ) |
| **Balance as of September 30,  2006** | ** ** | ** **                        | **$**      | **70**          |       | ** ** | ** ** | **$** | **17** |   | ** ** | **$** | **87** | ** ** |

 

The employee separation costs are related to workforceactions in the Europe, Middle East and Africa (“EMEA”) region as a result ofthe Company’s continuing efforts to improve the region’s operationalperformance, as well as a reduction in the Company’s service technicians in theU.S. The lease termination obligations relate to costs, net of estimatedsublease income, to close or consolidate international office facilities,primarily related to the consolidation of the Company’s Guildford, UnitedKingdom facility.

In addition to the chargesdescribed above, during fiscal 2006, the Company also recorded a $5 millioncharge for higher-than-expected per employee separation costs in Germanyaccounted for under the EITF 95-3 reserve, and $1 million of adjustments topreviously reserved lease termination obligations accounted for under the EITF94-3 reserve, for a total fiscal 2006 charge of $104 million. 

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***Fiscal 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 to optimizethe cost structure. The following table summarizes the activity related to thisrestructuring liability recorded in accordance with SFAS 146, “Accounting forCosts Associated with Exit or Disposal Activities” during fiscal 2006 and 2005:

| ** **                                 | ** ** | **Employee**                      | ** ** | **Lease**                   | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                                 | ** ** | **Separation**                    | ** ** | **Termination**             | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Costs**                         | ** ** | ** Obligations ** | ** ** | **Total**  | ** ** |
| ** **                                 | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2004     |       |                              | $          | —                      |       |       |       | $ | — |   |   | $ | — |   |
| Charges                                    |       |                              | 12         |                        |       |       | 10         |   |   | 22 |   |
| Cash payments                              |       |                              | (5         | )                           |       |       | —     |   |   | (5 | ) |
| Balance as of  September 30, 2005     |       |                              | $          | 7                           |       |       |       | $ | 10 |   |   | $ | 17 |   |
| Charges                                    |       |                              | —     |                        |       |       | —     |   |   | — |   |
| Cash payments                              |       |                              | (6         | )                           |       |       | (5         | ) |   | (11 | ) |
| **Balance as of  September 30, 2006** | ** ** | ** **                        | **$**      | **1**                       |       | ** ** | ** ** | **$** | **5** |   | ** ** | **$** | **6** | ** ** |

 

Lease terminationobligations relate to 74 properties and include both costs to terminate leasesand the present value of future cash payments, net of estimated subleaseincome, relating to real estate space vacated. 

***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 fiscal 2006 and 2005:

| ** **                                      | ** ** | **Employee**                      | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                      | ** ** | **Separation**                    | ** ** |
| ** **                                      | ** ** | **Costs**                         | ** ** |
| ** **                                      | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2004          |       |                              | $          | — |   |   |
| Initial reserve recorded in purchase accounting |       |                              | 106        |   |   |
| Cash payments                                   |       |                              | (30        | ) |   |
| Impact of foreign currency fluctuations         |       |                              | (6         | ) |   |
| Balance as of  September 30, 2005          |       |                              | $          | 70 |   |   |
| Charges                                         |       |                              | 5          |   |   |
| Cash payments                                   |       |                              | (46        | ) |   |
| Impact of foreign currency fluctuations         |       |                              | 1          |   |   |
| **Balance as of  September 30, 2006**      | ** ** | ** **                        | **$**      | **30** |   |   |

 

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 fiscal 2006 (see Note 4, “Business Combinations—Acquisitionof Tenovis,” for more information).

***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 Recognition forCertain 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 

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Consolidated Balance Sheets. The following tablesummarizes the components of the Company’s restructuring reserve during fiscal2006 and 2005: 

| ** **                                 | ** ** | **Lease**                         | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|
| ** **                                 | ** ** | **Termination**                   | ** ** |
| ** **                                 | ** ** | **Obligations**                   | ** ** |
| ** **                                 | ** ** | **Dollars in millions** | ** ** |
| Balance as of  September 30, 2004     |       |                              | $          | 41 |   |   |
| Changes in estimates and reversals         |       |                              | (5         | ) |   |
| Cash payments                              |       |                              | (12        | ) |   |
| Balance as of  September 30, 2005     |       |                              | $          | 24 |   |   |
| Changes in estimates and reversals         |       |                              | 1          |   |   |
| Cash payments                              |       |                              | (8         | ) |   |
| **Balance as of  September 30, 2006** | ** ** | ** **                        | **$**      | **17** |   |   |

 

The restructuring charge of $5 million recordedrelates to changes in sublease assumptions and is included within SG&Aexpenses in the Consolidated Statements of Income for fiscal 2005.

Other current liabilitiesof $335 million included in the Consolidated Balance Sheets as ofSeptember 30, 2006 include $86 million of current liabilitiesassociated with the Company’s restructuring plans.

**8.      Capital Lease Obligations and Long-TermDebt**

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

| ** **                                                                                      | ** ** | **September 30,**                       | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                      | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                                                                      | ** ** | **Dollars in millions**            | ** ** |
| Capital lease  obligations:                                                                     |       |                                         |       |   |   |   |   |   |   |
| Current portion—reported in Other Current  Liabilities                                     |       |                                         | $          | 4 |   |   |   | $ | 5 |   |   |
| Capital lease  obligations and Long-term debt:                                                  |       |                                         |       |   |   |   |   |   |   |
| 111¤8% Senior  Notes, net of discount, premium and net deferred gain on interest rate swap |       |                                         | —     |   |   |   | 14 |   |   |
| Capital lease obligations (long-term portion)                                                   |       |                                         | 9          |   |   |   | 11 |   |   |
| Total long-term debt—reported in Other Liabilities                                         |       |                                         | $          | 9 |   |   |   | $ | 25 |   |   |
| **Total debt**                                                                                  | ** ** | ** **                                   | **$**      | **13** |   | ** ** | ** ** | **$** | **30** |   |   |

 

The Company has entered into capital lease obligationsfor certain equipment and automobiles, for which payment obligations extendthrough fiscal 2010. 

See below for a detaileddiscussion of actions the Company took related to its long-term debt.

***Senior Notes***

During fiscal 2002 and 2003, the Company issued $640million principal amount of senior notes. In connection with these issuances,the Company recorded a net premium and deferred financing costs. The Companyalso subsequently entered into interest rate swaps to effectively convert thefixed-rate debt into floating rate debt. See Note 9 “Derivatives and OtherFinancial Instruments” for further discussion of these interest rate swapagreements. 

On November 1, 2004, the Company commenced a cashtender offer for any and all of its senior notes and a consent solicitation toamend the related indenture as described below. The offer included an early 

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consent date of November 15,2004, and expired on December 1, 2004. The consideration for each $1,000principal amount of senior notes validly tendered by the early consent date andnot validly withdrawn and accepted for payment was $1,158.95, which included aconsent payment of $30 per $1,000 principal amount.

As of the early consent date, holders tendered $271million principal amount of senior notes, and were paid $314 million in cash.An additional $100,000 principal amount was tendered prior to December 1,2004, and cash of $113,000 was paid. Upon repurchase of the notes, the Companypaid interest of $4 million, which had accrued from October 1, 2004through November 15, 2004. 

As a result of the cash tender offer, the Companyrecognized a pre-tax loss of $41 million, which was included in other expense,net for fiscal 2005. This loss consisted of (i) $43 million of premiums onthe repurchase, (ii) the write-off of $5 million of deferred financingcosts and (iii) $1 million of fees, partially offset by the recognition of(iv) $4 million of unamortized net premium recorded at the time of theoriginal debt issuances and (v) $4 million of deferred gain related to theinterest rate swaps.

Contemporaneously with the tender offer, the Companyreceived the requisite consents with respect to the consent solicitation for theadoption of certain proposed amendments to the indenture relating to the seniornotes. On November 16, 2004, the Company and the trustee for the seniornotes executed a supplemental indenture, which eliminated substantially all ofthe restrictive covenants, the reporting requirements and certain events ofdefault from the indenture. The supplemental indenture also eliminated therequirement to provide security for the senior notes and accordingly, theCompany’s obligations under the senior notes that remained outstanding wereunsecured.

As of September 30,2005, $13 million of principal amount was outstanding. The remaining13,205 notes were redeemed at the Company’s option in April 2006 for$1,056.25 each, for a total payment of $14 million.

***Secured Floating Rate Notes***

In November 2001, Tenovis entered into an assetsecuritization transaction whereby Tenovis Finance Limited, a VIE for whichTenovis is the primary beneficiary, issued Secured Floating Rate Notes due 2013(“secured floating rate notes”) that were secured by a pool of Tenovis’scurrent and future receivables associated with rental contracts. In accordancewith FIN 46(R), the Company consolidated Tenovis Finance Limited upon theacquisition of Tenovis. Tenovis Finance Limited is a special purpose companyestablished to issue the secured floating rate notes and enter into all relatedfinancial arrangements and is the consolidated VIE as discussed in Note 4 “BusinessCombinations and Other Transactions.”

The secured floating rate notes were denominated ineuros and were originally issued in a principal amount of euro 300 million,representing 3,000 notes each having a principal amount of euro 100,000. As ofthe date of the Company’s acquisition of Tenovis, each note translated toprincipal of $130,300 or $268 million in total for the 2,060 notesoutstanding. In connection with these notes, Tenovis Finance Limited alsoentered into two interest rate swap agreements, which are discussed further inNote 9 “Derivatives and Other Financial Instruments.” 

During fiscal 2005, theCompany repaid the outstanding principal amount of $262 million and terminatedthe related interest rate swaps. Additionally, the Company paid $15 million ininterest and related costs. As a result of the repayment, the Company recognizeda pre-tax loss of $3 million, which was included in other income (expense), netfor fiscal 2005. This loss primarily consisted of a $5 million reduction in thenet unamortized discount recorded at the time of the original debt issuance,partially offset by a $2 million gain on the change in the fair market value ofthe interest rate swaps.

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***LYONs Convertible Debt***

The Company issued LYONs during fiscal 2002 through anunderwritten public offering under a shelf registration statement. Through aseries of transactions during fiscal years 2004 and 2005, the Company repaidwith cash or converted into common shares all of its outstanding LYONs. 

Interest expense related to the amortization of thediscount on the LYONs amounted to $2 million and $10 million for fiscal 2005and 2004, respectively. In addition, interest expense related to theamortization of deferred financing costs on the LYONs amounted to aninsignificant amount and $2 million for fiscal 2005 and 2004,respectively. 

As of September 30, 2004, the outstanding LYONswere convertible into an aggregate of 20,557,415 shares, all of which werereflected in the diluted share calculations for fiscal 2004 included in Note 11“Earnings Per Share of Common Stock.” Upon conversion, the holders were not entitledto receive any cash payment representing accrued original issue discount. Accruedoriginal issue discount was considered to be paid by the shares of common stockreceived by the holder of the LYONs upon conversion.

Pursuant to the terms of the indenture, the Companyhad the ability to redeem all or a portion of the LYONs for cash at any time onor after October 31, 2004 at a price equal to the sum of the issue priceand accrued original issue discount on the LYONs as of the applicableredemption date. Conversely, holders had the ability to require the Company topurchase all or a portion of their LYONs on October 31, 2004, 2006 and2011 at a price per LYON of $542.95, $583.40 and $698.20, respectively. Theindenture allowed the Company at its option, to elect to pay the purchase pricein cash or shares of common stock, or any combination thereof. 

On October 31, 2004, 238 LYONs were put to theCompany for an aggregate redemption price of $129,000, which the Companyelected to pay in cash. On November 18, 2004, the Company announced thatit would redeem for cash all of the remaining outstanding LYONs on December 20,2004. As provided pursuant to the indenture governing the LYONs, the redemptionprice was $545.67 per $1,000 principal amount at maturity of LYONs. Each LYONremained convertible at any time prior to the redemption date at the option ofthe holder into 37.4437 shares of Avaya common stock. 

Prior to the redemptiondate, holders of $549 million principal amount at maturity of LYONs converted theiroutstanding LYONs into 20,546,199 shares of Avaya common stock pursuant toterms of the indenture. On the stated redemption date, December 20, 2004,$61,000 principal amount at maturity of LYONs, which represented all remainingoutstanding LYONs, were redeemed for cash at an aggregate redemption price of$33,000.

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

As of September 30, 2005, there were 13,205senior notes outstanding. The notes had a carrying value of $14 million, whichwas comprised of the aggregate principal amount outstanding of $13 millionincreased for $1 million of unamortized premium, net of discount and the netunamortized deferred gain related to the termination of interest rate swapagreements. The notes had a fair value of $15 million based upon quoted market prices and yields obtained throughindependent pricing sources for the same or similar types of borrowingarrangements taking into consideration the underlying terms of the debt. Asdescribed above, these remaining notes were redeemed at the Company’s option inApril 2006.

In addition, liabilitiesas of September 30, 2006 and 2005 include $13 million and $16 million,respectively, of capital lease obligations primarily associated with Tenovis. 

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***Credit Facility Amendments***

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

Under the credit facility, borrowings are available inU.S. dollars or euros, and the maximum amount of borrowings that can 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 notto exceed 50% of consolidated net income of the Company for the fiscalyear immediately preceding the fiscal year in which such dividend, purchase,redemption, retirement or acquisition is paid or made. For fiscal 2006, thecredit facility allowed the Company to repurchase, redeem or otherwise acquireshares of its common stock up to an amount not to exceed $461 million. On September 8, 2006,an amendment to the credit facility provided that the Company may use anadditional $500 million during the period from October 1, 2006 through September 30,2008 for such activities, over the amount provided for under the 50% ofconsolidated net income test each year.****As of September 30,2006, the Company was in compliance with all of the covenants included in thecredit facility.

Provided that the Company is in compliance with theterms of the credit facility, the Company may use up to $1 billion in cash(excluding transaction fees) and assumed debt for acquisitions completed after February 23,2005. The acquisition amount will be permanently increased to $1.5 billionafter consolidated adjusted EBITDA of the Company and its subsidiaries for anyperiod of twelve consecutive months equals or exceeds $750 million.

There are currently $35 million of letters ofcredit issued under the credit facility. There are no other outstandingborrowings under the facility and the remaining availability is $365 million asof September 30, 2006. The Company believes the credit facility providesit with an important source of backup liquidity.

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

**9.      Derivatives and Other FinancialInstruments**

The Company conducts itsbusiness on a multi-national basis in a wide variety of foreigncurrencies and, as such, uses derivative financial instruments to reduceearnings and cash flow volatility associated with foreign exchange rate changes.Specifically, the Company uses foreign currency forward contracts to mitigatethe effects of fluctuations of exchange rates associated with certain existingassets and liabilities that are denominated in non-functional currencies and,from time to time, to reduce anticipated net 

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foreigncurrency cash flows resulting from normal business operations. In addition, theCompany has used interest rate swap agreements to manage its proportion offixed and floating rate debt and to reduce interest expense. 

***Recorded Transactions***

The Company utilizesforeign currency forward contracts primarily to manage short-term exchange rateexposures on certain receivables, payables and loans residing on foreignsubsidiaries’ books, which are denominated in currencies other than thesubsidiary’s functional currency. When these items are revalued into thesubsidiary’s functional currency at the month-end exchange rates, thefluctuations in the exchange rates are recognized in the ConsolidatedStatements of Income as other income (expense), net. Changes in the fair valueof the Company’s foreign currency forward contracts used to offset these exposeditems are also recognized in the Consolidated Statements of Income as otherincome (expense), net in the period in which the exchange rates change. Forfiscal 2006, 2005 and 2004, the changes in the fair value of the foreigncurrency forward contracts were substantially offset by changes resulting fromthe revaluation of the items subject to foreign currency exposure. 

***Forecasted Transactions***

From time to time, the Company uses foreign currencyforward contracts to offset certain forecasted foreign currency transactionsprimarily related to the purchase or sale of products expected to occur duringthe ensuing twelve months. The change in the fair value of foreign currencyforward contracts is recognized as other expense, net in the period in which theexchange rates change. For fiscal 2006, 2005 and 2004, these gains and losseswere not material to the Company’s results of operations. As permitted underSFAS No. 133 “Accounting for Derivative Instruments and HedgingActivities,” (“SFAS 133”) the Company has elected not to designate its foreigncurrency forward contracts as hedges thereby precluding the use of hedgeaccounting for these instruments. 

The notional amount of theCompany’s financial instruments represents the face amount of the contractualarrangements and the basis on which U.S. dollars are to be exchanged. They arenot a measure of market or credit exposure. The notional amounts as of September 30,2006 and 2005 of the Company’s foreign currency forward contracts were$378 million and $323 million, respectively. As of September 30,2006, these notional amounts principally represent the equivalent in U.S.dollars for contracts in euros of $152 million, British pounds sterling of $130million, Mexican pesos of $26 million, Singapore dollars of $19 million,Australian dollars of $17 million, Canadian dollars of $16 million and otherforeign currencies. As of September 30, 2005, these notional amountsprincipally represented the equivalent in U.S. dollars for contracts in Britishpounds sterling of $174 million, euros of $162 million, Canadian dollars of $57 million,Mexican pesos of $27 million, Australian dollars of $16 million, Japanese yenof $14 million, Hungarian forints of $13 million and other foreigncurrencies. 

***Fair Value***

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

The estimated fair valuesof the Company’s foreign currency forward contracts are included in theConsolidated Balance Sheets, reflected as other current liabilities of $2million and $6 million as of September 30, 2006 and 2005, respectively. Theestimated fair values of these forward contracts were based on market quotesobtained through independent pricing sources.

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***Interest Rate Swap Agreements***

During fiscal 2004, the Company entered into a totalof five interest rate swap agreements each having a notional amount of $50million and a maturity date of April 2009. These interest rate swapagreements were executed in order to: (i) convert a portion of the seniornotes fixed rate debt into floating rate debt; (ii) maintain a capitalstructure containing appropriate amounts of fixed and floating rate debt; and (iii) reduceinterest payments and expense in the near term. These agreements qualified andwere designated as fair value hedges in accordance with SFAS 133. Under theseagreements, the Company received a fixed interest rate of 111/8% and paid a floating interest rate basedon the six-month LIBOR (in arrears) plus an agreed-upon spread of 6.55%,6.8575%, 6.94%, 6.8% and 6.98%, respectively. The interest rate swapseffectively converted $250 million of the senior notes from fixed rate debtinto floating rate debt. Since the relevant terms of the interest rate swapagreements matched the corresponding terms of the senior notes, there was nohedge ineffectiveness. Accordingly, gains and losses on the interest rate swapagreements fully offset the losses and gains on the hedged portion of thesenior notes, which were marked to market at each reporting date, both of whichwere recorded in other income (expense), net.

Subsequently during fiscal 2004, the Companyterminated all five of its interest rate swap agreements. The terminationsresulted in a reduction to other liabilities for the removal of the fair marketvalue of the interest rate swap and cash payments of $2 million representingthe loss on termination, which was recognized as an increase to interestexpense over the remaining term to maturity of the senior notes. Theunamortized balance of the loss was included as a reduction to long-term debt. TheCompany terminated these interest rate swap agreements as it anticipatedfurther repurchases of the senior notes.

In November 2001,Tenovis Finance Limited entered into two interest rate swap agreements, eachwith an original notional amount of Euro 150 million, which matched thenotional amount of the secured floating rate notes outstanding. Mirroring thesecured floating rate notes, the interest rate swaps had a final maturity dateof November 2007. These interest rate swap agreements were executed inorder to convert the floating rate debt into fixed rate debt. Under theseagreements, Tenovis received a floating interest rate based on the three-monthEURIBOR and paid a fixed interest rate of 4.72%. Because there was a 1.50%spread on the underlying floating rate notes, the total fixed rate interestpayment on the notes was 6.22% per annum. The swaps were marked to market ateach reporting date.

During fiscal 2005, theCompany repaid the secured floating rate notes and terminated the relatedinterest rate swap agreements, which resulted in a $2 million gain on thechange in the fair market value of the interest rate swaps. 

***Non-Derivative and Off-Balance-Sheet Instruments***

Requests for providingcommitments to extend credit and financial guarantees are reviewed and approvedby senior management. Management regularly reviews all outstanding commitments,letters of credit and financial guarantees, and the results of these reviewsare considered in assessing the adequacy of the Company’s reserve for possiblecredit and guarantee losses. See Note 17, “Commitments and Contingencies”for the disclosure of these items. 

**10.   Warrants to Purchase Common Stock and OtherEquity Transactions**

**Warrants toPurchase Common Stock**

In December 2002, the Company, together with theWarburg Pincus Equity Partners, L.P. and certain affiliated investment funds(the “Warburg Entities”), commenced an exchange offer to purchase up to $661million principal amount at maturity, or 70% at the time, of the Company’soutstanding LYONs (the “Exchange Offer”). In consideration of their agreementto participate in the Exchange Offer, in December 2002, the Companygranted the Warburg Entities Series C warrants that have a four-year term 

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and were exercisable foran aggregate of 7,355,824 shares of Avaya common stock. The fair value of thesewarrants was estimated to be $5 million and was included in additionalpaid-in capital. During the second quarter of fiscal 2003, upon completion ofthe Exchange Offer, the Company recognized the cost of these warrants as acommitment fee and recorded the amount in loss on long-term debtextinguishment, net, which is a component of other income (expense), net. 

As of September 30,2005, the Warburg Entities held warrants to purchase the following additionalshares of the Company’s common stock:

| **Warrants**  | ** ** | ** ** | ** ** | **Number of Shares** | ** ** | **Exercise Price** | ** ** | **Expiration Date** | ** ** |
|---------------|------------|------------|------------|--------------------------------|------------|-------------------------|------------|--------------------------|------------|
| Series B |       |       | 5,379,732  |                           |       |                    | $          | 34.73                    |       |   | October 2, 2005 |   |
| Series C |       |       | 7,355,824  |                           |       |                    | $          | 3.50                     |       |   | December 23, 2006 |   |
|          |       |       | 12,735,556 |                           |       |                    |       |                     |       |   |   |

 

The Series B Warrantsexpired unexercised on October 2, 2005. In October 2005, the WarburgEntities (i) exercised their 7,355,824 Series C Warrants, resultingin their acquisition of an aggregate of 5,236,861 shares of our common stockand (ii) distributed to their partners an aggregate of 15,299,993 sharesof our common stock. As of September 30, 2006, the Warburg Entities do nothold any warrants to purchase the Company’s common stock. As described in Note16 “Related Party Transactions,” the Warburg Entities sold their remaining156,529 shares of our common stock on the open market and thus as of October 2,2006, do not own any shares of our common stock. 

***Other Equity Transactions***

During fiscal 2006 and 2005, the Company repurchasedand retired 41,434,400 shares of its common stock at an average price of $10.50per share, under the provisions of the share repurchase plan authorized by theBoard of Directors in April 2005 (see Note 11 “Earnings per Share ofCommon Stock”). 

During the first quarter of fiscal 2005, the Companyissued 20,546,199 shares of its common stock to holders of the LYONs who choseto convert their LYONs into Company shares (see Note 8 “Capital LeaseObligations and Long-Term Debt”). 

In September 2004, the Company contributed $24million of its common stock to fund its portion of the Lucent securitieslitigation settlement. The payment was funded with a combination of 221,882shares of treasury stock and 1,600,303 shares of newly issued common stock. 

During the third quarter of fiscal 2004, the Companymade a voluntary contribution of $111 million of its common stock to fund itsU.S. pension plan (see Note 13 “Benefit Obligations”). The contribution wasfunded with a combination of 2,448,602 shares of treasury stock and 4,510,646shares of newly issued common stock. As of the date of the contribution, thetreasury stock had a carrying value of $27 million. The difference between the$27 million carrying value and the $39 million fair value of the treasury stockcontributed was recorded as an increase to additional paid-in capital.

In February 2004, theCompany sold 14,039,481 shares of its common stock for $17.85 per share in apublic offering. The Company received proceeds of $249 million, net of $2million of underwriting discounts and commissions, which have been recorded asa reduction to additional paid-in capital. The Company used the entire netproceeds to redeem a portion of its outstanding senior notes (see Note 8 “CapitalLease Obligations and Long-Term Debt”).

**11.   Earnings Per Share of Common Stock**

Basicearnings per common share is calculated by dividing net income by the weightedaverage number of common shares outstanding during the period. Diluted earningsper common share is 

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calculated by adjusting net income and weightedaverage outstanding shares, assuming conversion of all potentially dilutivesecurities including stock options, restricted stock units, warrants and convertibledebt.

| ** **                                                                            | ** ** | **Year Ended September 30,**                                                                          | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **         2006         ** | ** ** | **         2005         ** | ** ** | **         2004         ** | ** ** |
| ** **                                                                            | ** ** | **Dollars in millions, except per share amounts**                                      | ** ** |
| ***Earnings  Per Common Share—Basic:***                                          |       |                                                                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                                                                 | $          | 201 |   |   |   | $ | 923 |   |   |   | $ | 291 |   |   |
| (Loss) income  from discontinued operations                                           |       |                                                                                                                 | —     |   |   |   | (2 | ) |   |   | 5 |   |   |
| Net income                                                                            |       |                                                                                                                 | $          | 201 |   |   |   | $ | 921 |   |   |   | $ | 296 |   |   |
| Earnings per share from continuing operations                                         |       |                                                                                                                 | $          | 0.43 |   |   |   | $ | 1.95 |   |   |   | $ | 0.66 |   |   |
| Earnings per share  from discontinued operations                                      |       |                                                                                                                 | —     |   |   |   | — |   |   |   | 0.01 |   |   |
| Earnings per  share—basic                                                        |       |                                                                                                                 | $          | 0.43 |   |   |   | $ | 1.95 |   |   |   | $ | 0.67 |   |   |
| Weighted average shares outstanding—basic                                        |       |                                                                                                                 | 463        |   |   |   | 473 |   |   |   | 439 |   |   |
| ***Earnings Per Common Share—Diluted:***                                         |       |                                                                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Income from  continuing operations available to common stockholders                   |       |                                                                                                                 | $          | 201 |   |   |   | $ | 923 |   |   |   | $ | 291 |   |   |
| Interest charges  associated with LYONs convertible debt, net of tax effects          |       |                                                                                                                 | —     |   |   |   | 2 |   |   |   | 10 |   |   |
| Income from  continuing operations after assumed conversion of LYONs debt             |       |                                                                                                                 | 201        |   |   |   | 925 |   |   |   | 301 |   |   |
| (Loss) income  from discontinued operations                                           |       |                                                                                                                 | —     |   |   |   | (2 | ) |   |   | 5 |   |   |
| Net income after  assumed conversion of LYONs debt                                    |       |                                                                                                                 | $          | 201 |   |   |   | $ | 923 |   |   |   | $ | 306 |   |   |
| Earnings per share from continuing operations                                         |       |                                                                                                                 | $          | 0.43 |   |   |   | $ | 1.89 |   |   |   | $ | 0.63 |   |   |
| Earnings per  share from discontinued operations                                      |       |                                                                                                                 | —     |   |   |   | — |   |   |   | 0.01 |   |   |
| Earnings per  share—diluted                                                      |       |                                                                                                                 | $          | 0.43 |   |   |   | $ | 1.89 |   |   |   | $ | 0.64 |   |   |
| ***Diluted Weighted Average Shares  Outstanding:***                                   |       |                                                                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding—basic                                       |       |                                                                                                                 | 463        |   |   |   | 473 |   |   |   | 439 |   |   |
| Dilutive  Potential Common Shares:                                                    |       |                                                                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Stock Options                                                                         |       |                                                                                                                 | 5          |   |   |   | 6 |   |   |   | 8 |   |   |
| Restricted Stock Units                                                                |       |                                                                                                                 | 1          |   |   |   | 1 |   |   |   | 2 |   |   |
| Warrants                                                                              |       |                                                                                                                 | —     |   |   |   | 5 |   |   |   | 6 |   |   |
| LYONs Convertible Debt                                                                |       |                                                                                                                 | —     |   |   |   | 4 |   |   |   | 21 |   |   |
| Weighted average  shares outstanding—diluted                                     |       |                                                                                                                 | 469        |   |   |   | 489 |   |   |   | 476 |   |   |
| ***Securities excluded from the computation  of diluted earnings per common share:*** |       |                                                                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Stock options(1)                                                                      |       |                                                                                                                 | 40         |   |   |   | 36 |   |   |   | 25 |   |   |
| Restricted stock  units(1)                                                            |       |                                                                                                                 | —     |   |   |   | — |   |   |   | — |   |   |
| Warrants(1)                                                                           |       |                                                                                                                 | —     |   |   |   | 6 |   |   |   | 6 |   |   |
|                                                                                  |       |                                                                                                                 | 40         |   |   |   | 42 |   |   |   | 31 |   |   |

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(1)   Thesesecurities have been excluded from the diluted earnings per common sharecalculation either because the respective exercise prices are greater than theaverage market value of the underlying stock or their inclusion would have beenantidilutive.

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On April 19, 2005, the Board of Directorsauthorized a share repurchase plan (the “plan”). Under the provisions of theplan, Avaya may use up to $500 million of cash to repurchase shares of itsoutstanding common stock through April 2007. For fiscal 2006, the creditfacility limited the Company’s ability to make dividend payments ordistributions or to repurchase, redeem or otherwise acquire shares of Avayacommon stock to $461 million (which represents 50% of consolidated net incomefor the Company for fiscal 2005). On September 8, 2006, an amendment to the creditfacility provided that the Company may use an additional $500 million duringthe period from October 1, 2006 through September 30, 2008 for such activities,over and above the amount provided for under the 50% of consolidated net incometest each year.

During fiscal 2006, theCompany repurchased and retired 29,909,400 shares of common stock at an averagepurchase price of $10.98 per share, for a total of $328 million. Approximately$65 million is available through April 2007 for further share repurchasesunder the plan. These repurchases are made at management’s discretion in theopen market or in privately negotiated transactions in compliance withapplicable securities laws and other legal requirements and are subject tomarket conditions, share price, the terms of Avaya’s credit facility and otherfactors.

**12.   Income Taxes**

Areconciliation of the Company’s income tax provision at the federal statutoryrate to the provision for (benefit from) income taxes at the effective tax rateis as follows:

| ** **                                                          | ** ** | **Year ended September 30,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                          | ** ** | **Dollars in millions**           | ** ** |
| Income tax  provision computed at the federal statutory rate of 35% |       |                                        | $          | 99 |   |   | $ | 86 |   | $ | 85 |   |
| State and local  income taxes, net of federal income tax effect     |       |                                        | (3         | ) |   | 5 |   | 9 |   |
| Tax differentials  on foreign earnings                              |       |                                        | (5         | ) |   | 36 |   | (1 | ) |
| Non-deductible  restructuring costs                                 |       |                                        | —     |   |   | — |   | 22 |   |
| Audit settlements                                                   |       |                                        | (7         | ) |   | (109 | ) | (102 | ) |
| Other differences—net                                          |       |                                        | (2         | ) |   | (1 | ) | 3 |   |
| Valuation  allowance                                                |       |                                        | 1          |   |   | (693 | ) | (65 | ) |
| **Provision  for (benefit from) income taxes**                      | ** ** | ** **                                  | **$**      | **83** |   | ** ** | **$** | **(676** | **)** | **$** | **(49** | **)** |

 

During fiscal 2006, the Company recognized a $7million tax benefit resulting from the resolution of non-U.S. income tax auditmatters. In fiscal 2005, the Company recognized a $109 million tax benefitresulting from the resolution of U.S. federal income tax audit matters for thepre-distribution years 1999 and 2000. The $693 million tax benefit relating tothe reversal of a portion of the valuation allowance was partially offset by atax provision recorded for the year resulting in a net tax benefit of $590million. In fiscal 2004, the Company recognized a $102 million tax benefitresulting from the resolution of U.S. federal income tax audit matters for thepre-distribution years 1990 to 1998.

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Thefollowing table presents the U.S. and foreign components of income beforeincome taxes and the provision for (benefit from) income taxes for fiscal 2006,2005 and 2004:

| ** **                                     | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | **Dollars in millions**           | ** ** |
| INCOME BEFORE  INCOME TAXES:                   |       |                                        |       |   |   |   |   |
| U.S.                                           |       | $                                           | 218        |   | $ | 254 |   | $ | 170 |   |
| Foreign                                        |       | 66                                          |       | (7 | ) | 72 |   |
| Income before  income taxes                    |       | $                                           | 284        |   | $ | 247 |   | $ | 242 |   |
| PROVISION FOR (BENEFIT FROM) INCOME TAXES:     |       |                                        |       |   |   |   |   |
| CURRENT                                        |       |                                        |       |   |   |   |   |
| Federal                                        |       | $                                           | —     |   | $ | (109 | ) | $ | (95 | ) |
| State and local                                |       | —                                      |       | (12 | ) | 8 |   |
| Foreign                                        |       | 46                                          |       | 40 |   | 25 |   |
| Subtotal                                       |       | $                                           | 46         |   | $ | (81 | ) | $ | (62 | ) |
| DEFERRED                                       |       |                                        |       |   |   |   |   |
| Federal                                        |       | $                                           | 40         |   | $ | (468 | ) | $ | 12 |   |
| State and local                                |       | 14                                          |       | (117 | ) | 1 |   |
| Foreign                                        |       | (17                                         | )          | (10 | ) | — |   |
| Subtotal                                       |       | $                                           | 37         |   | $ | (595 | ) | $ | 13 |   |
| **Provision for (benefit from)  income taxes** | ** ** | **$**                                       | **83**     | ** ** | **$** | **(676** | **)** | **$** | **(49** | **)** |

 

Thecomponents of deferred tax assets and liabilities on continuing operations asof September 30, 2006 and 2005 are as follows:

| ** **                                | ** ** | **September 30,**            | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **Dollars in millions** | ** ** |
| DEFERRED INCOME TAX  ASSETS:              |       |                              |       |   |   |
| Benefit obligations                       |       | $                                 | 506        |   | $ | 562 |   |
| Accrued liabilities                       |       | 83                                |       | 163 |   |
| Net operating loss / credit carryforwards |       | 547                               |       | 492 |   |
| Other                                     |       | 54                                |       | 46 |   |
| Gross deferred  tax assets                |       | $                                 | 1,190      |   | $ | 1,263 |   |
| DEFERRED INCOME  TAX LIABILITIES:         |       |                              |       |   |   |
| Goodwill & intangible assets     |       | $                                 | (126       | ) | $ | (136 | ) |
| Property, plant and equipment             |       | (3                                | )          | — |   |
| Other                                     |       | (4                                | )          | (4 | ) |
| Gross deferred  tax liabilities           |       | $                                 | (133       | ) | $ | (140 | ) |
| Valuation  allowance                      |       | $                                 | (194       | ) | $ | (165 | ) |
| **NET DEFERRED TAX ASSET**                | ** ** | **$**                             | **863**    | ** ** | **$** | **958** | ** ** |

 

As of September 30, 2006, the Company had netoperating loss carryforwards (after-tax) totaling $488 million, comprised of$383 million for U.S. federal, state and local tax purposes and $105 millionfor foreign tax purposes, primarily in Germany. U.S. federal and state netoperating loss carryforwards expire through the year 2026, with the majorityexpiring in excess of 16 years. The majority of foreign net operating losscarryforwards have no expiration. Additionally, the Company has various othertax credit 

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carryforwards totaling $59million. Of this total, $16 million expire within 5 years, $22 million expirebetween five and ten years and $21 million expire in excess of ten years.

The valuation allowance of $194 million is comprisedof $161 million relating to foreign deferred tax assets for which we havedetermined, based on historical results and projected future book and taxableincome levels, that a valuation allowance should remain. The foreign valuationallowance includes approximately $126 million relating to our Germanoperations.

The Company has not provided for U.S. deferred incometaxes or foreign withholding taxes on $937**million and$847 million of undistributed earnings of its non-U.S. subsidiaries as of September 30,2006 and 2005, respectively, since the Company intends to reinvest theseearnings indefinitely.

On October 22, 2004,the American Jobs Creation Act of 2004, or 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 determined that it will not repatriate earnings pursuant to theAmerican Jobs Creation Act of 2004.

**13.   Benefit Obligations**

***Pension and Postretirement Benefits***

The Company sponsors non-contributory defined benefitpension plans covering the majority of our U.S. employees and retirees, andpostretirement benefit plans for U.S. retirees that include healthcare benefitsand life insurance coverage. Effective January 1, 2004, the pension planfor U.S. salaried employees was amended to eliminate benefit accruals forcompensation paid after December 31, 2003. Effective June 1, 2006,the Company entered into a new three-year collective bargaining agreement (the “Agreement”)with the Communications Workers of America (“CWA”) and the InternationalBrotherhood of Electrical Workers (“IBEW”). The Agreement affects the level ofpension and postretirement benefits available to U.S. employees of the Companywho are represented by the CWA or IBEW (“represented employees”).

Certain non-U.S. operations have various retirementbenefit programs covering substantially all of their employees. Some of theseprograms are considered to be defined benefit pension plans for accountingpurposes.

Our general funding policy with respect to ourqualified pension plans is to contribute amounts at least sufficient to satisfythe minimum amount required by applicable law and regulations, or to directlypay benefits where appropriate. In fiscal 2006 and 2005, contributions to ourU.S. pension plans totaled $48 million and $7 million, respectively,and contributions to our non-U.S. pension plans totaled $10 million and$9 million, respectively. The contributions to the U.S. pension plans infiscal 2006 consisted of payments totaling $6 million for certain pensionbenefits that are not pre-funded, and a voluntary cash contribution of$42 million. The contributions to the U.S. pension plans in fiscal 2005consisted of payments totaling $7 million for certain pension benefitsthat were not pre-funded. In fiscal 2006 and 2005, we were not required to makea contribution to satisfy the minimum statutory funding requirements in the U.S.In fiscal 2007, we estimate we will make payments totaling $6 million forcertain U.S. pension benefits that are not pre-funded, a $2 millioncontribution to satisfy the minimum statutory funding requirements in the U.S.and contributions totaling $12 million for non-U.S. plans.

Most post-retirement medical benefits are notpre-funded. Consequently, we make payments as these retiree medical benefitsare disbursed. In fiscal 2005, the assets in one of our retiree medical planswere exhausted, thus increasing the amount of post-retirement medical benefitsthat are not pre-funded. As a result, payments for retiree medical benefitsincreased from $27 million in fiscal 2005 to $52 million in fiscal 2006.In compliance with the terms of the Agreement with the CWA and IBEW, theCompany will contribute $47 million each year, during calendar years 2007through 2009, to fund retirement medical 

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benefits for therepresented employees. The contributions are expected to be made on a quarterlybasis. As a result, contributions plus payments for retiree medical benefitsare expected to total $63 million in fiscal 2007.

On September 30, 2006, our annual measurementdate, the accumulated benefit obligation related to our U.S. and non-U.S.pension plans exceeded the fair value of the pension plan assets (such excessis referred to as an unfunded accumulated benefit obligation). Changes in theamount of the unfunded accumulated benefit obligation result from factors suchas a change in the interest rate used to discount the accumulated benefitobligation to its present settlement amount, contributions to the pension plan,changes in the level of benefits offered to employees and the investment returngenerated by pension plan assets. For U.S. plans, the unfunded accumulatedbenefit obligation exceeded the Company’s accrued pension liability by$692 million, a decrease of $219 million from September 30, 2005.For non-U.S. plans with an unfunded accumulated benefit obligation in excess ofthe Company’s accrued pension liability, the excess totaled $63 million, adecrease of $9 million from September 30, 2005. As a result, inaccordance with SFAS 87, the Company recorded an adjustment to decrease theadditional minimum pension liability from $947 million at September 30,2005 to $719 million at September 30, 2006. This resulted in a$213 million net decrease to accumulated other comprehensive loss to$700 million at September 30, 2006, and a $15 million decreaseto intangible assets, to $19 million at September 30, 2006. Thecharge to stockholders’ equity represents a net loss not yet recognized aspension expense.

In connection with recognizing a decrease in theminimum pension liability in fiscal 2006, the Company also recorded a reductionto the deferred tax asset of $78 million. This reduced the deferred taxasset related to the minimum pension liability from $345 million at September 30,2005, to $267 million at September 30, 2006.

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Areconciliation of the changes in the benefit obligations and fair value ofassets of the defined benefit pension and postretirement plans, the fundedstatus of the plans, and the amounts recognized in the Consolidated BalanceSheets is provided in the table below:

| ** **                                                              | ** ** | **Pension Benefits**         | ** ** | **Pension Benefits** | ** ** | **Postretirement**     | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **U.S.**                          | ** ** | **Non-U.S.**              | ** ** | **Benefits**           | ** ** |
| ** **                                                              | ** ** | **September 30,**            | ** ** | **September 30,**    | ** ** | **September 30,** | ** ** |
| ** **                                                              | ** ** | **2006**                          | ** ** | **2005**                  | ** ** | **2006**               | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | **Dollars in millions** | ** ** |
| CHANGE IN BENEFIT  OBLIGATION                                           |       |                              |       |                      |       |                   |       |   |   |   |   |   |   |
| Benefit  obligation as of October 1                                     |       | $                                 | 3,082      |                      | $          | 3,023                  |       | $ | 369 |   | $ | 30 |   | $ | 561 |   | $ | 723 |   |
| Acquisitions/ transfers                                                 |       | —                            |       | —                    |       | 2                      |       | 314 |   | — |   | — |   |
| Service cost                                                            |       | 16                                |       | 17                        |       | 12                     |       | 10 |   | 4 |   | 5 |   |
| Interest cost                                                           |       | 165                               |       | 169                       |       | 16                     |       | 14 |   | 34 |   | 39 |   |
| Amendments                                                              |       | (7                                | )          | —                    |       | (2                     | )          | — |   | 193 |   | — |   |
| Actuarial (gain) loss                                                   |       | (132                              | )          | 68                        |       | (15                    | )          | 39 |   | (13 | ) | (157 | ) |
| Benefits paid                                                           |       | (197                              | )          | (195                      | )          | (8                     | )          | (7 | ) | (54 | ) | (49 | ) |
| Exchange rate movements                                                 |       | —                            |       | —                    |       | 21                     |       | (26 | ) | — |   | — |   |
| Curtailments, settlements and other                                     |       | —                            |       | —                    |       | —                 |       | (5 | ) | — |   | — |   |
| Benefit  obligation as of September 30                                  |       | $                                 | 2,927      |                      | $          | 3,082                  |       | $ | 395 |   | $ | 369 |   | $ | 725 |   | $ | 561 |   |
| CHANGE IN PLAN  ASSETS                                                  |       |                              |       |                      |       |                   |       |   |   |   |   |   |   |
| Fair value of  plan assets as of October 1                              |       | $                                 | 2,271      |                      | $          | 2,169                  |       | $ | 18 |   | $ | 18 |   | $ | 125 |   | $ | 143 |   |
| Sale of Connectivity Solutions                                          |       | —                            |       | (2                        | )          | —                 |       | — |   | — |   | — |   |
| Transfer to Lucent                                                      |       | —                            |       | —                    |       | —                 |       | — |   | — |   | (12 | ) |
| Actual return on plan assets                                            |       | 231                               |       | 292                       |       | —                 |       | — |   | 12 |   | 16 |   |
| Employer contributions                                                  |       | 48                                |       | 7                         |       | 10                     |       | 9 |   | 52 |   | 27 |   |
| Benefits paid                                                           |       | (197                              | )          | (195                      | )          | (8                     | )          | (7 | ) | (54 | ) | (49 | ) |
| Exchange rate movements                                                 |       | —                            |       | —                    |       | 1                      |       | (1 | ) | — |   | — |   |
| Settlements and other                                                   |       | —                            |       | —                    |       | (1                     | )          | (1 | ) | — |   | — |   |
| Fair value of  plan assets as of September 30                           |       | $                                 | 2,353      |                      | $          | 2,271                  |       | $ | 20 |   | $ | 18 |   | $ | 135 |   | $ | 125 |   |
| UNFUNDED STATUS OF THE PLAN                                             |       | $                                 | (574       | )                         | $          | (811                   | )          | $ | (375 | ) | $ | (351 | ) | $ | (590 | ) | $ | (436 | ) |
| Unrecognized prior service cost                                         |       | 4                                 |       | 16                        |       | (2                     | )          | — |   | 236 |   | 59 |   |
| Unrecognized net loss                                                   |       | 688                               |       | 900                       |       | 29                     |       | 42 |   | (9 | ) | 10 |   |
| Net amount  recognized                                                  |       | $                                 | 118        |                      | $          | 105                    |       | $ | (348 | ) | $ | (309 | ) | $ | (363 | ) | $ | (367 | ) |
| AMOUNT RECOGNIZED  IN THE CONSOLIDATED BALANCE SHEETS CONSISTS OF: |       |                              |       |                      |       |                   |       |   |   |   |   |   |   |
| Accrued benefit  liability                                              |       | $                                 | (574       | )                         | $          | (806                   | )          | $ | (375 | ) | $ | (345 | ) | $ | (363 | ) | $ | (367 | ) |
| Intangible asset                                                        |       | 19                                |       | 34                        |       | —                 |       | — |   | — |   | — |   |
| Accumulated other  comprehensive loss                                   |       | 673                               |       | 877                       |       | 27                     |       | 36 |   | — |   | — |   |
| **Net  amount recognized**                                              | ** ** | **$**                             | **118**    | ** **                | **$**      | **105**                | ** ** | **$** | **(348** | **)** | **$** | **(309** | **)** | **$** | **(363** | **)** | **$** | **(367** | **)** |

 

In fiscal 2006, plan amendments to increase retirementmedical benefits for the represented employees and to contribute$47 million each year, during calendar years 2007 through 2009, to fundsuch benefits pursuant to the terms of the Agreement, resulted in a$193 million increase to our postretirement benefit obligation.

In fiscal 2005, pursuant to the terms of a SharePurchase Agreement between the Company and Tenovis, the Company assumed a $314million benefit obligation in connection with the defined benefit pension plansof Tenovis.

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In fiscal 2005, the Company experienced a $157 millionnet actuarial gain with respect to measurement of our postretirement benefitobligation. The net gain was primarily due to expected cost savings associatedwith the Medicare Part D prescription drug subsidy, based on the finalregulations issued by the Centers for Medicare and Medicaid Services issued on January 21,2005, and due to changes in assumptions concerning enrollment in retireemedical coverage based on current experience.

In fiscal 2005, the Company and Lucent TechnologiesInc. (“Lucent”) agreed on a final resolution regarding the asset transfer forthe Avaya Inc. Life Insurance Plan (the “Plan”) with respect to the 2000divestiture of the Company from Lucent. This agreement resulted in the transferof $12 million of plan assets from the Plan to the Lucent Inc. Life InsurancePlan.

Thefollowing table provides the accumulated benefit obligation for all definedbenefit pension plans and information for pension plans with an accumulatedbenefit obligation in excess of plan assets:

| ** **                                                              | ** ** | **U.S. Plans**               | ** ** | **Non-U.S. Plans** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|-------------------------|------------|
| ** **                                                              | ** ** | **September 30,**            | ** ** | **September 30,**  | ** ** |
| ** **                                                              | ** ** | **2006**                          | ** ** | **2005**                | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                                              | ** ** | **Dollars in millions** | ** ** |
| Accumulated  Benefit Obligation for all plans                           |       | $                                 | 2,927      |                    | $          | 3,077 |   |   | $ | 384 |   |   |   | $ | 359 |   |   |
| **Plans with Accumulated Benefit Obligation in excess  of plan assets** | ** ** | ** **                        | ** ** | ** **              | ** ** |   |   |   |   |   |   |   |   |
| Projected Benefit Obligation                                            |       | $                                 | 2,927      |                    | $          | 3,082 |   |   | $ | 373 |   |   |   | $ | 369 |   |   |
| Accumulated Benefit Obligation                                          |       | 2,927                             |       | 3,077                   |       |   | 368 |   |   |   | 359 |   |   |
| Fair Value of  Plan Assets                                              |       | 2,353                             |       | 2,271                   |       |   | 2 |   |   |   | 18 |   |   |

 

Estimatedfuture benefits expected to be paid in each of the next five fiscal years, andin aggregate for the five fiscal years thereafter, is presented below:

| ** **     | ** ** | ** **                        | ** ** | ** **   | ** ** | ** **   | ** ** | **Federal**      | ** ** |
|----------------|------------|-----------------------------------|------------|--------------|------------|--------------|------------|------------------|------------|
| ** **     | ** ** | ** **                        | ** ** | ** **   | ** ** | ** **   | ** ** | **Prescription** | ** ** |
| ** **     | ** ** | ** **                        | ** ** | ** **   | ** ** | ** **   | ** ** | **Drug**         | ** ** |
| ** **     | ** ** | **Pension Benefits**         | ** ** | **Other**    | ** ** | **Subsidy**  | ** ** |
| ** **     | ** ** | **U.S.**                          | ** ** | **Non-U.S.** | ** ** | **Benefits** | ** ** | **Receipts**     | ** ** |
| ** **     | ** ** | **Dollars in millions** | ** ** |
| 2007           |       | $                                 | 225        |         |       | $            | 10         |             |       |   | $ | 63 |   |   |   | $ | — |   |   |
| 2008           |       | 197                               |       |         | 13         |         |       |             | 67         |   |   |   | 1 |   |   |
| 2009           |       | 200                               |       |         | 15         |         |       |             | 66         |   |   |   | 1 |   |   |
| 2010           |       | 203                               |       |         | 17         |         |       |             | 61         |   |   |   | 1 |   |   |
| 2011           |       | 205                               |       |         | 19         |         |       |             | 58         |   |   |   | 2 |   |   |
| 2012—2016 |       | 1,040                             |       |         | 117        |         |       |             | 266        |   |   |   | 15 |   |   |
|                |            |                                   |            |              |            |              |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

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The componentsof the pension net periodic benefit cost (credit) for fiscal 2006, 2005 and2004 are provided in the table below:

| ** **                                            | ** ** | **Pension Benefits—U.S.**         | ** ** | **Pension Benefits—Non-U.S.**     | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                            | ** ** | **Year ended September 30,** | ** ** | **Year ended September 30,** | ** ** |
| ** **                                            | ** ** | **2006**                                    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| ** **                                            | ** ** | **Dollars in millions**           | ** ** |
| **COMPONENTS  OF NET PERIODIC BENEFIT COST (CREDIT)** | ** ** | ** **                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Service cost                                          |       | $                                           | 16         |                                        | $          | 17 |   | $ | 16 |   |   | $ | 12 |   |   |   | $ | 10 |   |   |   | $ | 4 |   |   |
| Interest cost                                         |       | 165                                         |       | 169                                         |       | 170 |   |   | 16 |   |   |   | 14 |   |   |   | 1 |   |   |
| Expected return on plan assets                        |       | (205                                        | )          | (217                                        | )          | (217 | ) |   | (1 | ) |   |   | (1 | ) |   |   | (1 | ) |   |
| Amortization of unrecognized prior service cost       |       | 5                                           |       | 6                                           |       | 7 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Recognized net actuarial loss                         |       | 54                                          |       | 35                                          |       | 15 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Curtailment, settlement gain                          |       | —                                      |       | —                                      |       | — |   |   | — |   |   |   | — |   |   |   | (1 | ) |   |
| **Net periodic benefit cost  (credit)**               | ** ** | **$**                                       | **35**     | ** **                                  | **$**      | **10** | ** ** | **$** | **(9** | **)** |   | **$** | **27** | ** ** |   |   | **$** | **23** | ** ** |   |   | **$** | **3** | ** ** |   |

 

Thecomponents of the postretirement net periodic benefit cost for fiscal 2006,2005 and 2004 are provided in the table below:

| ** **                                            | ** ** | **Postretirement Benefits**            | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                            | ** ** | **Year ended September 30,** | ** ** |
| ** **                                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **Dollars in millions**           | ** ** |
| **COMPONENTS  OF NET PERIODIC BENEFIT COST (CREDIT)** | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Service cost                                          |       |                                        | $          | 4 |   |   | $ | 5 |   | $ | 4 |   |
| Interest cost                                         |       |                                        | 34         |   |   | 39 |   | 41 |   |
| Expected return on plan assets                        |       |                                        | (8         | ) |   | (11 | ) | (15 | ) |
| Amortization of unrecognized prior service cost       |       |                                        | 16         |   |   | 9 |   | 10 |   |
| Recognized net actuarial loss (gain)                  |       |                                        | 2          |   |   | 5 |   | 5 |   |
| Amortization of transition asset                      |       |                                        | —     |   |   | — |   | — |   |
| **Net periodic benefit cost**                         | ** ** |                                        | **$**      | **48** | ** ** |   | **$** | **47** | ** ** | **$** | **45** | ** ** |

 

Theweighted average assumptions used to determine the projected benefit obligationand net periodic benefit cost for the pension plans are provided in the tablebelow:

| ** **                                                                                                      | ** ** | **Pension Benefits—U.S.** | ** ** | **Pension Benefits—Non-U.S.** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2006**                            | ** ** | **2005**                                | ** ** | **2004** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| **Weighted-average  assumptions used to determine Benefit obligations at September 30**                    | ** ** | ** **                          | ** ** | ** **                              | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Discount rate                                                                                                   |       | 5.90                                | %          | 5.50                                    | %          | 5.75 | % |   | 4.74 | % |   |   | 4.24 | % |   |   | 5.22 | % |   |
| Rate of  compensation increase                                                                                  |       | 4.00                                | %          | 4.00                                    | %          | 4.00 | % |   | 3.03 | % |   |   | 3.04 | % |   |   | 3.40 | % |   |
| **Weighted-average assumptions used to determine  net periodic benefit cost for years ended September 30** | ** ** | ** **                          | ** ** | ** **                              | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Discount rate                                                                                                   |       | 5.50                                | %          | 5.75                                    | %          | 6.00 | % |   | 4.24 | % |   |   | 4.79 | % |   |   | 5.31 | % |   |
| Expected return  on plan assets                                                                                 |       | 9.00                                | %          | 9.00                                    | %          | 9.00 | % |   | 4.11 | % |   |   | 5.41 | % |   |   | 5.58 | % |   |
| Rate of compensation  increase                                                                                  |       | 4.00                                | %          | 4.00                                    | %          | 4.00 | % |   | 3.04 | % |   |   | 3.03 | % |   |   | 3.29 | % |   |

 

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Theweighted average assumptions used to determine the accumulated postretirementbenefit obligation and net periodic benefit cost for the postretirement plansare provided in the table below:

| ** **                                                                                                      | ** ** | **Postretirement Benefits** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                      | ** ** | ** 2006 **             | ** ** | ** 2005 ** | ** ** | ** 2004 ** | ** ** |
| ** **                                                                                                      | ** ** |                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| **Weighted-average  assumptions used to determine Benefit obligations at September 30**                    | ** ** |                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Discount rate                                                                                                   |       |                             | 5.90       | % |   |   | 5.50 | % |   |   | 5.75 | % |   |
| Rate of  compensation increase                                                                                  |       |                             | 4.00       | % |   |   | 4.00 | % |   |   | 4.00 | % |   |
| **Weighted-average assumptions used to determine  net periodic benefit cost for years ended September 30** | ** ** |                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Discount rate                                                                                                   |       |                             | 5.50       | % |   |   | 5.75 | % |   |   | 6.00 | % |   |
| Expected return  on plan assets                                                                                 |       |                             | 7.00       | % |   |   | 7.25 | % |   |   | 9.00 | % |   |
| Rate of compensation  increase                                                                                  |       |                             | 4.00       | % |   |   | 4.00 | % |   |   | 4.00 | % |   |

 

The assumptions in the above table were reassessed asof September 30, 2006. The weighted average discount rate used todetermine the benefit obligation was increased from 5.50% to 5.90% for U.S.plans, and from 4.24% to 4.74% for non-U.S. plans. The discount rate for ourU.S. pension and postretirement plans is selected by applying the publishedrates of an existing yield curve, such as the Citigroup Above Median PensionDiscount Curve, to the expected benefit payment streams to develop a rate atwhich we believe the benefit obligations could be effectively settled. We alsoconducted a study of the expected long-term rate of return on the pension andpostretirement plan assets. This study consisted of forecasting theforward-looking return, risk and correlation for all asset classes. Theforecasted inflation rate, productivity growth rate, dividend payout ratio, andrisk premium are examples of the inputs used to develop the forward-lookingreturn assumptions. The results of the study were applied to the target assetallocations to determine the expected long-term rate of return. As a result,the expected rate of return on the pension plan assets and postretirement planassets will remain unchanged at 9.0% and 7.0% respectively for fiscal 2007.

The assumedhealth care cost trend rates for postretirement benefit plans were as follows:

| ** **                                                                     | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                     | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Health care cost  trend rate assumed for next year                             |       | 9.7                    | %          | 9.7 | % |
| Rate to which the  cost trend rate is assumed to decline (ultimate trend rate) |       | 5.0                    | %          | 5.0 | % |
| Year that the rate  reaches the ultimate trend rate                            |       | 2011                   |       | 2011 |   |

 

Postretirement healthcare trend rates have a minimaleffect on the amounts reported for the postretirement health care plan. Aone-percentage-point increase in the Company’s healthcare cost trendrates would have increased the postretirement benefit obligation and theservice and interest cost components of net periodic benefit cost by less than$1 million. Conversely, a one-percentage-point decrease would havedecreased the postretirement benefit obligation and the service and interestcost components of net periodic benefit cost by less than $1 million.

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Theweighted-average asset allocation of the pension and postretirement plans byasset category and target allocation is as follows:

| ** **              | ** ** | **Pension Plan**  | ** ** | **Pension Plan**    | ** ** | **Postretirement**     | ** ** |
|-------------------------|------------|------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **              | ** ** | **Assets—U.S.**   | ** ** | **Assets—Non-U.S.** | ** ** | **Plan Assets**   | ** ** |
| ** **              | ** ** | **September 30,** | ** ** | **Long-term**            | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **Long-term** | ** ** |
| **Asset Category** | ** ** | ** **             | ** ** | **2006**                 | ** ** | **2005**               | ** ** | **Target** | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **Target** | ** ** |
| Equity  Securities(1)   |       |                   | 49         | %                        |       |                   | 61         | % |   |   | 48 | % |   |   | 0 | % |   |   | 0 | % |   |   | 69 | % |   |   | 71 | % |   |   | 70 | % |   |
| Debt Securities         |       |                   | 30         | %                        |       |                   | 28         | % |   |   | 30 | % |   |   | 70 | % |   |   | 75 | % |   |   | 31 | % |   |   | 29 | % |   |   | 30 | % |   |
| Other(2)                |       |                   | 21         | %                        |       |                   | 11         | % |   |   | 22 | % |   |   | 30 | % |   |   | 25 | % |   |   | 0 | % |   |   | 0 | % |   |   | 0 | % |   |
| Total                   |       |                   | 100        | %                        |       |                   | 100        | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |
|                         |            |                        |            |                          |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)   Equitysecurities in the pension plan included $26 million and $23 million of Avayacommon stock as of September 30, 2006 and 2005, respectively.

(2)   Otherincludes cash/cash equivalents, hedge funds and limited partnerships of varioustypes.

The Company’s asset investment strategy focuses onmaintaining a diversified portfolio designed to optimize returns subject to aprudent level of risk. An asset-liability study is performed every two to threeyears (or more frequently, if necessary) for the pension plans, and on anas-necessary basis for the postretirement plans, to determine the optimal assetmix to meet future benefit obligations. The most recent pension asset-liabilitystudy was completed in fiscal 2004.

The Company usesderivative financial instruments including futures, options and swaps insupport of our investment strategy, principally to limit or minimize exposureto certain risks, and to increase investment returns. The use of derivativefinancial instruments for speculative purposes is prohibited by the Company’sinvestment policy.

***Savings Plans***

Substantially all of the Company’s U.S. employees areeligible to participate in savings plans sponsored by the Company. The plansallow employees to contribute a portion of their compensation on a pre-tax andafter-tax basis in accordance with specified guidelines. Avaya matches apercentage of employee contributions up to certain limits. The Company’sexpense related to these savings plans was $50 million, $53 million and$40 million in fiscal 2006, 2005 and 2004, respectively.

Effective January 1,2004, the Company enhanced its savings plans for management employees thatincreased the value of the Company’s contribution towards the plans in order tooffset in part the freezing of pension benefit accruals as described above.

**14.   StockCompensation Plans**

The Company has a stockcompensation plan that provides for the issuance to eligible employees ofnonqualified stock options and restricted stock units representing Avaya commonstock. In addition, the Company has a stock purchase plan under which eligibleemployees have the ability to purchase shares of Avaya common stock at 85% ofmarket value.

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***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, have a term of 10 years or less and vest within four years fromthe date of grant. Most of the stock options granted in fiscal 2004 or laterhave a term of seven years and vest in three years. As of September 30,2006, there were 13.3 million stock options authorized for future grantsto purchase Avaya common stock under the Company’s stock compensation plan. Atthe 2004 Annual Meeting of Shareholders, the Avaya Inc. 2004 Long TermIncentive Plan (the “Plan”) was approved. The Plan became the successor planto, and no further grants will be made from, the Company’s four previousexisting plans: the 2000 Long Term Incentive Plan, the 2000 Stock CompensationPlan for Non-employee Directors, the Broad Based Stock Option Plan, and theLong Term Incentive Plan for Management Employees (the “Existing Plans”). Theconsolidation of the Existing Plans into the Plan resulted in an aggregatereduction in the number of shares eligible for awards under the existing plans.

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

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

Share-based compensation expense recognized in theConsolidated Statements of Income for fiscal 2006 is based on awards ultimatelyexpected to vest, reduced for estimated forfeitures. SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.Forfeitures were estimated based on the Company’s historical experience. In theCompany’s pro forma information required under SFAS 123 for the periodsprior to fiscal 2006, the Company accounted for forfeitures as they occurred.

Thefair value of each stock option grant made during fiscal 2006 was estimated onthe grant-date using the lattice-binomial model with the following weightedaverage assumptions:

| ** **                          | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **  2006  **            | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| WEIGHTED AVERAGE  ASSUMPTIONS:      |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Dividend yield                      |       |                                        | 0.0        | % |   |   | 0.0 | % |   |   | 0.0 | % |   |
| Expected  volatility                |       |                                        | 58.1       | % |   |   | 64.8 | % |   |   | 73.6 | % |   |
| Risk-free  interest rate            |       |                                        | 4.5        | % |   |   | 3.2 | % |   |   | 2.6 | % |   |
| Expected holding  period (in years) |       |                                        | 3.5        |   |   |   | 3.0 |   |   |   | 3.0 |   |   |

 

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Thefollowing table summarizes information concerning options outstanding includingthe related transactions for fiscal 2006, 2005 and 2004:

| ** **                                    | ** ** | **Shares**       | ** ** | **Weighted Average** | ** ** |
|-----------------------------------------------|------------|------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **(000’s)** | ** ** | **Exercise Price**   | ** ** |
| OPTIONS  OUTSTANDING AS OF SEPTEMBER 30, 2003 |       | 51,702           |       |                      | $          | 12.44 |   |   |
| Granted                                       |       | 10,230           |       |                      | 13.72      |   |   |
| Exercised                                     |       | (9,206           | )          |                      | 8.43       |   |   |
| Forfeited and  Expired                        |       | (4,186           | )          |                      | 13.89      |   |   |
| 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                                       |       | 6,503            |       |                      | 10.85      |   |   |
| Exercised                                     |       | (3,338           | )          |                      | 4.25       |   |   |
| Forfeited and  Expired                        |       | (2,759           | )          |                      | 15.57      |   |   |
| OPTIONS OUTSTANDING  AS OF SEPTEMBER 30, 2006 |       | 48,931           |       |                      | $          | 14.10 |   |   |

 

The weighted-average grant-date fair value of optionsgranted during fiscal 2006 was $4.57 per share. The total intrinsic value underthe lattice-binomial model ascribed to the options exercised during fiscal 2006was $24 million.

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

| ** **                                  | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options  Exercisable** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | ** **                              | ** ** | **Average**                         | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** |
| ** **                                  | ** ** | ** **                              | ** ** | **Remaining**                       | ** ** | **Average** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |
| ** **                                  | ** ** | **Shares**                              | ** ** | **Contractual**                     | ** ** | **Exercise** | ** ** | **Value** | ** ** | **Shares** | ** ** | **Exercise** | ** ** | **Value** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                              | ** ** | **(000’s)**                    | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **(000’s)** | ** ** | **(000’s)** | ** ** | **Price** | ** ** | **(000’s)** | ** ** |
| $0.01 to $6.39                              |       | 7,130                                   |       |                                | 2.93       |   |   |   | $ | 4.25 |   |   |   | $ | 51,977 |   |   | 6,884 |   |   | $ | 4.30 |   |   |   | $ | 49,861 |   |   |
| $6.40 to $11.18                             |       | 7,361                                   |       |                                | 5.84       |   |   |   | 10.51 |   |   |   | 7,562 |   |   | 1,126 |   |   | 9.55 |   |   |   | 2,235 |   |   |
| $11.19 to $14.84                            |       | 9,335                                   |       |                                | 4.14       |   |   |   | 13.18 |   |   |   | 179 |   |   | 8,758 |   |   | 13.27 |   |   |   | 164 |   |   |
| $14.85 to $15.89                            |       | 13,064                                  |       |                                | 4.05       |   |   |   | 14.90 |   |   |   | — |   |   | 13,064 |   |   | 14.90 |   |   |   | — |   |   |
| $15.90 to $51.21                            |       | 12,041                                  |       |                                | 3.50       |   |   |   | 21.99 |   |   |   | — |   |   | 12,041 |   |   | 21.99 |   |   |   | — |   |   |
| Total                                       |       | 48,931                                  |       |                                |       |   |   |   | $ | 14.10 |   |   |   | $ | 59,718 |   |   | 41,873 |   |   | $ | 14.71 |   |   |   | $ | 52,260 |   |   |
|                                             |            |                                         |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the preceding table represents the total pre-tax intrinsic value,based on the Company’s average stock price as of September 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 September 30, 2006 was approximately eight million. Theweighted average remaining contractual life as of September 30, 2006 foroutstanding and exercisable options is 4.04 and 3.69 years, respectively.

***Restricted Stock Units***

The Company’s stock compensation plan permits thegranting of restricted stock units (“RSU’s”) to eligible employees andnon-employee Directors at fair market value at the grant-date. RSU’s typicallybecome fully vested over a four-year period and are payable in shares of theCompany’s common stock upon vesting.

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Thefollowing table summarizes information concerning shares of common stockrepresented by RSU’s granted to Company employees for fiscal 2006, 2005 and2004:

| ** **                                   | ** ** | ** ** | ** ** | **Weighted-Average**         | ** ** |
|----------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Grant-Date**               | ** ** |
| **Nonvested Shares**                    | ** ** | ** ** | ** ** | **Shares (000’s)** | ** ** | **Fair Value** | ** ** |
| Nonvested shares  at September 30, 2003 |       |       | 8,336      |                         |       |   | $ | 6.58 |   |   |
| Granted                                      |       |       | 582        |                         |       |   | 13.91 |   |   |
| Vested                                       |       |       | (6,511     | )                            |       |   | 7.11 |   |   |
| Forfeited                                    |       |       | (219       | )                            |       |   | 11.74 |   |   |
| Nonvested shares  at September 30, 2004 |       |       | 2,188      |                         |       |   | 7.05 |   |   |
| Granted                                      |       |       | 2,420      |                         |       |   | 14.82 |   |   |
| Vested                                       |       |       | (714       | )                            |       |   | 5.41 |   |   |
| Forfeited                                    |       |       | (186       | )                            |       |   | 14.10 |   |   |
| Nonvested shares  at September 30, 2005 |       |       | 3,708      |                         |       |   | 12.08 |   |   |
| Granted                                      |       |       | 2,858      |                         |       |   | 10.75 |   |   |
| Vested                                       |       |       | (834       | )                            |       |   | 5.04 |   |   |
| Forfeited                                    |       |       | (413       | )                            |       |   | 12.52 |   |   |
| Nonvested shares at  September 30, 2006 |       |       | 5,319      |                         |       |   | $ | 12.44 |   |   |
|                                              |            |            |            |                              |            |  |  |  |  |  |  |  |

 

As of September 30,2006, there was approximately $36 million of total unrecognized compensationcost related to nonvested share-based compensation arrangements granted underthe Plan. That cost is expected to be recognized over a weighted average periodof four years. Compensation expense related to RSU’s was $13 million, $10million and $15 million for fiscal 2006, 2005 and 2004, respectively.

**Performance-BasedRestricted Stock Units**

Performance-based RSU’s vest upon the achievement ofcertain targets and are payable in shares of the Company’s common stock uponvesting, typically over a three-year period. The fair value is based on themarket price of the Company’s common stock on the grant-date and assumes thatthe target payout level will be achieved. Compensation cost is adjusted forsubsequent changes in the expected outcome of performance-related conditionsuntil the vesting date.

On December 15, 2005,the Compensation Committee of the Board of Directors approved awards of 350,000performance-vesting RSU’s to executive officers of the Company pursuant to theterms of the Plan.

***Employee Stock Purchase Plan***

Under the terms of the Company’s employee stockpurchase plan, eligible employees may have up to 10% of eligible compensationdeducted from their pay to purchase Avaya common stock. The Avaya Inc.Employee Stock Purchase Plan (“2003 ESPP”) became effective January 1,2003 and currently expires on July 31, 2009.

Under the 2003 ESPP, theper share purchase price is 85% of the average high and low per share tradingprice of Avaya’s common stock on the New York Stock Exchange on the lasttrading day of each month. During fiscal 2006, 2005 and 2004, 1.4 million, 1.4million and 1.1 million shares were purchased under the 2003 ESPP at weightedaverage prices of $9.29, $10.11 and $12.03, respectively.

**15.   OperatingSegments**

The Company reports its operations in two segments—GlobalCommunications Solutions and Avaya Global Services. The GCS segmentdevelops, markets and sells communications systems including 

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IP telephony systems,multi-media contact center infrastructure and converged applications in supportof customer relationship management, unified communications applications,appliances such as IP telephone sets and traditional voice communicationssystems. The AGS segment develops, markets and sells comprehensive end-to-endglobal service offerings that enable customers to plan, design, implement,monitor and manage their converged communications networks worldwide.

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

The segments are managedas two individual businesses and, as a result, include certain allocated costsand expenses of shared services, such as information technology, humanresources, legal and finance (collectively, “corporate overhead expenses”). At the beginning of each fiscal year, theamount of certain corporate overhead expenses, including targeted annualincentive awards, to be charged to operating segments is determined and fixedfor the entire year. The annual incentive award accrual is adjusted quarterlybased on actual year to date results and those estimated for the remainder ofthe year. This adjustment of the annual incentive award accrual, as well as anyother over/under absorption of corporate overhead expenses against plan isrecorded within Corporate/Other Unallocated Amounts. Restructuring andimpairment charges are also recorded and reported within Corporate/OtherUnallocated Amounts.

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***Reportable Segments***

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

| ** **                        | ** ** | **Reportable Segments**      | ** ** | ** **   | ** ** | ** **          | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                        | ** ** | **Global**                        | ** ** | **Avaya**    | ** ** | **Corporate/Other** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Communications**                | ** ** | **Global**   | ** ** | **Unallocated**     | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Solutions**                     | ** ** | **Services** | ** ** | **Amounts**         | ** ** | **Total** | ** ** |
| ** **                        | ** ** | **Dollars in millions** | ** ** |
| **2006**                          | ** ** |                              | ** ** | ** **   |       |                | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Revenue                           |       |                              | $          | 2,786        | ** ** |                |       | $ | 2,362 | ** ** |   |   | $ | — |   |   | $ | 5,148 |   |
| Operating income  (loss)          |       |                              | 197        | ** **   |       |                | 171        | ** ** |   |   | (105 | ) |   | 263 |   |
| Capital  expenditures(1)          |       |                              | 41         | ** **   |       |                | 27         | ** ** |   |   | 49 |   |   | 117 |   |
| Depreciation and  amortization(1) |       |                              | 171        | ** **   |       |                | 94         | ** ** |   |   | 4 |   |   | 269 |   |
| Interest expense(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 3 |   |   | 3 |   |
| Provision for  income taxes(2)    |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 83 |   |   | 83 |   |
| Restructuring  charges            |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 104 |   |   | 104 |   |
| Assets:                           |       |                              |       | ** **   |       |                |       | ** ** |   |   |   |   |   |   |   |
| Inventory                         |       |                              | 128        | ** **   |       |                | 157        | ** ** |   |   | — |   |   | 285 |   |
| Goodwill                          |       |                              | 658        | ** **   |       |                | 283        | ** ** |   |   | — |   |   | 941 |   |
| Corporate assets(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 3,974 |   |   | 3,974 |   |
| Total assets                      |       |                              | $          | 786          | ** ** |                |       | $ | 440 | ** ** |   |   | $ | 3,974 |   |   | $ | 5,200 |   |
| **2005**                          | ** ** |                              | ** ** | ** **   |       |                | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Revenue                           |       |                              | $          | 2,572        | ** ** |                |       | $ | 2,330 | ** ** |   |   | $ | — |   |   | $ | 4,902 |   |
| Operating income                  |       |                              | 57         | ** **   |       |                | 166        | ** ** |   |   | 75 |   |   | 298 |   |
| Capital  expenditures(1)          |       |                              | 12         | ** **   |       |                | 5          | ** ** |   |   | 130 |   |   | 147 |   |
| Depreciation and  amortization(1) |       |                              | 169        | ** **   |       |                | 98         | ** ** |   |   | 5 |   |   | 272 |   |
| Interest expense(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 19 |   |   | 19 |   |
| Benefit from  income taxes(2)     |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | (676 | ) |   | (676 | ) |
| Restructuring  charges            |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 22 |   |   | 22 |   |
| Assets:                           |       |                              |       | ** **   |       |                |       | ** ** |   |   |   |   |   |   |   |
| Inventory                         |       |                              | 162        | ** **   |       |                | 126        | ** ** |   |   | — |   |   | 288 |   |
| Goodwill                          |       |                              | 642        | ** **   |       |                | 272        | ** ** |   |   | — |   |   | 914 |   |
| Corporate assets(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 4,017 |   |   | 4,017 |   |
| Total assets                      |       |                              | $          | 804          | ** ** |                |       | $ | 398 | ** ** |   |   | $ | 4,017 |   |   | $ | 5,219 |   |
| **2004**                          | ** ** |                              | ** ** | ** **   |       |                | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Revenue                           |       |                              | $          | 2,044        | ** ** |                |       | $ | 2,021 | ** ** |   |   | $ | 4 |   |   | $ | 4,069 |   |
| Operating income                  |       |                              | 71         | ** **   |       |                | 249        | ** ** |   |   | 3 |   |   | 323 |   |
| Capital  expenditures(1)          |       |                              | 7          | ** **   |       |                | 6          | ** ** |   |   | 68 |   |   | 81 |   |
| Depreciation and  amortization(1) |       |                              | 89         | ** **   |       |                | 52         | ** ** |   |   | 6 |   |   | 147 |   |
| Interest expense(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 66 |   |   | 66 |   |
| Benefit from  income taxes(2)     |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | (49 | ) |   | (49 | ) |
| Assets:                           |       |                              |       | ** **   |       |                |       | ** ** |   |   |   |   |   |   |   |
| Inventory                         |       |                              | 97         | ** **   |       |                | 142        | ** ** |   |   | — |   |   | 239 |   |
| Goodwill                          |       |                              | 187        | ** **   |       |                | 70         | ** ** |   |   | — |   |   | 257 |   |
| Corporate assets(2)               |       |                              | —     | ** **   |       |                | —     | ** ** |   |   | 3,663 |   |   | 3,663 |   |
| Total assets                      |       |                              | $          | 284          | ** ** |                |       | $ | 212 | ** ** |   |   | $ | 3,663 |   |   | $ | 4,159 |   |

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(1)   Managementdoes not allocate to the segments certain capital expenditures that are notdirectly managed by or identified with the reportable segments and, as such,has reported these amounts in 

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the other unallocatedcategory. However, the associated depreciation and amortization expense hasbeen allocated to each segment since these amounts are included in each segment’sresults for purposes of evaluating performance. The increase in unallocatedcapital expenditures relates primarily to acquisitions.

(2)   Interest expense, Provision for (benefit from) income taxes andRestructuring charges are managed at a corporate level by senior management ofthe company and not at a segment level. These are therefore disclosed in theCorporate / Other Unallocated Amounts column. Corporate assets consistprimarily of cash and cash equivalents, deferred income taxes, and property,plant and equipment. Corporate assets are included in Corporate / OtherUnallocated Amounts since they are managed at a corporate level and are notidentified with the segments.

***Geographic Information***

Financialinformation relating to the Company’s revenue by geographic area is as follows:

| ** **                                                    | ** ** | **External Revenue(1)**                | ** ** | **Long-Lived Assets(2)** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------|------------|
| ** **                                                    | ** ** | **Year ended September 30,** | ** ** | **September 30,**        | ** ** |
| ** **                                                    | ** ** | **2006**                                    | ** ** | **2005**                      | ** ** | **2004** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| ** **                                                    | ** ** | **Dollars in millions**           | ** ** |
| U.S.                                                          |       | $                                           | 2,994      |                          | $          | 2,908 |   | $ | 3,089 |   |   | $ | 399 |   |   |   | $ | 453 |   |   |
| Outside the U.S.:                                             |       |                                        |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Germany                                                       |       | 733                                         |       | 724                           |       | 45 |   |   | 200 |   |   |   | 214 |   |   |
| EMEA (excluding Germany)—Europe  /  Middle East / Africa |       | 765                                         |       | 696                           |       | 493 |   |   | 45 |   |   |   | 52 |   |   |
| APAC—Asia Pacific                                        |       | 383                                         |       | 336                           |       | 226 |   |   | 18 |   |   |   | 14 |   |   |
| Americas, non-US                                              |       | 273                                         |       | 238                           |       | 216 |   |   | 6 |   |   |   | 5 |   |   |
| Total outside the  U.S.                                       |       | 2,154                                       |       | 1,994                         |       | 980 |   |   | 269 |   |   |   | 285 |   |   |
| **Total**                                                     | ** ** | **$**                                       | **5,148**  | ** **                    | **$**      | **4,902** | ** ** | **$** | **4,069** | ** ** | ** ** | **$** | **668** |   | ** ** | ** ** | **$** | **738** |   |   |

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(1)   Revenue isattributed to geographic areas based on the location of customers.

(2)   Represents property, plant and equipment, net.

**16.   RelatedParty Transactions**

In August and September 2005, the Warburg Entitiesdistributed to their partners an aggregate of 24,999,988 shares of theCompany’s common stock, according to Schedules 13D/A filed with the SEC onAugust 4, 2005 and September 2, 2005, respectively (see Note 10, “Warrants toPurchase Common Stock and Other Equity Transactions”).

In October 2005, 5,379,732 warrants held by theWarburg Entities expired pursuant to their terms.  Also in October 2005, the Warburg Entities(i) exercised the remaining warrants held by them, resulting in theiracquisition of 5,236,861 shares of common stock and (ii) advised the Companythat they had distributed to their partners an aggregate of 15,299,993 sharesof common stock.  On September 19, 2006,the Warburg Entities advised the Company that they sold 156,529 shares of our commonstock in the open market.  As a result ofthe foregoing, as of October 2, 2006, the Warburg Entities ceased owning anyshares of our common stock, based upon public filings and information providedto us by these entities.  

As previously disclosed, in 2004, Gyro GraphicCommunications, Inc. and its affiliates (“Gyro”) were selected toprovide certain services regarding marketing events and demand generationactivities related to the launch of various Avaya products.  Avaya continued to obtain services from Gyrofor similar events and activities during 2006. Garry K. McGuire, Jr., the President of Gyro USA, a division of Gyro, isthe son of Garry K. McGuire, Avaya’s Chief Financial Officer.  In June 2005, Daniel Peterson, the son ofAvaya’s 

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former Chairman and ChiefExecutive Officer, Donald K. Peterson, became employed by Gyro.  During fiscal 2006, 2005 and 2004, theCompany paid Gyro $5.5 million, $4.6 million and $1.3 million, respectively,for its services.  The terms, includingpricing, on which Avaya did business with Gyro during fiscal 2006 werecompatible overall with those on which Avaya obtained similar services fromother vendors

**17.   Commitmentsand Contingencies**

**Legal Proceedings**

In the ordinary course of business the Company isinvolved in litigations, claims, government inquiries, investigations, chargesand proceedings, including, but not limited to, those identified below relatingto intellectual property, commercial, securities, employment, employee benefits,environmental and regulatory matters. Other than as described below, theCompany believes there is no litigation pending against the Company that couldhave, 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 the plaintiffand the Company, it is owed commissions on sales by the Company to the Ministryof Russian Railways on a continuing basis. The Company believes that theagreements relating to the plaintiff’s claim have expired or do not apply tothe products in question. As the sales of products continue, CDC may likelyincrease its commission demand. An arbitration hearing originally commenced in December 2005concluded in July 2006. The parties have submitted their respective briefsto the panel and a decision may be issued in late calendar 2006 or early 2007.

As the arbitration panelhas not issued its decision, 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.

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***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.

The complaints, which aresubstantially similar to one another, allege, among other things, that theplaintiffs were injured by reason of certain allegedly false and misleadingstatements made by us relating to the cost of the Tenovis integration, the disruptioncaused by changes in the delivery of our products to the market and reductionsin the demand for our products in the U.S., and that based on the foregoing wehad no basis to project our stated revenue goals for fiscal 2005. The Companyhas been served with a number of these complaints. No class has been certifiedin the actions. The complaints seek compensatory damages plus interest andattorneys’ fees. In August 2005, the court entered an order identifying alead plaintiff and lead plaintiffs’ counsel. A consolidated amended complaintwas filed in October 2005. Pursuant to a scheduling order issue by theDistrict Court, defendants filed their motion to dismiss the consolidatedcomplaint in December 2005. In September 2006, the District Courtgranted defendants’ motion to dismiss the case in its entirety and withprejudice, which was appealed by the plaintiffs. The appeal is currentlypending with the United States Court of Appeals for the Third Circuit.

***Derivative Litigation***

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 haveagreed to stay these matters pending outcome of the motion to dismiss describedin “Securities Litigation” above, these actions are still in the early stagesof litigation and an outcome cannot be predicted and, as a result, we cannot beassured that these cases will not have a material adverse effect on ourfinancial position, results of operations 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. The parties have completed their respective briefingsubmissions to the court and are awaiting a notice as to whether the court willentertain oral argument. Although the defendants believe that the DistrictCourt correctly decided the motion to dismiss, given the uncertainties of theappeal, at this time the Company cannot determine if this matter will have aneffect on its business or, if it does, whether its outcome will have a materialadverse effect on its financial position, results of operations or cash flows.Due to the uncertainty surrounding the issues involved in this matter and basedon the facts and circumstances known to date, the Company believes that anestimate of any loss that may be incurred cannot be made at this time.

***ERISA Class Action—StockFunds***

In April 2006, apurported class action was filed in the United States District Court for theDistrict of New Jersey, alleging that the Company, certain employees and thePension and Employee Benefits Investment Committee violated the EmployeeRetirement Income Security Act of 1974 (“ERISA”), by including in the AvayaInc. Savings Plan for Salaried Employees, the Avaya Inc. Savings Plan and theAvaya Inc. Savings Plan for the Variable Workforce (“Plans”), investmentoptions for the Lucent Technologies Inc. Stock Fund (“Lucent Fund”) and theAvaya Inc. Stock Fund (“Avaya Fund”) for the period of October 2000 to April 2003(“Alleged Class Period”). The complaint asserts, among other things, thatduring the Alleged Class Period defendants breached their fiduciary dutiesunder ERISA by violating ERISA’s provisions against prohibited transactions; offeringthe Lucent Fund and Avaya Fund imprudently as investment options; failingproperly to monitor the funds; and, failing properly to monitor the actions ofother plan fiduciaries, thus causing the Plans to suffer damages. The complaintseeks monetary relief on behalf of the Plans and its participants, and alsoseeks injunctive relief and costs, including attorneys’ fees. Defendants havefiled a motion to dismiss this case in its entirety and with prejudice, andthat motion is currently pending with the District Court.

This matter is in theearly stages of litigation, and an outcome cannot be predicted and, as aresult, we cannot be assured that this case will not have a material adverseeffect on our financial position, results of 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.

***Antitrust Lawsuit***

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

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

**Other Matters**

***GovernmentSubpoenas***

On April 29, 2005,the Company received a subpoena to produce documents before a grand jury of theUnited States District Court, District of South Carolina, relating to theUnited States’ investigation of potential antitrust and other violations inconnection with the federal E-Rate Program. The subpoena requests records fromthe period January 1, 1997 to the present. The Company complied with the subpoenaand has received no indication from the Department of Justice that it has anyfurther obligations or involvement in this matter. Nonetheless, at this time,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 ourfinancial position, results of operations or cash flows.

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

The Company is cooperatingwith the relevant government entities with respect to these subpoenas. Based onthe facts and circumstances known to date, the Company believes that anestimate 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 toa wide range of governmental requirements relating to employee safety andhealth and to the handling and emission into the environment of varioussubstances used in its operations. The Company is subject to certain provisionsof environmental laws, particularly in the United States and Germany, governingthe cleanup of soil and groundwater contamination. Such provisions imposeliability for the costs of investigating and remediating releases of hazardousmaterials at currently or formerly owned or operated sites. In certaincircumstances, this liability may also include the cost of cleaning uphistorical contamination, whether or not caused by the Company. The Company iscurrently conducting investigation and/or cleanup of known contamination atnine of its current or former facilities either voluntarily or pursuant togovernment directives. Based on currently available information, none of thesites is reasonably likely to generate environmental costs that will beindividually material nor will environmental costs for all sites in theaggregate be material in any fiscal year. There are no known third parties whomay be responsible for investigation and/or cleanup at these sites andtherefore, for purposes of assessing the adequacy of accruals for theseliabilities, the Company has not assumed that it will recover amounts from anythird party, including under any insurance coverage or indemnificationarrangement.

It is often difficult toestimate the future impact of environmental matters, including potentialliabilities. The Company has established financial reserves to coverenvironmental liabilities where they are probable and reasonably estimable.Reserves for estimated losses from environmental matters are undiscounted andconsist primarily of estimated remediation and monitoring costs and are, dependingon the site, based primarily upon internal or third party environmental studiesand the extent of 

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contaminationand the type of required cleanup. The Company is not aware of, and has notincluded in reserves any provision for, unasserted environmental claims.

The reliability andprecision of estimates of the Company’s environmental costs may be affected bya variety of factors, including whether the remediation treatment will beeffective, contamination sources have been accurately identified and assumptionsregarding the movement of contaminants are accurate. In addition, estimates ofenvironmental costs may be affected by changes in law and regulation, includingthe willingness of regulatory authorities to conclude that remediation and/ormonitoring performed by the Company is adequate.

The Company assesses theadequacy of environmental reserves on a quarterly basis. The Company does notexpect the outcome of these matters to have a material impact on its financialposition. Expenditures for environmental matters for fiscal 2006, 2005 and 2004were not material to the Company’s financial position, results of operations orcash flows. Payment for the environmental costs covered by the reserves may bemade over a 30-year period. Although the Company does not separatelytrack recurring costs of managing hazardous substances and pollutants inongoing operations, it does not believe them to be material.

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

**Product Warranties**

The Company recognizes aliability for the estimated costs that may be incurred to remedy certaindeficiencies of quality or performance of the Company’s products. These productwarranties extend over a specified period of time generally ranging up to twoyears from the date of sale depending upon the product subject to the warranty.The Company accrues a provision for estimated future warranty costs based uponthe historical relationship of warranty claims to sales. The Companyperiodically reviews the adequacy of its product warranties and adjusts, ifnecessary, the warranty percentage and accrued warranty reserve, which isincluded in other current liabilities in the Consolidated Balance Sheets, foractual experience.

| ** **                                           | ** ** | **Dollars in millions** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| Balance as of  September 30, 2005               |       |                              | $          | 30 |   |   |
| Reductions for payments  and costs to satisfy claims |       |                              | (46        | ) |   |
| Accruals for warranties  issued during the period    |       |                              | 45         |   |   |
| Balance as of September 30, 2006                |       |                              | $          | 29 |   |   |

 

***Guarantees of Indebtedness and OtherOff-Balance Sheet Arrangements***

***Letters of Credit***

The Company has enteredinto uncommitted credit facilities that vary in term totaling $129 million asof September 30, 2006, for the purpose of obtaining third party financialguarantees such as letters of 

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creditwhich ensure the Company’s performance or payment to third parties. Additionally,the Company has a $400 million committed credit facility, which is discussed inNote 8, “Capital Lease Obligations and Long-Term Debt.”  As of September 30, 2006, the Companyhad outstanding an aggregate of $108 million in irrevocable letters of creditunder the committed and uncommitted credit facilities (including $35 millionunder its $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 $6million of our letters of credit. If the Company fails to perform under itsobligations, the maximum potential payment under these surety bonds is$26 million as of September 30, 2006. Historically, no surety bondshave been drawn upon.

***PurchaseCommitments and Termination Fees***

The Company purchasescomponents from a variety of suppliers and uses several contract manufacturersto provide manufacturing services for its products. During the normal course ofbusiness, in order to manage manufacturing lead times and to help assureadequate component supply, the Company enters into agreements with contractmanufacturers and suppliers that allow them to produce and procure inventorybased upon forecasted requirements provided by the Company. If the Company doesnot meet these specified purchase commitments, it could be required to purchasethe inventory, or in the case of certain agreements, pay an early terminationfee. As of September 30, 2006, themaximum potential payment under these commitments was approximately $197million. Historically, the Company has not been required to pay a charge for notmeeting 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 FinancingArrangements***

The Company sells productsto various resellers that may obtain financing from certain unaffiliated thirdparty lending institutions.

In March 2001, theCompany entered into a product financing arrangement with one U.S. resellerwhich expired during fiscal 2005. Accordingly, Avaya is no longer obligated torepurchase inventory previously sold to this reseller in the event the lendinginstitution, which financed the transaction, repossesses the reseller’sinventory of the Company’s products.

For the Company’s productfinancing arrangement with resellers outside the U.S., in the event participatingresellers default on their payment obligations to the lending institution, theCompany is obligated under certain circumstances to guarantee repayment to thelending institution. The repayment amount fluctuates with the level of productfinancing activity. The guarantee repayment amount reported to the Company fromthe lending institution was approximately $5 million as of September 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 September 30, 2006 is not significant. There can be noassurance that the Company will not be obligated to repurchase inventory underthis arrangement in the future.

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***PerformanceGuarantee***

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 September 30, 2006, would be approximately$16 million. The Company has assessed the probability of default by theassignees and has determined it to be remote.

***Credit FacilityIndemnification***

In connection with itsobligations under the credit facility described in Note 8, “Capital LeaseObligations and Long-Term Debt—Credit Facility Amendments,” the Company hasagreed to indemnify the third party lending institutions for costs incurred bythe institutions related to changes in tax law or other legal requirements.While there have been no amounts paid to the lenders pursuant to this indemnityin the past, there can be no assurance that the Company will not be obligatedto indemnify the lenders under this arrangement in the future.

***Transactions withLucent***

Pursuant to theContribution and Distribution Agreement, Lucent contributed to the Companysubstantially all of the assets, liabilities and operations associated with itsenterprise networking businesses (“Company’s Businesses”). The Contribution andDistribution Agreement, among other things, provides that, in general, theCompany will indemnify Lucent for all liabilities including certainpre-distribution tax obligations of Lucent relating to the Company’s Businessesand all contingent liabilities primarily relating to the Company’s Businessesor otherwise assigned to the Company. In addition, the Contribution andDistribution Agreement provides that certain contingent liabilities notallocated to one of the parties will be shared by Lucent and the Company inprescribed percentages. The Contribution and Distribution Agreement alsoprovides that each party will share specified portions of contingentliabilities based upon agreed percentages related to the business of the otherparty that exceed $50 million. The Company is unable to determine themaximum potential amount of other future payments, if any, that it could berequired to make under this agreement.

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

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.

***Leases***

The Company leases land,buildings and equipment under agreements that expire in various years through2025. Rental expense under operating leases, excluding any lease terminationcosts incurred 

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relatedto the Company’s restructuring programs, was $116 million, $136 million and$130 million for fiscal 2006, 2005 and 2004, respectively.

Thetable below sets forth future minimum lease payments, net of sublease income,due under non-cancelable operating leases, of which $39 million of suchpayments have been accrued for in accordance with accounting principlesgenerally accepted in the U.S. pertaining to restructuring and exit activities.

| ** **                        | ** ** | **Future minimum**           | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **lease payments**           | ** ** |
| ** **                        | ** ** | **Dollars in millions** | ** ** |
| 2007                              |       |                              | $          | 139 |   |   |
| 2008                              |       |                              | 115        |   |   |
| 2009                              |       |                              | 94         |   |   |
| 2010                              |       |                              | 69         |   |   |
| 2011                              |       |                              | 55         |   |   |
| 2012 and thereafter               |       |                              | 232        |   |   |
| **Future minimum lease payments** | ** ** | ** **                        | **$**      | **704** |   |   |

 

**18.   QuarterlyInformation (unaudited)**

| ** **                                     | ** ** | **Fiscal Year Quarters**                                                                             | ** ** |                                           |
|------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|
| ** **                                     | ** ** | **   First   **                                                                  | ** ** | **   Second   ** | ** ** | **   Third   ** | ** ** | **   Fourth   ** | ** ** | **   Total   ** | ** ** |
| ** **                                     | ** ** | **Dollars in millions, except per share and stock price amounts** | ** ** |                                           |
| **Year Ended September 30, 2006**              | ** ** |                                                                                                           | ** ** | ** **                                     |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Revenue                                        |       |                                                                                                           | $          | 1,249                                          |   |   |   | $ | 1,238 | ** ** |   |   | $ | 1,297 |   |   |   | $ | 1,364 |   |   |   | $ | 5,148 |   |   |
| Gross margin                                   |       |                                                                                                           | 589        |                                           |   |   | 578 | ** ** |   |   | 588 |   |   |   | 635 |   |   |   | 2,390 |   |   |
| Operating income                               |       |                                                                                                           | 107        |                                           |   |   | 53 | ** ** |   |   | 28 |   |   |   | 75 |   |   |   | 263 |   |   |
| Provision for (benefit  from) income taxes     |       |                                                                                                           | 40         |                                           |   |   | 19 | ** ** |   |   | (11 | ) |   |   | 35 |   |   |   | 83 |   |   |
| Net income                                     |       |                                                                                                           | $          | 71                                             |   |   |   | $ | 38 | ** ** |   |   | $ | 44 |   |   |   | $ | 48 |   |   |   | $ | 201 |   |   |
| Earnings per share—Basic:                 |       |                                                                                                           | $          | 0.15                                           |   |   |   | $ | 0.08 | ** ** |   |   | $ | 0.10 |   |   |   | $ | 0.11 |   |   |   | $ | 0.43 |   |   |
| Earnings per share—Diluted:               |       |                                                                                                           | $          | 0.15                                           |   |   |   | $ | 0.08 | ** ** |   |   | $ | 0.10 |   |   |   | $ | 0.10 |   |   |   | $ | 0.43 |   |   |
| Stock price (1):                               |       |                                                                                                           |       |                                           |   |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| High                                           |       |                                                                                                           | $          | 12.70                                          |   |   |   | $ | 12.08 | ** ** |   |   | $ | 13.11 |   |   |   | $ | 11.97 |   |   |   | $ | 13.11 |   |   |
| Low                                            |       |                                                                                                           | $          | 10.21                                          |   |   |   | $ | 10.13 | ** ** |   |   | $ | 10.73 |   |   |   | $ | 8.85 |   |   |   | $ | 8.85 |   |   |
| **Year Ended September 30, 2005**              | ** ** |                                                                                                           | ** ** | ** **                                     |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Revenue                                        |       |                                                                                                           | $          | 1,148                                          |   |   |   | $ | 1,222 | ** ** |   |   | $ | 1,236 |   |   |   | $ | 1,296 |   |   |   | $ | 4,902 |   |   |
| Gross margin                                   |       |                                                                                                           | 543        |                                           |   |   | 563 | ** ** |   |   | 575 |   |   |   | 616 |   |   |   | 2,297 |   |   |
| Operating income                               |       |                                                                                                           | 88         |                                           |   |   | 52 | ** ** |   |   | 76 |   |   |   | 82 |   |   |   | 298 |   |   |
| Provision for (benefit  from) income taxes     |       |                                                                                                           | 7          |                                           |   |   | 11 | ** ** |   |   | (117 | ) |   |   | (577 | ) |   |   | (676 | ) |   |
| Income from continuing  operations             |       |                                                                                                           | 33         |                                           |   |   | 36 | ** ** |   |   | 194 |   |   |   | 660 |   |   |   | 923 |   |   |
| (Loss) from discontinued  operations           |       |                                                                                                           | (2         | )                                              |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | (2 | ) |   |
| Net income                                     |       |                                                                                                           | $          | 31                                             |   |   |   | $ | 36 | ** ** |   |   | $ | 194 |   |   |   | $ | 660 |   |   |   | $ | 921 |   |   |
| Earnings per share—Basic:                 |       |                                                                                                           |       |                                           |   |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from  continuing operations |       |                                                                                                           | $          | 0.07                                           |   |   |   | $ | 0.08 | ** ** |   |   | $ | 0.41 |   |   |   | $ | 1.39 |   |   |   | $ | 1.95 |   |   |
| (Loss) per share from  discontinued operations |       |                                                                                                           | —     |                                           |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Earnings per share                             |       |                                                                                                           | $          | 0.07                                           |   |   |   | $ | 0.08 | ** ** |   |   | $ | 0.41 |   |   |   | $ | 1.39 |   |   |   | $ | 1.95 |   |   |
| Earnings per share—Diluted:               |       |                                                                                                           |       |                                           |   |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Earnings per share from  continuing operations |       |                                                                                                           | $          | 0.07                                           |   |   |   | $ | 0.07 | ** ** |   |   | $ | 0.40 |   |   |   | $ | 1.36 |   |   |   | $ | 1.89 |   |   |
| (Loss) per share from  discontinued operations |       |                                                                                                           | —     |                                           |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Earnings per share                             |       |                                                                                                           | $          | 0.07                                           |   |   |   | $ | 0.07 | ** ** |   |   | $ | 0.40 |   |   |   | $ | 1.36 |   |   |   | $ | 1.89 |   |   |

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(1)   Shows theintraday high and low sales price per share of the Company’s common stock asreported on the New York Stock Exchange for the periods indicated.

95

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